9

Overview of Funding Sources

Who invests in startups? Five funding sources make up the vast majority of where startups get money. Each source differs in how much money it invests, at which stages it invests, and in what it brings to the table in addition to funding.

Key Elements:

• Friends and family

• Crowdfunding

• Accelerators

• Angel investors

• Venture capital firms

The Five Funding Sources

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Friends and Family

At a Glance

How much? $5,000–$100,000

When? Seed stage

A scrappy, talented guy decides to go out on his own to launch or buy a business. Without a huge network of seasoned “finance” people, he turns to the most business-minded and/or wealthy people he knows: a rich uncle, the family doctor, the neighbor who found out his ranch sat on a few million dollars of shale oil. That’s the typical story of finding “friends and family” investors.

According to one study, 82 percent of all funding for startups in 2012 came from friends and family of the founders. As a group, it is the largest funding target in the United States (and probably the world). In 2011, friends and family invested a total $50 billion, far more in total money invested than venture capital and angel investment combined.

If you plan to take money from friends and family, make sure you are up front and honest about the risks associated with the venture. The reality is, most startups fail, and they need to know they could lose all their money. If losing their investment would significantly hurt the family member’s or friend’s finances, don’t do the deal. As a rule of thumb, you don’t want to ask for more than 5 percent of someone’s net worth, ideally much less.

Pros Cons
Compared to other forms, can be very easy to get. These people are your family and friends. Many relationships have been hurt by deals gone wrong. You should be very aware of the risks to family money.
Capital comes faster. Typically, they don’t provide that much capital.
Leverages the trust you’ve already built. Some investors are deterred by messy investor groups, so don’t invite too many family members.
Typically, more patient. Not sophisticated.
Better terms. May hurt future rounds of capital.

Notable Friends and Family

• The rich relative

• Doctors and lawyers

• The corporate exec at church

• High school friend

Crowdfunding

At a Glance

How much? $5,000–$100,000

When? Seed stage, early stage

Crowdfunding is a very different and potentially disruptive form of startup fundraising that involves many investors pooling small amounts of cash to fund a venture or some aspect of it. Crowdfunding can be divided into two categories:

• Rewards-based. People act as “patrons” instead of investors, giving cash in exchange for different levels of rewards. In some cases, those rewards are presales of the product. This is what most people think of when they think of crowdfunding. Examples include the platforms Indiegogo and Kickstarter.

• Equity-based. People make actual investments in exchange for equity in a venture. In the past, equity-based crowdfunding platforms could legally accept only accredited (read: rich) investors. With the new SEC rules that came out through the JOBS Act in March 2015, equity-based crowdfunding now extends to almost anyone. Examples include the platforms CircleUp and Crowdfunder.

Crowdfunding platforms can do a lot more than just raise capital. Entrepreneurs use them as marketing tools, to validate a prototype or concept, to collect presales, and to test things like pricing and messaging.

Pros Cons
With rewards-based platforms, you don’t have to give up equity. Everybody sees it. You may not get enough traction on the site, which looks bad if the funding campaign didn’t pan out.
Offers you immediate feedback on the viability of your idea; bad ideas don’t get funding. Donors can be impatient and may complain if you don’t deliver rewards on time and as promised.
Creates word-of-mouth advertising. Competitors see what you are doing, which may incite copycats.
Creates a built-in customer base of people who liked your business enough to invest in it.

Notable Crowdfunding Platforms

• Kickstarter

• Indiegogo

• CircleUp

• Crowdfunder

Accelerators

At a Glance

How much? $5,000–$50,000

When? Seed stage, early stage

They’ve been called the MBA for entrepreneurs. For early-stage, prefunded companies, these organizations can take your good idea and put it on steroids.

Accelerators are more often runways to funding rather than sources of funding themselves. Admission to one can get you access to capital, idea refinement, developers, co-working space, and validation. Billion-dollar companies have been birthed from accelerators, including Airbnb and Dropbox. Many accelerators also give you access to investors, vendors, suppliers, and potentially other cofounders. Companies typically have to give up a small slice of equity in return for the network the accelerator provides.

