The $250,000 Funding Trap

$250,000 is a lot of money. Venture investors might not think so, but for most of us it’s a lot of moolah. And for early stage startups it’s often the amount they ask for coming out of the gate (or $500,000 – which seems to be pretty standard as a first, seed ask). The problem is that $250,000 is a dangerous amount of money to invest in an early stage startup.

For first-time entrepreneurs, $250,000 sounds like a million dollars. Maybe more. They’ve just raised money, they feel like giants ready to take on the world, they feel validated, and success is guaranteed! So they start spending. Office space. Office furniture. Business cards. T-shirts. Introductory video about their business. And then they spend more – particularly on hiring. All of a sudden, a founding team of two is a small startup of five.

The problem is that $250,000 runs out very quickly. And the milestones needed to raise the next round of financing are either not properly defined (and then it’s just a wishy washy mess later on), or they’re unrealistic. Founders – with their pockets bulging full of cash – get distracted from the core of building a product that customers want, and all of a sudden those seemingly easy-to-hit milestones 6-9 months out are impossible, and the company is losing momentum. This experience may be inevitable (think: The Startup Curve and the Trough of Sorrow), but it’s made particularly worse and potentially deadly when a startup doesn’t have enough capital.

$250,000 is a lot of money. I don’t like the idea that people can be flippant about spending that kind of money when there are many, many ways that money could be used for something useful in the world. But psychologically to startup founders it seems like even MORE money than it really is, and that puts a lot of startups into trouble. It results in a lot of startups struggling to raise follow-on capital, and ultimately failing before they even have a chance to succeed (what I’ve called Startup D.O.A.)

At Year One Labs we decided to invest up to $50,000 per startup. This is more than typical accelerators/incubators but far less than $250,000, or even $100,000. The thinking was that anything more than $50,000 and entrepreneurs would more readily make mistakes with the money. Anything less and they wouldn’t be able to survive (for up to 12 months in the program.) We didn’t want founders starving to death, but we also didn’t want them feeling comfortable or overly confident in their ability to spend. One thing accelerators and incubators have done successfully is chip away at the early stage $250,000 funding rounds. They make it possible and acceptable for entrepreneurs to take a lot less money, but get a lot more help and guidance. That help and guidance, the mentorship and focused access into key networks (of partners, other entrepreneurs, investors, etc.) is a value that traditional venture investors and even angel investors don’t provide (at least not on a consistent basis.) More startups will emerge further along with more traction out of relatively short accelerators than they would have with $250,000 in funding (and less value-add). They can then raise a more substantial follow-on round and give themselves a proper runway.

Going from a $250,000 round to a $500,000 or $1M round is extremely difficult. Founders are given too much flexibility to make too many mistakes with $250,000 in their pocket, and they realize (often too late) that they’re out of money, and haven’t hit key milestones. They also get too distracted (with that amount of money) but also realize that they have to start raising almost immediately, which is a further distraction. One advantage of (most) accelerators and incubators is the focus of a demo day that brings a lot of concentrated investor interest at one time. That can speed up some of the normal process of fundraising, which is great.

This isn’t meant to be a pro-accelerator/incubator post per se. I’ve certainly raised some concerns and issues with the accelerator model. But I’ve seen a lot of companies raise $250,000 or thereabouts only to run into a heap of trouble after the fact. These startups were most likely not able to raise more (even if they wanted to), so they go with a lower raise. Investors may look at this as hedging their bets instead of investing too much too early, but I think they are doing startups a disservice.

October 5, 2011 Posted in Startups by

  • Anonymous

    I often use the phrase, not sure where I heard it, “the quickest way to destroy a man is to give him a million dollars”. The same likely applies to startups.. “the quickest way to destroy a startup is to give it a million dollars”

  • http://context.io Bruno Morency

    We raised between 250k$ and 500k$ and I can’t disagree with your assessment of problems you’re running into as the end on the runway is approaching. Especially with your point on expected milestones. Expectations can be managed but they can’t be forced. 

    That being said, I still think that amount was the right one to take at the time we raised it. The fact is, no matter how much you raise and at which valuation, it remains ?%$# hard to make it to the next level. Focus and extreme frugality (in spending and hiring) will take you a long way.

  • http://twitter.com/annatalerico Anna Talerico

    I couldn’t agree more—in the beginning more money brings more opportunity for waste and less laser focus. I would just also say whether the amount is $2,500 or $250,000 a strict budget can help with runaway ‘necessities’ like T-shirts and extra nice office furniture. Putting every single expense through the filter of ‘literally, how does it help us grow?’ can really make a difference when deciding on which foosball table to buy.

