Raising Capital: Friends, Family and Fools

February 10, 2006

There comes a time for many software entrepreneurs (and would be entrepreneurs) where they simply need cash to make any further progress. At this time, they start thinking about capital raising. Unfortunately, for too many startup people, capital raising = Venture Capital. This article focuses on the “real world” of early-stage capital raising for software startups. I’m generally not a big fan of venture capital for software startups (but this is a topic for another day). Its not that I don’t think VCs are smart (they are) or that they’re intrinsically evil (they’re not), but that venture capital is often not the right choice for a large majority of software startups, and too many entrepreneurs get overly frustrated with the process of pitching to VCs, ultimately give up, and have little (if anything) to show for it.

In the early stages of a company, many entrepreneurs use “friends and family” money. This is fine (within reason), but its important to remember that in most cases these people are not sophisticated investors, will likely not understand your business and don’t really provide you one critical service that you absolutely need: validation. Its imperative to verify that you’re not drinking your own cool-aid (too much) and verify that your business idea has some modicum of merit and is worth pursuing. Once again, I’m not suggesting “professional” investors (VCs), because often their bar is too high in terms of validation. Not all companies are VC fundable (and many great ideas are not VC-optimized).

Your family will generally give you money because they have likely known you for most of your life, and you have somehow managed not to manifest career-criminal tendencies. If you’ve done well at school, have been able to hold down a job, and are perceived as being “reasonably intelligent” that’s all a plus. This is basically the degree of “due diligence” that this friends/family group as investors will likely go through.

Fools (um, “private investors”) like me, on the other hand, haven’t known you most of your life and have very little to go on to even know that you’re not a career criminal (or possess those personality traits). So, what compels people like me to act so foolishly and invest in people we don’t know that well, with ideas that are only half-baked and that we know are going to become huge time sinks? One, simple answer: we’ve been there before and have a pathological desire to remain involved in the startup process. I’ve made three early-stage investments in technology companies so far, and the thoughts below are a result of thinking back on why I made the investments I did and what common patterns there were.

So, here are my top practical tips if you’re ever looking to attract capital from fools like me:

  1. Be passionate about the idea. If you can’t convince me that you’re laying awake at nights plotting, scheming and dreaming about how your idea is going to change the world, you’re going to have a really hard time getting me to part with my money.

  1. Be likeable. If I’m going to put cash in your company, chances are, we’re going to be spending a fair amount of time together. (If not, then I’m likely not investing anyways). You don’t have to be obsequious (I’d prefer that you weren’t), but a certain level of respectfulness is always appreciated.

  1. Demonstrate that you’ve made some progress on the product/idea before talking to me. I don’t invest when the first use of the capital is to go find a developer to help implement the idea. Or worse – if you’re dismissive of the risks of the entire software development process. Software is hard. Its not simply a matter of saying “we’re going to outsource it to India!” and putting a line item in your financial plan. I don’t give a flip about financial plans, but I care a lot about how you think you’re going to build your offering, and why it’s going to be sooooo cool. I like to see people that are fanatically obsessed with “hand-crafting” their solution and taking pride in their work.

  1. Be realistic about your capital needs. Sure, you’d love to have $5 million of funding so that you can “do it right” and build the software company of your dreams. But, lets face it, you shouldn’t need that much money, and if you do, then go the VC path (and I wish you the best, may your travels be fruitful…) The question you have to ask yourself is: What’s the least amount of money I need to build something that someone will pay a little bit of money for. I’ll give you a hint: Its usually less than $50,000 --- with $25,000 left over to build what you should have built in the first place – but couldn’t, because you hadn’t yet gotten the feedback from your first user/customer who ended up practically throwing up all over your shiny new software…

  1. Seek analog business models. Let me explain: Binary business models are a 0/1 proposition. You go off and build a product after months/years/lifetimes of grueling work and launch it to the world. At that point, it is either phenomenally successful (i.e. result=1) or it’s a complete failure (result=0). Analog business models are those that have incremental value all along the way. You make $2,000 revenue within your first 90 days. Maybe $10,000 the month after that, etc. The nice thing about analog business models is that in the worst case, you’ve at least created something of value. And paradoxically, approaching the problem this way actually increases your odds of a blow-out success. In my experience, overnight successes take at least three years. But a different way (if you’re a programmer, which I’m hoping you are), use “agile practices” for your business, just like you do for your code. In agile development, we have “release early, release often”. In agile business, we have “revenue early, revenue often”. [Note to self: This is likely a worthy topic for its own article. ]

  1. Do your homework. There are excellent resources for learning about the basics of how capital is raised and the legal stuff around it. Though I’d love to teach you about all of this stuff (because I enjoy talking about it), I simply don’t have the time. Others can do it a lot better, and this is the kind of stuff you can learn mostly through reading.

Obviously, the above opinions are my own and may not necessarily be shared by other fools (um, “private investors”) that you talk to. But, I’m pretty sure that none of the above will hurt you. Worst case scenario, even if you don’t raise the money, you’ll be better off having followed the advice anyways.

Good luck!

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