Where to raise money: bootstrap, angels, or venture capital?

Where should entrepreneurs turn to for investors is an important topic. I regularly see entrepreneurs dealing with this question, esp. the first-time entrepreneurs, often because each venue requires significant time and effort.

So if you are putting together a business idea with your best buddy, where should you look for funding?

Bootstrapping: Are you confident enough and have the means to bootstrap for a while? Can you save some equity along the way or are you being penny-wise, pound foolish?

Angels: How do you find the right angels? Is this dumb cash, or smart money? How many angels is too many? What to do if they become damending, like a seat on the Board?

VCs: Is your business idea ready for VC prime-time? Are you still sellable if it is shot down by a few leading VCs? Are they sharks that one must avoid at all costs?

I have these discussions with entrepreneurs all the time. Frankly, while there are general thoughts around this question there is no perfect answer. It all depends, on the idea, on the team, and the people involved – not to mention the investment climate in the space you are working on. But here I want to link to an interesting extract from an article by Ananad Rajaraman on GigaOm. Read on:

Where to raise funding is an important decision every startup founder has to make. The three viable sources at the very early stages of a company are:

  • Venture capital.
  • Angel investors. Usually wealthy individuals, but includes outfits such as Y Combinator.
  • Friends and family. Yourself, if you can afford it.

To decide which option is best for your startup, you need to understand how investors evaluate companies. There is a range of criteria, of course, but the three most important ones are team, technology and market, and angels and VCs evaluate them in different ways. Here’s how.

How Venture Capitalists Evaluate Startups

  • Market — VCs want to invest in companies that produce meaningful returns in the context of their fund size, which typically is in the hundreds of millions of dollars. To interest a VC firm, a company needs to be addressing a large market opportunity. If you cannot make a credible case that your startup idea will lead to a company with at least $100 million in revenue within 4-5 years, then a VC is not the right fit for you. It’s often OK to use consumer traction as a substitute for market opportunity; many VCs will accept a large and rapidly growing user base as sufficient proof that there is a potentially large market opportunity.
  • Team — VCs use simple pattern matching to classify teams into two buckets. A founding team is deemed “backable” if it includes one or more seasoned executives from successful or fashionable companies (such as Google) or entrepreneurs whose track record includes a least one past hit. Otherwise, the team is considered “non-backable.”
  • Technology — VCs aren’t always great at evaluating technology. To them, technology is either a risk (the team claims their technology can do X; is that really true?) or an entry barrier (is the technology hard enough to develop to prevent too many competitors from entering the market?) If your startup is developing a nontrivial technology, it helps to have someone on the team who is a recognized expert in the technology area, either as a founder or as an outside adviser.

Here’s the rule of thumb: To qualify for VC financing, you need to pass the market opportunity test and at least one of the other two tests — either you have a backable team, or you have nontrivial technology that can act as a barrier to entry.

How Angels Evaluate Startups

There are many kinds of angels, but I recommend picking only one kind: someone who has been a successful entrepreneur and has a deep interest in the market you are targeting or the technology you are developing. Here’s how angels evaluate the three investment criteria:

  • Market — It’s all right if the market is unproven, but both the team and the angel have to believe that within a few months, the company can reach a point where it can either credibly show a large market opportunity (and thus attract VC funding), or develop technology valuable enough to be acquired by an established company.
  • Team — The team needs to include someone the angel knows and respects from a prior life.
  • Technology — The technology has to be something the angel has prior expertise in and is comfortable evaluating without all the dots connected.

Here’s the angel rule of thumb: You need to pass any two out of the three tests (team/technology, technology/market, or team/market). I have funded all three of these combinations, resulting in either subsequent VC financing (e.g. Aster Data, Efficient Frontier, TheFind), or quick acquisitions (Transformic, Kaltix — both acquired by Google).

Friends and Family, or Bootstrap

This is the only option if you cannot satisfy the criteria for either VC or angel. But beware of remaining too long in “bootstrap mode.” An outside investor provides a valuable sounding board and prevents the company from becoming an echo chamber for the founder’s ideas. An angel or VC can look at things with the perspective that comes from distance. Sometimes an outside investor can force something that’s actually good for the founder’s career: Shut the company down and go do something else. That decision is very hard to make without an outside investor. My advice is to bootstrap until you can clear either the angel or the VC bar, but no longer.

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