Skating on Thin Ice: Leveraging Seed Capital to Get Started
Many founders launch their start-ups with the expectation that they’ll begin to earn income from the business not long after going to market. This is a big mistake. One of the most common misconceptions about building a start-up is that soon after you launch, you’ll be able to pay yourself a good—or at least an adequate—salary either out of your revenue or out of capital raised. The truth is that very often, revenue is not enough to cover expenses well into the blade years—often three years—and that getting the business solidly into growth mode usually requires that the lion’s share of earnings and of any capital raised be invested back in the business. This money should go toward paying for increasing operating expenses, such as salaries for employees and office space; to make product improvements; to do more marketing and advertising; to maintain the product; and to expand operations. You should plan to reinvest in the business rather than pay yourself a desirable salary even when revenues are quite healthy.
Don’t Plan on Paying Yourself
Hockey Stick Principle #12: Earning a living from your start-up will take at least twice as long as you think.
Take the case of my brother-in-law Brad McCorkle, which is a pretty typical experience for entrepreneurs. He started his company when he was thirty-six years old and was married with two young children, so he had several mouths to feed, and he hadn’t been saving up for launching a business. He wasn’t expecting to become an entrepreneur, but he seized a good opportunity when he saw it.
Brad was working as a salesman of ophthalmic drugs, which treat ailments of the eyes, and when his employer, Alcon Labs, wanted him to relocate to become the manager of a sales territory, he decided that he didn’t want to move his family. Instead, he left Alcon and started Local Eye Site (LES), a Web-based service that connects eye care practices with job applicants, which was the first of its kind. He had determined that Monster.com and the other job boards weren’t doing their job in the eye care business because his clients often asked him to help them find new employees.
To get started, Brad raised $60,000 from two angel investors to build the LES site and a sophisticated recruiting tool. One angel was a well-connected leader in the eye care industry, and I was the other. Brad made a full-time commitment to the business and owned 51 percent of the firm. He used none of this seed money to pay his living expenses, instead drawing from his savings for those, and as his revenue slowly grew over the next several years, he started to pay himself a very small salary. Even when revenue grew to $429,000 in the third year, he continued to dig into his savings to pay his family’s living expenses and poured most of that revenue right back into the business.
This may seem foolish, but one of the important truths of achieving start-up success is that being willing to continue to put a vast majority of earnings and capital raised into fueling growth is often the differentiator in getting your business to take off. So founders must plan on this. It’s true that some start-ups do manage to generate enough cash from sales early on to provide a good flow of founder income while also investing adequate funds into growth, and in a bit, we’ll discuss great models for generating cash up front and a predictable future cash flow, but even in these cases, pulling in an adequate pool of first customers may take quite some time. Meanwhile, raising outside capital is much more difficult than most founders predict. The result is that far too many end up raiding their personal finances and drowning their prospects for success in overwhelming debt.
So often, founders anticipate they’ll have to work for no or low pay for six or maybe as long as twelve months, but that stretches out to twenty-four months or longer. Keep in mind that the Hockey Stick study found that the average time from starting a company to growth takeoff was three to four years. Not anticipating the financing challenges of this period means that far too many founders are forced to abandon a business that might have great potential because they’re broke and have maxed out all of their credit cards.
It’s vital not to plan to pay yourself a sizeable salary from either earnings or financing for the duration of the blade years, and to not delude yourself about how long these lean times will last.
Hockey Stick Principle #13: Accurate predictions of costs and revenue are not possible; plan to spend more than you think you’ll need and to earn little to nothing.
Financial projections to help you navigate through this stage are important, and you should definitely calculate detailed ones. But they’re likely to change. Product delays and redesigns are the rule, no matter how well you’ve planned, and they always cost something, whether in more outlays or loss of sales. When we started Vertical IQ, our first interface was confusing and had to be completely redone, delaying launch by three months. That mistake cost us roughly $20,000 that we’d originally projected from advance sales I’d made, and another $15,000 to redo the interface, so suddenly our operating budget was much tighter.
Even businesses that end up becoming huge successes take off slower than planned. For example, the music-streaming service Spotify, which in late 2014 was worth $8 billion and seems to have exploded virtually overnight, took much longer to make into a viable business than its founders, Daniel Ek and Martin Lorentzon, expected. As early investor Sean Parker recounted, “The thing that made Spotify very different when I first met Daniel and Martin was that they had this incredible stubbornness.… Daniel said, ‘I think it’s going to take six weeks to get our licenses complete.’ It ended up taking two years.”31
This is why the only prediction you should truly rely on is the rule of thumb that you should expect achieving sizeable earnings to take at least twice as long as your gut tells you you’ll need, and therefore, your financing will be spread much thinner than you’ve hoped.
Fast Growth Is Way Overrated
The problem of financing in the blade years is often made much worse by founders throwing far too much cash into trying to speed up the process of growth. One of the most dangerous misconceptions about the early growth phase is that you can speed it up by pouring cash into attaining scale. The Startup Genome Report, conducted by entrepreneurs Bjoern Herrmann and Max Marmer in collaboration with Stanford lecturers Steve Blank and Chuck Eesley, researched thousands of Internet start-ups. One of its findings, from an analysis of more than 3,200 firms, is that “one reason for failure has shown up again and again: premature scaling.”32
As we’ll consider more fully in chapter 6 about the right way to scale up, premature scaling occurs when a start-up builds up large fixed expenses by hiring employees, overbuilding the product without enough customer feedback, and investing in expensive marketing and customer acquisition strategies. In short, it occurs when start-ups throw a bunch of money at an idea before they truly understand how the idea will actually work. Practically speaking, a start-up gets ahead of itself and skips the tweaking needed to make its model work.
The scaling mistakes of high-profile Internet and software firms account for a great deal of the press coverage about the problem, but they aren’t the only types of start-ups that scale prematurely. The founders of any type of business can be tempted to do the same. Start-ups that sell physical goods are especially vulnerable. After achieving some early success, they often purchase too much inventory, which they then have trouble selling. Many of these founders also don’t fully understand the challenges of customer returns and slow payers, so they miscalculate their cash flow. What happens next? They end up with more bills than they can possibly pay, and a good idea goes bust.
Rather than planning to quickly ramp up spending—such as with a big marketing campaign—and achieve fast growth, founders should plan for the blade years to be a patient time of deep market investigation and product and marketing trial and error, while continuing to learn what’s working well for their business and what isn’t.
So many founders miscalculate how much funding they’ll be able to raise in this stage. With so much press coverage of high-profile start-ups receiving big funding, investment money can seem to be plentiful. During the blade years, though, the hard truth is that it’s not.
So rather than focusing on how to raise funds from the professional investing community, we’ll start by taking a good look at the best tricks of the trade for getting through the blade years with only minimal—or even no—seed capital, largely using out-of-pocket funds or money from friends and family. Then we’ll consider how to approach professional funders.
Models for Customer-Funded Growth
Some start-ups lend themselves to making at least some money early on, and sometimes, though rarely, these earnings can take off fast. The ideal method for raising capital is to earn it from paying customers, and as pointed out by London School of Economics professor John Mullins in The Wall Street Journal, this is in fact the most common way that founders raise cash. In his book The Customer-Funded Business, Mullins highlights that there are five main business models to consider: 1) matchmaker models (e.g., Airbnb) wherein you don’t have to hold inventory or maintain an expensive product, you just connect two parties; 2) pay-in-advance models (e.g., Threadless) wherein customers pay you the full amount or a deposit for a product before you build or ship; 3) subscription models (e.g., Netflix) wherein the product or service is delivered to a customer on an ongoing basis but the customer pays up front; 4) scarcity models (e.g., online retailer Zara) wherein the customers make purchases before you pay your vendors; and 5) service-to-product models (e.g., iContact) wherein businesses start out providing a service to a customer, and that service transforms into a product.33 For example, iContact originally provided the service of writing more efficient applications for sending e-mails to customers, and the founders then got the idea of packaging their e-mail marketing solutions into a marketing software product.