Be aware that entrance into an accelerator comes with a particular set of relationships, capital sources, and brand, so choose wisely. As the number of accelerators increases, the quality of the programs and the deals coming out of them will decrease. As a result, more accelerators are specializing in specific verticals.

Pros Cons
Increase the likelihood of raising money. Not a great option if you need lots of cash quickly.
Relational capital is very helpful to get intros and feedback on your venture. The good ones can be extremely selective.
Creates word-of-mouth advertising and PR. Time consuming and potentially distracting due to all the meetings.
Training and increased business skills. They can be expensive; many require that you give up a high percentage of equity for a small amount of cash.
Peer advice and support through cohort companies. Tons of advice can be confusing (five different mentors can have five different pieces of advice).

Notable Accelerators

• Y Combinator

• Techstars

• 500 Startups

• Seedcamp

Angel Investors

At a Glance

How much? $150,000–$500,000

When? Seed stage, early stage

Angel investors are rich people who professionally invest their own money into early-stage companies. Some of the best businesses of the last thirty years started out with investments from angels, including Google, Yahoo, Amazon, Starbucks, Facebook, Costco, and PayPal. An angel’s investment tends to be quicker and more personal than investments from venture capital firms. One of the TreeHouse investors put $50,000 in the company without ever meeting Loomis in person because he worked in the home improvement space and liked the concept. The first Outbox meeting yielded a $100,000 investment from a technology angel investor. Many angels are entrepreneurs themselves. There are also angels who are former or current corporate leaders and business professionals.

Pros Cons
Angels often invest in spaces they have an expertise in and understand. Some angels may not be well respected. Entrepreneurs should ask the same questions investors ask themselves: Do I like you, do I trust you, do I want to do business with you?
Some angels may even work in the same industry as you. This is categorically “smart money,” and other angels love to follow these types of investors. They get involved, which may not be a good thing.
They can introduce you to lots of other investors, suppliers, and other relationships. You’ll need lots of them to raise enough money, which can be like herding cats.
If they get in on the first round and like what they see, then they may save you the hassle of doing another road show for your second round of financing. Many angels don’t bring anything to the table other than money.

Notable Angel Investors

• Peter Thiel

• Mike Maples

• Dave McClure

• Naval Ravikant

DEEP DIVE

AngelList

Overview

At a basic level, AngelList is the LinkedIn for startups—a directory for finding and researching great startups. Many of the biggest seed venture capital firms and angel investors are on the list, and many use it to help them source and validate deals. But AngelList is also a crowdfunding platform, a way for startups and investors not only to connect with each other but also to actually raise money through what AngelList calls syndicates. Most startups that are on the list and do well raising money with AngelList are in their seed or A round.

AngelList as a Directory for Startups and Investors

Even if you aren’t likely to raise money on AngelList, it may be worth creating a profile there for both you and your company. Follow people who you find interesting; do due diligence on your competition. Search for great designers and engineers to hire.

Raising Money on AngelList

Posting your profile to AngelList is very easy, but that doesn’t mean it is easy to raise money through it. Many founders are tempted to bet on a build-it-and-they-will-come strategy with AngelList: get your profile out there and then sit back and wait for some rich billionaire to reach out wondering how you came up with such a brilliant idea and where he can send the money. This is the lottery scenario. The vast majority of ventures on AngelList raise no money at all. Those that do pay attention to how the round dynamics and momentum affect their strategies. If you plan to try to raise money on AngelList, here’s what you should pay attention to:

• Connect every influential person you can to your profile in any way possible. You can list people as informal advisers, employees, even as customers, and ask them to give you a testimonial. The more people who are connected to your profile, the more people who will see your profile when you raise money. You want to make your company look as if you have a really great set of friends and supporters.

• Raise before you raise. The most ideal time to post on AngelList is after you have already raised at least a third, if not half, of the total amount of the money you want to raise. Most investors are likely to rely on the due diligence that other lead investors have already done. If you already have some major supporters, lots of additional people will be interested in taking part in something someone else has already done the homework on. Also important is the quality of those investors. The more well known they are and the larger their followings on AngelList, the better.

