App-to-Market: Show Me the Money
In this ongoing series on turning from developer to startup, we now look at what you'll need to know about funding your idea. So, who are the players you need to bring in and at what benefit?
More on This Topic:
Now that you've moved your idea to prototype and developed an actual minimum viable product that you can give to customers for some feedback, you're almost ready to take the next step and make some valuable time and monetary investments in it. It's time to talk about funding: Where to get it, how to get it, and how to use it.
Before we talk about funding, though, a few things you should know about the investors you go after and what makes technology startups riskier for those investors.
What's an Accredited Investor?
Before you talk to the first potential investor in your business (outside of family, friends and close acquaintances), you must understand who you are legally allowed to solicit money from and who you must stay away from. You are not allowed to just solicit money from anyone. Many countries only allow you to solicit from an "accredited investor." In the United States, an accredited investor must have a net worth greater than $1 million excluding a personal residence; that investor has to have made $200,000 per year for the last two consecutive years, and the investor has to meet several other requirements most recently amended in the Dodd-Frank Wall Street Reform and Consumer Protection Act. To be clear, you can only solicit money from individuals who meet requirements based on country-specific requirements, and those requirements vary by country.
The general assumption is that accredited investors will understand the risk that they are taking on by investing in your company. Even then, I have personally seen accredited investors who do not understand the inherit risk associated with a technology-based startup. So, be cautious who you might take on to invest in your company.
Technology Startups are Riskier
Technology startups are fundamentally different from other types of companies. Most companies have physical assets that they can borrow against. These physical assets have value. If the company were to go under, a bank or another creditor would get some money back from the bankruptcy of the company through the sale of the company's assets. These assets would be sold and the money divided up by creditors.
Unfortunately, software-based technology startups don't have much in the way of physical assets. These companies have software and intellectual property. However, these assets are not worth much without the entire team. It is hard to keep an entire team together during the bankruptcy of a software startup. When a real estate developer goes bankrupt, there tends to be properties and other assets that a bank or other creditors can divide up to recoup some of their losses. When a software company goes bankrupt, there is not much of anything left besides physical computers, office furniture, and zeroes in the bank account. There is not much left over for its creditors. Software startups have a higher risk than other companies. They also tend to have the potential for higher income and higher profit. As I have often heard, software startups either win big or go to zero. There is often not much in between.
The 3 Fs
There are lots of options to get some amount of funding. Who are the first people that you should look at? The easiest ones to start with are the people closest to you. These are commonly referred to as "The 3 Fs". This stands for Family, Friends, and Fools (no one uses the last F in front of anyone, so it may also be referred to as 2Fs). They are the easiest to contact and talk to.
A few words of warning with regard to the 3Fs:
- Don't assume that all you have to do is make a quick pitch, and you will get money from the 3Fs. These people are investors and should be treated like that.
- A failure can make for an awkward get-together. Do you want to sit down for Thanksgiving with the family and start an argument about losing money from your startup?
- There are stories about families that mortgage homes to invest in a son's/daughter's technology startup. Do you want to have this on your conscience? How about a cashed out retirement plan? If you talk one of the 3Fs into investing from it, a failed startup can make for real awkwardness thereafter.
- Don't look at the 3Fs as the mechanism to fund your company for a long time. You can get a few shillings from these folks. This will be enough for you to take care of some immediate needs, but these people won't typically give you millions and take care of you for 24-36 months.
The 3Fs will typically get somewhere in the 5- to 10-percent range based on investing somewhere between $5k and $15k and being the first investors in the company.
Looking for Angel Investors
Most of us are familiar with the concept of a guardian angel. In investments, angels are a similar concept. An angel is typically a high-net-worth individual who has an interest in either you or the technology that you are working with. Angels will tend to invest with their own money. I have known several angels, and the common theme is that these people have been entrepreneurs and are willing to invest up to several million dollars through a number of start-up companies. These investments are typically somewhere along the lines of $50k and $500k. Depending on the status of the company, they will get between 10- to 25-percent of the company.
Along with individual angel investors, there are angel groups. The members of angel groups will tend to be angels who may work together as a group or do deals individually.