Founders can either copy such successful models or can experiment with their own versions. For example, if you have a Software as a Service (SaaS) business model, instead of billing customers monthly, as is typical, you could offer them a discount if they pay up front for a full year. Getting paid up front for annual subscriptions made a world of difference in funding First Research’s first year or two. In fact, we couldn’t have hired our first salesperson as early as we did without these customer commitments.
These models may not work for your business, and if one or another does, the cash you raise this way may well not cover costs. At this early stage, you most likely will not be making a substantial amount of money, so you’re also going to have to become a great bootstrapper.
Everybody Should Bootstrap, Funding or Not
Hockey Stick Principle #14: “Bootstrapping” should be the start-up founder’s word for “standard operating procedure.”
“Bootstrapping” is the hands-on, low-budget, hand-to-mouth method of starting a business that minimizes the amount of financial capital required. A great deal of advice in recent years has encouraged founders to bootstrap as opposed to raising outside capital early from professional investors. I agree that this is generally the best way to go, but what I think has gotten somewhat lost in the discussion is that it’s also generally the only real choice.
There’s no widely accepted definition of what qualifies as bootstrapping. Must the founder begin with no financial capital? Or just a little capital? Is $20,000 or less the cutoff? How about $50,000? Is that too much to constitute bootstrapping? Any attempt to draw the line would reinforce a false distinction. I’ve found that most successful founders of innovative firms bootstrap in the earliest years, regardless of whether or not they’ve raised substantial funding.
The most important question regarding funding that founders should be asking themselves from their earliest days is not, “Should I bootstrap or should I try to get outside financing?” but instead “What is the appropriate mix of human, social, and financial capital that I can leverage to get my start-up going and sustain it long enough to discover the improvements that will lead to takeoff?” The discussion of capital can often be too focused on financing, but it’s really the human and social capital that make any financing effective, and all the money in the world won’t make your business take off without them.
Leveraging the Three Types of Start-Up Capital
Harvard Business School professor Noam Wasserman, author of the excellent book The Founder’s Dilemmas, highlights the need for all founders to maximize the use of the three sources of start-up capital: human, social, and financial. He defines human capital as the founder’s “skills, knowledge, and expertise,”34 including his or her work, school, and managerial experience; industry knowledge; and experiences from outside his or her schooling or work life, such as hobbies.
He defines social capital as the “durable network of social and professional relationships through which founders can identify and access resources.”35 In referring to resources, he means advice and connections that help founders discover partners, suppliers, marketers, and customers as well as financing.
The definition of financial capital seems obvious, but it’s important to appreciate that it can take many forms, which have different implications for your freedom in building the company. As said earlier, the ideal source of financing is revenue generated by the business, but many founders need to raise cash up front in order to get the business launched and to fund operations until earnings cover costs. The main ways of doing so are:
• Out-of-pocket money from savings and credit card debt
• Loans from friends and family or a bank, with repayment terms
• Investments from friends and family, which may or may not involve a transfer of some shares in the business to them, often referred to as an equity stake
• Investments from angel investors, which do involve the transfer of some portion of equity in shares
• Investments from professional venture firms, which also involve equity transfer, usually at a higher, and quite a substantial, stake.
The term “seed capital” is generally used to refer to the money drawn on before revenue is coming in. However, the lines have become fuzzy because new venture creation has become much more fluid, with launches coming earlier and more models for raising cash before product delivery emerging, most prominently crowdfunding.
The real line to be aware of is between money to fund your initial growth, your seed capital, and venture capital (VC). VC is not usually offered until substantial earnings have been achieved and indications are strong of substantial additional growth. In 2014, only 1 percent of VC investments were made at the seed stage.36 The rest were early-stage, expansion, or later-stage investments.
Despite the popular mythology that businesses raise a significant chunk of change up front and then develop the product, many new ventures actually begin with the founders tinkering and injecting only, say, $1,000; working on development part-time for a month; borrowing another $3,000 off their credit cards; working another three months and then raising $100,000 as a “seed round” from friends and family or a professional angel investor.
Hockey Stick Principle #15: Raise the minimum amount you need to get to launch; financing is scarce and expensive.
There is no formula to use for figuring out your seed funding plan. When it comes to making this assessment, each founder must discover the right recipe for him or herself. While some businesses can be grown with virtually no up-front money and minimal operating expenses, relying almost entirely on the founder’s own talents and contacts—and less so on revenues coming in—others require a great deal of cash investment up front in order to even get going at all. But as a best practice, when first starting out, you should raise only as much as you absolutely need to begin testing your idea and then, once you’ve determined to go ahead with building the business, only as much as you need to get to launch.
As we’ll explore further later in the chapter, outside capital is very hard to raise at this stage, and you have to pay a significant cost for it, usually either in interest on a loan or in equity shares in the business. Even if you do raise a large amount, that money can give you a false sense of security about not needing to watch your expenses. Before you know it, you’ve spent a huge amount of your cash on a fancy Web site design or on getting samples of your product made, and then when you discover you’ve got to make fixes in the site or the product—which is inevitable—you don’t have the cash to pay for them. As chapter 3 will explore fully, this is the stage when you’re experimenting with your idea, and you will always have to make some changes to your plan or fixes in your product. It’s best to waste as little money on those experiments as you possibly can and to raise funding in increments as you make progress.
The Hockey Stick study shows that the median amount of money raised during the tinkering stage (before committing to it full-time) was $3,500. The median seed money the founders required was $150,000 but that ranged widely, from $600 to $4 million.
No matter how much money you need to get to launch and how much you’re able to raise, you must be intensely careful when spending and consider all other means for getting work done.
Bootstrapping Best Practices
The best way to think about bootstrapping is that you are always looking for ways to leverage your creativity, ingenuity, time, living space, sweat, and connections so that you don’t need to spend cash. Bootstrapping entrepreneurs wear many hats, doing most tasks themselves that established companies usually hire professionals to do or finding a partner or partners with the complementary skills for doing them. They design their own marketing brochures, draft their own customer agreements, devise their own bookkeeping systems, and, if required, sell door-to-door despite having no sales experience. They often barter for services or supplies. They generally either keep their day jobs through much of the blade years or find alternative means of making income, often a hodgepodge of odd jobs, allowing them to take very little or no earnings out of the start-up. They often work out of their homes, in the garage, or in a spare bedroom, and they zealously look for all sorts of cost-cutting opportunities.
I’ll use the story of how the founders of iContact, the $50 million–plus revenue provider of e-mail marketing software, achieved growth takeoff without raising any seed capital as a guide for considering the best tactics for making bootstrapping work. Their tactics are relevant for all founders, but of course if you’re building a tangible goods business, then it’s generally not feasible to make do entirely without seed capital. If a product must be manufactured, warehoused, and distributed, seed capital of some kind is required. So later on here, we’ll consider the many sources of seed funding.
