You’re looking to start a new business. You have a great idea, see an unmet opportunity, and know you can execute on it. You just need to get started, and capital would certainly help. So you need to go talk to angel investors and venture capitalists, right? It’s just how things are done.
As a long-time investor, I get approached all the time by entrepreneurs looking to raise such capital, and asking for advice as to how to pitch to angels and VCs. And I always stop them and ask them one really basic question: Why are you raising venture capital in the first place, instead of another capital structure?
This is a really basic question that all entrepreneurs need to ask themselves, instead of just making the assumption that they need their funding to be structured in this way.
Because such funding almost always comes with a particular structure – “preferred equity”. And while that structure can be the right fit for some startups, for many great business ideas it can have long-term implications that are not so great. Although it may be more painful in the short-term to bootstrap or raise capital via “common equity” structures, it may very well end up saving your business in the long run.
Okay, before we get into the trade-offs and the reasons for asking yourself this question, what are these terms I’m talking about?
Venture capital is classically structured as “preferred equity”, which means the dollars come in to buy a new class of shares with special rights (versus the founder shares or other common shareholders). Those rights typically involve a lot of protections, so that even as a minority-stake shareholder, the preferred equity holder gets some input into decision-making. That can be a good thing, in my experience, because if you’ve raised capital from an experienced professional investor, hopefully they can bring a lot of acquired wisdom and other benefits to the table. Making sure they’re in a position to be listened to can benefit the right entrepreneurial team.