New technologies have unlocked new ways to raise money for your startup. Here's how you can choose which type of funding is right for you from among the big three options.
Conner Forrest | TechRepublic | July 22, 2014 – Raising capital for a startup has traditionally been one of the most difficult parts of getting your idea off the ground, but new technologies and platforms have given entrepreneurs a plethora of new ways to make that happen. Nowadays, there are more options than ever to get a new company funded.
“One of the really cool things that’s happening right now is this massive proliferation of ways to start a company and ways to get your company funded,” said Aaron Harris, a partner at Y Combinator.
New enterprises were once only birthed by born-wealthy proprietors, or business leaders who could roll capital over from another successful venture. As the venture capital industry began to grow, capital became available to innovators who wouldn’t have had access to it before. Then, as angel investors grew in popularity, founders had a new way to get capital at an early stage where some VCs wouldn’t tread. Now, consumer crowdfunding has added another layer to the investment equation for entrepreneurs.
As funding becomes more and more democratized, we are seeing what Harris calls, “the progressive elimination of gatekeepers.” But, the process can still be difficult to navigate, especially if you are a first-time founder.
“Entrepreneurs, whatever they’re doing and whatever company they’re trying to start, they’re so different,” said Bobby Franklin, NVCA President and CEO. “Clearly, some of the funding routes that one might go would be better suited for one type of entrepreneur, or one type of idea, than another.”
As Franklin noted, certain funding options will work best for specific types of companies. Here are the three most popular forms of funding and how to better understand them.
The advent and relative growth of crowdfunding platforms such as Kickstarter and Indiegogo have proven a great advancement for nonprofits and other organizations; but they also give startup founders a unique opportunity to sell their idea direct to the consuming public.
“We don’t see crowdfunding and venture capital as mutually exclusive. We’re seeing Indiegogo become an incubation platform for traditional financiers to come in and discover new ideas,” said Danae Ringelmann, co-founder of Indiegogo. “A successful crowdfunding campaign helps prove to VCs, angel investors and banks that there is a demand for a product in a marketplace, removing some of the risk from the equation. ”
For startup founders, public crowdfunding is a way of pre-selling a product or service to test the market. Harris mentions that crowdfunding is most useful for entrepreneurs who subscribe to the “hardware or creative line of thought.” He noted the Kickstarter campaign for the Pebble smartwatch, which broke the Kickstarter funding record at the time it concluded.
According to Peyton Worley, a partner at Cooley LLP, one of the benefits of crowdfunding is that none of your “investors” are shareholders in your company, so you get to maintain equity while raising capital to get your company off the ground. The difference is that you have to deliver something to get that money; whereas angel investing and VC provide investments up front so that you can build out a company and deliver a product to customers down the road.
Crowdfunding works mostly as a viability play for startups. It makes a lot of sense if you are trying to prove an idea, and it can definitely help you better your pitch if you are planning on taking additional funding from an angel or a VC. But, sometimes the audience you’ll find crowdfunding won’t represent how your product will do in the real world.
“Just because your Kickstarter campaign gets funded, it doesn’t mean that you are going to have wide-scale market adoption,” said Tony Schy, an angel investor. “Kickstarter by definition, the people who pre-order things on Kickstarter, myself as an example, we’re early adopters of things because we like that type of thing, and not a mainstream buyer by any means.”
While crowdfunding is a great way to get through the first run of your product, or prove to other investors that people are interested in what you are doing, it’s not the best option for long-term funding. It is also in its infancy, so it’s hard to tell how public crowdfunding will affect companies in the long run.
An angel investor is a wealthy individual who invests his or her personal capital in a company in exchange for equity in that company. Angels are usually accredited investors, meaning he or she has a net worth of $1 million, or they had an individual income of $200,000 each of the last two years and an expectation of the same for this year, or they and their spouse had a combined income of $300,000.
Angels typically fund a startup at the seed stage of a company. There is a higher risk associated with angel investments as they are dealing with an unproven business model. It’s also probable that the company doesn’t have a product and, if they have customers, they might not have significant revenue. However, they are more forgiving on the types of metrics that VCs use to measure a potential investment. According to Harris, when angels came along they “expanded the reach of the venture capital model.”
