by Brad Feld
Of course, reality often knocks loudly. The vast majority of the startups that we work with will not be able to achieve profitability—or even positive cash flow—quickly enough to avoid death. So, they have to look to investors—both angels and venture capitalists—to help them get their businesses up and running.
Entrepreneurs often fail to recognize that whether to raise funds is one of the most important decisions of an early-stage startup. When raising money from outside investors, there are always trade-offs. Before you raise money, the company is unambiguously your business. You create the business plan, you hire the people you want, you make all the decisions, you set the culture, and you decide what to share with others. After you raise money, regardless of the amount, you now have new partners in your business. Investment usually comes with some level of board control and an expectation of larger returns. You have new people to share your ups and downs with.
Investors can be a great thing for a business, but they can also cause problems. It’s critical for startup entrepreneurs to understand the trade-offs of outside money and know how, and how often, to communicate with investors. You’ll have to learn how to manage investor expectations, and it’s equally important that you let investors know what they should expect from you. As with any new relationship, the dynamics between you and your investors will likely be at a peak the day after you close the investment. The future looks bright and everyone is optimistic and happy. Your goal should be to develop and sustain that optimism through an authentic and productive relationship over time with your investors. Even when your business hits the inevitable bumps in the road, you still need to have a healthy, constructive, and collaborative relationship with each other.
Some of the essays in this section are about the tactics of raising money, but you’ll see that several of them relate to the alternatives. We think that you shouldn’t start with the assumption that you need to raise money. If you do decide to raise money, make sure you know what you are getting yourself into.
Chapter 57
There’s More than One Way to Raise Money
Brad Feld
Brad is a partner at Foundry Group and one of the cofounders of Techstars.
As a venture capitalist, I regularly hear the question “How do I raise money from a VC?”
My response is usually “Why do you want to do that?”
Many entrepreneurs view raising money from a VC akin to finding the Holy Grail. Very few companies are VC-backed, however; most raise money from other sources, including friends and family, angels, customers, partners, and grants. Let’s look at a few of these.
Friends and Family: This is the most common form of a seed or early-stage investment. Your first $10,000 will likely come from someone you know, like a parent, sibling, or coworker. Sometimes this category is called the 3Fs (friends, family, and fools). Mostly it’s a tongue-in-cheek way to signify how much of a risk your early investors are taking. Recognize that they are betting on you, which is why they are often the first ones to invest.
Angel Investors: Angels come in many forms: the lone angel who is a successful entrepreneur and who likes to invest in and get involved with startups; the super angel who invests in a large number of early-stage companies; the newbie angel who has recently made some money and is looking to make some investments; or the angel group, which has a collection of angels who periodically invest together. Each category is different and as more organized angel groups have appeared, a wide variety of activities—some good and some bad—have emerged that connect entrepreneurs and angel investors. Many VC-backed companies get their first round from angel investors, which is a logical bridge to a VC round, especially for a first-time entrepreneur. But be careful; for every angel investor, there is a corresponding devil investor.1
Customers: The most satisfying form of early financing is revenue and is often referred to as “organic growth.” My first company—Feld Technologies—raised just $10 to get started. The balance of our investment came from our early customers. My partner and I started generating revenue shortly after we started the business, worked out of our apartments, and paid ourselves very little. At some point we were generating several thousand dollars per month of profit (not to be confused with positive cash flow, although we also got there pretty quickly) and we were able to bootstrap our company, never needing to raise any additional capital.
Partners: When you start your company, it’s likely that you will collaborate with some other, more established companies. If you are working on something of value to them, they will often be willing to figure out a financial arrangement to help fund some of the work you are doing together. Don’t be bashful about asking; if you don’t ask, you’ll never have a chance of getting something.
Grants: There are a number of R&D programs backed by the U.S. government aimed at small businesses. The most notable is the Small Business Innovation Research (SBIR) program, which publishes a wide variety of technology research grants that startups can apply for. These grants are typically low margin, cost-plus types of arrangements, but the company gets to keep the intellectual property associated with the R&D. As a result, for R&D intensive companies, these can be good initial sources of financing.
Before you start thinking about raising money from venture capitalists, remember that there is more than one way to raise money to get your business started.
Brad Feld talks to Techstars founders about raising money.
Note
1See Chapter 58, “Beware of Angel Investors Who Aren’t,” to get a better understanding of angel funding.
Chapter 58
Beware of Angel Investors Who Aren’t
David Cohen
David is a cofounder and the co-CEO of Techstars.
I have been involved in several angel groups and most of them have sucked. The reason is simple—most of the members of most angel groups are not actually angel investors. They’re often there for what I call gig-flow. They’re looking for startups that they can jump on board with, either as an employee or a consultant. Or they are there to meet rich people, drink wine, and eat tiny sandwiches. They’re often there to preside over cute little startups that ask them for money. As a special bonus, they get to have a good laugh afterward.
