This column describes the spectrum of capital sources available to entrepreneurs starting businesses. Since the topic is more worthy of a book than a monthly column, links to complete articles on each funding type are provided. Entrepreneur’s Corner would appreciate feedback on both the usefulness of this column and on additional related topics that might be addressed in the future.
As entrepreneurs think about starting a business, they use their own personal resources to convert ideas and innovations into product and service concepts. The most obvious of these include savings, personal computers and home offices. Entrepreneurs also use home equity as collateral for loans and personal credit cards to provide the cash necessary to start their companies. Using a spouse’s or partners income for living expenses while starting a company is also common. Extending these personal resources as long as possible before looking for outside sources of capital is called “bootstrapping,” which is described in more detail at this link.
Entrepreneurs bootstrap their companies as long as possible until their personal resources are tapped out for two distinct reasons: (1) Outside investors want to make sure entrepreneurs are fully committed to the new venture before providing more funding to startups. After all, if you are not fully committed, why should others help? (2) Funding product development and implementation as long as possible creates value. The more value created by the entrepreneur with personal funds the smaller the percentage of ownership that entrepreneurs must sell to investors to grow their companies.
As innovations are converted into products, two additional sources of capital become available to entrepreneurs – government grants and capital from friends and family. Government agencies provide over $2 billion in funding to startup entrepreneurs annually, while friends and family provide much more – estimated to exceed $50 billion annually. Entrepreneurs use government grants and friends and family to optimize products and seek out potential customers to beta test products. These sources typically provide $5,000 to $100,000 in startup capital to entrepreneurs, often enough for companies to begin selling products and generating the cash necessary for growth. In these cases, grants or friends and family funding may be all a business needs to growth without additional infusions of cash.
If startup ventures need more than $200,000 in capital to achieve viable cash flow from internally generated cash (earnings), angel investors may be the appropriate source. Angel investors typically invest $200,000 to $1 million in capital to entrepreneurs, in exchange for 20-40% of the equity of the new business. But, angel investors are much more selective about the types of entrepreneurs and companies they fund – choosing only those management teams with appropriate experience and venture which can grow revenues quickly to $20 million or more in five to eight years. Angel investors don’t fund service businesses, real estate ventures or retail stores. See this link for typical angel investor Criteria for Investment.
Venture capitalists (VCs) fund entrepreneurs with much larger amounts of capital, ranging from $4 million to over $50 million in funding. There are two huge limitations to seeking capital from VCs:
1. VCs are incredibly selective about the new ventures they fund. They seek companies with revenues and perhaps earnings. They only invest in companies that already have a good understanding of the business sector (and probably already have portfolio companies in those business sectors – check their websites). They only invest in proven teams or will insist that the entrepreneur be willing to step aside in favor of an experienced CEO to run the venture.
2. Venture capital does not travel well. VCs prefer to invest close to home, convenient for kicking the tires and attending board meetings. Unfortunately, only a few VCs are located in or interested in investing in Montana companies. Less than a dozen companies have successfully raised money in Montana in the past decade.
Finally, the capital food chain for entrepreneurs is lumpy. Many more friends and family investors are willing to invest $5,000 to $10,000 in new companies than are willing to invest more than $20,000. Angel investors seldom invest less than $200,000 in new deals and very few angel deals raise more than $1 million in one round of investment. Furthermore, there is a huge Funding Gap between angel investors and Venture Capitals – with very few investors available to fund rounds of investment between $2 million and $4 million.
The lessons here are: Understand the capital sources available to entrepreneurs. Seek the appropriate amount of capital from each source only when your company is at the stage of development most comfortable for each investor group. And, design the milestones or objectives for startup companies that accommodate the lumpy nature of this capital food chain. In other words, make sure you raise enough money at each stage of development to achieve important goals which justify raising more money, hopefully at a higher valuation.
Columnist Bill Payne is an entrepreneur and angel investor. He may be reached by email at [email protected] or see his website at www.billpayne.com where his book The Definitive Guide to Raising Money from Angels is available. This is the fifth in a series of monthly articles in the Entrepreneurs’ Corner written by Bill Payne for the Flathead Beacon.