Capital Opportunities for Small Businesses - sbtdc

C A P I T A L O P P O R T U N I T I E S F O R SMA L L B U S I N E S S E S
CHAPTER 6: EQUITY CAPITAL SOURCES
Equity Funding “Food Chain”
You may have heard of something called the funding “food chain”. This occurs when bigger fish are
participating in each subsequent round of equity investment in a company. Ideally, deals are
structured, milestones met, and value created in such a way that the bigger fish takes a nourishing bite
in return for larger and larger amounts of capital as opposed to swallowing all the smaller fish.
For “food chain” funding to be successful for everyone, the entrepreneurs and investors should make
sure that there is room for everyone to profit from a successful company. To accomplish this, the
valuation of the company has to continue to be attractive at each stage, including late in the funding
cycle. Thus, even later stage investors need to have an opportunity for an attractive return
commensurate with the risk they are taking. Of course, the early investors want to be rewarded for
their significant risk.
All investors typically have an interest in the entrepreneur/founders/management team having
sufficient equity or an option pool that will provide incentives and reward them for their successful
contributions. The idea is to grow the pie so that the shrinking pieces of ownership are actually worth a
lot more when some form of exit is achieved. It is critical that each participant figures out how
everyone can win.
Having said this, “food chain” funding rarely occurs in a linear fashion and should not be counted on
as the sure way to grow. In fact, very few companies will actually fit this model through to its
conclusion. For companies that don’t fit the high growth and exit mode, other types of approaches may
be appropriate to satisfy the investors and entrepreneurs. Nevertheless, the “food chain” idea provides
a framework to consider when looking at funding strategies and options. Be prepared for funding
efforts to take incredible amounts of physical and creative energy.
Here is how it can work. As a founder, an entrepreneur often starts with her own funds in combination
with or followed by funding from family and friends. Or a company may be formed out of a university
with some start-up help and, on occasion some funding help, prior to or concurrent with its emergence.
Although the following terms may vary in meaning from person to person, here is one way to look at
them. The term, pre-seed funding, is being used more frequently. These are funds invested to help
develop the idea. Next comes seed funding, which is often used to get the business plan together and
develop the initial work on the technology, market/industry research or business model. These funds
can come from within or outside the founder or founding team.
The first outside money may come from private equity investors, often called “angel” investors. They
are sometimes called angels because they are not always as tough on valuation as other sources,
sometimes to their own detriment, and they are often or should be looked upon to pass on added value
from their industry knowledge, experience and contacts to the entrepreneur. As angels and
entrepreneurs learn more about the funding process and become more sophisticated in structuring
deals, the understanding will be greater and the expectations more realistic and clear. This should lead
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