  • http://www.techentrepreneurship.com Helge Seetzen

    I think this has less to do with the amount and more with the currently “trendy” attributes of founders. Lots of hype in the Web2.0 space has created the illusion that product/tech guys make good entrepreneurs. Lean pivoting to a minimum viable product – and all that…

    What everybody seems to forget it that entrepreneurship isn’t about building products, it’s about building companies. Thus, the founding team better have the skills to understand financials (incl. cash flow forecasting), operations (incl. how to build a team and not just a loose federation of “ninjas”), product (incl. proper project management and not just “20 hour coding days”) and sales.

    What you describe above is simply a failure of basic financial and product abilities of the founders. No amount of financing will fix that (more or less).

  • http://twitter.com/alamnash Jordan Menashy

    Completely agree.  Let’s get to the root here, instead of striking at the leaves.  

  • http://www.instigatorblog.com Benjamin Yoskovitz

    As always, I appreciate your comments. I do agree that entrepreneurship is about building companies not products, and that a lot of newbie founders fail at building companies, because it’s not their expertise. I do think certain amounts of funding and certain circumstances cut the knees off of entrepreneurs and don’t give them the opportunity to grow into the roles of “businesspeople” – they don’t have the runway and/or the support when they raise too little and set expectations for the next funding milestone that are unreasonable. I’ve always believed that a certain amount of delusion is important, but there are gotchas in that delusion that cause stumbles (we all stumble) that turn into failures.

    But the broader point is very much around what are the best ways of building companies – and the post is designed to highlight circumstances that look like they’re helping where they very well may not be.

  • http://MainStStark.com Jeff ‘SKI’ Kinsey

    Sorry Ben, ANY amount of money given to startups is too much. It almost always is at exactly the same time, too little. Hence “up on” Main Street Startups, we don’t give them any. They earn every penny they raise. Of course, we work with entrepreneurs mostly in a virtual sense, and they continue to live at home [where ever or what ever that might mean]. But good insight into some of the behind the scenes thinking… thanks for sharing.

  • http://startupcfo.ca startupcfo

    Good post Ben. For startups outside the Valley in can take up to 6 months to raise follow on $ and often these seed rounds provide 6 months runway. Just does not work. I have seen many cases (in fact it more often that not) where seed funded companies need a 2nd seed round as they are not truly series A ready. This can be really dilutive to founders. Don’t spend until you feel you’re really close to product market fit and have truly engaged users.

  • http://www.instigatorblog.com Benjamin Yoskovitz

    So what do you recommend startups do? Do they raise more up-front? Do they raise a lot less, but just stretch the dollars? Does that mean *not* paying themselves a salary for awhile until they’re closer to product-market fit and know more about how to spend the money?

    The 2nd seed round or “bridge round” is deadly…totally agree.

  • http://startupcfo.ca startupcfo

    I’m going through this discussion right now with a company we are about to invest in. What I discussed this with them is the need for ‘controlled aggression’: don’t become your planned spend with the assumption that you will hit the planned milestones, because you likely won’t and when you find that out it’s too late to pull back without killing all momentum. So you actually need to spend *below* plan upfront and continue to operate as if you had incubator/ no funding until the signs are there that you can step on the gas pedal. Everything, including spend, should move up and to the right steadily.

    It’s an art, not a science.

  • http://www.facebook.com/pratyushagarwal Pratyush Agarwal

    I guess being on the receiving end, I beg to differ. I think giving enough money to survive, or hire/retain a key employee is really important, and not doing so, can greatly disadvantage a bootstrapping entrepreneur. Giving $2-$3K a month doesn’t leave too much space for wastage, but does give space for some genuine investments. It also gives the main founder a chance to recruit key employees for some money, instead of losing control by giving out too much equity. In the end, the investment they made in the founder pays off if the founder is in control, but if the founder loses control on the firm, then the incubator loses control on the firm. Ultimately, this can lead to a loss of a lot of time spent, and the loss of a potentially successful company. 

  • http://www.instigatorblog.com Benjamin Yoskovitz

    So what do you think of Eric Ries’ statements of late that startups should be more science and less art? He talked in an interview with Chris Dixon on TechCrunch TV about trying to standardize the startup creation process – particularly through accelerators (that are in his opinion a bit overblown right now) – and make it more analytical and scientific.

    Leaving it up to “art” seems a bit wonky.

  • http://MainStStark.com Jeff ‘SKI’ Kinsey

    Interesting points Prat. If you [or a co-founder] cannot raise funds, your business probably won’t make it. And yes, give up too much equity, and that ultimately can lead to failure. Good points, thanks for sharing.

  • http://context.io Bruno Morency

    I kind of feel like the more startups try to act like they should follow a standardized process the more they lose their biggest advantage against incumbents. Taking a process, optimizing it and milking it as long as possible is what established companies are good at.

  • http://startupcfo.ca startupcfo

    I am exploring how lean principles can be applied to VC. There is clearly room for more science. But there will be clear objective proof of the merit of his theory: startup failure rates should go down. Yes, through lean practices you may decide to stop doing it, but that aside if he’s right then failure rates should go down

  • http://startupcfo.ca startupcfo

    Agreed. Eric’s stuff is very useful but there is no formula and the startups and founders that kill it have luck and magic on their sides. That cannot be reduced to a set of processes.

