Funding, the ABCs, post #5 of “Startup Briefs”

It is very important to understand the different types of funding, the different types of funders. Remember that any investment is an investment into YOU, so you had better be well-versed in the terms and conditions of private investment. You had also better be up to the task of fundraising. To help you along that path, I present a basic outline below of types of investment/investors. Without thinking about these as sequential, it is very important that the first-time entrepreneur understand the various types of funders and funding approaches. While we will begin with sources of non-equity funding, I will progress through sources and types of equity funding. For specifics on equity vs. debt, please look out for the next post, #6 in the “Startup Briefs” series.

1. Bootstrapping

The first to think about is bootstrapping. The term stems from picking yourself up by your own bootstraps (literally). It is helpful to think about this approach as an early way to to de-risk your deal for future investors. Meaning, do as much as possible yourself. Be the first investor in your own startup. Invest in your idea by doing everything that you can to move forward prior to raising money from outside investors. Think of Steve Jobs and Steve Wozniak in the garage. Think of building a prototype, testing it, conducting customer discovery and validation – all of this BEFORE you ask for other people’s money. Investors want you to have some skin in the game, so put it in and do what you can on your own. Investors also want you to take the risk out of it for them, so lower the risk by proving that: a) you can build it; b) customers want it: c) customers are willing to pay; and d) you know how to get to the next steps. As much as you can, bootstrap. This varies from industry to industry of course. It’s very difficult to bootstrap in the life sciences space, for instance. That said, the tenant remains, do what you can and lower the risk for investors.

2. Federal Funding

Next you might look towards the White House. Federal funding is awesome. Grants are non-dilutive. While some folks complain (naively I think) that grants take a long time to get, I think that they don’t understand how hard it is to raise equity funding. Go for Small Business Innovative Research (SBIR) http://www.sbir.gov/ and Small Technology Transfer (STTR) awards. EVERY agency in the federal government has a set-aside for grants to small businesses. They are prepared to invest in high-risk early stage startups. Duh? Go for these! Understand the rules and DO YOUR HOMEWORK. Talk to the program managers well in advance. The NSF SBIR program  (and this agency originated the SBIR program), for example, can be close to a million dollars by the time you consider Phase I ($150,000), Phase II ($750,000) and the sub-phases in between (like Phase IB and IIB). We are not talking about chump change here. And with an agency such as the NIH, the dollar amounts can even be higher. If you have legacy with the NSF, go for their Innovation Corps program (I-Corps). It’s not a lot of money but it is great training. Other sources of grant funding need to be researched based on your geographical location, industry, and other factors. I would encourage all first-time entrepreneurs to look seriously at grant programs.

3. TBEDs

TBEDs are your next bet. Often, these “technology-based economic development organizations” will be the first outside money in a startup. Why? Because they are non-profit, state-funded organizations that are measured by job creation, which means they will take risk and invest in early-stage startups. In Pittsburgh, for example, we have several such TBEDs: AlphaLab, AlphaLab Gear, Idea Foundry, Innovation Works, Pittsburgh Life Sciences Greenhouse, and Thrill Mill. That’s not even mentioning co-working spaces, such as RevvOakland, The Beauty Shoppe, Startup Town and others. What form do investments by TBEDs take? Often, the mechanism of investment is convertible debt. However, many accelerators offer straight equity: $x for y% of the company. Usually, the investment is around $25,000 for 5% of the company. This formula “values” a company arbitrarily at $500,000. But the valuation is not what an accelerator is about. A good accelerator is always about the network, the training, getting to the next stage. The most well-known accelerator is probably Y Combinator. The founder of Y Combinator is Paul Graham, an icon in Startupsville (Silicon Valley), although originally from Pittsburgh. In Pittsburgh, we have TBEDs (mentioned above) which are also accelerators. Each has its own flavor and focus. Do your homework. Visit all of the accelerators and TBEDs in your area. Talk to the leaders. Do due diligence on past participants. What did they gain from the experience? What was the most valuable learning? Figure out which program is best for you. Then hedge your bets and go after a couple of them!

4. Friends & Family

Friends and family fit in here somewhere. Not everyone will agree with me, but I believe that showing some demonstrable skin in the game is a good thing. Investors will like that. It is less about the amount of money that your friends and family invest in your startup then about the fact that you believe in it so much that you went to them with your funding needs at the earliest stages. We call that “commitment.” Do yourself and your friends and family a favor and give them a professional deal, like convertible debt. Or, put them into a deal with a TBED so that they are not on their own. Make it clear to them that they might lose their money. But make it clear to them also that you will do your best to create something of value that will benefit them. Don’t feel that you would rather do it on your own. Outside investors will wonder why didn’t you go to your friends and family? Do you think that it’s easier to raise money from strangers?

