Raising Capital: The Three F’s, Friends, Family and Fools
by Brian Acord
There comes a time for many entrepreneurs where they simply need cash (or think they need cash) to make any further progress. Too many would be entrepreneurs equate raising capital with venture capital. This way of thinking is flawed in many ways.
First, most entrepreneurs, when really pushed will realize that they really don’t need the capital. Sure, it would be nice if a big truckload of money fell out of the sky next to us but they really could live another day without it.
Second, even if they really did need the money, entrepreneurs who really understand what they are giving up will probably not be very interested in the requirements imposed on them in the term sheet.
Third, even if they really did need the money and they were actually willing to give in to the terms of the term sheets, they would have to work really hard to find a venture capitalist who would be even remotely interested in looking at them. (Fewer than 4% of all investments come from venture capital.)
Let me say that again, fewer than 4% of all investments in startups come from venture capital. The reasons are fairly simple. Venture capitalists are extremely focused on a very narrow niche in the market. They are only interested in high-potential returns that are exactly the right time for their model, and the average VC firm typically does only 3-4 deals a year. In a nutshell, they are looking only for the cream of the cream of the cream and never deviate from the course.
So how do businesses get funded? In the early stages of a company, the first source of money for most successful entrepreneurs is their own pocket. This often means eating into personal savings, taking out a second mortgage on the house, and collecting credit cards to meet cash demands. Oh, you’ll also be going without a paycheck for quite some time so get use to the ramen diet.
Once you have used all of your own money and have shown significant traction, the next most common source of money comes from the fabled Three F’s…Friends, Family, and Fools. While generally not classified as sophisticated investors, this next round of funding comes in small doses from acquaintances that you already know. They are most likely to trust your personal character, can understand the basic concepts of your business, have been impressed by your success to date, and they know where you live (often under the same roof). Due diligence is much faster with this group and while they may not have enough funds to take you through to your IPO, you won’t waste the next nine months developing the “perfect pitch” and sleeping in disease-invested motels begging for a meeting either.
Fools (um, “private investors”) like me, on the other hand, haven’t known you most of your life and have very little to go. They may not be aware of your squeaky clean (and completely non-existent) criminal record. So, what compels people like me to act so foolishly and invest in people we don’t know that well? What would sell us on ideas that are only half-baked and have the strong potential of becoming a huge time sink?
One, simple answer: we’ve been there before and have a pathological desire to remain involved in the startup process. I’ve made several early-stage investments in various companies so far, and the thoughts below are a result of thinking back on why I made the investments I did and what common patterns there were.
So, here are my top practical tips if you’re ever looking to attract capital from fools like me:
- Be passionate about the idea. If you can’t convince me that you are personally laying awake at nights plotting, scheming and dreaming about how your idea is going to change the world, you’re going to have a really hard time getting me to part with my money.
- Be likeable. If I’m going to put cash in your company, chances are, we’re going to be spending a fair amount of time together. (If not, then I’m likely not investing anyways). You don’t have to be obsequious (I’d prefer that you weren’t), but a certain level of respectfulness is always appreciated.
- Demonstrate that you’ve made some progress on the product/idea before talking to me. I don’t invest when the first use of the capital is to go find a developer to help implement the idea. Starting a new business is hard. It is simply not good enough to say “we’re going to make our product better!” To be honest, I don’t put too much emphasis on your initial financial models until I can actually see revenues substantial enough to draw my interest. I do care a lot about how you think you’re going to build your offering, and why it’s going to be sooooo cool. I like to see people that are fanatically obsessed with “hand-crafting” their solution and taking pride in their work.
- Be realistic about your capital needs. Sure, you’d love to have $5 million of funding so that you can “do it right” and build the software company of your dreams. But, lets face it, you shouldn’t need that much money, and if you do, then go the VC path (and I wish you the best, may your travels be fruitful…) The question you have to ask yourself is: What’s the least amount of money I need to build something that someone will pay a little bit of money for. I’ll give you a hint: Its usually less than $50,000 --- with $25,000 left over to build what you should have built in the first place – but couldn’t, because you hadn’t yet gotten the feedback from your first user/customer who ended up practically throwing up all over your shiny new software…
- Seek analog business models. Let me explain: Binary business models are a 0/1 proposition. You go off and build a product after months/years/lifetimes of grueling work and launch it to the world. At that point, it is either phenomenally successful (i.e. result=1) or it’s a complete failure (result=0). Analog business models are those that have incremental value all along the way. You make $2,000 revenue within your first 90 days. Maybe $10,000 the month after that, etc. The nice thing about analog business models is that in the worst case, you’ve at least created something of value. And paradoxically, approaching the problem this way actually increases your odds of a blow-out success. In my experience, overnight successes take at least three years. But a different way (if you’re a programmer, which I’m hoping you are), use “agile practices” for your business, just like you do for your code. In agile development, we have “release early, release often”. In agile business, we have “revenue early, revenue often”. [Note to self: This is likely a worthy topic for its own article. ]
- Do your homework. There are excellent resources for learning about the basics of how capital is raised and the legal stuff around it. Though I’d love to teach you about all of this stuff (because I enjoy talking about it), I simply don’t have the time. Others can do it a lot better, and this is the kind of stuff you can learn mostly through reading.
- Talk to everyone you know about your business. Ask for their opinions. Don’t require them to sign a non-disclosure agreement. Be honest about your current challenges and don’t over-inflate your idea because as soon as a potential investor gets the faintest whiff of B.S. they are going to cut you lose permanently. Remember, you already know all of the people who are likely to invest in the first stage of your new company…you just need to convince them to come out of hiding…preferably by demonstrating competence and significant traction with a profitable (and sustainable) business model.
Obviously, the above opinions are my own and may not necessarily be shared by other fools (um, “private investors”) that you talk to. But, I’m pretty sure that none of the above will hurt you. Worst case scenario, even if you don’t raise the money, you’ll be better off having followed the advice anyways.
Good luck!
Check our blog for our latest articles or return to the library.