How Two Bootstrappers Struck Gold with Negative Income
Ryan Allis and Aaron Houghton brilliantly leveraged their human and social capital, allowing them to launch iContact with no seed funding. They started the firm in 2003 and grew it to be used by more than 70,000 organizations in 2012, the year it was acquired by Vocus for $169 million. Though e-mail marketing software is now a crowded business with a number of large rivals, such as Constant Contact, MailChimp, ExactTarget, and VerticalResponse, the business was in its infancy in 2003. Only a few companies provided the service, and hardly any businesses purchased it. Small- to medium-sized businesses with little technical ability could easily install iContact’s software and use it. Given how big the business has grown, one might expect that iContact took off rapidly. The founders had certainly hoped it would, but, as Ryan recalls, the first year was a brutal surprise. They earned $11,964 and had $17,000 in expenses. As Ryan put it, “We had worked a year of our lives to lose $5,000. I just thought it would go faster. It took three years to get to a million dollars in revenue, and I thought it’d take a year and a half.”
Ryan and Aaron made it through this lean period and were able to put all their scant earnings back into the business because they managed their expenses well, divided up responsibilities to maximize their human capital—which they had a good deal of—and leveraged their social capital in order to get valuable advice for free.
Ryan was an eighteen-year-old UNC–Chapel Hill freshman, and Aaron was a senior when they started the company. When the two met at UNC’s Entrepreneurship and Venture Capital Club, both had started Web-based companies previously. Ryan was running a Web consulting and design business, Viranté, while Aaron was running a Web design company called Preation, Inc. Aaron was a talented programmer, and he had developed several Web products, such as an online calendar and an affiliate marketing tool. Ryan’s eye was struck by another service Aaron had created for one client, a small business called Mountain Brook Cottages, which was an efficient system for sending bulk e-mails to customers or registrants. Ryan had experienced trouble in sending bulk e-mail newsletters to his customers, and he thought lots of small businesses would be interested in the service.
The two decided to work together to market the product through a joint venture between their firms, with Viranté handling the marketing and Preation the product development.
In making the arrangements for setting the company up, they smartly tapped the social capital of relationships with their business professors for advice about how to establish the company. One recommended that they create one company instead, which would streamline administration duties and simplify finances. Others advised them about the legal agreements to sign, the best practices for corporate governance, and equitably dividing shares of stock, with Aaron receiving a larger stake because he had written the software. Ryan became CEO, and Aaron was chairman of the board and CTO. They smartly divided their responsibilities according to their strengths, with Ryan, who knew more about marketing, taking charge of sales and advertising, and Aaron, who was a more experienced programmer, taking charge of making product improvements.
If you aren’t in college and don’t have these connections, you can get this type of advice from one of the nine hundred Small Business Development Centers supported by the Small Business Administration (SBA), SCORE, a mentor program supported by the SBA, and local entrepreneurial organizations found in most communities around the country, such as the Center for Entrepreneurial Development in the Research Triangle area of North Carolina, where I live. And as I pointed out in chapter 1 but is worth repeating, I strongly encourage you to reach out to many lawyers who are willing to offer entrepreneurs some basic advice at no charge.
Find Alternative Sources of Income
Both Ryan and Aaron kept their separate businesses going while they got iContact off the ground, which brought in moderate income. Many entrepreneurs find odd jobs to help them through the early years that are synergistic with the work of their start-ups, such as consulting in the same field. Jim Goodnight, John Sall, Jane Helwig, and Tony Barr, the cofounders of giant software services provider SAS, used consulting income to help pay monthly expenses during the company’s first year. Bill Gates and Paul Allen wrote specialized software for a number of PC companies while developing their Microsoft products. When starting First Research, I was pitching an economic developer in a rural North Carolina county when the man said, “Bobby, I don’t believe I need your research portal, but if you’ll research these five companies and their CEOs, I’ll pay you $1,000 for your time.” I gladly accepted the deal. He was pleased with what I produced and referred me to other economic developers in surrounding counties. I had myself a little minibusiness and earned about $10,000 doing this until First Research was up and running. This income wasn’t only helpful in paying my bills; even more importantly, it boosted my confidence during these especially tough years.
Hockey Stick Principle #16: Making money by other means allows you to leverage your time to support the building process.
I cannot recommend more emphatically that you have a plan worked out about how you’ll pay your living expenses by other means during the blade years. My main backup plan was that I would get a job as a waiter at nights. Graham Snyder, founder of SEAL Innovation, continued working as an emergency room physician on weekends. Nick Woodman, founder of GoPro, maker of handy wearable video cameras, which today is worth more than $3 billion, helped pay the bills by selling Indonesian shell necklaces from the back of his Volkswagen bus.
One option for finding work is today’s “sharing economy,” with services such as Uber, Lyft, and Airbnb, to sign up as a driver or host, as well as services that hook freelancers up with jobs, such as TaskRabbit and Upwork.
Be a Maniac about Keeping Costs Down
Ryan and Aaron were extremely rigorous about keeping the company on a shoestring budget, watching every nickel, and they took out no loans to fund operations or marketing, not even to pay for a backup server after their server broke and the service was offline for a week and a half, during which time they lost 35 percent of their customers. That was a painful lesson, but it is typical of the setbacks that founders should expect in the early going. It simply isn’t realistic to think that you can anticipate every problem.
Creative scrimping can get you a very long way. Ryan told me, “I remember going down to UNC Surplus for a twenty-dollar desk and a forty-dollar computer. I ate at the same sushi restaurant day after day where you can get six pieces of sushi for a dollar. I sat in the hallway of our dorm working because we ran out of space. I jumped into dumpsters to get proof-of-purchase tags off our chair boxes to get the fifty-dollar rebates at Staples.”
Darren Pierce, founder of etailinsights was a clever money-saver. “We just didn’t have much cash, and the little cash we did have we invested into our product. I shopped for everything in our office on Craigslist. We bought these huge desks from an insurance agency going out of business. I persuaded my sweet wife to help me move them in late at night using her employer’s work truck. When we got there, the desks didn’t fit, so we had to take them apart in the dark, move them inside, and reassemble them. Also, phone systems were ridiculously expensive, like $5,000, so I just set up Vonage phone lines and a free Google voice number that I could point at any of our other phones, which at that time worked great.”
I watched every dime during First Research’s first two years, and that philosophy naturally carried over to my personal expenses, as well. While I lived in Wilmington, North Carolina, my ten-year-old, beat-down Nissan Maxima and I would drive four hours to Charlotte, North Carolina, to make a few sales calls. If I spent $20 on gas and sold $500 worth of product, I’d make a $480 profit. This was my early-formulation growth. But in August 2000, a little more than a year into my venture, my intern and I made this trip when my passenger-side window was stuck permanently down. It was rainy the entire trip, and my intern had to just deal with it because I simply couldn’t afford to get it fixed. These sacrifices are common for founders. I consider them badges of honor.
Even Amazon founder Jeff Bezos watched costs zealously. For example, instead of paying for an expensive automated system for updating information about book titles on the Web site, he had his small staff manually input the information. Those first employees also had to kneel on the concrete floor of the warehouse while packing books to ship out until one of them, Nicholas Lovejoy, suggested to Bezos that he buy packing tables. Bezos recalls, “I thought that was the most brilliant idea I had ever heard in my life!”37
Use Creativity in Lieu of Cash for Marketing
iContact had no budget for advertising, so Ryan put in thousands of hours of sweat equity, leveraging creative Internet marketing strategies, such as SEO, permission-based e-mail marketing, and pay-per-click advertising, to find customers. One creative and effective tactic Ryan tried was lining up affiliates, or sales partners, to promote iContact to find their own paying customers in exchange for a 25–30 percent lifetime referral commission on iContact’s earnings from them. iContact used technology to track the referrals and offered affiliate partners with support, such as statistics, banner art images, and instructions. As Ryan says, “The great thing about affiliate programs is that you pay out only after a sale is made. You already have the money in your bank account before you write the check for the commissions, completely eliminating risk.” To persuade companies to join the program, they made sure it was easy to sign up for, using win-win partnership agreements rather than cash to incentivize affiliates and build the network.
