There’s nothing that will bring realism into your world as quickly as realizing that you’re out of cash.David Heinemeier Hansson, Cofounder of Basecamp
May 16, 2011
Once you know how much money you’ll need to start and sustain your business, you’ll need a way to get the cash to get started. There are plenty of options to get that initial funding, from freelancing to side projects, and all the way up to venture capital, and no single approach is inherently right or wrong, or better or worse. It depends entirely on your context.
If you need $20,000 but only have access to $5,000, you’ll need to either lower your expenses or find more money. If you lower your expenses too far, the business may no longer be viable; that is, you can’t afford servers. On the other hand, if you need only $10,000 but you’re considering taking $100,000 from friends and family, that’s not the best approach either. You need to strike a happy medium between those. Moreover, if you don’t have a clear and confident plan on how to use that investment, then you’re better off not taking it.
Funding isn’t just about fund-raising–in fact, that should be your last resort. Your best source of funding is you, because your largest fixed costs are almost exclusively founder labor. If you and your cofounders can get by on lower incomes, you really won’t have many other significant fixed costs. You can likely earn enough money to fund the venture yourself. Either save up the cash through a regular day job, or find a way to earn some money on the side; this way, you won’t have to worry about distributing equity or meeting other people’s expectations.
In the beginning, there’s no better way to fund an idea than through your own efforts. Whether you freelance to make ends meet or launch a series of side projects to help cover the early costs, by funding yourself early you’ll end up in a drastically better position long-term. In some cases, cutting your business or personal expenses can be just as good as making more money.
Once you’re up and running, customers are often your best source of funding. When you tie your ability to grow to the willingness of others to give you money for your product, you’re creating a tangible feedback loop to help you know whether you’re building a product people value. If they neither value it nor know about it, they won’t give you money, and you’ll know you need to improve. This organic growth can be frustratingly slow at times, but it’s also incredibly sustainable.
Of course, using your own or your customers’ money isn’t always possible, and you could reach out to others. If you choose that option, understand the implications of each source of funds.
Freelancing. You won’t owe anybody anything, but it does require significant amounts of your time. Context switching between your freelance work and your application efforts can quickly become taxing as well.
Savings. You won’t owe anybody anything, but you are risking more. Putting your life savings into a business could pay off well, or it could wipe you out. More reward, more risk.
Your other half. If you’re in a long-term committed relationship, you may have had a time where one person worked while the other went to school–and the same idea can apply to starting a business. It’s not always easy, and it can put a strain on your relationship, but it’s often worth considering.
Business partners. These people are in the game with you, but you could run into some challenges if control of the company were to be at stake, and some of their investments were significantly larger or smaller than others. If one person has less skin in the game, it’s much easier for them to walk away at the first sign of difficulty. That can create some big distractions.
Friends and family. This can be either the best or worst source of money. The important thing is to take an honest look at how your relationship with them would be affected if the business were to fail and they lost their money.
Angel investors. Angel investors will generally be focused on a return on their investment. They will lean towards smaller amounts of funding, and negotiations are likely to be simpler. With good angels, you may also get advice and introductions as well, but it can be a steep price to pay if you’re capable of building up your own funding.
Venture capital. Generally speaking, venture capital would happen in later rounds, and they’re going to have the highest expectations for a return. Adding venture capital to your business is like putting lighter fluid on a fire. It’s going to get started quick and burn bright, but if the foundation isn’t in place, it won’t be sustainable, and you’ll run out of cash before the fire can take hold. Moreover, the pursuit of venture capital can require massive amounts of time and attention that will pull you away from actually working on your product.
These aren’t the only options, but they are the most common. Like any choice, there are pros and cons for each one. If anything sounds too good to be true, make sure you’ve thought through all of the potential downsides.
If you do turn to outside money, consider three things. First, is it “smart” money or not? Second, what happens to your relationship with the investor if the business fails and the money disappears? Finally, what are their expectations for a return, regarding both a timeline and a multiple?
An investment can be classified as “smart” money or “dumb” money. With smart money, your investor is contributing not only funds but also knowledge and experience within your industry–so you’re getting more than just cash. In our case, my business partner and investor, Keith Jacobs, had been working in IT for well over ten years when we started the business. In my younger years, however, I had accepted money from my parents for a venture that they barely understood–and I didn’t receive any value beyond their ability to write a check. Smart money does more than just prop up your bank account, and you should consider that when choosing your funding source.
Let’s say that you turn to friends and family for investment. Imagine that your parents give you $10,000. Now imagine it’s six months later: the money is gone and the business hasn’t launched. Perhaps you fell ill or simply underestimated how much time you could put into it. The reason doesn’t matter–the result is the same. But would your parents disown you or would they be understanding? If losing your parents’ money would ruin your relationship with them, think carefully before involving them.
It’s also worth thinking about expectations. Let’s say you get $50,000 from an angel investor. Are they giving you the money because they believe in the idea and want to support you, or are they giving you the money because they expect a five-fold return in two years? If they’re only looking for profits, you could be put in a tough position; you might be pressured to sell the business or take steps you’d otherwise prefer to avoid.
You can think of outside investment as a ticking clock. Your external investors are looking for a return, and every day that return is delayed, their expectations grow larger. Instead of your company growing at a slow, steady, and sustainable pace, you may be expected to grow quickly and scale up significantly–and that can saddle you with immense pressures and responsibilities that could fly in the face of your goals.
Anecdote: Sifter’s Initial Funding
Sifter was funded through an investment from my business partner and my own freelancing. He put in cash and business knowledge, and I put in time and equipment, and I did some freelancing on the side to help pay my bills while I worked on Sifter.
When we originally ran the numbers, we looked at and estimated the value of each of our contributions to the business. I provided the hardware, software, and my time; Keith provided cash and a smaller portion of his time. Ultimately, I ended up owning a significant majority of the business.
Let’s consider my three requirements for an investment. Keith was smart money as he knew and worked in the industry for years. He also had extensive experience running businesses. And he had a savings account set up for precisely this kind of investment. He had confidence in me, but he wouldn’t need to sell his house if I screwed up and lost all the money. Finally, having worked together for years, we knew each other, and I could trust him not to exert pressure on the company to see a return on his investment right away. We both agreed that the goal was to build a business, and that a return would happen eventually if we focused on the right things.
We made some ridiculous projections based on something like 4% growth, and we calculated all the expenses we could think of. At the time, this included hosting, some basic software subscriptions, and a few other expenses like legal and advertising. We calculated how much money we would need in the bank for our account never to dip below zero, and then we added a couple of thousand dollars as a cushion. We came up with $16,000, and Keith said he could do that–I quit my job and got to work.
Be Your Own Angel–How to Make Money Happen. Amy Hoy puts fundraising in perspective and reminds us that we can create our own funding if we really want to.
Email Marketing Startup ConvertKit Raises $1.8M from Large Group of Angel Investors. A tongue-in-cheek press release by Nathan Barry about how he used revenue from real paying customers to grow ConvertKit.