The amount of capital you will need depends on what kind of venture you plan to build. You may need to go no further than the first rung of the ladder. You might be able to build a very good business that meets all of your financial needs without raising a dime from anybody. You might also strike it lucky and get phenomenal growth without needing capital. But being under-capitalized is a big source of venture failure. So you need to assess how much capital you'll need. Your chances of realistically getting that capital should factor into your planning. If you can reach only the lower rungs of the ladder, don't plan a business that needs higher levels out of your reach. If your first venture is a success, the other steps on the ladder will be more easily accessible if you decide to pursue another venture.
10 Steps on the Ladder
You may need only a few of these steps. This is not meant to be a "do this, then do this, and then do this" progression. You can skip steps and stop at any point.
- No cash, moonlighting, sweat
- Credit card or savings (personal round)
- Friends and family round
- Serious angels and small VCs
- Classic VCs
- Corporate VCs
- Non-recourse working capital bank loans
- Exit: Capital Realization
Our aim with this chapter is to help you understand what these investors want. Habit #5 in Steven Covey's "7 Habits of Highly Successful People" is:
Seek first to understand. Then to be understood.
1. No Cash, Moonlighting, Sweat
This is the earliest possible phase, when all you need is to build a website that can be uploaded to your server and that demonstrates your idea. If you are a non-technical entrepreneur, this step is not feasible. The non-techie equivalent would be a business concept: identifying a big gap in the market, doing enough research to be credible, and developing a unique approach to filling this gap.
2. Credit Card or Savings (Personal Round)
Now you need to load your site onto a production server (or create a fancy slideshow) and buy business cards. Maybe your phone bill just went up, or you need to travel somewhere to meet someone. No problem; no need to ask anyone for money. Just keep track of these little items. They are pre-operating expenses. If you get to profitability without external investors, these loans of yours to the company can be re-paid. If you raise external capital, this is almost always regarded as sweat equity (meaning you don't get it back until exit time, when you sell your equity).
Be careful. Loading up on credit card debt is risky. You almost always need more money than you think, and it takes longer than you think to raise real money. You can rack up a sizable debt fairly quickly. If your credit card company tightens up, you'll have no options. If your venture fails, you'll be left with a nasty bill, probably with crippling interest rates.
3. Friends and Family Round
You are now at the stage where this venture of yours might really take off. But now you need more than you can afford but less than is sensible to ask from an angel. This is the friends and family round, people who "invest" because they know you, like you, and trust you. Don't take this as validation of your venture. It is purely validation of how they feel about you.
Keep the deal simple. This has to be convertible debt. That means:
- They loan the money to your business,
- It converts into equity at the first equity round.
This lets you avoid having to ask your friends and family to valuate your venture. They are not experts, and it makes for difficult conversations with people who still like you.
Your friends and family will always be important to you... more important to you than this venture. Don't make promises you are not 100% sure about. Be totally open and transparent, and do your best. If you follow these simple rules and your venture fails, you at least won't lose your friends and family.
Document what has been agreed on, even if only with an email trail. Memories may prove faulty.
The US alone has 600 technology incubators. One may be near you.
Some are little more than office space and offer no real value: don't waste your time with them. Look for ones with a track record of successfully incubating ventures. That track record means that angels and VCs look to these incubators for deal flow, meaning you will get access to capital when you need it.
Incubators should give you four things:
- Cash. Not all incubators have cash to invest. Look for the ones that do. This could replace a friends and family round. They might do a convertible deal, letting the angels or VCs set the valuation. That is ideal. If they insist on a percentage for a small amount of cash, take a long hard look at their track record. Those deals of, say, 10% of the venture for $20,000 may work for some first-time entrepreneurs if the incubator can really deliver the credibility and network you need. But note that later investors make their decisions based on the merits of your venture. The incubator just gets you through the door and may coach you on what to say as you walk through. Is that worth 10%? Because $20,000 is probably not worth 10%.
- Services on a deferred-payment basis. These would be from vendors (landlords, lawyers, accountants, designers, advisors, etc.) who get paid only after the venture is funded. So, these vendors are also betting on the incubator's track record.
- Mentorship and championing. This should come from the person in the incubator who really believes in your venture but also challenges you at every step to make sure you are really ready to take it to the next level. Look for a mentor/champion who has been an entrepreneur. There has to be chemistry. See the chapter on Building An Advisory Board and follow those guidelines when choosing a mentor/champion in an incubator. Yes, you choose them. It is not just about them choosing you.
- A network of entrepreneurs and investors they can tap into on your behalf.
Why do successful entrepreneurs put time and money into becoming incubators?:
- To get in on the ground floor of a great venture and make some money.
- The buzz of startup life is addictive.
- To do some good, and repay the good fortune they have had.