Ryan also used ingenuity when contacting Web sites and convincing them to link to iContact, which improved the company’s presence on Google. “The entire summer of 2003 was all about getting links from other Web sites to link to us,” he recalls, “so we could get #1 in Google for e-mail marketing software. Because once you have that, it’s free traffic. We set up five or six hundred links that summer.”
They were also willing to use one of the most effective customer acquisition tactics; they gave the service away for free to a select number of local restaurants. Many founders are reluctant to offer giveaways because it’s a direct hit to earnings. But Ryan and Aaron understood that this was a way to do high-quality user research with which to make more improvements. Free giveaways are harder for companies selling tangible goods, because of the variable costs involved in both making and distributing the product. One way to lower those costs is to offer a deep discount instead, so that at least you cover your costs and are only forgoing profit.
Offer Equity to Partners or Employees
Another smart move Ryan and Aaron made was to hire a top-quality Web designer their second year to help them improve the product even more. They couldn’t afford to pay him market rate, so they leveraged their future equity by offering him shares, paying him a below-market-rate salary. They did the same to bring in their second employee, a customer service representative to man a phone line.
Hockey Stick Principle #17: Equity is worth incalculably more than its current value.
If you’re going to offer equity, you want to carefully consider the implications for the future. This may sound obvious, but it’s important to keep in mind that your early ownership allocations are just the first ones and that if you’re successful, you’ll have to dish out more ownership later. Let’s say you start a company with a cofounder who agrees to work with you for no pay for two years, and you also agree to work with no pay. You negotiate that he or she will get 40 percent, so you get 60 percent. Some people disagree that a founder should get a premium for coming up with the idea, because it’s really the execution of the idea that matters. But in most cases, when founders bring in a partner, they have spent some serious time formulating the idea, investigating it, and have probably invested at least $5,000 or so to get it started. So I think such a division is generally fair.
Now say that six months later you can value the business at $500,000 and you’re able to raise $100,000 but have to give away another 20 percent for that cash. Now your partner owns 32 percent and you own 48 percent and you haven’t yet set up a stock option plan for new employees or raised additional capital for future growth. In essence, you’ve already given away control of your business. Of course between you and your partner, you still own 80 percent, but if you disagree about future strategic decisions, you no longer have the majority stake with which to definitively win the day. Some entrepreneurs are fine with owning less than 50 percent, and with the risk they take, due to the rewards gained. The risk is that you lose voting control of your company, which can lead to founders being fired from the companies they started. The rewards are that you have more partners to share responsibilities with and to help in decision making, and you have more cash to fund growth.
The calculation for how much ownership to maintain depends upon what your goals are. But many founders I interviewed strongly advise retaining majority ownership. As Brian Hamilton of Sageworks put it, “It’s a simple formula. Keep 51 percent.” Some people argue that it’s better to have 10 percent or 15 percent of a billion-dollar company than a majority share of a ten or twenty million–dollar company. But if you truly believe your company can grow that big, also consider that it might be well worth taking longer to get there. After all, a majority stake in a billion-dollar company is even better. And stories of founders being forced out of their own companies, which were then run into the ground, are plentiful.
The Founder’s Dilemmas offers helpful insight about making your calculations in splitting up early equity. Wasserman identifies four contributions as the main criteria to be factored in: past contributions (capital, the idea), opportunity cost (sacrifices founders have to make), future contributions (level of commitment, titles), and founder motivations and preferences (wealth motivations, risk aversion).38 He also advises against splitting equity between founders and divvying it out to employees in the very early days. He cautions that “seventy-three percent of teams split the equity within a month of founding, a striking number given the big uncertainties early in the life of any start-up.”39
Ryan Allis voiced these equity ownership concerns about the early share offers he and Aaron made: “I wish I had known how valuable equity is and not given it away so easily. We gave our first employee 7 percent of the company. Fortunately, we vested him over four years, so when he left eight months later, he only got 1.5 percent. Theoretically, it was worth little then, but it ended up being worth a lot. Our second employee got 15 percent, and he vested the whole thing.
“I wish I’d had a better ability to translate equity into what the potential value might be down the road so we hadn’t unnecessarily diluted ourselves as much early on. I should have explained, ‘What do you think the proper compensation would be for four or five years of work? Maybe a million bucks a year, risk-adjusted? But not three million bucks a year!’”
By contrast, other founders I interviewed followed the principle Wasserman suggests and split shares more in keeping with contributions. For example, Jim Goodnight, cofounder of SAS, told me that when it came time to divide up shares between him and his cofounders John, Tony, and Jane, “There was a lot of negotiation.… I tended to want to be egalitarian, but the attorney said no because [Tony and I] deserved a lot more than the other two since they had been working for us only a short time.”
Microsoft cofounder Paul Allen recalls in his memoir, Idea Man, what a shrewd negotiator Bill Gates was about splitting early shares. He writes, “I’d assumed that our partnership would be a fifty-fifty proposition. But Bill had another idea.” Gates made the case that “You had your salary at MITS [a computer company where Allen worked at the time] while I did almost everything on BASIC [the computer language Gates used to write software] without one back in Boston. I should get more. I think it should be sixty-forty.” But the split didn’t end up there. Allen further recounts:
Bill’s intensity was nonstop, and when he asked me for a walk-and-talk one day, I knew something was up. We’d gone a block when he cut to the chase: “I’ve done most of the work on BASIC, and I gave up a lot to leave Harvard,” he said. “I deserve more than 60 percent.”
“How much more?”
“I was thinking 64–36.”
Allen agreed.
This is a great example to keep in mind for negotiating your fair share, because as a start-up evolves, the proportion of work each founder puts in usually evolves, as well. There’s nothing wrong with asking cofounders for more equity, but you should be sure to do so thoughtfully and with a light touch, because this issue can be highly sensitive.
The timing of offering shares must also be considered carefully. If you split shares too early, you risk miscalculating how much each shareholder will actually contribute. Say one founder says he or she will contribute twenty work hours a week, but then circumstances change and he or she can only contribute ten work hours a week. What happens then? Negotiating a change of terms might be complex and combustible. On the other hand, if you wait too long and nothing has been put in writing between founders as they’re building the business, negotiations to split up shares after you’ve launched and are growing can be brutal. My advice is that you agree on terms very early in the process.
To split up the shares for Vertical IQ, my four cofounders and I agreed within the first month that ownership would be primarily based upon cash and nonpaid work contributions. We basically all came up with the idea for the company, so there was no premium for that. The only special consideration was that one shareholder received a relatively small amount of bonus shares for his contribution of intellectual property. We created a spreadsheet that tracked everyone’s nonpaid work contributions at eighty dollars per hour and cash invested. But to close the deal, we had to estimate future nonpaid work contributions, which required a vesting schedule—an agreement making the award of shares contingent on work being completed. We waited a year before signing the shareholder and other legal agreements in order to avoid managing the complex issues and expenses associated with that until we confirmed there was interest in our product and that the equity split was a good formula. In the end, this solution worked very well for me and my partners.
