The “Series A Crunch,” which is the significant decline in the number of startup companies per quarter that are completing their first equity financing, appears to be deepening. The latest data from PitchBook indicates that the number of startup companies closing their first equity financing is at the lowest level of the past four years, and the numbers from the first quarter of 2014 were only one-third of those seen in the first quarter of 2012. There are several factors contributing to this unfortunate phenomenon, including the sky-high pre-money valuations that some companies are commanding these days. Many venture capitalists are describing the current valuations as frothy, and some are questioning whether it makes sense to invest right now. Founders who are struggling to raise equity financing in this environment should remember that there are alternatives to continued bootstrapping and personal debt.
First, consider accepting smaller investments from a large number of investors. Many companies have closed seed rounds or Series A rounds of $1 million–$2 million over the past two years by selling convertible notes or stock to a self-created syndicate of 30 or more angel investors, family members and friends, many of whom invest only $25,000 or $50,000. While raising a seed round or Series A round like this may require a significant amount of time, effort and angst from a founder, it can be effective and often leaves the founder with greater control over the company than if the funds had been raised in a round led by a venture capital investor (or a small group of angel investors), who would usually insist on a board seat and protective covenants in the company’s certificate of incorporation as a condition to their investment.
Second, consider alternatives to the usual stock or convertible note offerings. Some investors prefer to invest in debt rather than equity, so you may find new sources of funding by offering to sell regular, nonconvertible promissory notes. You can be creative with the payment terms in these notes. For example, an investor’s return could be interest, a fixed multiple of the loan amount or a capped revenue share from a new product. Bear in mind that promissory notes sold in a note offering will likely be restricted securities, even if they are not convertible into equity, so you should consult with an attorney before doing a note offering, and you may need to limit the offering to accredited investors.
There are also a variety of venture lenders who cater to startups, especially those that have some revenue. Venture lenders often make loans of as little as $50,000 or as much as $5,000,000 and may allow repayment over time out of the company’s revenues, rather than on a fixed payment schedule. The interest rate or structured return on these loans may seem high in some cases; however, if you are confident that your business will be significantly more valuable in the future, then this sort of debt financing could end up being much cheaper than equity.