• Know what kind of money you are trying to raise. AngelList helps you raise money in two ways. First, it helps provide introductions to larger investors, including traditional VC firms. When these seed firms ask for an introduction or reach out to you on AngelList, they are beginning a conversation that will likely evolve in the same way it normally would outside of AngelList. You probably start with a phone call, maybe followed by a meeting in person. If someone chooses to invest, it will feel just like a traditional round—lawyers putting together documentation, wire transfers, and so on. The other mechanism that AngelList has created for investing is called syndicates. Syndicates are ways for angel investors to pool together much smaller investments, $1,000–$10,000, and co-invest it in a venture. In a syndicate, a group of angels precommit capital that is unlocked every time the syndicate’s lead angel invests in a startup. With syndicates, Angel-List handles the logistics of the actual financing, including validating that an investor is accredited and handling the transfer of money. AngelList takes 5 percent of each deal done in the platform.

Why You Would Raise Money from a Syndicate

While a traditional seed firm may invest $500,000, a seed investor on AngelList may invest only $5,000. Thus, for your round, you may have dozens of small investors come together to form a pool of $500,000. If your company is the kind that needs lots of support, maybe launching in different geographical markets, getting the word out, or sending you business, AngelList presents a way for you to engage a special kind of fan—the investor fan.

Venture Spotlight: Outbox

For Baehr’s first venture, Outbox, he chose to raise money through AngelList. At the time, he closed the second- largest amount ever raised on the platform. Here’s his story.

We were interested in raising a Series A and knew we’d likely have one lead institutional investor. We decided to raise money alongside our traditional investor from AngelList for two reasons:

1. We wanted to see if we could raise an additional million or two to increase the overall size of our round beyond what the lead institutional investors had planned to do.

2. We wanted to find a way to engage dozens, maybe even hundreds, of people in our future success as a company. In that sense, AngelList was, for us, a way to connect with different kinds of investors. Given that they are investing significantly less money, there will obviously be significantly more people involved in your round.

We were advised that we should have lined up a major institutional investor and 50 percent of the capital before we posted to AngelList. When we actually posted on AngelList, we published that we had already closed $2.5 million of the total $4 million round. Over the following week, we received introductions and offers for an additional $8 million. In the end, we ended up closing $2.5 million from investors through Angel-List. About $2 million of that came from only a handful of people who were actually institutional investors and had their own funds. The other $500,000 came from about forty individuals who were bundled through the AngelList invest online product. This gave Outbox an added fifty people who were rooting for our success and wanted to be helpful however they could.

DEEP DIVE

Anatomy of an AngelList Profile

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Venture Capital Firms

At a Glance

How much? $1 million–$300 million

When? Early stage, growth stage, late stage

VC firms are companies that pool money from foundations, insurance companies, pension funds, and institutional investors and invest that money into high-risk ventures for equity.

VC firms are startups. A team of founding partners has a vision for making money by buying equity in other early to midstage ventures. In order to create a fund large enough to pay for those equity stakes, they have to raise money. The founding partners must convince their investors that they have access to amazing startups and entrepreneurs and the ability to recognize great businesses in very early stages. According to the National Venture Capital Association, the average VC fund is $149 million. Because of the high-risk nature of the kinds of investment VC firms make, funds expect a very high return on their investments.

Pros Cons
Social proof. Raising funds from a well-respected VC firm is a powerful signal. They have the leverage to drive down your valuation.
Lots of cash. You lose control.
“Smart” money—they often have a depth of experience. There is an expectation that you will sell the company.
Allows you to scale quickly. VC firms can put a lot of pressure on their portfolio companies, especially if the fund is near retirement and investors want their money back.

Notable Venture Capital Firms

• Kleiner Perkins Caufield & Byers

• Greylock Partners

• Andreessen Horowitz

• Sequoia Capital

What All Funding Sources Have in Common

No matter which funding sources you pursue, all have one thing in common: they exist to find you.

Without access to deal flow—a steady stream of high-potential ideas and ventures—funding sources die. Some investors like to make entrepreneurs feel as if the power dynamics are heavily weighted to their advantage. They’re not.

Broader economic trends ebb and flow. Sometimes, there is more money to go around than there are ventures to put it in. Other times, it’s the opposite. At the end of the day, both sides need each other and get the most out of treating each other as respected peers.