- To help the local region. Perhaps they came from here, went to Silicon Valley because it was their only option, but wished they had an incubator like them locally when they were starting out.
Good incubators are a great rung on the ladder. But choose carefully: some will only waste your time.
5. Serious Angels and Small VCs
Serious angels do what they do for a living. That is their day job. Sure, they love it and are passionate about it, but they also want to make money from investing. These serious angels are very different from the person in a full-time job who enjoys the distraction of hearing pitches and occasionally writing small checks.
The serious angels operate just like small VC firms. Some work in association with other angels so that they can provide enough funding that the company doesn't have to rely on VCs too early on. Some have raised money from other angels and in effect become small VC funds themselves. Serious angels take all of these steps because of one overriding fear:
They fear getting squeezed by a VC that invests in a later round.
As an entrepreneur, you need to be sensitive to that fear. Almost all entrepreneurs are too optimistic about their plan. They assume they can reach whatever milestone they have with less time and money than they really need. Then, when the venture runs out of money, the angel has two options:
- Invest more money. At this point, they are investing in an entrepreneur who has not hit their numbers and whose credibility is questionable. So this does not feel good. The smart ones will just assume at the outset that they will have to invest way more money than you are asking for. For example, if you say, "We can get to profitability (or some other milestone) with $500,000," they will assume that something more like $1 million is needed and plan accordingly (by reserving as much of their or their partner's capital as is needed).
- Get squeezed by a VC. In this case, their stake will be massively diluted. Say they invested $500,000 and got a 20% stake. Now, the venture is running out of money and needs $3 million urgently. The venture has good prospects, so VCs are interested. Some VCs will extract harsh terms under these conditions. Angels obviously don't like being treated this way. The venture is a winner, and they spotted it early, so why should they be the loser in this game? Bear in mind that you, the entrepreneur, get squeezed in this situation as well, but you are in a better position than the angel because the VC needs you to continue working to build value. But basically, this is bad news all around.
You can avoid this situation in two ways:
- Be more realistic in your business planning. Yes, this is hard. Planning with multiple levels of uncertainty is hard. That is why investors, who know this fact very well, usually want more time to evaluate your venture than you'd like to give them. Use the angel's experience to help you with business planning. Check your assumptions against their experience. The mechanics of a spreadsheet are simple; the mistakes always lurk in one or two main assumptions. This is why the real-world experience of your advisor, incubator champion, or angel is critical.
- Work with angels who, with their partners, have enough cash to invest if you do end up needing more money than planned. Work with angels who have a strong track record and good connections with people on the next rung of the ladder: the classic VC funds. VC funds are less likely to squeeze (read, alienate) an angel who they know is a great source of ventures.
6. Classic VCs
If you are a serial entrepreneur who has already built and sold a VC-funded company, you can jump straight to this rung of the ladder. If not, don't even think about it. For Web technology ventures, classic VC funds have become a source of late-stage expansion capital. Some of those VCs are getting back in the early-stage game by one of three methods:
- Establishing a separate early-stage fund. Unless the VC has different partners, this separate fund is probably little more than a name and hypothetical allocation of money.
- Acting as Incubator. This works like a convertible loan and can be a great solution.
- Cultivating a network of friendly angels. The idea here is that they send deals to these angels, who bring those deals back when the ventures need more money.
Be careful. Many classic VCs like to work with a few "entrepreneurs in residence" to create ventures in-house. Their interest in any of these projects may be no more than due diligence.
In short, if you don't have a good relationship with a classic VC, don't start here.
7. Corporate VCs
Higher up on the ladder are corporate VCs. They get their deal flow from classic VC funds and invest with strategic objectives. They typically look to grow the market for their core product. They may want a minority stake in a venture that they see value in acquiring later on. Corporate VCs can be great, but make sure the deal does not come with strings attached that would scare off other potential acquirers.
8. Non-Recourse Working Capital Bank Loans
This is the high-five moment for bootstrapped ventures. It means you have been profitable for a while but need working capital because of fast growth. Most banks like to fund these. The big deal about non-recourse loans is that you are not personally liable. The bank uses your company's cash flow as collateral. For entrepreneurs who have gone into personal debt to build their venture, this is a big, big milestone.
This is the golden ticket for a VC-backed business. Well, at least it used to be. And it may be so again. It is another rung on the capital-raising ladder. You do an IPO to raise money, at least in theory. In reality, the larger motivation is to get your stock tradable (i.e. "liquid") so that you and your investors can sell some of it.
10. Exit: Capital Realization
The final step is to realize value by selling some or all of your stock either in a trade sale or to public market investors if you have done an IPO.
If you are starting out, then yes, all of the steps above the fifth rung on the ladder may as well be on the moon. But as with anything, take it one step at a time.