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Startup Capital

I'm setting up my own s/w house and am in a position where I have a good financial plan for growing quite slowly. I really don't see the need for more development staff than I have already planned for (<5 right now) however my instinct is that a company can always use more cash for marketing and the occasional ups and downs, plus, while I'm willing to risk my own capital in the company it would be nice to share that risk with some other investors.

I've established that I can get funding from venture capitalists of various types, but most people flinch when I mention the idea, and argue that I'll regret it because the VCs will eventually try to oust me and take control (and block out the sun etc. etc.)

So, is availing of VC cash such a bad thing? How did you raise the initial start-up capital and would you do anything differently knowing what you do now?

About to Jump
Thursday, April 01, 2004

If you're really just starting up, then actual VCs are not going to be interested. You can raise cash from what are called "angel investors" -- small amounts, perhaps $50,000 or at most $500,000, and they will expect a very significant share of stock just for that small amount of money.

Basically the amount of ownership you give the investor is based on the value of the company before they give you the money. Right now you have an idea and nothing else. That's worth, let's say, $100,000. An angel investor will give you $50,000 but then he will expect to own 33% of the company.

If you can hold off a year and build the company to the point where it has a product as well as an idea, although maybe you're not selling it yet, the company is worth much more, let's say, $1,000,000. Now the investor gives you, say, $200,000 but only gets 1/6th of the company.

If you can delay until you're actually selling a product, have established customers, a bunch of employees, and you're breaking even, the company is worth a lot more. Maybe $10,000,000. So now a VC has to give you $1 million and only gets 9% of the company.

Even people who are fans of the VC approach will tell you to delay as long as possible before taking an investment.

And I'm not a fan of the VC approach, for reasons which I have amply documented here:

http://www.joelonsoftware.com/articles/VC.html

Joel Spolsky
Fog Creek Software
Thursday, April 01, 2004

I agree strongly with Joel.

Borrowing money gives you another "boss" to please.  They may want you to grow faster (so they can get their money back), etc.

There are also lots of other reasons:  without money to throw at a problem, you are forced to be a bit smarter.

GREAT article on retired sw exec who started a new company like that: no money down.

http://www.inc.com/magazine/20020201/23855.html

Mr. Analogy
Thursday, April 01, 2004

Joel himself did an item on the difference in <A HREF="http://www.joelonsoftware.com/articles/fog0000000056.html">Ben&Jerry vs. Amazon philosophy</A>. If you're planning on slow growth, try to keep outside investment out or low as long as possible and retain maximum control of your company (and eventually maximum control of the profits...). If you're planning Amazon-like explosive growth you probably have no choice but to accept outside investment.

CT
Friday, April 02, 2004

When I worked at another humongous multinational company there were two groups I was familiar with who spun off software companies because the R&D bigwigs wouldn't continue funding them.

One group took VC money and grew from 3 to 8 to 30 employees in about 3 years and the principles got quite rich in the process. However, at the point where they had 8 people and were about to hire more, the VCs forced them to move from New York to a state 600 miles south where the business climate was "better" according to the VCs.

The second group took no VC money and were determined to muscle their way into a competitive field on the strength of their superior technical abilities. The if-we-build-it-they-will-come mentality. They went from 5 to 3 to 0 employees in about 3 years. None got rich, but they maintained full control of their own destiny after all.

old_timer
Friday, April 02, 2004

Ownership-wise, venture capital is very expensive.  You are essentially selling a portion of future value at a cut-rate price today.  That is, you are getting $1 today for $20 at some future date.  It is like a loan that you do not have to pay back if you are unsuccessful but has an absurdly high interest rate if you are successful.

Would you go to bank to borrow money just in case that you needed it in the future?  Probably not.  (If you are a financial genius who forecasts a large economic change such that money is easy to borrow today but difficult to borrow in the future, you might.  But most people are not financial geniuses.)  So, it is probably not a good idea to get money now in anticipation of some future need.  Later, you will more likely be a better "risk" so you will get a better "rate".

If you plan to spend the money on marketing (rather than just saving it for a rainy day), you want to get a good return.  Can you generate more than $20 worth of sales for every $1 that you spend on marketing?  Until you have a marketing plan that you can be that confident in, you are better off not spending money on marketing but just doing it yourself.