Leaving Bootstrapping Behind in the Haze of Your Gold Dust
All the tactics Ryan and Aaron deployed began driving revenue, and by the middle of year two, August 2004, revenue had improved to $20,000 a month, and total revenue that year was $296,000.40 But they still didn’t draw salaries. Instead, they hired more employees and invested heavily in Google AdWords advertising. That ramped sales up nicely, and Ryan recalls that “by the end of that second year, in May of 2005, we were at $60,000–$70,000 a month in sales with about twelve employees.” That’s when he decided to commit full-time to the business. Aaron had graduated from college the year before, and Ryan decided that he should quit college, which worked out well, as it was in that year that the company hit its growth-inflection point.
We’ll pick up the balance of the iContact story in chapter 7 when Ryan and Aaron learn to raise capital and discover explosive growth. For now, the takeaway is that for more than two years, they invested very little cash into building the business, and they invested just about every dime of revenue back into building it.
Of course, sometimes there’s no way around getting some up-front funding—sometimes quite a bit of funding. The good news is that there’s a wide range of options founders can pursue. However, this doesn’t mean the quest will be easy. It means you’ve got to be open to a wide range of possibilities, and most founders who raise cash tap several of these sources.
Chasing Cash
Knowing where to start when it comes to funding can be overwhelming, so here is a good basic list of the possibilities to consider.
• “Love money” from family and friends
• Individual angel investors
• Professionally managed angel funds
• Investments or loans from customers, suppliers, or industry insiders
• Incubators
• Seed or early stage venture capitalists
• Pitch-offs and demo days for investors
• Bank debt financing
• Nonbank debt financing from lenders, such as OnDeck, Lending Club, and IOU Financial that lend money at higher interest rates than traditional banks
• Crowdsourcing
• Grants from federal government entities, such as Small Business Innovation Research (SBIR)
• Grants from local and state governments, such as economic growth initiatives
• Grants from nongovernment entities, such as foundations and organizations that support entrepreneurship
• Advocacy groups
Not to harp, but the single most important thing to keep in mind when pursuing outside funding during the blade years is that it won’t be easy. Sramana Mitra, founder of incubator One Million by One Million (1M/1M), points out in Harvard Business Review that the most difficult time to raise money is the seed round before you have a proven business model and execution capacity: “To be precise, the capital gap is in the sub-million dollar revenue level,” she explains.41
This is probably the key reason that self-funding out of savings and personal borrowings is by far the most common scenario. Of the founders in my Hockey Stick study, nearly 80 percent invested their personal funds. Just less than half of those also received other funding mostly through angel investors. That finding is in keeping with the results of a study by Noam Wasserman that showed that 77 percent of the firms he had studied had at least one founder who contributed money early in the life of the start-up.42
One of the great advantages of self-funding is that you typically retain control. Of course the downside is that you expose yourself to financial loss, and there are too many stories of founders who get themselves into dire financial straits this way.
Hockey Stick Principle #18: Don’t invest any money that you aren’t willing to lose.
How much of your own money you should be willing to devote to getting the business into growth mode is again, of course, a matter of personal choice, but doing so with the expectation that you will not see that money again really helps to motivate creative approaches to finding other means. Because so many founders fall into the trap of cashing out their 401(k)s and mortgaging the equity they have in their homes—resources that are extremely difficult to make up for if the business fails—I advise great rigor in following this set of guidelines when deciding to use personal money to back your business:
Calculate Your Amount of Affordable Loss
Many successful founders have made the choice to invest every dime they have in order to keep their building efforts going. Doing so is certainly a valid decision, but you must first conduct a serious analysis of what the consequences of losing that money will be.
I advise operating on the principle of affordable loss, proposed by Professor Saras Sarasvathy of the Darden School of Business, who has studied how successful entrepreneurs make what she and her coresearchers call the “plunge” decision about whether to go all-in and how much money to commit. The principle is that founders should calculate an upper limit to what they’re willing to lose, calculate a worst-case scenario of losses, and then weigh that against how important it is to them to give the idea their best try.
One of the worst and most common mistakes entrepreneurs make is determining how much money they’re willing to commit based instead on a prediction of costs and returns, such as: “If I put in $250,000 and in two years I’m making $1 million, and I can keep my costs at that time under $750,000, then I’ll be at breakeven or better.” The hard truth is that it is simply impossible to accurately estimate these costs. Recall Hockey Stick Principle #13 on here. Accurate predictions of costs and revenue are not possible.
Factor in the Opportunity Costs of the Time You Devote to the Business
Opportunity costs are the amount of money—or other kinds of payoff—that you might have earned by doing something else with your time. Founders should make a hard-nosed assessment of the costs of the time they’re taking away from their former income-generating work when figuring out what their losses may be. If you’re making $150 an hour at your job and you walk away from it to work full-time on your start-up, then you’re not only spending the money you may be putting into the business out of your savings, but there’s also a considerable amount that you’re not earning by not working. You may be able to compensate for some of this loss of income by beginning to pay yourself out of first earnings, but remember that, as said earlier, for many start-ups, earnings won’t allow for this for a couple of years.
Ensure You Receive Adequate Compensation for Your Input and Loss of Income
Because founders so often don’t factor in their loss of income from the job they would have been doing had they not quit it to start the company, they sometimes settle for too small an ownership portion. They also fail to take advantage of other means of compensating themselves appropriately for that lost income. This becomes especially problematic the longer the business takes to earn revenue sufficient to provide them with a good salary. One way to ensure adequate compensation is a clause in the shareholder agreement that allows a founder to receive more shares if it turns out over time that he or she is committing more than expected. You can also set up a deferred compensation plan, which stipulates wages that will be owed to the founder in the future by the company. Those wages will be paid once the company can afford to do so or if the firm is sold. An attorney can easily draw up the paperwork for this.
Doling Out Equity
In preparing to approach potential funders, another key issue to consider is how dilutive the funding source will be, meaning how much equity you’ll have to give up. Professional investors tend to require substantial equity stakes of 10–45 percent. Rarely do they take more than 50 percent, because they want the founders to be motivated and empowered to succeed. However, professional investors require stringent corporate governance and often board control so that if the company isn’t performing well they have options to replace management (a.k.a. you). This is a key reason to think hard about how much control you’re willing to relinquish and make no mistake: Trading equity for cash is always giving up some degree of control.
This is one reason that as an alternative to investors, you might want to try securing a loan from a bank, because bank loans are rarely dilutive at all, and they are also a relatively inexpensive source of capital.
Let’s say you need $100,000 to get your business going. If you borrow the $100,000 from a bank at 5 percent interest and repay it in five years, you’ll pay roughly $13,200 in interest. However, if you receive $100,000 for a 25 percent stake in your new venture (assuming a $400,000 valuation of your business) and in five years your business has become worth $4 million, you’ve given up $1 million for that $100,000—overwhelmingly more expensive than the 5 percent bank loan.
But obtaining a traditional bank loan for a new venture is difficult because you generally have no proven source of repayment. Banks generally want to make only very safe bets because they’re lending their depositors’ money. So for the most part, the only way to get a bank loan is by having a very strong secondary source of repayment, such as putting up high-quality stocks, bonds, or equity in your home as collateral, or you might get someone else who can easily repay the loan to cosign, which is often a parent.
Occasionally, you can qualify for an SBA loan guarantee program or another special loan program to get a strong secondary source of capital. Most traditional banks can underwrite SBA loans, and you may qualify if you’re willing to guarantee it with your personal assets. This is why it’s smart to speak with a small business banker to figure out if you are eligible. Try to meet with two or three different bankers from different banks, because they often have different levels of experience and banks have varying degrees of appetite for offering these types of loans.
