An Introductory Guide to Startup Funding

Getting a startup funded isn’t easy. There’s no shortage of hype, and multiple announcements daily of new companies getting money. And there’s an equal (and growing) amount of chatter about a “new bubble” that we’re entering. Still, raising money is far from a cakewalk.

Most people I’ve spoken to say it takes a solid 4-6 months to raise money. Mark MacLeod, CFO at Mobivox, echoes those thoughts (Mobivox recently raised $11 million dollars.)

Sure, it can happen faster than that. In the hottest startup hubs it might seem like everyone and their brother is getting funded for something. Don’t let that fool you.

You might also think that everyone knows everything about startup funding, but that’s not the case. Recently someone sent in a question asking about the differences between angel and venture financing. With that in mind, I’ve put together a brief, introductory guide to startup funding.

1. Can You Boostrap It? Should You?

Boostrapping means you fund your startup on your own. Scrimp, save and squeeze by on the minimum you can. Guy Kawasaki does a good job of explaining how to bootstrap, and in most cases, every business starts out this way.

The principles behind bootstrapping – watching every penny, weighing spending options versus return on investment, doing more with less – have merit regardless of your funding situation. Companies that raise lots of money tend to overspend (and spend poorly); they forget about running lean & mean.

Sramana Mitra says bootstrapping is becoming sexy again. Certainly, second and third-time entrepreneurs are bootstrapping more; in many cases they can afford it. I think the bigger trend is in small angel/seed financing rounds to help kickstart companies.

The advantage of bootstrapping is simple: you retain control. You’re not diluted (by investors), there are no additional chiefs (read: board of directors, influencers, etc.), you can go at whatever pace you see fit and retain your vision. Bootstrapping gives you control.

But the disadvantage of bootstrapping is a lack of capital (unless you’re rich.) That lack of capital can be a significant constraint. Of course creativity loves constraints but there’s a limit on that. If you can’t afford to keep the business moving forward, you’re in trouble. And first-time bootstrappers frequently under-estimate what things will cost.

A final note on bootstrapping: You might think it’s an “either or” option — bootstrapping vs. raising money — but it’s not. Venture capitalist, Matt Winn makes this point clear in his VC view of bootstrapping.

2. Love Money

I love money, too, but that’s not what I mean. “Love money” is money you get from friends and family.

This is an extremely common way of raising money. From Connecting People I found out that:

“…$100 billion ‘friends and family’ money is used annually to fund 3 million start ups. This compares to only $25 billion through venture capitalists. The average amount invested by friends and family is between $20,000 and $25,000, and further, 58% of the fastest-growing companies in the U.S. started with $20,000 or less.”

If you can get, go for it. The benefit is that it should be easier to get the money (vs. raising from outside sources), and you’ll gain some experience pitching in a friendly environment. The disadvantage is that you run the risk of ruining personal relationships. And, unless your friends and family are wealthy, $20-$25k won’t get you that far.

3. Angel Financing

This is where the real action and opportunity lies for entrepreneurs. We’re seeing the most movement in the angel & seed financing space.

Venture capital firms are moving into the space, developing early stage programs (some already exist like Charles River Venture’s QuickStart Program). And of course, we have the now-famous, Y Combinator which turned the entire early stage funding market on its head. It was followed by a similar program called TechStars (and others.)

And in-between Y Combinator and VCs we’re seeing angel funds pop up like Montreal Startup which attempt to blend the VC and angel worlds into one. Jeff Clavier’s new SoftTech VC II fund is another good example of this — a $12 million dollar fund dedicated to seed funding between $100k-$500k.

VCs are moving into early stage financing to get access to the freshest deals and brightest, new entrepreneurs. It makes complete sense, although they still have to change the way they invest and their mentality towards investment. Bernard Lunn makes the point clearly in his article: New VC Model For Small Scale Financing:

• Early stage Web 2.0 companies need way less money to get started.
• The pace that companies get to market and develop is much faster.
• There’s less risk putting $250k at work versus $2.5 million.

Be wary of the VC that claims they’re interested in early stage financing but has yet to complete a deal. Or the VC that still wants to overload you with paperwork, complex terms and endless amounts of due diligence.

Carl Showalter does a good job of explaining why you don’t need big money from VCs to get started.

