By Ed McLaughlin and Wyn Lydecker
I’m a firm believer in bootstrapping to start your own company, as I wrote in an earlier blog, “The Cost of Control,” but there are a lot of funding methods. If bootstrapping is not possible for you, venture capital and angel investors are popular choices you may want to look into. Before you settle on either as your method of choice, make sure you internalize three important facts about investors in startups.
1. You Need a Plan for Profitability, Not Just a Better Mousetrap
Especially with the advent of shows like Shark Tank, VCsare very much in the public eye as a source of capital. It seems like someone with a good presentation of an interesting idea can go before the panel and come away with thousands of dollars. Off-camera, venture capitalists typically do not invest in startups, especially ones with no revenue. You’ll notice the sharks tend to like to put money into businesses that are already running and generating sales revenue. Usually at the seed stage, you need to raise funds from friends and family or angel investors. When you present to them, you have a complete vision for how you will make money already worked out. Previously, if you could demonstrate that your industry was shiny, new, and growing, a professional investor might have been happy to invest seed money. Now, having been burned by companies that failed to realize their potential because of poor planning, the lack of a sustainable business model, or the inability to create a viable product, investors want to know more about how you will produce your product and put your business on the path to profitability. They want to know how they will make their money back.
“Ah,” you say, “But I have heard of a lot of little companies who got round one financing with a great vision and a dazzling pitch.” Which brings me to my second point:
2. First Round Funding Isn’t the Sticking Point, the Second Round Is
Though from the perspective of having no investor at all, any round is a hurdle, in the long run, startups are failing more often to receive continued funding than they are to raise their first round, as Sarah Lacy wrote for Pando Daily as far back as November of 2012. Some investors are willing to fund a first round on the belief that they are investing in the next Facebook. They will invest in something that is a great idea with a demo product but still has no revenue. This creates something of a false positive for people with an incomplete business model. They see the first round of funding being passed out like candy and think, “I could do that!” Once that initial amount is gone, though, investors crack down on how larger amounts will be spent. The result is that unprepared companies who made it through round one often don’t make it through round two and die off. It’s not getting that first infusion that’s tough, it’s proving you’re worth another $2 – $5 million to take the next step that may prove impossible. Hence number one on this list: have a business model that will generate a sustainable profit. That way, regardless of the number of rounds, you are on solid ground with your investors.
Those investors may not look the way you pictured them, by the way, which brings me to the third point:
3. The Investor Landscape is Changing
An investor, particularly a VC, is not just a bank account you get to draw on as an extension of your own funds. Increasingly, investors can be sources of knowledge and expertise in your field. The very makeup of the venture investment industry is changing to include far fewer firms. Investors now, however, have greater experience and knowledge across a variety of disciplines. This diversity is allowing more startups to draw both money and wisdom from their investors. Startups can get traditional financial know-how and managerial advice, along with personal connections to industry leaders, all from the same group of investors who are supporting a startup’s growth. As Knowledge@Wharton reports in its article, “The Next Generation Model for the Investor-startup Ecosystem“:
.”..many institutional VC firms, such as Andreessen Horowitz, Kleiner Perkins, and Sequoia, are selling more than money. “Other things like the operational metrics, recruiting capability, marketing and industry expertise and connections, these things have become hugely important,” says Chaudhuri.”
As a result of this changing content, the relationship between VC and startup is shifting from a sporadic-infusion-based model to a constant stream. Relationships with the new, holistic VC firms are more long-term and committed. Simultaneously with this deepening, the breadth of the field has narrowed, from some 1,000 VC firms active in 2000 to the present field of a mere 300. Other funding methods have taken up the slack, with crowdfunding and super-angel investors to filling in the gaps.
Choose your investors with an eye to what they can bring you in total. Traditional or not, venture capital can be much more than currency with the right partner.
Ed McLaughlin is currently co-writing the book “The Purpose Is Profit: Secrets of a Successful Entrepreneur from Startup to Exit” with Wyn Lydecker and Paul McLaughlin.
Copyright © 2014 by Ed McLaughlin All rights reserved.