One thing to be careful of with angels is that because they're often high-net-worth individuals, they get hit up for money all the time. If someone somehow gets their private phone number, e-mail, or contact info, these people will be inundated with proposals and requests.
I sat at lunch once with my father when one of his friends, an angel, got a call asking for several million dollars for a startup. This call came from out of the blue and was from someone who the angel had had no interaction with before the phone call. The angel returned clearly frustrated that his private weekend lunch had been interrupted. There was never going to be an investment anyway, since this was outside of the angel's area of interest.
Some of the lessons I have learned from discussions with angels and their interactions with entrepreneurs:
- "Don't pitch me on your time bro." Just because the time is convenient for the entrepreneur, it does not mean that the time is appropriate for the angel. If you want to pitch an angel, call them via formal channels and make an appointment.
- Just because you have an idea, and they have money, it does not mean that an angel is interested in your idea. Don't think that the money will magically flow. You need to have a valid business plan with realistic goals in it.
- Angels have a fairly long time horizon. Entrepreneurs don't need to make money day one, but they do need to be able to get to income and profit at some point.
- Angels have very little time in their lives. You only get one shot with an angel. You have to have all of your facts and know your numbers. Don't think that an angel will meet with you multiple times even if they say that they will. It just doesn't happen. Have it all right the first time or don't schedule the meeting to begin with.
What VCs Can Do
Venture capitalists are at the top of the food chain when it comes to entrepreneurs. VCs are companies that have funds that can provide up to hundreds of millions of dollars to your company. VCs can often make available multiple rounds of investment. VCs are looking for somewhere between 20 to 40-percent of your company per round of investment.
A few of the key things to understand about VCs:
- VCs raise money via funds. These funds open and close, so they will have a deadline associated with them. For example, a fund may have a ten-year lifetime, open in 2016 and close in 2026. That means that you will need to have a plan, so that the VC can get their money out of your company before their fund closes; money must be reimbursed back to their limited partners in 2026.
- VCs don't just invest their own personal money. A lot of their money comes from what are called "Limited Partners." LPs could be nearly anyone from a retirement fund to an investment bank to a billionaire investor. VCs can be independent companies or part of a larger company such as Intel, Google, Microsoft, or even The Coca-Cola Company.
- There are many people that work for VC firms. Any contact is good, but don't get too excited until you get the opportunity to talk to a senior partner. Typically, senior partners are the people that vote on whether or not a VC firm makes an investment.
- Meetings with VCs, and angels, take months to get to the point of a yes or no on investing. This isn't a bad thing for either side. It gives both sides the opportunity to feel each other out. While the TV show "Silicon Valley" showed VC offers being made within hours/days of a first meeting, this is fairly rare (the process is sped up for TV). It can take months to get a deal done.
- VCs often only fund 0.5-percent of the companies that they meet. So, don't get down because a VC did not fund you.
- The VC system is based on making a bunch of investments that can make a 20+ times return on their investment. VCs are interested in investments that can make a large amount of money. Linear growth and profitability may be good to you, but it may not be enough for a VC. VCs want the ability to get a major win out of their investments. They want to make an investment of $5 million and get $100 million out of the investment. This will make a sizable return on their investment and help them pay off their limited partners.
- VCs have a large network of contacts. Don't be afraid to ask them for help.
- At the same time, the people who work for VC firms are people. You can ask them for help on some things, but don't expect a huge amount of their time.
You may or may not have just one round of funding that you go through. The first round is generally referred to as a seed round. The general terms for these further rounds are referred to as A, B, C, etc. For example, Uber, the darling of the moment in the startup world, is currently in an E round of funding.
One of the questions that comes up is why do companies need all of these series of funding? There are several reasons for this:
- Startups are high risk. Typical consumer banks that provide home loans are not going to loan money to technology startups. Startups are just too risky for them. Angels and VCs are much more comfortable with this risk and know how to work within it.
- Startups are typically too small for investment banks.
- While the goal of a business is to make money, it takes money to make money. The company may not be able to generate the amount of money to hire 2 or 50 new people, expand overseas, or to start work on a new product/service.
- Between the series of funding events, it is important to continue to generate value for the customer, generate income for the company, expand the number of customers, and expand the number of features that your company can provide to its customers. Growth in the way of paying customers is important at all of the stages of funding. You want to grow the value of the company so that each time a funding event occurs, the company is worth more.