Angel and seed financing comes into play before a business has launched its product, or shortly thereafter. It’s the money you need to make it happen out of the gate. Generally, there are a few sources of angel money:

1. Venture Capitalists. I’ve already mentioned this group. You can expect “heavier” deals by involving VCs, but they’re more accessible than other investors.
2. Strategic Angels. A strategic angel is someone with industry or domain expertise in what you’re doing. For example, if you’re starting an e-commerce business, Pierre Omidyar would be a very, very strategy investor. In the Web 2.0 world another strategic investor would be Reid Hoffman. Having strategic angels is great, because not only will they provide some cash, they’ll provide expertise, contacts and legitimacy to your fledgling startup.
3. Non-Strategic Angels. When most people think about angel financing, this is who they think about — wealthy people looking to diversify their portfolios (and perhaps have some fun) by investing in startups. Lots of people fit into this category: businesspeople, doctors, entrepreneurs, etc. If they have money and want to part ways with it for a “piece of the action” they’re potential angel investors. Often, these angels work together in groups – angel networks – to share opportunities. The problem is that it might be hard to find non-strategic angels, even if they might be the easiest to raise money from (since they’re typically the least scrutinizing.) But they don’t often publicize their interest in angel investing, so finding them can be tricky.

A few more points about angel and seed financing:

• Amounts range from $25,000-$1,000,000. Venture capitalists that play in this area will often look at the $250,000+ range, whereas individual investors will be (typically) less. The higher you go, the closer it gets to a Series A (described below), which means more effort and paperwork to close.
• The most popular structure for angel and seed financing deals is convertible debt. At least that’s the current trend. I’ll let others (more knowledgeable in this stuff) explain convertible debt.
• If you’re raising a seed or angel round, keep it as simple as possible. You can’t afford to get buried in process and paperwork at this stage. But please, please, please make sure you understand it fully and you’re comfortable with it. This could very well be the most important money you raise.
• Just because you’re keeping it simple and only raising a seed round doesn’t mean it won’t take 4-6 months to complete. Craig Hayashi has a nice angel investment timeline you should take a look at.

4. Series A Financing

Series A investments can happen at a fairly early stage – just after launch, for example – depending on how long the company has existed beforehand. A company with lots of technology and heavy intellectual property (IP) might have taken a couple years to get off the ground and already need a Series A when it launches.

But in most cases, a Series A is used once the company has shown some traction and needs more money to expand. It’s the money that will take you to new heights, massive revenues, cash flow positivity and a huge payday via acquisition (or some other exit.) At least, we hope that’s the case!

Series A financing ranges a great deal: think $2 million to $10 million or more. Depends on how much money you need, the valuation you can get for your company and what investors are willing to put in.

Series A financing typically comes from venture capitalists. And at this stage, you’ll want to bring in the strongest partner possible; the VC firm with the most experience in your space, the highest pedigree and the most success stories.

Final Funding Tips

Here are some final thoughts I can leave you with:

• Be prepared to pitch a lot. Don’t get discouraged. Refine your pitch. You will get better at it.
• Get organized. This sounds silly, perhaps, but the more organized and professional you look, the more comfortable investors will feel. This is especially true when it comes to presenting financials. Use a real financial model (not the back of a napkin!)
• Get help. Seek out the advice of mentors, advisers and lawyers. A good lawyer can really help with more complicated deals.
• Do your own due diligence. You’re about to get into bed with someone, you might want to check what they have under the covers. Don’t be afraid to ask for references. Go ahead and contact other companies your potential investors have put money into. Make sure you’re comfortable; because your investors are going to be major influencers on your company’s success.
• Never stop fundraising. I’m definitely not in love with the fundraising process, but there’s no point stopping. Keep building relationships with investors, keep nosing around for opportunities. When the time is right to raise more money you don’t want to be starting at zero.

Great Resources on Financing

The best way to get a good deal is to be informed. Here are some necessary resources for anyone looking to raise startup financing:

• Get Venture
• Venture Hacks
• Wil Schroter’s Bigger Blog
• Don Doge on The Next Big Thing
• Ask the VC
• Ask the Wizard
• Fred Wilson’s A VC
• Paul Graham