Monday, March 29, 2010

Iterative funding of startups- an entrepreneur's perspective

I am a first-time entrepreneur, and have not raised any external funding yet for my venture. So far it is self-funded (a.k.a bootstrapped). Recently I started to explore different funding options available to us. All the blogs and articles I read are from VC (investors') perspective. So, this is a view from the other-side of the table- an entrepreneur's (an inexperienced one I might add) perspective.

 As I am dabbling with the concept of "Lean" model of building startup, what I see is missing from the model is the "funding" side of the equation. Traditional sources of external funding are Angels and VCs. We all start our venture with a "big" dream. Yet, the success in our minds is subconsciously anchored in getting "funded," instead of building a "sustainable business." As a result, we spend a lot of energy in pursuing VC funding (a proxy for success). If we are lucky, we get a sizable chunk of money to build out your business. We get the whole amount upfront based on a "carefully crafted pitch" and a "big plan." Although the investor will try to hold our feet to the fire, but once we are funded, we get to spend the money in the hope that the plan will come to fruition before we use it all up. If not, we get to work on raising our next round of funding, and repeat the cycle. This time along with our first round investor. It feels there is a "big waste" hiding in there somewhere. That is why 37signals guys are so dead against raising money.

I see this is not an issue of external funding vs. self-funding or customer-funding (customer pays for your product or service that funds the growth of the business) though. It is an issue of how we earmark fund and spend it. Dave McClure has eluded to it in this presentation. He calls his alternative funding model as Incubator 2.0. I like the idea a lot. The gist of it is instead of making a commitment for an amount (usually large) upfront for a longer horizon, fund the business based on "progressive learning." Dave's funding model has 3 stages-

1. "Micro seed" (3-6 months) corresponds to "Customer Discovery" stage of "Lean Startup" model. Expect to spend between 0-$100K.

2. "Seed" (6-12 months) corresponds to "Customer Validation" stage of "Lean Startup" model. Expect to spend about $100K-$1M.

3. "Series A" (12-18 months) corresponds to "Transition to Growth" stage of "Lean Startup" model. Expect to spend  about $1M -$5M.

I would like to extend this funding model further. Why not break the funding into even smaller amounts that actually funds a set of experiments (hypothesis). We make these funding decisions "iteratively." If externally funded, we set up an MoU with the investors to enable "incremental funding" as opposed to "big upfront funding." The whole model would look something like this,

The goal of funding should be "just enough" funding to "sustainable growth." If we could do it through self-funding, great. If not, external funding is fine so long as it is in sync with the iterative model of building a business.

Am I missing anything that would prevent us from implementing a true iterative funding model that works in lock step with iterative customer and product development model? By the way, we are looking for an Angel investor who would like to try this with us...:-) Seriously.

4 comments:

  1. I wrote a longer comment but I'll boil my primary thought down to this: there is a big difference between cash and a promise of cash.

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  2. Giff, I agree. That is the status quo. But, I am sure we can find a way to structure the funding relationship that supports "iterative funding." If it is matter of trust, then there is even a bigger issue with the current practice. Maybe I am being naive...:-)

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  3. well it's not so much trust as just the fact that things change. It's the same reason why you need to close a big deal asap -- a verbal agreement is not enough -- and even after it's closed there is always risk. If you don't have the cash in your account, you need to discount the chance you will ever get it. Further, svery entrepreneur prays for perfect alignment with investors, but it just doesn't always stay that way. Other concerns, at first glance, include needing to constantly update valuation of the business (a distraction), and the risk that you will end up being in perpetual fund-raising mode (even more than CEOs find themselves today). But that's just a gut reaction, and it would be interesting to think through it more.

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  4. Why couldn't we setup an appropriate funding structure upfront so that we all can avoid some of the concerns you mentioned? The upfront MoU ( a real legal binding, not just promise) could include how the valuation would change, amount of funding (e.g., could be a fixed amount every iteration, fixed amount + a fixed increment, or some other arrangement). All these could be tied to some key AARRR metrics appropriate for the stage and nature of the business. This will eliminate the need for being in the perpetual fund-raising concern that you mentioned. Once an investor decide to invest in a business, both entrepreneurs and investors want the venture to succeed, right? These iterative funding will require all parties to manage funds to a set of appropriate metrics.

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