  • http://startupcfo.ca startupcfo

    Just reading more stuff on Steve Jobs (kind of consumed with that at the moment). Great quote that we should all remember as we think about how far lean can take us:

    “If Apple and Steve’s incredible comeback teaches us something, it’s that when you are right and the world doesn’t see it that way, you just have to be patient and wait for the world to change its mind.”
    http://summify.com/story/To0HOy7Xrx2TACSo/gigaom.com/2011/10/05/the-tao-of-steve/

  • http://techarda.com sanjay hora

    I agree to an extent but a lot also depends upon the individual entrepreneur and the stage where their product is. Someone who has spent his/her own money to build a product will have a lot more respect for money compared to someone who has been lucky enough to raise the money on the strength of a powerpoint. 

  • Anonymous

    You are right on that too Ski. I guess, it differs on a situational basis, and on the company’s needs. IMHO its great when an incubator can work closely with the company/entrepreneurs to map out the least amount of money needed, and see that its being used properly. I think “no money” is almost a shortcut. 

    I dont know enough to comment/discuss much on this. What do you think?

  • http://MainStStark.com Jeff ‘SKI’ Kinsey

    On the StartupBus, to succeed you need the ability to fundraise.

    As the Japanese taught the world, the longer you take to design, build and deliver a car the more it cost. Pretty simple math.

  • http://twitter.com/jscournoyer JS Cournoyer

    I believe every startup is unique and requires its own
    funding strategy. It all depends on the people, the idea, the stage of
    development, and the milestones to be achieved with the funding.  My approach it to work with the
    founding team to come up with milestones that we both feel are aggressive but
    achievable, and fund to that, with a little buffer. The milestones should
    always get the company to the next value creation milestone, which is usually
    market validation. As a seed investor, that number will vary between $25K and
    $500K. There are many reasons why a company may run out of money before
    reaching its milestones, but a good investor should be smart enough to make the
    difference between the good and the bad and react accordingly. A lot of it is
    about setting the right expectations upfront. Make sure the interests are
    aligned. It’s really important for entrepreneurs and investors to partner at
    the seed level. When you do that, there are no surprises and the investors can
    be part of the solution. Getting to market validation is hard. Most startups
    don’t make it there. Communication is key. Most of the entrepreneurs and
    companies I have had the chance to work with in the past couple of years did
    not reach their milestones with the initial seed round and had to raise
    additional capital to get there, but none of them raised that extra money at a
    lower valuation because the interests were aligned from the start.

     

    As for magic formulas, I think they can be used to
    streamline (like product market fit) and even automate (like inventory
    management) processes that are crucial, but great companies are all about great
    leaders and people dynamics, and you can’t automate that.

  • Anonymous

    Will remember that lesson ans use it Ski, thanks.

  • http://www.instigatorblog.com Benjamin Yoskovitz

    Thanks for the comment JS – always appreciated.

  • http://grumomedia.com Miguel Hernandez

    Introductory video for a startup is money well spent, especially if it is a Grumo video. I’m bias cause I am Grumo.. Grr.. grr.

  • Marrywebpaper

    Photo Recovery, Media Recovery Software-Image Recovery Software to Recover Deleted Photos By Freshcrop

  • http://www.shggucheng.com Importer

    They’re willing to take risks because they are venture capitals, LoL

  • http://twitter.com/JohnTCrago John Crago

    $250,000 is a lot of money but it can run out very quickly if people do not know how to spend it wisely. The project should be planned carefully and a detailed research on the nitty grits is essential before jumping into a decision. A trustworthy adviser should also be needed so as to reach the goal.

  • Drkennedy

    thanks so much for such insight.

  • http://www.inflationeffects.com James

    Whether it is $250,000 or $25, it will turn into zero in one night if we don’t have a good plan on it. The point is how we use what we have, not to consider how much we have.

  • Pingback: Size Matters in Seed Investments

  • Pingback: ????????????10??? | ??????

  • Pingback: ????????????10??? | ?????

  • Pingback: ????????????10??? | ?????

  • Pingback: ????????????10???

  • Pingback: ????????????10??? | ???

  • Pingback: ????????????10??? | ??????

  • Pingback: ???????????? 10 ??? | dropBlog

Ben Yoskovitz
I'm VP Product at GoInstant (acq. by Salesforce).

I'm also a Founding Partner at Year One Labs, an early stage accelerator in Montreal. Previously I founded Standout Jobs (and sold it).

My bio »

or

Follow me on Twitter

Get updates and special content
When I publish new content, get it directly in your inbox. Subscribers will get special stuff as well not available on the blog (but I promise it will be infrequent + high quality.)
Get the Lean Analytics Book!
Awesome Jobs
Check out the job opportunities at my portfolio companies.
Startup & Investor Resources
Find Stuff
My Photos