Do I sound jaded? I draw on direct experience. When I first started angel investing, I quite naturally joined the local angel group in my city. I’d estimate that 95% of the members of the group had done at most one angel investment in their entire lives and many had never done any. I quickly figured out that I could generate much more interesting deal flow by getting to know other real angel investors and by creating my own independent brand and visibility. It turns out that strong entrepreneurs are pretty good at finding people who actually make angel investments. And it seems to me that people who don’t actually make angel investments, but tell the world they do, aren’t really serious about it.
Adverse selection was plainly evident to me in the angel group meetings I attended because the companies that were pitching typically had been unsuccessful at raising money from committed and professional angel investors. While there were a few exceptions, they already had some momentum with their financings and were looking for a few more investors to help them finish up their round.
After talking to a number of other active angel investors, I determined that although there were a few excellent angel groups, most of them were full of fake angel investors. These fake angels are unlikely to fund your company. There’s also a second class of angel investors who really aren’t. They are the unscrupulous types who often use egregious tactics and terms to line their pockets, but not to help you and your business.
One example that I seem to encounter over and over again is the bait-and-switch angel investor. He’s usually got an interesting background and it seems like he might have a pile of cash to invest. The story goes something like this. He offers to put together a half-million-dollar round for you. He’s personally committing a hundred thousand dollars! So far
, so good. However, once the round starts coming together, he starts backing off his personal investment (usually all the way down to zero) and instead rides the momentum into a job. Instead of investing, he’ll become the CEO or chairman, and will take a bunch of equity to boot. Unbeknownst to you, this supposed angel investor is running this same game with as many interesting (and struggling!) startups as he can until he finds the one that people actually want to invest in. Bingo—the bait-and-switch angel investor just landed a year or two of guaranteed salary and a bunch of equity on the backs of bright young entrepreneurs overly desperate to raise a round.
Then there’s the term driver. This type of angel investor is going to drive a hard bargain. They’re going to put in $50,000 and spark the round for you. They just ultimately want about 75% of the company to do it. And if they can’t swing that deal, they keep hunting for suckers. You’re not a sucker, but you’re still going to spend months with this person if you’re not careful. The cost to you is going to be measured in time, missed opportunities with real investors, and lots of aggravation.
I’ve learned a handful of very straightforward tactics to making sure you’re dealing with a legitimate angel investor. First, ask the prospective investor how long he has been making angel investments, how many he has made, and how much he typically invests each time. If you get dodgy answers, or fundamentally tiny ones such as “I’ve done one angel investment in the past 17 years,” beware. This is not a serious investor and they don’t have the knowledge or experience to help you. Don’t proceed with any other questions until you have these very basic answers about their investing background.
If an angel investor says he is just getting into making angel investments, this should set off your Spidey sense. In this case, do your homework and start checking highly trusted references that you source yourself. Check with known reputable angel investors and local venture capitalists on both the person and the companies he has been involved in to get a sense of how real the prospective investor is. Research his background—is he really likely to have the type of money necessary to make angel investments? A first-time angel investor can be very good—after all, I was a first-time investor at one point. But do your research on the person’s past to make sure that they can be trusted and that they have quality skills to bring to the table.
If your prospective investor says she has been investing for a year or more, ask her to introduce you to two companies she has invested in during the last year. If she can’t name two in the past year, then ask her for the last three she has invested in. If there aren’t three, recognize that this person is at best investing as a hobbyist and has very limited experience doing so. Next call or email all three companies and ask to speak to the founders. Verify that the person actually invested dollars in that company. Check the reference while you’re at it and ask if they were helpful to the company or not.
None of these questions or tactics will be offensive to real angel investors. In fact, it’s just the opposite: tough questions of real angel investors will give them more confidence in you. These tactics might offend the fake ones and drive them away. That’s fine, and the sooner you can figure out who is serious and who is not, the better off you are.
Beware of angel investors who aren’t. They’ll put you through endless diligence, play bait-and-switch with your financing, and generally waste your time.
David’s crappy experiences with several angel groups led him to check out an event in Los Angeles that Jason Calacanis put together, called the Open Angel Forum. It was a zero-pretense event with five high-quality companies having dinner with 15 to 20 super angels (those who have made at least four notable investments in the past 12 months). It’s free to entrepreneurs, which was the key attractor for David. He loved it so much that he started the second chapter in Colorado. Now the Open Angel Forum is spreading all over the world. Check it out at openangelforum.com.
David Cohen explaining something that he’s obviously emphatic about.
Chapter 59
Don’t Forget about Bootstrapping
David Brown
David Brown is the cofounder and co-CEO of Techstars.