“Don’t get nervous about it, realize you have some of the leverage and power as well because it’s the investor’s job to meet with you. If you shadowed a VC for a month, you’d see it is their job to have deal flow and to understand what is happening out there and what are the popular deals.”

—Jeff Avallon, Cofounder, IdeaPaint

Questions You Need to Ask Yourself before You Raise Money

Deciding whether or not to take equity funding is a big decision. These questions help you break down your thinking as you consider raising money and from which funding sources.*

1. Why do you want to raise money?

No, really, why do you want to raise money? To quit your day job? Hire more people? Reassure yourself it’s a good business? Feel cool at a cocktail party? Get all of those reasons out and on paper—the financial, psychological, and business cases for raising a funding round.

2. How much do you want?

There is no scientific way to answer this question. Most startups calculate the amount they want to raise by starting with a milestone they want to achieve (say, a minimum viable product or cash flow breakeven), and then planning backward to identify the people and resources they will need to get there.

3. If you didn’t raise money, what would you do?

If you had no other option but to grow the venture without raising money, what would you do? What would the next six months look like?

4. If you did raise money, what would you do?

Get as specific as possible. Where would you spend each dollar? When would you spend it? Who would you hire? What are their names? What resources would you buy or build? This exercise may make you uncomfortable; push through it.

Introduction to the Friendship Loop

When Francis Pedraza landed in Silicon Valley looking to get his startup, Everest, off the ground, he knew a whopping total of four people there. So, the first thing he did was ask those four people to coffee.

Having just graduated from Cornell, he moved to the West Coast to create an app that helps people live their dreams. He had no team and no resources, just a fire in his belly and a conviction that what he was doing would change the world. A lot rode on those four people.

With each meeting, he focused on building a strong connection with the people he met. He pitched the idea and listened to their feedback. He asked questions and looked for ways that he could add value to their lives by sharing what and who he knew with them. Then, he asked them to introduce him to three people and, without fail, followed up. Within a few weeks, he had every breakfast, lunch, and dinner booked with someone new. These meetings led to introductions to people like Peter Diamandis from the X Prize Foundation and Dave Blakely from IDEO, both of whom agreed to join the board of advisers. The more he engaged with people, the more they wanted to help him. Some entrepreneurs were making ten introductions for him.

Six months later, when he decided he was ready to raise money, Francis had a substantial list of advisers to turn to—a list that would eventually lead to an investment from his childhood hero Bono (more on that later). What made Francis so good at building a network of people willing to help him?

Francis engages in a strict discipline of connecting, cultivating, and following up with people that we call the friendship loop. It’s a process focused on relationship building, runs on trust, and takes advantage of often overlooked opportunities to delight others and invite them to be part of the adventure. It’s a process used—intuitively or intentionally—by every successful and well-respected entrepreneur we’ve met. It’s also the most ignored aspect of successfully raising money.

Fail to Meet the Right People, Fail to Get the Right Cash

When founders realize that they need to raise money, many react like a man falling backward off a cliff: they find whatever’s in front of them and grab like hell. The lure of insta-cash and the fear of the unknown distort the founders’ vision so that they begin to treat their relational networks like a series of slot machines to be pulled. Know which machines pay out, discover the right ways to play, and eventually you’ll hit the jackpot.

When their immediate networks turn up empty, or if they are too ashamed to ask people they know to invest their own personal savings, the founders start looking for institutional money—venture capitalists, bankers, and established funds. Although a very small percentage of startups meet the criteria for this kind of financing, many founders seek them out because they are much more visible, the process for applying appears straightforward, and there’s a certain aura of cool that comes from “going out for VC.” Months later, having been strung along by a half dozen responses like “come back to me when you have a lead investor” and hundreds of unanswered e-mails, the founders fold their hands and admit defeat, telling themselves that it just must not have been the right opportunity, never realizing they were toast from the beginning.

The Three Snares

Lost in the moment, founders can often get caught by three seemingly obvious snares during what is known as the road show—the weeks, months, or years an entrepreneur spends raising money.

