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B2B Marketing Bopcast Episode 5: Funding A Startup in San Diego

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Bop Design: Hi everyone. This is episode five of the B2B Marketing Bopcast. For this month we had our business principal Jeremy Durant interview Carlos Heredia, Founder of YourGreatBusiness.com. Carlos gave a lot of insight to businesses looking to startup in San Diego and specifically around funding and the options in the San Diego area for small businesses, which is perfect timing since Forbes just recently named San Diego one of the top 10 cities to start a small business.

I’ll let Jeremy take it away and here is Jeremy and Carlos discussing startup funding for the B2B Marketing Bopcast. Enjoy!

Jeremy Durant: This is Jeremy Durant, business principal of Bop Design and today we have Carlos Heredia with us. Carlos Heredia is a startup in small business finance consultant at YourGreatBusiness.com. YourGreatBusiness.com uses the SIMPLE business framework—meaning startup, infrastructure, money, people, leverage, exit—to organize and educate entrepreneurs to starting, funding, growing and running a great company. Today, with that simple acronym, we are going to focus on the money aspect of SIMPLE. Welcome Carlos.

Carlos Heredia: Thank you. Happy to be here.

JD: Thank you for attending. Really I just want to talk about, first up, let’s say there’s a couple or an individual has a business idea and they need money not only to develop the product or service, also to market it. What are some of the traditional funding sources for a startup business?

CH: Sure. Well, that’s a good question and I think something that many entrepreneurs and startup businesses don’t really understand until they get into it because we all have big dreams and we all should have big dreams, but we may not be ready to go for professional financing like getting money from a venture capitalist.

Most startups have to get money from I would call the hanging fruit. One source of money that’s pretty obvious is just personal savings and that really is the largest funding source for startups and small businesses. You might have savings, you may take a second on your mortgage. You may bootstrap it so you want the savings to last a little bit longer and fund your business for a longer period of time. Personal savings is the lowest thing in fruit and what’s utilized the most.

After that, friends and family funding. Money from friends and family, people that know you that may be excited about the business opportunity that you’re pursuing and maybe more willing to be flexible and allow you to get that funding more quickly than you might otherwise with someone you don’t know.

JD: Now let’s move to the professional financing. You mentioned venture capitalist. Talk about different avenues a business can go with professional financing and the pros and cons of each one.

CH: Going back to what we just talked about, many companies have to step through the personal funding and the friends and family before they even should think about approaching angel investors or venture capitalists. That’s a whole different financing process because you’re dealing with people who have done it many times before. They’re professional investors. They have a lot more experience in terms of how to structure the deals.

I think what is really important though is assessing early on whether your company is a type of company that even has a shot at getting that money because they’re looking for opportunities that have 10X returns, big opportunities because many of their investments, not surprisingly, don’t pan out. They’re investing in cutting edge technologies, new ideas, things that have very high potential returns. Many of them fail so they need some of them to be homeruns to compensate for the funding deals that don’t work out.

If you have a service business or something that’s not that new big thing, you may not even have access to that money. What I counsel people on or suggest that they do is find a mentor or an adviser that’s been through the process before because you’re trying to raise money and if you’re wasting time and wasting money it’s working against your whole objective of getting money. Find someone that preferably is in your industry space that’s done it before and that will tell you straight up whether you should really pursue that path to getting more professional money because that might not be the best course of action for you.

JD: You’re saying in respect to industry’s typically professional finance businesses, typically around the tech sector, biotech sector, web sector. If you’re, as you even said, a service delivery business, marketing agency, a PR agency, a printer, really if it’s not an earth shattering idea, not even an earth shattering idea but something that’s an innovative idea that hasn’t been done before, professional financing is not an option.

CH: You might still be able to find some angel investors that may recognize that you’re doing it differently or that may not have the same return expectations. Certainly everyone wants to get a bigger return than not. You still might have access to angel investors, but chances are you’re not going to have too many doors open at the venture capitalist. Jeremy, you’re correct. Biotech, software, new ideas, new innovations that really can change the marketplace are the areas that are prime to get venture capital funding.

JD: I hear people ask this a lot and I’ve asked people this a lot and sometimes I don’t get a coherent answer to this. With angel investors versus venture capitalists, what is the difference? Sometimes I hear people use those almost interchangeably but I know there is a difference between the two. Can you talk a little bit about the different between an angel investor versus a venture capitalist?