I wish David Cohen and I had a program like Techstars when we started Pinpoint Technologies in 1993. We had no mentors other than a former boss or two, we had no funding opportunities, and we didn’t even know what an angel investor was. So, we had to make it up as we went along and, in many cases, we reinvented the wheel.
One of the silver linings (at least with the benefit of my 100% accurate retrospectascope) is that without funding opportunities, we had to bootstrap our business. We had no money of our own, so we were forced to be extremely frugal. Armed with a few thousand dollars earned on nights and weekends doing odd consulting work (including the glorious job of pulling cable and installing a network for a pest control company), we created a prototype and persuaded a prospective customer to lend us $100,000 in exchange for a free product and a repayment of the loan with interest. That product, without any additional investment, spawned a 25-year-old company with $40 million in annual sales and 200 employees.
The value in bootstrapping wasn’t that we retained 100% of the stock when we exited (although that was nice). More important to us was the ability to run the business as we saw fit, making the right decisions for us, for our customers, for our employees, and for the long-term benefit of the business. Conversely, so many companies raise money that then burns a hole in their pocket; they start hiring people, growing infrastructure, and in general spending way too much. Remember, investment is like a credit card—you don’t have to max it out immediately; what you want in the long term is revenue. Revenue is justification that your customers want what you made; investment is just a one-time shot in the arm and can cloud the long-term view of your company.
The most common argument for raising a large sum is to go faster: competitors are lurking around the corner, ready to launch at any second—we have to strike while the iron is hot! My experience is that this is rarely true. A good idea needs a little time to ferment and to be fine-tuned to make sure it truly delights customers. Take the time at the start to get it right, and you’ll find that those competitors might not be as close as you think.
Bootstrapping, of course, isn’t always possible. Sometimes startup costs such as inventory, development work, or infrastructure require some investment. In fact, I take the liberty of defining bootstrapping as raising the least amount of money needed to get a business off the ground. Taking this approach makes sure that you right-size your business, not letting your expenses get ahead of your revenues. After all, you wouldn’t want to pay your rent by credit card, would you?
David Cohen and David Brown founded Pinpoint Technologies together in 1993. They were bootstrappers from the start. Early on, they hired a great programmer named Eran Shay. Rather than buying a second computer (Pentium-90s were expensive at the time!), David and Eran worked in 12-hour shifts so that they could share the one fast machine that they owned. David worked from 9 a.m. to 9 p.m. most days, and Eran worked from 9 p.m. to 9 a.m. It was only when they got their first paying customer that they splurged for a second computer.
Chapter 60
You Don’t Have to Raise Money
Joe Aigboboh and Jesse Tevelow
Joe and Jesse are the cofounders of J-Squared Media, a company that builds applications for social networks that are used by millions of end users. J-Squared completed Techstars in 2007 and quickly bootstrapped itself to profitability. The company changed its name to PlayQ and is a leader in mobile gaming, building high-quality games for iOS, Google Play, Amazon, and Facebook. PlayQ has never sought outside funding.
We entered the inaugural class of Techstars in 2007 with a simple concept for a content-sharing site. On the second day of the program, we decided to abandon our idea in search of a better idea. Within weeks, Facebook announced its platform and opened it to developers. While our business model was still unclear, we recognized the Facebook platform was a g
reat opportunity to distribute products to a large and growing user base.
After about a week of experimenting, we launched our first app—Sticky Notes—that allowed users to send customized notes to their friends. The app grew to more than 10 million users in a matter of months, bringing in considerable revenues from banner advertising. By the time Techstars ended, we had funding offers from VCs as well as several acquisition offers. While most companies were seeking funding, we felt our early success had put us in a position to bootstrap our company.
The decision to bootstrap will affect many of your future operating decisions. We quickly realized that we needed to continue to drive revenue while controlling our costs. While this might have been obvious in hindsight, it caused us to focus on product decisions that resulted in a lot more revenue while operating under the constraints of very little cash. Our early revenue was composed primarily of advertising and sponsorships. We focused on growing revenues by searching for creative ways to increase traffic, optimizing our ads, and securing sponsorships.
With such a strong focus on maintaining profitability, we constantly evaluated the long-term feasibility of our revenue sources. As the online ad market soured, the constraints of self-funding forced us to identify viable long-term revenue sources. We made a transition from advertising to virtual goods as a primary source of revenue faster than many well-funded competitors. Embracing the constraints of self-funding has allowed us to build a solid company with annual revenues of seven figures and growing.
Bootstrapping is not without its challenges. Although it is often viewed from a financial perspective, it can also present challenges in other parts of the company. Some of our early hires sought the peace of mind offered by the backing of a VC despite our growing revenues and profitability. Fewer stakeholders means there are less people with a vested interest in helping you achieve your goals. For some, bootstrapping may also pose working capital challenges, making it difficult to grow quickly.