First, they prioritize cash over relationship. They assume that money is the most important resource their venture needs. It is actually relationships—the vital connections between the right people who have the right resources— that have the greatest impact on a startup’s chance for long-term success. Cash burns up faster than you can imagine, but reputation endures. Cash is likely to be the least valuable asset you accrue on a road show.

Second, they assume all money is good money. Entering into a relationship where an investor gives you cash in exchange for ownership in your business is like getting married. That marriage may come with access to new information, industry expertise, or supplier, distributer, or partner relationships. It also may come with burned bridges, control issues, or misaligned incentives, so knowing what investors bring to the table in addition to money should have a significant impact on which people the founders pursue.

Third, some startup entrepreneurs can be terrible stewards of the relationships people offer them. Everyone loves connecting one world-class person to another when it’s a gift to both parties. Who wouldn’t want to be the guy who introduced someone to his next cofounder or the next entrepreneur who made his $10 million? On the other hand, no one wants to be the guy who introduces someone to the flakey know-it-all who stands people up. Mishandling a well-placed introduction makes everyone look bad. Even though there are a few simple things you can do to leave a lasting positive impression on someone who helps you, few people learn to take advantage of them. There’s a better way.

Rather than seeing every high-net-worth individual or firm as a bag of money, entrepreneurs can build relationships with investors whose involvement would be mutually beneficial. They can create such rapport and excitement among the people that they meet that others will go out of their way to help them.

Cash isn’t king; friendship is.

We call this paradigm shift the friendship loop, and it starts by taking stock of your personal social graph—who you know and how much access you have to the things and people your startup needs. Starting with the people you already know, you bridge to new social networks by asking for introductions to people they know. Then, you build trust through those new relationships, delight people with gratitude, and invite them to participate in your venture by advising or partnering, introducing you to others who can help you, or investing.

Intro, build, delight, invite. (Repeat). That’s the loop.

The Friendship Loop

Intro to someone who can help move your venture forward.

The first big challenge facing entrepreneurs who are raising money is building trust with the people who have the power to help them. Investors get hundreds of e-mails a day from startups that claim they are launching the next big fill-in-the-blank. What can you do to get them to trust you? You find a bridge. No matter how isolated, every entrepreneur on the planet is one degree from someone who can push his or her venture forward. If you can find a bridge to that person through a well-placed introduction, the trust that characterizes the relationship between the person you know and the person you want to know will transfer to you. By starting with the people who are directly in front of you, who already trust you and have an investment in your life, you utilize your own strengths and use your first few warm meetings as opportunities to practice your story, identify unexamined areas of the business, and strengthen your pitching muscle.

Build a relationship with that person by finding commonalities, asking questions, and “playing” together.

Through that newly transferred trust, successful entrepreneurs get rare opportunities to sit down with potential connectors, advisers, and investors. With pitch decks in tow, they make their ways to coffee shops, restaurants, and home offices. What happens next may be shocking. They shut up and listen. The second step of the friendship loop is to build a relationship. Through finding commonalities that exist between you, through asking questions and listening, and through invitations to play with your idea, killer fundraisers establish genuine connections with the people they pitch to. They seek to understand what each person wants, and they work to help each person accomplish his or her goals.

Delight through gratitude, follow-up, and thoughtful introductions and resources.

When entrepreneurs follow up with those they meet in sincere and unexpected ways, they turn an ordinary connection into a warm and meaningful memory. Crafting a handwritten thank-you note, sending a thoughtful gift, volunteering time to something the person cares about, and offering valuable connections and resources are the calling cards of friendship loopers. As you’ll see later, these small actions can have astonishing consequences when done without expecting anything in return.

Invite them into the adventure by partnering or advising, introducing you to others, or investing.

The last step of the friendship loop is to extend an invitation to the person you’ve met. Having carefully thought out what you’re asking, how it will benefit both of you, and what needs to happen once that person says yes, you make a clear offer for your new friend to join you on your journey. Whether you are asking him or her to invest in your venture, join your advisory board, or introduce you to new investors, advisers, or experts, you take the responsibility for making it as easy as possible to do whatever it is you are asking.

*Thanks to Jeff Avallon, cofounder of IdeaPaint, for suggesting some of these questions.

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