One of the questions I often get from would be founders is ‘Where do I get the money to do my startup?’ This is an interesting question that has been covered in a lot of introductory business books and beyond. Here I will highlight some of the interesting facts about how to find and raise money to found your project.
First, be aware that most conversations regarding funding result in a “not right now” or outright “no” answer. You need to get used to approaching people with your idea and having them not invest for one reason or another. These are often not commentaries on your idea, you as a person, or your talent. There are many things that go into the decision about whether or not to invest in a startup.
We should also highlight that the initial money to fund a business model comes from a few sources including the classic three F’s: Friends, Family and Fools. This is a tongue in cheek way of saying that the initial funding for any business model is often extraordinarily high risk and that only someone who really cares about you or who is very foolish should invest in your new, unproven idea. Shows like ‘Shark Tank’ etc. highlight that business models that have income or demonstrable sales can be valued a lot more readily in different ways than brand new ideas with new, novice, or even an experienced team.
After the initial business model is created and funded by the three Fs or even the founding team itself, there are additional sources of funding that can come in different rounds. One of the ways you can obtain seed funding for your business is with what’s called angel investors. Angel investors are individuals or teams that provide seed funding according to certain criteria. Often teams have what is called an investment thesis. An investment thesis describes that team’s approach to investing, the niche in which they choose to invest and other important factors they consider when it comes to investing.
In addition to the idea of an investment thesis, you may be interested to learn some factors that venture capitalist are well aware of. It is important to understand some of the interesting consequences of an investment thesis, whether that be for a venture capital (VC fund) or an angel investment team. There are other important facts as well. First, interestingly, 99% plus of cold calls, meaning deals that come to a venture capitalist or angel investor which are not referred to them by someone they know, fail. This is an incredible attrition rate and one well known to VC and angel investors. In short, if high quality deals are not introduced by people the VC team knows, there is already a known substantial failure rate.
Next, interestingly, you may be surprised to hear that the vast majority of VC is in one of two geographic areas. This is the Silicone Valley area and the Boston / Greater Metropolitan area of Boston. In other words a great deal of the United States VC funding occurs in one of these two areas and of these two the Silicone Valley / Stanford area has significantly outnumbered the Boston area in terms of total amount invested and other measures like the number of startup boards on which a given venture capitalist sits. (Many VC team members sit on multiple boards.) These are indicators of VC activity and really highlight the geographically narrow venue for VC in the United States. Other centers are starting; however, these two comprise far and away the majority of VC in the United States.
So, when you go to take on investors for your newly minted business, it is again important to realize that often their decision to invest or not invest is not a direct commentary on the quality of you, your idea, your team or your experience. Importantly, in fact the VC / Angel Investors decision is often contingent on their investment thesis. You may not be in the area of interest or expertise for the Angel / VC investor. They may refer you to someone who is. Again, remember, there is a great deal of failure before success when you are seeking seed or series A funding.
Last, there are some interesting consequences to VC and Angel funding, which we could easily fill a book with. One of the more interesting ones, and least understood ones, is called liquidation preference. This is the manner in which venture capitalist or angel investor extracts their money in a so-called exit event from the company.
An exit event can be, for example, when the company is purchased by another company. Purchases such as those constitute the majority of exit events. Then, what is known as the ‘stack’ gets executed. The stack, if you can imagine as a stack of a deck of playing cards, means the last round of investors are paid first from the top of the stack etc, down to the your initial or seed investors at the inner most layer. The manner in which payouts occur is called liquidation preference and there are many interesting factors in liquidation preference. Before you start a company and take on investors I encourage you to read and learn more about liquidation preference. For now, let me share that liquidation preferences often cause a misalignment between the interests of the investor and the initial startup designer and owner.
Investors become part owners of the startup in almost every deal. However when an exit event occurs there can be significant misalignment between the investor-owner and the initial startup team’s interest. These may be owing to liquidation preference. Interestingly, the liquidation preference sometimes means that the investor owner would be willing to sell the company for a much lower amount than the initial startup team. Again, liquidation preference is often misunderstood and has significant consequences for eventual payout from the startup in the event of an exit strategy execution. For more information regarding liquidation preferences, exit strategies, and how these may impact your startup idea along with investor opportunities I would perform a quick google search and learn all you can. Specifically focus on terms like “1x”, “participation”, and “cap”.
In startups I have helped perform we use multiple techniques to keep everyone aligned. These include some classic techniques like dynamic ownership equity and liquidation preferences that attempt to keep everyone’s interest in the company aligned, so the company can move forward as a team. These are just some of the challenges and nuances of startups and some of the ideas that make starting a business so interesting and so much fun.
In the next blog entries we will describe other interesting facts about business model innovation and how to mitigate certain risks while accentuating the benefits of a startup. I would also add that one of the single most useful tools in business model innovation has been the concept of dynamic ownership equity. I first encountered this concept of dynamic ownership equity in a text by Noam Wasserman, from Harvard press called The Founder’s Dilemmas. For more information regarding tools to improve alignment in your fledgling business model I invite you to take a look at that useful text.