CH: I think a few years back that difference was more distinct, but as time passes I would say that the two groups are converging in many respects, certainly in the way that the deal structures are done. Many of the angel investors have gone through the venture capital process, have been on the other side of the table from a venture capitalist and they saw all the bells and whistles that the VC got so when they structure their deals, they want the same things now as an investor.
In terms of the term sheets and the agreements and the structures and just all the protections that the investor gets, it’s very similar in an angel investment round or working with angel investors as with working with venture capitalists. If you’re able to work with a venture capitalist or a group of venture capitalists, there’s some efficiency. They’re coming in with big chunks of money so you get two or three working together and you can put that financing pretty quickly.

We did a financing or helped a technology company raise $3 million in a series B preferred stock round recently. They have 40 investors and they were all angel investors. There’s a lot more hand holding and herding of cats bringing all of those people together. There’s more work bringing in 10, 25, $50,000 per angel investor but in terms of the structure and how it affects your company, very similar in terms of the deal terms and how they’re put together.

JD: You mentioned series B funding. Can you talk about series A, series B, series C funding and what the different is and the different stages of the funding process?

CH: I think just to step back even a little bit further than that, we talked about friends and family rounds and their seed financings and angel investors and venture capitalists, depending on where your company is one of the key initial decisions that you have to make is whether you’re going to bring that money in as debt or bring it in as equity.

When we talk about equity, at the seed round or the friends and family round, but we’re talking about it in investment in common stock. If you have a company, a corporation, your corporation would issue shares of common stock to the investors in exchange for cash investment coming into your company.

As your company grows and as you start to see larger amounts of money, you will bump up against angel investors and ventures capitalists, not everybody does but you might, and they are going to put more sophisticated deal structures in place. I think that once you get north of $500,000 or north of $750,000 in dealing with angel investors, there’s a good chance that you’re going to see a series A financing. A financing using series A preferred stock.

We talked about common stock and that’s common stock. It’s basic. When you get into preferred stock and these more venture capital type deals, there’s a lot more bells and whistles that are put in place to protect the investors. It might be if the company’s sold they get their money back first. They may demand representation on the board. They oftentimes want to approve all major decisions of the company. Nothing major is going to happen unless the series A investors approve it. They may have rights after five years to get their money back, demand their money back, receive periodic information. You get the idea, right? They are putting in protections and rights that protect their investment.

Then you get into the alphabet soup. In the ideal case your company is growing, you need more money so you do a series A round. Let’s say you raise $3 million. You do a series B round, you raise more money and on and on. Thinking about the alphabet soup, we help the company, and actually it was a biotech company, they went through more than half the alphabet. They ended up doing over a 14-year period, actually a little bit longer than that about 18-year period. They actually raised money through series N, as in Nancy. We helped them from series G on to series N.

Most companies don’t get that far and to their fortune they actually sold their company for a half a billion dollars a couple of years back. That worked out but you can imagine going through that many letters of the alphabet. There were some up rounds, down rounds, a lot of creative structures to get those financings done.

JD: What role does a traditional business bank play in financing? Is it just capital loans? Talk a little bit about how a business bank may complement the investments going on from a venture capitalist or angel investor.

CH: Many companies believe that they are going to get bank funding early on and oftentimes they don’t have the history or the financial statements or just the financial performance to support traditional bank lending. There may be opportunities, if there’s a personal guarantee or through an SPA program to get funding, but it’s difficult. You need to meet all of the requirements that the bank wants to have in place before they’ll lend the money.

There are some banks though that are referred to as venture banks and they will look at a company that just raised $2 million or $3 million and see that they’re supported by good investors and they might be willing to lower their requirements a little bit and put some type of line of credit or bank financing in place. They typically would take warrants so they would get a small piece of the equity of the company. There are those tag-on venture bank financings that sometimes are associated with the equity stock financings that we’ve talked about.

There are other opportunities depending on how your business is structured. There may be access to accounts receivable, financing from different funding sources. If you have a business and you’re kicking off quality accounts receivable, they might be willing to loan you money against the accounts receivable as security. There’s other ways to access money as well through banks or other lending sources.

