Funding strategies to go the distance

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Good evening everybody. I hate to compete with food, so those of you who are getting food, just enjoy. There’s plenty of time to catch up, and it will all be posted up on the website, so don’t worry.

Amazingly, this subject is one where I always feel like there’s tons and tons of content already out there on the web, and that there’s nothing I can add value to. Yet I get more questions about this than probably any single other topic, which is: how do I get funded, how do I stay funded, and what should I expect along the way? So we’re going to try to tackle that quite openly tonight, with a series of different introductions.

We’re lucky to have players like Maya from CommonAngels, who has recently been made managing director. The angel group represented by Maya is very typical of what you’d find in the earliest of stages if you’re going to go out for angel funding. As you go from angel, the next typical area we talk about is seed funding, and we’re lucky enough to have Jeffrey Beer here from Seed to A. In recent years there’s also been a new phenomenon, going beyond incubators to accelerators, and there’s a great program in town, TechStars, so we have Reed from TechStars joining us. And then one of my partners, Carmichael Roberts, whose specialty is something a lot of you asked about in previous sessions: how do you do funding for not-for-profits, and in many instances non-equity funding, off-balance-sheet grants or loans. He has done literally hundreds of millions of dollars of funding that way. The star of our show is actually not here yet tonight: Steve Papa, coming live from a board meeting. Steve was the founder of Endeca. He started just like many of you and built his business to a billion-dollar-plus valuation and outcome, so it’s the perfect story to have as our case this evening.

The whole point of this is to break the barriers down and make this a transparent opportunity. The idea is not to give you the answers; it’s to put a framework up that gets you to think through the challenges of getting funding. This is just like sex, relationships, and money: it can get really complicated, and on the other hand it needn’t. So I’ll simply say, raising money is just like sex: a lot of people want to know about it, but very few people actually talk openly about it. The whole goal is to get beyond the issue that people are afraid to ask. It feels like there’s this opacity that VCs want to protect. We don’t. So you have people like me who are going to give you the chance to ask everything you were afraid to ask. And I’ll get to the bottom line: it is fun once you get it.

Typical sources of funding

At the most basic level you should know the typical sources of funding. They range from angel, to seed, to accelerator, and then typically equity of some sort, which we talk about as venture capital, growth equity, or private equity, depending on your stage. And then, hopefully, if you’re very successful, you get to the place where you’re a sustainable business in your own right and can be a public company, where you don’t need to raise money from anybody other than a public marketplace.

But there are a lot of other ways to raise money, and in the early stages they can be really important.

Startup secret: the best funding of all is if you never have to raise money because you can successfully bootstrap your business. The first business I did, I was lucky enough to bootstrap to a twenty-million-dollar-plus business, very profitably, before we raised VC and screwed everything up from there. I learned more in that process than in any other period of my life. And I’m privileged tonight to have with me the investor who made that bet on me, Rich, my partner and now friend thirty-one years later. I learned the hard way what I’m going to tell you tonight, and the whole point of this series is to give you a chance to avoid a lot of the mistakes I made.

VC is changing, and the way funding comes to market is changing. You’ve got new alternatives like crowdfunding. For businesses, you have funding sources like AngelList, which are very successfully helping entrepreneurs get to the initial sets of funding. For products and services, you’ve got things like Kickstarter, which has helped people not only raise money but in some cases validate their product or service even before it’s actually funded. This is an evolving landscape and an exciting part of the learning opportunity.

Should you raise money at all?

In some cases you should not raise money. If you don’t have a need, don’t raise money. There are personal issues that play into this. Are you somebody who’s very risk averse? If so, taking somebody else’s money is probably not a good idea, because you’re putting them at risk and putting a lot of pressure on yourself.

Another reason you wouldn’t raise money: lots of people want to run what I’d describe as a lifestyle business, which is perfectly successful in generating cash flows to support their own income but may not generate enough returns to invest in hiring people or building a large business. And lifestyle businesses are not necessarily small. There’s a company, about a two-billion-dollar lifestyle business, called SAS Institute, run by a fellow named Goodnight who has a very nice lifestyle: his wife built a hotel nearby that I’ve stayed at. He figured out how to do it all without taking external capital. So don’t think of this as being small; it’s really a choice, and it depends on your personal profile for risk and the kind of hard work you want to put in. Think about this first, before you get into any of the rest of this, because funding follows from what you personally are looking to do.

An overview of the stages

Frameworks are always there to be torn down and built back up, so this one changed about five times as I went around a few entrepreneurs and asked them what they thought the process of building a business was: what discrete stages would they name? These are the stages I heard: ideation, confirmation (a different word than I’d have thought of), creation, validation, repeatability, and so on. The point is that there are distinct stages people think about when building a business, and your funding really needs to follow along with these.

Startup secret: there are two great times to raise money. One is when you have a brand new venture that’s full of potential. All the potential makes you really attractive, because people can get excited about it, and they have absolutely nothing they can disprove, because there’s nothing actually proven yet. As you move down the road and start to get data points, everybody starts to do the diligence and create their own theory about how your business will evolve, and that gets a lot tougher. Until, of course, you get to the second great time: when you’ve got plenty of proof, and instead of a bunch of jumbled data points you can show a clear vector that leads to a valuable company. (One person also noted: if you’re making a lot of money you may not need to raise it, and not needing it can be a great time too, because people ask, “Why is this person raising money?”)