During the course of these series of funding, original investors are diluted. Their ownership stake and that of the founders becomes less and less with each round of funding. For example, Google's Larry page and Sergey Brin had approximately 15 percent of the company at the time of its initial public stock offering. As long as the value of the company goes up, this is okay. If the value of the company goes down between rounds, this is referred to as a down round. You want to avoid a down round as much as possible.
Getting the Money Out
How do you get the money out for your investors? There are three types of events that I am familiar with. These are:
- An ongoing business. There is nothing wrong with building a company to have it run as an ongoing private company. This is just fine for the 3Fs that own their 5-to-15-percent. This is probably just fine with the angel investor who continues to get paid off via disbursements to ownership. VCs will not be interested in this type of company. They need some event that will allow them to get their money out so that they can turn around and pay out to their Limited Partners.
- Merger and Acquisition (M&A). In a M&A event, big company A shows up and buys your startup. Everyone with an ownership stake makes money from this. VCs may grumble if they don't make enough money on this. They may have language inserted into their funding contract that gives them special rights in situations like this depending on the amount of money involved in the M&A event.
- Initial Public Offering (IPO). This is the holy grail of events. Everyone loves it. This tends to be the highest paying outcome for company ownership. This is also the least likely of the events.
What are you going to do with the money? You have to have a plan before you talk to anyone. This must be much more detailed than, "We're going to spend $25k on advertising and $250k on a couple of engineers" and such. There needs to be more detail than looking like something that has been white boarded in a few minutes. Come up with a good plan that you can articulate and feel comfortable about being accurate. Angels and VCs hate generalizations and want to see specific plans. These plans will almost definitely change. You should be open to changes as these are driven by the marketplace. Don't worry, angels and VCs understand that things will change. Don't be tied to your plan, especially if it becomes clear that the marketplace wants something different.
I was involved with one startup where the managing director refused to listen to the marketplace. Nothing was as frustrating as going out, talking to potential users, putting together what we needed to change, and listening to him scream like a parakeet cackling, "That's not my plan!"
Funding Your Operation
Each situation is unique. Some will need more money. Other startups will have fewer needs. In my current situation, I am not interested in external funding. If we get to the point of proving that a marketplace exists and that customers will pay for our product, we will be open to exploring external funding. This may not be realistic for your business. If you do receive external funding, you must be realistic regarding what this means. You have not won the lottery.
What About A Salary?
The question of salary for a founder is one of the most contentious. Some people believe that being compensated with stock means that someone is not eligible for a salary and vice versa. First off, this is a negotiating position. Whatever the members of your startup group can negotiate between each other is what you get. Several of my thoughts and experiences are:
This is an issue where people tend to get jealous. Be careful, but be open.
If a startup cofounder is to give all of their effort, they need to be comfortable enough in their income so that it is not a distraction. Banks, utilities, and the grocery store don't take IOUs based on startup stock.
I was once offered 5-percent equity in a startup to do all of their development, travel to do application validation, and take on all the expenses and risk. For this, I was offered nothing to offset the expenses that I would entail or anything to be on the front line with their customer. I share this not to be negative towards what happened, but to show that people will make offers that do not make sense. It is your responsibility to negotiate an offer that makes sense for you.
The biggest suggestion is to negotiate not just on what is happening at this moment but what is going to happen over the next 18-24 months.
Duties and Obligations
When your company gets external funding, you have a responsibility to those people. This is referred to as fiduciary duty. A fiduciary duty means that you must provide the highest standard of care to that person. You must be extremely careful with that group's money. You will want to treat it as if it is your own. You cannot play favorites. On a payout, everyone gets paid.
When spending money, don't be a drunken sailor on shore leave and spend it all with nothing to show. Don't just pay a $20k/month salary to yourself. Be reasonable, be frugal, be smart. Think about an Amazon.com desk. When Amazon first got started, Jeff Bezos' desk was a door taken off the hinges and placed between two saw horses. Don't think of a $20k desk for yourself.
In this article, we've looked at various investor types for your startup, how you should work with them, and the magnitudes of money that you can expect to get from them. Along with this, the article has covered the question of whether you need outside funding or not.