I find that a very high number of my mentees plan to raise funding from venture capitalists. They seem to do this because to them it’s expected behavior in a high tech startup. However, they don’t seem to understand the issues they should about venture capital funding and their alternatives.
- As a venture capitalist told me, venture money is the most expensive money you can buy! You will be selling your equity to a venture capitalist in exchange for cash. Of all the ways to raise capital you will “give up”, meaning sell, much more equity to a venture capital firm than to any other type of investor. Not to speak of the terms and conditions that will come with that money.
- Here’s one way to think about VC money: it is rocket fuel. Rocket fuel is very, very expensive, it is highly combustible. Like a rocket your firm is expected to get big, fast. That translates into 80 and 90 hour work weeks and a totally unbalanced work vs. life balance. Say goodbye to your family. That’s why investors love young entrepreneurs who aren’t married, don’t have kids and don’t have a mortgage. Young entrepreneurs can deal with not having a life, because they aren’t weighed down by obligations.
- Your rocket may get stuck on the launchpad and never get off the gantry, due to technical problems, team problems or a host of other problems.
- Your rocket may not have enough fuel to reach escape velocity, and fall back to earth, with disastrous results.
- That expensive rocket fuel you bought is highly combustible and your rocket may blow up in the air ,as the VCs kick out the founders and replace you with professional management.
So what are your alternatives to the most expensive money you can buy?
- Friends and family money. This includes your money, which needs to go in first, assuming you have any! The key thing with friends and family is that they need to understand the very low probability they will ever get their money back. So they can’t invest more than they can afford to lose. That goes for you too. Now I’ve met investors, mainly angels who actually expect you, the founder, to have skin in the game by putting your own money in. I can understand why they say this, after all why should they invest if you won’t? Of course, at perhaps years of 90-hour weeks you will be investing – your time, everyone’s most precious asset, superseded only perhaps by your health. If you do raise money from your family consider doing it as a convertible note.
- Angels. They are wealthy individuals who are what is known as accredited investors. The rule of thumb is that they must have a net worth, excluding their primary residence, of a minimum of $1 million. There’s a bit more to it than that. Hit the link for details.
- Angel groups. Angel groups have been growing as venture capitalists are tending to put more and more money into later rounds, leaving an opening for seed rounds of much smaller amounts. Angel groups operate in one of two ways: either the group invests as whole or individuals who belong to the group may make their own investments. Established groups are getting more and more like VCs, doing extensive due diligence and tying their investment to terms and conditions that favor the group at the expense of the entrepreneur, these Ts and Cs are known as preferences.
- Strategic investors. I’m very biased in favor of strategic investors as I’ve had many, including MIT (twice) and Apple Computer. However, there are significant differences between strategic investors. See my post The pros and cons of taking corporate VC money
- Royalty investors. These investors are rare as hen’s teeth. But they do invest. Instead of taking equity in your venture in return for giving you cash, royalty investors put in a sum of money in exchange for you paying them a share of your revenue over some fixed period. This can be a great choice if you will have very predictable revenue, such as a SaaS model with subscription revenues. But you will have to prove out this model before any royalty investor will put any money into your company.
- Grants and foundations. Virtually all grants and foundation capital is invested in non-profit companies. However, there are a few exceptions like SBIR grants. If you or your co-founder is a research scientist Small Business Innovation Research grants may be a viable route for you. But you’ll need to do your research, as usual you can start with Wikipedia, but since this is a Federal program there’s plenty of information on the Web from the government.
- Your credit card. There are a few companies that have been launched by the founder taking out a number of credit cards and maxing out every one of them. This is a risky strategy at best, only advisable as a last resort and when you have revenue in sight but you really need a bridge loan. That’s the best way to think about it.
- Crowdfunding. Kickstarter, Indiegogo and numerous others harness the power of the crowd to fund product startups. Almost always in exchange for funding the members of the crowd receives not equity but some significant benefit over regular consumers: a steep discount on the product to be developed, receiving the product sooner than consumers or receiving a special version of the product or an accessory. I have zero experience with this but even if I did I would advise you to research it deeply by studying the success stories of the major crowdfunding sites to see if you think you have the elusive investor/venture fit.
- Incubators. Y-Combinator pioneered this program for startups and they have been wildly successful. Not only do you receive a small amount of capital from incubators and accelerator, usually $100,000 for 6% of your equity, you gain access to their very valuable and active alumni network. But getting into the topflight incubators and accelerators can be as difficult as getting into an Ivy League school. I was told by MassChallenge that this year they will receive 1,700 applications for 120 slots in their incubator! But I highly recommend going this route if you can.
- Going public. This may seem far out of reach for a startup. The rules and regulations governing going public have recently changed to make it easier for small firms via JOBS – Jumpstart Our Business Startups Act. This is well worth checking out. The program, like most federal programs has been slow to get off the ground. As with most ways of raising capital you will need the advice and guidance of a CFO with deep experience in raising capital for startups.
I may have left out one or two other avenues, your consulting CFO (you don’t want to hire a CFO out of the gate) and a law firm with deep experience with the financing of startups can both help you. Several law firms in the hotbeds of startups like Boston, New York, and of course Silicon Valley have special programs for helping startups. If you can qualify for one they are well worth participating in. Basically blue chip legal firms are making a bet that by helping you out they will get your business, generating substantial fees over the years. Wilmer Hale in Boston is one such firm. The Web in general and Quora in particular have a wealth of information about how to raise money. And I’d be remiss if I didn’t put in a plug for my former advisor and investor Brad Feld’s book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.
Finally the best means of raising money is also the oldest: customer revenue.