You’ll typically see an angel investment in one of two options. Angels can invest independently or with a group. If investing with a group they can do it as part of an angel fund or as part of an angel syndicate. Angels back a syndicate, which is lead by a notable angel investor, and they pay a carry (carried interest) back to the lead as a percentage of a profit they make on the deal. The Securities and Exchange commission (SEC) limits the total number of accredited investors who can participate in a syndicated deal to 99.
These group invests are sometimes referred to as “crowdfunding” but, for the sake of clarity, we will not refer to them as such in this article. Regardless of the type of angel investing you pursue, you should be sure to vet the investor or investors beforehand.
“When you bring an angel on board, you want to make sure you have the right one,” Schy said, “because it’s like getting married, except you can’t get divorced easily. They become your business partner whether you like it or not. You would hope that the angel, in addition to capital, brings a rolodex that they can tap into and/or relevant business experience that they advise you in.”
The glaring opportunity with angel investing is for companies that are just getting started and haven’t been able to completely think through all of the aspects of building a business. It also works well for companies that need quick access to capital.
“Usually the time needed to take an investment from an angel is significantly shorter than the time needed to raise a similar investment from a traditional VC firm,” Harris said.
While you may be able to get money for a fresh company, or raise capital quicker than you expected, there are still some considerations to make. While there are individual angels that have tremendous insight into building a company, there are also young founders fresh from an IPO or acquisition who might not have the knowledge that can help your company. Try contacting other startup leaders in that angel’s portfolio to see if he or she would be a good fit for you.
Angel syndicates provide access to even more capital, but they they might be difficult to get non-financial help from as well. According to Schy, individual subscribers to the syndicate don’t have any connection to the founders at all, and the person who has the experience or knowledge may be difficult to get ahold of.
Venture capital investing
Venture capital investing is by far the most well-known way of raising capital for your startup. According to Alex Oppenheimer, partner at New Enterprise Associates, it begins with setting your expectations.
“I think you first have to assume that you’ll be getting what you expect out of venture capital. That being: value added investors, productive board members, portfolio benefits, follow on capital, guidance, access to experts, and media exposure,” Oppenheimer said. “I think these are the key value adds of traditional VC. That being said, not all VCs are created equal and not all are willing or able to provide this upside to companies for a variety of reasons.”
Worley said that most of the companies that he represents pursue venture capital investing over the other options. The reason being is that venture capitalists, and the firms behind them, are set up to help you grow and evolve. Their job is to make sure your company is profitable, because it means that their firm will make money.
With VCs, you are tapping into a larger pool of capital. According to Harris, If you are working with a great VC firm that believes in you, it will be easier to raise large amounts of money.
“As a founder, your main goal in life is to build your company, not to spend time fundraising,” Harris said.
Venture Capitalists typically reserve additional capital for follow-on investment rounds. This is helpful for companies that have a long runway, or need more time to build out their businesses. Another huge value that VCs provide, is access to their networks for employees or clients to use the products or services you are building.
“These days, capital might be the least important item that they bring,” Franklin said. “They bring a wealth of experience. Many of them bring a particular expertise. Many of them were serial entrepreneurs themselves. They’ve been there, they’ve done that. They know the pitfalls that folks trying to start companies and be successful face.”
Of course, there are some dangers in taking venture capital. One of the dangers is in taking VC early; there is the potential that you could overvalue your company, which will affect you in later rounds. The rules around a VC investment are usually a little more stringent, and there is a timeframe for the return on an investment in your company.
“The venture capitalists bring a lot of things to the table besides a check,” Franklin said. “The crowdfunding and the other means and platforms by which startups are getting funded today is something that we as a country ought to celebrate, and recognize that every startup is not created the same. Every startup is going to have its own unique needs, and some of those will be better suited for crowdfunding, and some of those will be better suited for venture capital, and some of those may be better suited for angels.”
Whatever type of funding you pursue, make sure you have a plan for the money so that you can target the right investment for your company.
About Conner Forrest
Conner Forrest is a Staff Writer for TechRepublic. He covers Google and startups and is passionate about the convergence of technology and culture.