Is Less Worth More in Early Stage Startup Funding?

There has been a debate recently in the VC community if angels are becoming more important for early stage startups because of the financial gains required by VCs on their investments. Angels also invest small money, and hence it is being discussed if startups that are funded with small seed investments have a better chance of survival (and success). Frugality is expected to lead to hard work, dedication, and less distraction. (Note: It is estimated that US angel investments in early stage companies is more than $20 billion, vs about $5-7 billion for VC).

This debate was started when Charles River Ventures, an early stage venture capital firm, launched a new investment strategy to offer rapid but tiny $250,000 checks to Internet start-ups. In not so subtle words, the idea is simply to invest in larger number of ideas and place a bet that even if a small number of ideas make it to success, the company will find itself hugely profitable.

In many ways this is not much different than Angels investing small seed amounts in very early stage companies, vs traditional VCs who now want to invest so much money in their portfolio companies (to make large returns worth their overhead costs), that they are going ever more later stage in their investments.

However, what triggered my post here is a recent item from VentureBeat:

Angel investor Paul Graham, who runs the Y-Combinator incubator gives a notable quote in a New York Times story about the how cheaply a new Internet company can get started — and how angels like him have a much easier time with this than elephantine venture capital firms.

“We are like mice, and VC’s are more like elephants. They can only make a few deals, so each one has a whole amount of weight and worry attached to it,” he said

From the article:

As for the target investment of $6,000 for each employee, an explanation on Y Combinator’s Web site makes it clear that Mr. Graham and his colleagues are not looking for computer science entrepreneurs who want to be pampered: “C.S. grad students at M.I.T. currently get $2,000/month to live on, so this represents three months’ living expenses. Though in fact most groups make it last longer.”

Would this model work in companies outside the IT space? I am left thinking what would I do with a new idea if all I had was $10K? Maybe I can put together a business plan and get some research reports to make sure my business plan had some meat on the bones. But give away 10% to do something like that? i can’t build a website and launch a cleantech business, can I?

I think there is a kernel of an idea here but others should develop it further. Having been an entrepreneur, I would certainly advise first-time entrepreneurs to be wary of what I could call ‘investor sharks’ though. Be apprehensive if you see someone too interested in your idea for no good reason. A good advice I heard recently is “Do your due diligence on investors like you would for your core employees’.

A good investor invests in people, and not one-shot gimmicks. First-time entrepreneurs need encouragement – yes they need the money but they also need counseling, advisory services, and a smart/been-there-done-that person to bounce ideas off of.

Small investments do not, and should not, mean that the founders have to live on grad student salaries and eat Ramen Noodles. These are just funds to give you that breathing space so you can live entrepreneurship for a while and give it a shot. But don’t get caught up in it. If someone gives your money, and not much else, walk away if you can afford it. Again personal experience tells me that money is cheap (especially such small numbers), it is the advice and the network that is most valuable. 

And here’s just a few words on angels. They can be great, but they can also be a pain in the ass. So chose them carefully, at the right stage, and set their expectations right from the beginning so you have a healthy relationship. And please try to get advice from multiple people when you start thinking of accepting funding from anyone. You could lose a lot if you give in too early, too cheaply, or even at high valuations. [I read with surprise and dismay that the MySpace entrepreneurs, despite a 580 million dollars sale to NewsCorp, barely made $5 million each?]

Going back to the Y-Combinator approach. I find it interesting though I warn people to venture into these small early stage seed investments with their eyes wide open for investor sharks out there. In the clean-tech/energy space, I find the <$10K investments to be missing the point, but that doesn’t seem to be his focus anyways. If you have good ideas on how to encourage first-time entrepreneurs, and on seeding early stage clean-tech business, I am all ears!