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Early Stage Startup Finance: What You Need Is Dumb Money

Guest post by: Nathan Beckord

Article Overview: Many startups seeking angel capital aren't actually far enough along from a development perspective to be attractive to early stage investors. In essence, there is an entrepreneurial myth that angels invest in concepts or ideas. This is rarely the case- angels typically want to see some level of progress being made with the business before getting seriously interested. So what does a cash-strapped entrepreneur do to get off the ground? They raise what is called a "friends and family" round. This article discusses the attributes of this type of seed stage investing, and provides some tips for putting together a viable deal.

Early Stage Startup Finance: What You Need Is Dumb Money

I am frequently contacted by startup founders who are seeking help raising angel capital. I give an explanation of what angels are looking for, point out a few of the more active angel groups (Band of Angels, TechCoast Angels, New York Angels, etc.), and describe the growing army of "super angels" like Ron Conway or Aydin Senkut that has emerged in recent years.

And then I gently shatter their hopes and dreams by telling them there is no way in hell any angel will fund them; I tell them they are not ready to raise outside capital from professional investors.

I do this because of a common disconnect, a misperception of angels as mythical creatures willing to shoulder all the financial risk in a startup. Granted, angels are opportunistically driven by a desire to get in early. But the reality is that they are still highly risk averse (especially since it’s their own money), and are seemingly becoming more so (according to a recent NY Times article, total angel investing fell by 27 percent in the first half of 2009, and the average deal size shrank by 30%).

The point I try to drill home is that although angels play early in the game, they rarely invest in pure ideas or business plans. Instead, they tend to invest in entrepreneurs who have been able to get the ball rolling through their own hustle, creativity, and chutzpah. You may not have solved all the technical or market risks, but angels want to see that you’re sufficiently resourceful to have built enough of “something” that they can see the shape it’s taking, and kick the tires a little.

So what do I suggest for those who are not ready for angels, and who don’t have enough personal savings to bootstrap the business?

I tell them to seek "dumb money."

This pejorative term comes from the fact that an investment in a pre-launch company is almost never rational when viewed by any traditional investment lens. Given the lottery-like odds that a pre-launch company will ever return money to its initial backers, dumb-money investments are more akin to a grant or donation than an “investment.”

But “dumb money” is often exactly what is needed at the idea stage of a business, and it usually means hitting up friends and family—people who know you well enough that they are willing to take a leap of faith on your ability to pull it off. In short, you are raising money from people who are willing to invest in you, as opposed to investing in the fundamentals of a deal.

I dislike this term, as it is both pejorative and a misnomer—anyone who can bankroll the $50k or $100k needed to get your startup off the ground has probably done quite well for themselves based on their own smarts and drive. They may not be savvy private equity investors, but they probably know a few things about business.

Further it neglects how important the friends-and-family funding economy is to a healthy startup ecosystem. Indeed, it is the invisible army of doctors, dentists, parents, grandparents, and great aunts who catalyze the dreams of wild-eyed entrepreneurs and who enable crazy ideas to come to fruition and change the world.

So this holiday season, let’s raise our glasses to the unheralded champions of entrepreneurship, the ones you don’t read about on TechCrunch but who in aggregate are more vitally important to the startup world than all the VCs combined.

And, as the liquid refreshments begin taking effect, and as you move in to seal the deal, let’s review a few tips to ensure the "dumb money round" does not become a disaster:

Understand The Risks: If you raise friends-and-family money and your startup fails—and odds are it will—you’ll still see your “investors” each Thanksgiving and at each wedding, baptism or bar mitzvah. Is this going to cause significant heartburn and family strife? Proactively visualize your father-in-law’s reaction to losing his money, and it’s effect on your relationship. Make sure you can stomach this before cashing his personal check.

Make Them Understand The Risks: Directly related to the above, you should temper your pitch by being painfully, explicitly candid about the risks of the venture. Talk through all the reasons the company might fail, and state that although you will do everything legally possible to make the business a success, the odds are that they will never see their money again. Is this something they are willing to accept? Perhaps more importantly, is this going to cause them financial hardship? If so, you’d do best to look elsewhere.

Structure It As A Loan: Selling a percent of your company at an early stage is exceedingly difficult, not only because you must issue shares, but because it generally implies you are setting a valuation. Further, a messy cap table—with many small investors who may or may not be “accredited”—can make it difficult to raise money later from professional angels or VCs. A better approach is to structure it either as a non-recourse loan, or as convertible debt (i.e., a loan that converts into equity once a valuation is negotiated later with VCs).

Paper It Up: Many friends-and-family rounds are done via lunch and handshake. In general, I think this is a mistake, and you are better served by drafting a written deal. It need not be overly complex, but it should state the amount being loaned or invested, repayment terms (if any), and an acknowledgement of the risks involved. The most valuable takeaway is that you’ll have something tangible that you can refer to later if things go awry or if perceptions diverge.

Go Like Hell: The best way to solve all of the issues above is to execute like hell and make the business a success. Granted, this should be a given, but building a startup is always a roller coaster ride with serious highs and lows, and many entrepreneurs want off when things get rocky. Taking other people’s money brings an additional level of obligation and pressure; it means you need to be more committed; it means you can’t easily walk away. In particular, this manifests itself in a sacrifice of personal life and freedom. But this is the deal with the devil you make when you take other people’s money. Further, for your investors, demonstrating that you gave it your all will lessen the pain of losing their money if the startup fails.

In sum, if you don't have the resources to bootstrap it yourself, "dumb money" is what you need at the idea stage. But let’s come up with a better term for this critical bedrock of innovation. How about “concept capital”?

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Article Tags: angel capital, angel investors, bootstrap, early stage funding, seed capital, seed funding



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