5/25/2007

Technology Startup Funding in a Nutshell

"Venture funding works like gears. A typical startup goes through several rounds of funding, and at each round you want to take just enough money to reach the speed where you can shift into the next gear. Few startups get it quite right. Many are underfunded. A few are overfunded, which is like trying to start driving in third gear...

Friends and Family

A lot of startups get their first funding from friends and family...The advantage of raising money from friends and family is that they're easy to find. You already know them. There are three main disadvantages: you mix together your business and personal life; they will probably not be as well connected as angels or venture firms; and they may not be accredited investors, which could complicate your life later...

Consulting

Another way to fund a startup is to get a job. The best sort of job is a consulting project in which you can build whatever software you wanted to sell as a startup. Then you can gradually transform yourself from a consulting company into a product company, and have your clients pay your development expenses...

Angel Investors

Angels are individual rich people. The word was first used for backers of Broadway plays, but now applies to individual investors generally. Angels who've made money in technology are preferable, for two reasons: they understand your situation, and they're a source of contacts and advice. The contacts and advice can be more important than the money...

With angels we're now talking about venture funding proper, so it's time to introduce the concept of exit strategy. Younger would-be founders are often surprised that investors expect them either to sell the company or go public. The reason is that investors need to get their capital back. They'll only consider companies that have an exit strategy-- meaning companies that could get bought or go public...

Another concept we need to introduce now is valuation. When someone buys shares in a company, that implicitly establishes a value for it. If someone pays $20,000 for 10% of a company, the company is in theory worth $200,000. I say "in theory" because in early stage investing, valuations are voodoo. As a company gets more established, its valuation gets closer to an actual market value. But in a newly founded startup, the valuation number is just an artifact of the respective contributions of everyone involved...

The best way to find angel investors is through personal introductions. You could try to cold-call angel groups near you, but angels, like VCs, will pay more attention to deals recommended by someone they respect.

Deal terms with angels vary a lot. There are no generally accepted standards. Sometimes angels' deal terms are as fearsome as VCs'. Other angels, particularly in the earliest stages, will invest based on a two-page agreement...

The key to closing deals is never to stop pursuing alternatives. When an investor says he wants to invest in you, or an acquirer says they want to buy you, don't believe it till you get the check. Your natural tendency when an investor says yes will be to relax and go back to writing code. Alas, you can't; you have to keep looking for more investors, if only to get this one to act.

Seed Funding Firms

Seed firms are like angels in that they invest relatively small amounts at early stages, but like VCs in that they're companies that do it as a business, rather than individuals making occasional investments on the side...

Seed firms and angel investors generally want to invest in the initial phases of a startup, then hand them off to VC firms for the next round. Occasionally startups go from seed funding direct to acquisition...

Venture Capital Funds

VC firms are like seed firms in that they're actual companies, but they invest other people's money, and much larger amounts of it. VC investments average several million dollars. So they tend to come later in the life of a startup, are harder to get, and come with tougher terms...

Because VCs invest large amounts, the money comes with more restrictions. Most only come into effect if the company gets into trouble. For example, VCs generally write it into the deal that in any sale, they get their investment back first...

The most noticeable change when a startup takes serious funding is that the founders will no longer have complete control...

Like angels, VCs prefer to invest in deals that come to them through people they know. So while nearly all VC funds have some address you can send your business plan to, VCs privately admit the chance of getting funding by this route is near zero...

So when do you approach VCs? When you can convince them. If the founders have impressive resumes and the idea isn't hard to understand, you could approach VCs quite early. Whereas if the founders are unknown and the idea is very novel, you might have to launch the thing and show that users loved it before VCs would be convinced...

Read much more in How to Fund a Startup by Paul Graham from which the foregoing was quoted.