Knocking on the Doors of Angels
The definition of an angel investor isn’t simply a wealthy individual who likes to invest in companies at early stages of the growth process. Angels are accredited investors. This means that, according to the requirements of the SEC, which regulates the terms according to which you can officially offer shares in your company, they must have a net worth of at least $1 million and make a minimum of $200,000 a year (or $300,000 a year jointly with a spouse). According to a study by Harvard Business School professors William R. Kerr and Josh Lerner and Sloan School of Management professor Antoinette Schoar, firms started by founders who received angel capital were significantly more likely to survive the blade years than those that didn’t. The advice and connections angels provide may be an even more important factor than the capital itself.43 Many angels have a great deal of wisdom to offer, but keep in mind that while they’re called angels, they’re no pushovers. Most angel investors are or were successful entrepreneurs themselves, and they have a knack for knowing if an idea is good and if a founder is experienced enough to make it successful. They can poke all sorts of holes in your pitch, so you should make sure that you have your ducks in a row before approaching them.
When you approach a potential investor, even if at first just informally, you must have a well-organized business plan in hand, but you cannot expect the plan to make the case for you. While almost all investors want to see one, most know enough not to believe them.
Hockey Stick Principle #19: Business plans don’t raise seed money; tangible results do.
The experience of Doug Lebda in raising seed money for LendingTree is typical in this way. Doug benefited a great deal from the wisdom of the angel investor he got his first money from, even though the investment was for much less than Doug had asked for—it was only $10,000. There is no question that in this case, the advice was much more important than the cash. And though Doug had written a fantastic business plan, that wasn’t what got him the money.
The investor was Lee H. Idleman, who had a long and illustrious career in investment research and portfolio management for Wall Street firms, and at the time Doug approached him, he was a member of the board of trustees of Bucknell University. In other words, Lee was no slouch as far as giving advice goes. He told Doug that he’d invest $10,000 if Doug could show him three things: that customers would want the service, that a bank would agree to offer loans through it, and that Doug could line up a professional banker to work for the company. This advice is what led Doug to build the proto–Web site that got such a strong response from potential customers. It also spurred him to approach banks again, and he managed to get a letter of intent from National City Bank, which Idleman deemed sufficient for his second condition. And for the professional banker, Doug convinced a former Goldman Sachs investment banker to agree to work with him to raise funds. That wasn’t quite what Idleman had stipulated, because investment banking is different from mortgage banking, but he found it acceptable nonetheless.
Doug’s creativity and persistence in meeting Idleman’s demands made all the difference in impressing him and convincing him that the plan that looked so good on paper might actually be made to work.
Doug’s first capital raise for LendingTree is a lesson in not wasting your time approaching even the early stage investment community with only a paper promise; approach them when you have some actual progress to show. And ideally you won’t have to cold-call them. When it comes to pursuing angel investors, I recommend you first try to seek them out through warm introductions from other successful entrepreneurs you already know. Many angels are entrepreneurs themselves, and even if they are not, they generally like to learn about new ventures from other successful entrepreneurs. Most of the time, the process of raising funds from them is very different from approaching banks or VCs. They don’t generally invite you to a conference room meeting to pitch your idea with a PowerPoint presentation. Instead, many angel investors try to spend lots of time with founders before they make a commitment. The process is iterative and ongoing: you might meet several times trying to solve business challenges together.
Also, most angel investors have particular types of businesses they like to invest in, so don’t get discouraged if the first few you speak with aren’t interested; that’s normal. Ask instead if they know of angels who might have an interest in your type of firm. This is especially wise to do because identifying potential angel investors can be difficult and can take quite a bit of time. Doug Lebda advises that founders should leverage the law of averages to find seed money—meaning the more people you talk to, the better your chances are of getting funding. “Raising money is just really a conversion funnel, so a quick no is okay. You just need to know where your conversion funnel is. If you need one investor, you need to get three offers to consider, which means you need to get fifty meetings, which means you need to mail three hundred business plans and make three thousand phone calls. Whatever the numbers are, it’s just a numbers game. So work the numbers.”
To speed the process, you might want to also contact angel groups, which pool investors’ resources and develop portfolios of companies they’ve invested in. You can find a listing of them online from Angel Capital Association (ACA), a trade association of angel groups.
Another option is to seek funds from one of a number of platforms for crowdfunding of angel investments, such as Crowdfunder.com or AngelList. These sites were made legal by the JOBS (Jumpstart Our Business Startups) Act passed in 2012. Before that, crowdfunding platforms were not allowed to facilitate the selling of equity shares. The act, however, opened the door to making equity deals on these sites—but only for accredited investors—to protect novices from being burned.
Time Is Not Only Money, It’s Progress
In making the call about whether or not and how much to pursue outside funding, it’s vital to think through the opportunity costs of the time the chase takes away from working on the product and on sales and marketing to customers.
Hockey Stick Principle #20: All funding comes with hidden costs.
Figuring out your game plan for fund-raising is again a personal choice. Some successful founders will tell you that every minute they spent hustling for funding was worthwhile. The founder of online course company Udemy wrote a blog post titled “Udemy’s $1M Fundraising: Lessons Learned about Pitching Investors from a First-Time Entrepreneur,” in which he recounted how constant hustling paid off: “I went to every conference I could and literally killed myself while there. I attended tons of networking events and met as many entrepreneurs and investors as I could. While at events/conferences, I rarely ate dinner because I was too busy schmoozing and grabbing business cards. During the weekdays, I’d spend hours e-mailing potential [investors] to start using Udemy.”44 This is a typical story for plenty of founders.
But in thinking this through, you’ve got to factor in that you’re most likely going to have to keep at it and go back to the well repeatedly. A common misconception about raising seed funding is that you can get a good lump sum up front and that will carry you through to growth takeoff. Sometimes that does happen, but what’s much more common is that you won’t get the amount you’re looking for from one source or all at one time, and you’ll have to seek multiple sources and repeated injections.
One piece of wisdom to take away from this is that founders should be flexible about what they really need for funding versus what they’d like to get. Savvy founders leverage what money they do get in order to build momentum to get more money if they need it. You might think it’s more efficient and orderly to get as large a sum up front as possible and to devote a serious chunk of hustling time to that so that you can then focus exclusively on building the business. But in fact, planning for an ongoing process of fund-raising is not only more realistic, it gives you better odds, because you’re asking for less. As you move into a more serious development phase, you’re going to have to get used to doing all sorts of different kinds of tasks all at once, so it’s better to get used to this juggling act now before you’re in the heat of the run-up to launch.
The Friends and Family Plan
The difficulty of raising seed money from professional investors or from banks explains why it’s so common for founders to rely on “love money.” Yet many aspiring entrepreneurs are reluctant to ask family and friends to make investments because they believe it’s brazen to do so.
Hockey Stick Principle #21: Taking love money is nothing to be ashamed of when you’re open and optimistic.
Asking for money from those who will feel a special incentive to offer it is brazen only if you do so dishonestly. If you’re forthright about the status of your operation, the challenges you face, the prospects for growth and your plans for achieving it, and if you’re clear about the risk of failure, emphasizing to your loved ones that they may never see the money again, then they are making a legitimate choice to support you, and it’s fine to offer them this opportunity to invest in your business. Taking money from people you care so much about is also a very strong incentive to work even harder. And keep in mind that the amount friends and family will invest is usually the amount they’re comfortable losing. Many of them offer the money with little or no expectation of getting it back—though, of course, sometimes they do, and sometimes they get it back many times over.