5. Angels

Angels, what a lovely word. You know the story don’t you? Here goes… Once upon a time there was a rich man who had promised a young playwright that he would produce his play on Broadway. Before that happened, however, the rich man died. The playwright went to the widow to ask if she would still back him. She refused. But, a couple of weeks later she went through her husband’s desk and found a check written out to the playwright. Wanting to fulfill her husband’s wishes, she gave it to the young man, who then declared that the man was an “angel” since the money came down from heaven. Cute, right? But make no mistake, an angel’s investment in your startup is a financial transaction. For which there is a price and a set of expectations. You need to know what both mean. An angel invests his or her own money. Why do they do this? Maybe because they believe in you? In your idea? Maybe they are/were an entrepreneur themselves? Maybe they are an expert in your industry? Maybe they are a junkie for entrepreneurship? There are many reasons why an individual might want to invest in you and your startup. But, as a financial transaction, they expect to get their money back with a return. Angel investing is not charity. It’s an investment. Thus, like any investment, you need to explain why you need the money, what you will do with it, and how it will build value, not just for you and your company, but for the angel. How will they get their return? And please don’t say from profits! Only inexperienced entrepreneurs believe that they will earn so much revenue that they can pay dividends to their shareholders. A few statistics about angels from the Halo Report put out by the Angel Capital Association:

• In 2013, angels invested approximately $25B.
• This amount represented 71,000 deals.
• The average investment was approximately $600,000.
• 73% of angel deals are co-invested with angel groups and other angels.
• $2.5M was the median value of the companies.
• The annual Internal Rate of Return (IRR) expected on an angel deal is 27%.
• Many angel deals are done with angel groups. Our local angel group is BlueTree Allied Angels.

6. Venture Capitalists

Venture Capitalists are professional investors. While some of them may have been former entrepreneurs, these are a group of folks who have investors themselves. Therefore, they are obligated to provide returns to their investors, which are called limited partners or LPs. The venture capitalists themselves, called VCs, are likely the managing partners of a fund. It might be fund #1 or fund #11 depending on how successful they have been providing those returns to their LPs. Realize that VCs are not like angels. Whereas angels invest their own money, VCs invest other people’s money. They may have money of their own in the fund but they are investing money that they raised from other individuals and organizations. VCs raise their money from individuals and organizations/institutions like universities, retirement funds and other pools of capital where having a small amount of their overall portfolio invested in high-risk investments (like VC funds) is acceptable. VCs make their money in what is called the 2 and 20: ~2% of the fund goes to the VCs and their operations annually; ~20% of the returns goes to the VCs (actually the amount is less than 20% as usually the LPs get their money back first and then the split happens with the VC managing partners). Some interesting data about VC investments (from the MoneyTree™ Report by PricewaterhouseCoopers LLP, PwC, and the National Venture Capital Association, NVCA, based on data from Thomson Reuters):

• Venture capitalists invested $48.3B in 2014.
• This represented 4,356 deals.
• That was an increase of 61%i n dollars and a 4% increase in deals over 2013.
• This also represented the highest dollar amount in a decade.
• Perhaps skewing the data, this represented two deals over $1B and more than 40 megadeals, with investments exceeding $100M.
• Seed stage investments fell 29% in terms of dollars and 18% in deals with $719M going into 192 companies, the lowest number of seed deals since 2002.

7. Corporate Venture Capital

Corporate venture capital is another potential route for investment. Corporate venture capital refers to the investment by existing companies into startups. “Tech giants like Intel, Dell and AMD all have strong track records with their proprietary funds, and more companies like Microsoft and Salesforce are now entering the venture-fund game. During the past four years more than 475 corporate venture funds have started, bringing the worldwide total to more than 1,100, according to Global Corporate Venturing.” (from a DEc 2014 article in Entrepreneur.com). Large firms want to innovate but their corporate culture, size and general lack of flexibility make innovation a challenging goal to achieve. Such firms will often look to early stage companies for ideas and technologies that are strategic to their core businesses. Crunchbase found that about one third of startups funded by corporate venture capital are acquired vs. about 10% of venture only backed companies. In 2014, corporate venture deals accounted for 1,068 deals worth $19.6B. This comprised nearly 20% of all deals and 40% of transaction value worldwide. Corporate venture capital can be attractive because it is based around strategy more than financial returns. Your corporate venture partner might just be your acquirer. However, I caution entrepreneurs on relying on corporate venture capital: deals can be slow in the making; priorities of the larger firm can change, leaving your project on the cutting room floor; and the deal structures can have clauses that might impede growth in the future.

In conclusion about types of investors and investment, do your homework! Know what stage you are at, how much you need to raise, what you have accomplished to date to de-risk the investment, and don’t be naïve about fundraising. Know who you are raising money from and why. What is in it for them?