Since you are a founder, you cannot really share risk.  VCs can invest at 20 startups at the same time but, since your hard work is your contribution, you can only invest in 1 startup at a time.  That is total investment and total risk for you.  If you want to keep your savings, then keep your day job or do consulting on the side.  You have said that you have a plan to grow slowly.  (If you company had strong time-to-market problems, venture capital would be required and you would not have a choice.)

Or, think of this another way.  If you want to make $10M, you can either build a $10M company from scratch or build a $150M company with $2M-$3M of venture capital.

Daniel Howard
Friday, April 02, 2004

Very well put Daniel.

Mr. Analogy
Friday, April 02, 2004

You also have to consider how accepting outside investment may affect your slow growth strategy and the long term goals of your company. Obviously investors are going to want to earn a return in some way. For a small software company that generally means one of two things: get big and go public or find a bigger fish to buy you and eat you. Is this what you want? If this is okay with you what is your timeframe? VCs probably aren't trying to crank out companies quite as fast as they were a few years ago. However, they usually don't favor slow organic growth strategies.

Craig
Friday, April 02, 2004

When I said, "keep your day job", I didn't mean quit.  I meant, "keep your day job and use the other 40 hours a week to work on your startup."

Daniel Howard
Friday, April 02, 2004

Hi.

I came across this blog that is reviewing an interesting book on various profit models.

art-of-profitability.blogspot.com

It may be helpdful to anyone who is thinking of starting a new business.

good luck.

Jerry
Saturday, April 03, 2004

sorry, i missed out the http.

http://art-of-profitability.blogspot.com

Jerry
Saturday, April 03, 2004

I agree with taking the money as late as possible.  I think the biggest reason is the "hockey stick" curve of growth.  Joel correctly points out it is very, very hard and very, very expensive to shorten the "blade" part of the curve.  Therefore it is best to wait until you can see the "stick" part of the curve and take money during that part of your growth.

I will point out one reason to take vc money, however, if you are a software company.  People are used to seeing things in a certain way.  Sad, but true.  Therefore companies are used to aquiring/merging/having cash out events in future large mezzanine rounds with software companies that are partly owned by vc firms.

People just aren't used to seeing companies that are purely owned by insiders.  If you try to sell a position of your equity, they assume you have inside information which means it can't be a good deal.  They understand the vc needs to "monetize" their holdings.  As the entrepreneur you can participate. 

If you are purely owned by insiders you either need to grow quite large to sell or find "buyout" group which will basically give you multiple of cash flow that you could probably generate yourself in four years. 

Philip Sugar
Monday, April 05, 2004

Additional thoughts:

So from my previous post you can see that if you have an up round and if you can get a premium for your company because its partly vc owned you can make up the premium.  Much like paying a real estate broker to sell your house.  Painful to the thrifty side, but a good business proposition.

Where I find most entrepreneurs get "screwed" and I put this in quotes because nobody held a gun to your head to give you money is if:

They agree that the vc gets multiples for their money and/or they they have a down round (where big, big multiples come into play) and/or they take many, many rounds to get to a cash out position.  Each round is going to cost you 20% to 40% of the company.  Unless each round gets you much, much bigger then you are in trouble.

Vc money is very, very expensive and you have to pay it back.  That second point is the one that people forget.  You are saying your company is worth x and with money you are going to grow the company in ways you couldn't and it'll now be worth y and 60%y > x.  If it turns out y=x and you gave the vc a three time multiplier, the vc gets y and you get nothing.

Philip Sugar
Monday, April 05, 2004

For what it's worth, the angel that I hooked up with was willing to provide working capital of 100k for 30%.  I was pretty happy with that ...

I have ulitmately chosen option B, whereby I keep my day job and use the other < 30 hours (day job takes > 50 ... be realistic) to investigate the commercial properties of 'project x'.

Brad
Wednesday, April 07, 2004

"willing to provide working capital of 100k for 30%. "

30% interest or 30% of your business?

(The former sounds like a great deal for you. The latter sounds not so great.)

Mr. Analogy
Friday, April 09, 2004

Alas, 30% interest on the company, not 30% interest against principal.  On the good side, it was an investment, no repayment was expected.  Unusual terms perhaps, but it would have worked out ok ...

As I noted in my previous post though, I, at this stage of my life (1 teen, 1 pre-teen, 4 dogs, spouse, etc.) could justify the risk of leaving a nice, stable development director position for a barely funded start-up.  The idea was great and it'll be great in a year or two, assuming no other smart sole fills up the niche.

Brad
Saturday, April 10, 2004

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