JD: That works into mezzanine funding. Talk a little bit about mezzanine funding and where that fits in. Is that with the accounts receivable or is that something different?

CH: That’s something different. Mezzanine financing is typically seen with more mature companies and it’s more growth fundings, it’s a debt funding but really for the growth of a company. Before an IPO, for example, you might see a mezzanine round come in. You’re getting into or we’re getting into areas that might not really be accessible to the small business owner.

JD: In San Diego, which is a land of many startups, there are different venues or groups for a startup that may even have a business idea, a business plan or maybe they even need help with that. Talk about some groups that can help an idea person or a business owner be linked up with angel investors or venture capitalists.

CH: There’s actually a lot of groups here in San Diego and in many communities that can help startups. There’s a lot more incubators that you find in San Diego now if they like your business model they may make a small loan or investment in your company, sometimes it’s a convertible note that they put in place. They may give you office space. They’ll give you mentoring and coaching and open up their contacts to you and put you through a process that will take your company and push it forward so that it is fundable and it has a better shot at accessing capital.

There are number of incubators in town. There’s the Connect Group in town that also has a variety of coaching programs and various resources that you could use. I think there’s just also the networking among other startup business owners and entrepreneurs and really leaning on them and networking and creating relationships so that you can learn from their experiences and accelerate your process as well.

JD: If you don’t have that network really, you’re going to have to tap into one of those groups. Let’s say you have the greatest idea and you’ve actually even generated some revenue from it already but you really want to take from either a marketing perspective or from infrastructure investment perspective takes to the next level, you’re really going to have to tap into that network. I always hear more about Silicon Valley is having this big venture capitalist up there. Is there a pretty strong network of connections down here that could finance something that could really ramp up to be a fairly large venture?

CH: Yeah. Here in San Diego we don’t have the same presence of venture capitalists that you find in Silicon Valley. To your earlier question at the difference between angel investors and venture capitalists, there are a lot more sophisticated and more organized angel investor groups, Tech Coast Angels is a group located in San Diego. They fund sizable amounts of money and are increasingly more organized. I think it’s one of the biggest angels groups in the country.

There’s also the angel groups that you find online so the laws are changing in terms of how you can access money. There are angel networks that you can tap into as well. If you have a good idea and it really is something that will attract the attention of big money investors, they’ll find you. Certainly you’ll have to do some networking and do it in a smart way to make sure you’re properly protecting what you have. You can find them and they’ll find you if you really have something that’s remarkable and a game changer.

JD: That leads into the next question of control. Making sure that as you bring in other investors, how do you safeguard making sure that you still, with your idea and with your vision, you still maintain enough control of where this product or company is going and making sure that the investors coming in aren’t taking that all over for you?

CH: There’s no guarantee that you will always control your company and I think that the investor will come to the table with his or her idea of what investment structure they need to get the deal done and you’re going to approach that proposed investment with a different perspective. Each financing transaction is going to be different and there may be a different valuation. Valuation of your company will determine how much of your company you give away depending on how much money is invested.

That’s one of many different points that you need to look at but overtime if you like that example where the company raised through series N, the original founders at the end of that process were washed out and didn’t have any control. They didn’t have really any ownership of the company.

You need to look at these financing transaction separately with an eye to what it means in the future because what you do now will affect the money that you raise in the future. You need to have, again, good advisers, good mentors, people that can leverage their experience to guide you through that process, but you need to cut the best deal that you can and understand how that might affect other financing opportunities that you have in the future.

Just one other thing though, Jeremy. Valuation is something that people look at a lot but there’s also board control or the ability to affect decision, some of the various protections that we talked about a few minutes ago. Those things are equally important. We have a term sheet for a local company that we received yesterday and it’s a deal for $2 million but the term sheet alone is 11 pages long. When you add water to that term sheet and want to expand it into actual legal documents, you might have over 200 pages of legal documents that define what that investment structure is. There’s a lot that you need to balance and look out and negotiate to make sure that you get that right deal for you and your company.

JD: Thank you for the time today. Very valuable information here in terms of financing a startup business. Definitely go to Carlos’ website at YourGreatBusiness.com if you want to have more information. If you want any more information on B2B marketing options, definitely check out BopDesign.com. Have a great day. Bye.

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