Ask YC: How does funding actually work? | Hacker News Reader

Ask YC: How does funding actually work?

16 pointsj2d213 comments

I realize this is a naive question, but I've never seriously considered doing a startup until recently and I'm realizing how much I don't know...

So here is hypothetical: I have 40K of my own money to start something. Let's say after 6 months I've built something cool and monetizing it is likely. My cash is starting to run out.

1) What would you do?

2) Are there obvious places to turn for funding?

3) If I get one round of funding, hire two people to help me out and then need more funding but get it from a different source, how does this reconcile? I assume it's in a contract, but what should one expect?

4 from 3) If the original source of funding denies a second round, what does this mean for their original investment? Do they write it off? If I get a second round of funding, are they still expecting a pay-out?

5) Any book suggestions for books for learning about this? The book suggestions in YC News's archive is a bit overwhelming to dig through...

One of my professors in law school wrote some great papers about the structure of venture capital deals. What each party is searching for, how they structure the legal documents to protect them, etc. The answer to your question about what to expect is that you negotiate the deal, so you get what you can, and give up what you have to.

His papers deal with the nitty gritty, and are kind of nerdy, but you'll learn a ton of how things actually work. You can download them here. http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=1769...

I recommend the first two in the list, The Exit Structure of Venture Capital, and How Early Stage Entrepreneurs Evaluate Venture Capitalists.

That said, while thats how funding actually works, the work of getting funding all takes place before an agreement is signed.

This link looks awesome. Thanks!

You should have been in the class - what an eye-opener. Venture Capitalists are really the repeat players in the industry, and it shows. Every concern is covered. Granted, I'm not saying everything in an agreement is tilted completely in a VC's favor, but they definitely have their interests addressed and contingency plans in place. An entrepreneur has to figure out what his/her interests are and what to do about them, all the while asking for money and trying to close the deal.

1) If monetizing is likely, start to monetize. Proving that you can at least start will help fundraising immensely, and it's a long road.

2) Fundraising is a 3-6 month long process. Start before you need it. Angels are hard to find (especially in a non-hub), so start networking now.

3) You're talking about raising multiple rounds. Common! Angel, seed, series A, series B, etc. etc. The first round investors get a better valuation for their dollar but will expect to get diluted in later rounds.

4) Original source may opt to not invest more in later rounds. They retain the (diluted) ownership that they bought and generally have no special cash out options. Oftentimes early funding is convertible debt (aka bridge loan). Any investor expects a pay-out really only in a liquidity event (IPO or acquisition). Most have a 3-7 year horizon.

In general, read:

http://paulgraham.com/startupfunding.html http://venturehacks.com http://www.askthevc.com/

In addition to the comments above, once you wrap your head around the basics of the process, I find Venture Hacks a great place to get a feel for a lot of the caveats ahead:

http://www.venturehacks.com/

You are very unlikely to get funding. And, by that, I mean that everyone is very unlikely to get funding. If you're going to throw down 40k of your own money, have a plan that gets you from A to B without the "and then a miracle occurs" step.

To answer 4 from 3, the first investor still owns shares in the company. Except in the worst of circumstances, the next investor will always invest at a higher valuation than all before him/her. Thus, even if the second investor does nothing after the initial investment, not only to they still own part of the company, but that part is going to be worth more (theoretically) based on what kind of equity the last investor got for the amount of money put in.

IE if I buy 100 shares of your company in exchange for a $100,000 investment, you can sell 50 more shares in the next round as long as they're worth more than $50,000. It's actually more confusing than that, because the total worth of the company becomes the valuation PLUS the investment.

The only way anybody writes off an investment is if the company goes completely under and there's nothing left to salvage. Most VC's have deals in place that give them preferential treatment if the company goes under and has to liquidate assets - they get their money back first.

If you incorporate, this is handled by creating or exchanging shares. You would probably start out owning 100% of it -- say there are 100 shares. If you sell someone else one third to fund the business, they will own 50 shares (out of 150 now outstanding) and the company will get the money. So yes, they should expect a payout, even if they don't invest the next time you ask.

And when you think about it, that makes sense: the opposite would be to sign a contract saying "I will invest $X in the company. And if they ask for more money, I will either give it to them or forfeit my investment." It would make it very easy for a startup to screw anyone who backed them.

1. Ask family and friends if they're willing to invest in your idea and look for an angel investor. How? Network like crazy!!

5. A good book to check out is Art of the Start by Guy Kawasaki.

Sounds like you need a really basic primer on business, especially 'debt' vs. 'equity' as a source of financing.

I would search Amazon for "starting a business". This isn't meant to be an insult, but maybe you even want to get one of the "...for Dummies" or "Complete Idiot..." books, because it sounds like you want a general grounding from the absolute beginning, and that will take more than a comment thread here.

I feared my above comment would be taken wrong, but the way questions (3) and (4) are worded, the core concept of an equity investment isn't yet in the asker's mind.

The comments from byrneseyeview and swivelmaster try to address this, but a few sentences in a comment thread aren't going to create the necessary understanding. j2d2 needs to do some basic reading about (small) business finance, just to be able to speak the lingo of investors and lawyers. Something approachable like those general-audience books with the self-deprecating names could be a reasonable place to start.

Until then, tips about subtle legal terms and multiple-round raises with professional VC firms are very premature, and perhaps even a disservice.

No worries. The advice is appreciated.

(2)

Consult. Take a half salary. Use the other half to pay for a developer who will work for half salary. Wean your way out with product revenue.

Reply on news.ycombinator.com