But life isn’t that simple, and you’re going to need to raise money multiple times. So break up this overview and think about what the milestones are at each point where you can either build great potential or have enough proof to move to the next stage. If you don’t have those two things, don’t go and raise money. Figure out how to get beyond those points.

The early stages

I literally hand-wrote this slide because I want you to feel it’s fluid. In the early stages, what people struggle with is how to take an idea and validate or confirm it with enough people to reach a place where they say, “This is worth building a product around, this is worth building a company around.” If you don’t get to that point, don’t move forward. Figure out what you learned, what didn’t get confirmed, and what questions remain, and go address them, because you can sure as heck expect them to come up with a VC or an angel.

Startup secret: ask the hard questions of yourself before they get asked of you.

What makes a great basis to develop this initial critical mass? Things like paper prototypes you can take out to initial potential customers, engaging with them to figure out not the product but what problem you’re really solving for them. There’s a whole workshop on this, the value proposition workshop, designed to help you specify the problem so well that when the customer hears it they go, “I would pay money for that if you solve it.” If you can get them to literally say, “If you build this, I’ll pay for it,” then your response should be, “If it’s that painful, why wouldn’t you invest in me building this with you?” That’s actually how a lot of great companies get started. There’s no better money than a customer’s money. If you can’t get that, then at least get to the validation of the problem. As the head of GE’s innovation group said, “A problem well defined is half solved.” That’s what I look for at this stage.

The worst thing you can do is go hurtling down building your product without validating whether it meets any need or solves any problem. That’s the number one mistake we see at the early stage. Entrepreneurs are so excited to build something, they’ve got the lean startup book and they’ve nailed the Minimum Viable Product, but they haven’t figured out who it’s for or what problem it solves. That is not a seed investment that’s going to succeed in my book. Now, some will disagree, and there are instances, consumer investing being a good example, where you probably do have to build something before people really understand what it is. There are also latent, aspirational needs. Who thought they needed an iPad five years ago? Nobody, even in Sweden, before the thing existed, and now anybody who has one will tell you it’s become indispensable. But even in that instance I’d encourage you very early on to figure out how you might validate the opportunity ahead of you, and then move to the next stage.

The Series A crunch

This early piece is typically friends-and-family funding, seed funding, and A funding. There is an apparent Series A crunch out there, and there’s a reason for it. (For the rock fans: I grew up in England, and Supertramp’s “Crisis? What Crisis?” was one of the best albums; I thought there’d never be a crisis. The real world is a little different.)

Getting your seed and Series A doesn’t mean you’re done. What’s happening is a phenomenon where people are getting their seed funding easily because investors are willing to throw money out there to see what works. The money is not a big deal to the investor, but your life should be a big deal to you. There’s a crisis here I want you to think about one step ahead: if you take your seed, how will you get to a place where you have enough value (a product, not just a vision) that gives people confidence to make the next investment? Because there are way too many seeds being done and nowhere near enough capital available to do the follow-on for all of them. So even though people are at fault for what I call the spray-and-pray seed investing, ultimately you own this. Stay clear of it by thinking ahead about where your seed gets you and how it justifies people saying, “Yes, we should invest more.”

Building value, reducing risk

Assuming you get past Series A, for Series B, C, D you’re showing things like customer validation and, better still, references once you get a number of them. As you get into later-stage rounds, you show how your go-to-market really works, building beachheads, getting defensible segments. Ultimately each of these should generate a clear business model that shows how you’re going to make money. I threw this up in handwriting for a reason: you could change the order, you could do all of this in parallel; there’s no right or wrong way. The point is that at each stage you’re trying to move down the field and show more and more proof of how you’re going to build a valuable company, all the way to a place where you can IPO.

Investors on the other side are looking at two things: how are you decreasing their risk all the way through, and how are you increasing the value all the way through? At the end of the day, when you want to be a public company, they’ll be looking for one thing: a financial model that shows tremendous leverage to generate high value for low investment. Start with the end in mind. As you define your own milestones, think about how each will cause an investor to say, “This has decreased the risk since I was last here, they’ve increased the value, they’re showing clear progress, so why wouldn’t I take the next step?”

The most important thing that’s not on the slide

There’s one thing I purposely left off, and it’s a really important piece of building a company: it’s not even management, it’s team. Management is a great place to start, but this is a people business. Particularly in the tech world, most of your IP walks out the door every night. So we really want to understand what you’re doing at each step to build a team that in its own right can stand alone and grow the business. There’s no right answer to how you build your team; there’s a whole post on hiring and building culture on the site. As an investor, the thing we’re constantly thinking about is: has the founder figured out how to build around their strengths and weaknesses, in a self-aware way, to put themselves in a position to ship a product, get it into customers’ hands, and make those customers successful references? Those are all different skills.

It’s not an exact science. It’s not like for every Series B you must have reference customers. From our own portfolio: we had a company called Starent that went literally twenty-four months without a dollar of revenue. You might say that sounds high-risk, and it was one of the toughest Series Bs I remember in our office. The good news is it ended up being a two-point-eight-billion-dollar exit six years later, one of the best IPOs and later acquired by Cisco. So it’s not a perfect science, but the principle holds: building value, reducing risk, and being able to show progress at each stage.