One founder I interviewed had a memorable take on this issue. Bob Young decided to seek seed money from friends and family, and eight of them offered funds, for which he compensated them with a total of approximately 10–15 percent of Red Hat’s stock. He was aware they were investing without expectations, and the way he saw it was “a love-money round is precisely what it says—people are investing in your business not because they know anything about your business or because they think you’re clever. They’re investing because they love you.” Investopedia, an online platform that provides a financial dictionary and investment advice, wisely says about this issue that the terms on which love money is offered “are usually based on qualitative factors and the relationship between the two parties, rather than on a formulaic risk analysis.”45
Suffice it to say, those love-money Red Hat investments turned out to be good ones. Bob’s aunt Joyce Young, who donated $40 million to the Hamilton Community Foundation out of her proceeds, told The Hamilton Spectator about her good fortune: “It was exactly like buying a lottery ticket. You don’t expect to win.…”46
One piece of advice when it comes to accepting money from friends and family is to treat them like any other shareholder, both in terms of communication and documentation. As consultant and author Wayne Rivers of the Family Business Institute warns, the lines between business and family can get uncomfortably blurry. “Families operate informally, but growing successful businesses requires formal rules, roles, responsibilities, accountability, and communication in order to function. Your family rules and roles are what they are; don’t make the mistake of superimposing them onto your business. You’ll find they hold back your company’s success and add tension during the times when you’re trying to relax with the ones you love.” In other words, just because a relative offers you funding, even a parent, doesn’t mean that he or she is a member of your management team. You must establish clear limits to their input. Not only might you face extremely difficult disagreements otherwise, but you’ll scare away other investors who don’t want to be bullied or be the odd-man or woman-out in family quarrels.
Build It First and Investors Will Come
If you don’t believe enough in your product or service to go ahead and put some of your own money into building it, you should not feel entitled to ask others to fund it.
One founder I interviewed who was ultimately able to raise substantial seed funding is Graham Snyder, the inventor of the SEAL antidrowning device. His story is exemplary of the belief that you should have in your product and the tenacity that will be required of you to get others to back it. It also demonstrates how different your results might turn out to be once you’ve raised some funds to develop early versions of your product to a point that allows you to show investors proof of concept.
After his considerable tinkering on a rough prototype, Graham realized he’d have to pay a professional engineer to create a much more effective device. But after eighteen months of pitching to potential investors—about twenty angel investors and venture capitalists—he had no takers. As he recalls, “Selling an idea with a plan when you’re not well known and don’t have a track record is very, very difficult.” So he decided to do what most founders have to do—invest a considerable amount of his own savings. “I was at a highly feisty point where, if the investors didn’t do it, fine,” he told me. “I’d put my own chips in. I would just basically do everything … short of ending [my] marriage, to advance it.”
Most engineering firms he looked into were too expensive, but he found one with good ideas and paid $20,000 for the firm to improve his prototype. He expected that the $20,000 would get him a product he could manufacture. But that was not so, not by a long shot. The firm had worked for several months on improvements that made the device much less clunky, but it was still nowhere near ready for the market. “I didn’t quite have ‘buyer’s remorse,’ afterward but I thought, That’s it? I wanted more. What I saw showed me I wasn’t even close to done.”
So he got more work done, hiring two other part-time engineers who had particularly good experience in working with start-up inventions, this time paying them with a combination of cash out of his savings and stock options. This time, the result was a device and business model that Graham believed was ready to show to investors. The new engineering team had not only raised the reliability of the device above 90 percent and made it smaller, they had also made the smart suggestion that Graham offer the product two ways, one for individual purchase and the other for purchase by the owners of public swimming pools, which would monitor all the swimmers in a pool. Swimmers could be given a SEAL device when they registered at the pool, and the lifeguards would have monitors that could keep track of all the swimmers.
Graham quickly applied for a number of patents on the invention, and when he was awarded them, he decided that the best way for him to pursue further development of the product was to sell the rights to a large company that had the expertise and funds to get it to market much faster than he could on his own. But what he discovered after a great deal of traveling to pitch companies was that “what most large companies do now when it comes to consumer products is they let another company develop the device, and then they buy the rights to it or buy the whole company. A guy who owned a large national safety firm told me, ‘We’ve got 140 products in the queue. The only way you get moved to the top is if you’re already selling. Then, it makes sense for us.’”
By this time, nearly three years into the project, Graham had invested $100,000 of his own cash for engineering, marketing, materials, patents, and travel expenses. He believed the SEAL SwimSafe had been improved enough that he decided to test market interest by meeting with several national swimming organizations. Though he got their blessing that the SEAL SwimSafe concept was good, they also told him that his prototype needed more work. “It did the job,” he explains, “but it looked like a medicine bottle swinging from your neck. And it wasn’t durable. That was a nonstarter. It has to be virtually indestructible so pools can use them for many seasons.” With more consultation with his engineering team, he determined that making the necessary improvements would require another $350,000.
In light of that large sum, he set out to raise capital, focusing exclusively on high–net worth individual investors. He had learned by this time that the product still wasn’t far enough along for venture capitalists, so he took a smart approach, pitching first to investors who he didn’t think would be a good fit, which was like practicing with a net. Rather than money, what he was really looking for was feedback from these investors. The presentations were fairly simple, done in his home with PowerPoint and some product videos he had made and live demonstrations of the prototypes in an aquarium and his hot tub. It wasn’t ready for prime time, but it was impressive enough for these motivated investors. He made fifteen presentations to forty serious investors, and some of them wanted to hear the presentation four or five times before they made a decision. But most liked his pitch and believed the SEAL SwimSafe had a good chance of success.
During the fall of 2010, Graham successfully raised $365,000 by selling 15 percent of his company’s stock to fifteen individuals, with the investments averaging about $24,000.
Graham also personally invested another $40,000 in order to maintain majority ownership and voting control of the company, assumed the chairmanship of the newly formed board, and demonstrated to the investors that the price was fair. He also decided not to pay himself any salary out of the funds, investing almost all the money directly into product development.
The SEAL SwimSafe story is a good representation of the twists and turns to expect when getting any product ready enough for pitching to professional investors. Of course Graham’s product is an especially complex one, but even with much simpler requirements, getting your product to the level of proof of concept that most professional investors want to see will almost certainly cost a good deal more money and take much longer than you’ve originally calculated.
This is why I am so adamant that founders have a good plan for earning money by other means during their blade years.
Alternate Funding Sources
One of the biggest developments in recent years regarding entrepreneurship is what’s often referred to as the “democratization of funding” through such new sources as crowdfunding and increasing numbers of accelerators and incubators. The federal government and many state and city governments have put a new focus on encouraging entrepreneurship and have created programs and awards to assist founders with funding. You should seriously investigate all such options, but it’s important to keep in mind that some of them can take considerable time to pursue and some have potential pitfalls.
Crowdfunding and “Pretailing”
Kickstarter and Indiegogo are the two largest crowdfunding sites, and there are many others worth looking into, such as Crowdfunder and RocketHub. Crowdfunding keeps booming, and more than $6.5 billion was raised for “business and entrepreneurship” in 2014 according to estimates.47 Many start-ups have received huge boosts from their campaigns, such as Pebble Watch, which raised $20.3 million on Kickstarter, and Coolest Cooler, which also raised $13.3 million through Kickstarter.
And, of course, the boost is not only in funding but in publicity; campaigns can ignite a tremendous amount of buzz. While at the start, most campaigns asked for donations and offered those who contributed relatively moderate rewards—such as posters, T-shirts, and mugs—more recently, campaigns have been increasingly using crowdfunding sites for preselling products, sometimes referred to as “pretailing” or “pre-commerce,” which can be a good way not only to raise cash but to get product feedback. By racking up preorders well in advance of launch, you can also fine-tune your initial order of stock, which is one of the trickiest judgments to make for launch. The process allows you to test your pitch and the story you’re telling about your product, as well.
But it’s important to be aware that this process also takes quite a bit of time, and it has some potential problem areas that can get founders into trouble. The time you spend on writing your pitch and making product or pitch videos will surely be well spent, as you should be creating these regardless of whether or not you’re going to pretail. But they’re only a relatively small part of the job. You can’t just post your content on the platform and expect the platform to drive interest; you’ve got to drive eyeballs to your product page, and the primary way of doing so is through an e-mail campaign. That takes creating a curated e-mail list and crafting your e-mail and sending follow-up e-mails, as well. You should also be posting on all the social media sites to promote your crowdfunding page.
Research by Indiegogo indicates that “personalized e-mail is the most effective channel of online communication for your campaign” and that at least three follow-up e-mail updates are advised. They also advise creating a dedicated Facebook page and Twitter account for the campaign, and their research shows that “on average, about 22 percent of the funds raised by a campaign come from people clicking on social media posts.”
You may also want to send out a press release, and you should be prepared to respond to press inquiries whether or not you do, as some campaigns attract a good deal of press attention if they’ve gained good traction. You should also be prepared to respond to queries from backers or customers.
Time is another big factor in managing customer expectations. Once you’ve promised a product to people and have given them an expected delivery date, the clock begins ticking furiously for you to actually make your product ready for market. Many products have run into serious delays, as with the Pebble Smartwatch, which attracted almost sixty-nine thousand backers who were then eagerly awaiting their cool new watches. Shipment was delayed for many months due to a number of manufacturing glitches, and some backers still hadn’t received their watches by the time they were available in some retail locations, leading many of them to voice great irritation toward the company.
You may also end up delivering quite a different product, for a different price, than you’d initially advertised in your campaign. For example, the campaign for the Bluetooth- and Wi-Fi-enabled Lockitron keyless door lock that allows you to unlock your door from a remote location through your wireless device generated fourteen thousand preorders, totaling $2.2 million—though in this case, those were only pledges, and the cash wasn’t actually sent. The campaign generated a ton of press, which drove people to the company’s Web site and generated another seventy thousand preorders. But only fourteen thousand of all those orders were fulfilled because they ran into manufacturing problems with the factory they had selected in China. The founders decided to switch gears and totally redesign the product, so more than two years after the expected delivery date, all those who hadn’t received the first version—apart from the ten thousand who canceled their orders—were still waiting for the product to arrive. Imagine the stress of that for the founders, not to mention the ill will you risk generating in the market.
You may well be able to recover from such a setback, as the founders of Pebble did, going on to successfully launch a growing line of watches. But you also risk turning the early adopters you’re hoping will become evangelists for your product into evangelists against it. As Daryl Hatton, CEO of the Vancouver-based FundRazr crowdfunding site, cautions, “You have to be careful how much you hype your product. You’re putting yourself in a much more transparent position than you used to be. Your actions are monitored. An unhappy customer can create a lot of grief in your community.” Another pitfall he highlights is failing to factor in all the costs and logistics of order fulfillment, including packaging, warehousing, shipping, and customer support. As he says, “What are you committing yourself to when you receive $50 from someone? Will it mean $100 in costs?”48 It’s vital that before you launch a campaign you calculate every single cost that will be involved with fulfilling the commitments you’ve promised to contributors.
Pitch-Offs and Demo Days for Investors
These events and conferences are good venues that offer the chance to pitch, normally in ten minutes or less, to several investors at the same time. Universities and local entrepreneurial organizations put them on often. They are highly competitive, so winning one takes serious preparation, and the amount of prize money varies greatly. Most are in the low five figures to low six figures, but some seven-figure prizes are also awarded. Spending the time to participate in some of these may well be worthwhile, not only for the award money but probably even more importantly for the networking and the potential to receive some great advice from top investors and entrepreneurs.
Grants or Awards from Government Entities
Federal, state, and local governments are active in supporting new business ventures and offer financial support. For example, the Small Business Innovation Research Program (SBIR) provides awards of up to $100,000 for “approximately 6 months support exploration of the technical merit or feasibility of an idea or technology.” These programs can be great for certain types of technology, but applying also requires lots of work, and the odds of winning are minimal. One company I invested in applied for a $50,000 grant from NC Idea, a program in North Carolina that gives five or six awards per year. The founder spent a great deal of time applying and got down to the top ten finalists. He then had to do a great deal more work, and in the end, he didn’t win. Meanwhile, he’d been pulled away from actually building his business.
Nonbank Lenders
If you type nonbank business lenders into Google, you’ll get thousands of results. These are firms that offer loans but do not have a banking license. One reputable nonbank lender on the rise is OnDeck, which has loaned more than $1.7 billion in only seven years. The key things to keep in mind here are that they almost always charge higher interest rates than banks, and that while some are reputable, others simply are not. Instead of going into one cold, ask your attorney, banker, or CPA for a referral.
Incubators and Accelerators
There are dozens of incubators and accelerators that provide mentoring support, funding grants and investments, and physical locations to work. The important thing to know is that each incubator has its own vibe and criteria for selection. Techstars, for example, has twenty-two locations and provides $118,000 in seed financing in exchange for 6 percent equity, plus a wealth of support from mentors and educational programs. Other prominent accelerators are Y Combinator, Capital Factory, DreamIt Ventures, and Flashpoint.
Seed and Early Stage Venture Capitalists
While most venture capitalists fund later-stage growth, some focus on early-stage, as well. Generally speaking, they look for firms that have managers who have already been successful and transformative and big ideas that have big potential. Many of these firms are in Silicon Valley, but there are some in other areas that are hotbeds of entrepreneurship, as well. To learn more about early-stage venture capitalists, I recommend you contact the National Venture Capital Association (nvca.org) that, for a fee, provides a detailed list of VC firms organized by various categories, one being “stage of development.”
How to Craft Your Best Plan
There is no way around the fact that you can never know what sources of funding will come through for you or how much you’re really going to need before you’re fully funding your operations with earnings. To do the best job possible of preparing to start a company, though, here is a set of questions that all founders should carefully consider:
• What capital investments and ongoing expenses are necessary to create a sellable product?
• How much salary, if any, do I have to earn for myself until the business can support me?
• How long am I willing to work on growing my business before I am earning the salary I want to make?
• Do I want to have financial partners in my business?
• Do I have the personality type that seeks advice and ideas from partners who might have more experience than I? Or is this venture about providing me with the opportunity to build something on my own?
• How much ownership am I willing to give up at this very early stage of my new venture?
By thinking carefully about these questions right when you start planning your business, you will set yourself up much better for success. And the better you are at anticipating the costs you’ll have to pay and the hit to your income you’ll take, the more rigorous a plan you’ll be able to come up with for getting through these lean years. If you seriously consider how long it may take to grow your business to the point that you’re earning the salary you aspire to—which generally requires three to four years—you will have a much better understanding of how much your current lifestyle is likely to change while you’re building the business due to the need to cut back on expenses. Right at the start, if you begin to consider whether or not you’re open to partnering with someone to build the business, you may be able to find someone to take some of the load of work off your plate and also complement your own skills, as well as easing some of the financial burden. But it’s important to think through these ownership and control issues right from the get-go, as well, because the decisions you make at the start have such significant consequences later on. Wrestling with all these questions before you get going in earnest with the building process will help to assure that your expectations match with the reality of what the commitment will require of you and to assure that you are prepared to make that commitment.