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November 02, 2006

Raising Money Too Late and Too Early

It’s hard to get this right. Yesterday’s post was near rhapsodic about how the Charles River Venture QuickStart model lets entrepreneurs get some seed capital without suffering early dilution. This is a great option for an entrepreneur to have.  But when to raise how much capital is still a very tough decision; too late is usually worse than too soon.

There’s a fundamental difference in point of view between you the entrepreneur and “them” the VCs. This difference is especially stark when you go to a VC or an angel early before a business has built any assets.

You think: “all they’re doing is putting in some money; why should they end up with a huge share of MY company?”

They think:  “She has nothing but an idea. This company is being funded entirely with OUR money. How could she think she’s going to end up with the lion’s share of an asset we paid for?”

Compounding this difference is that the VCs know that you can walk away but their money can’t. If you decide that this isn’t gonna work or you’re tired of eating pizza or you wanna go home; it’s pretty much over. It’s even worse if you decide this but don’t leave and just continue to burn through the assets.  They don’t even get to recover the unspent portion.  Not the subject of this post but VCs DO need a liquidation preference (the right to enough assets to pay them back which usually means everything and they still don’t get paid back) in case you lose interest. Assuming they came in right at the beginning and the enterprise needs to be folded, you shouldn’t have a claim on the assets they paid for.

Bottom line: if you raise equity money before the business itself has real equity value, you’re gonna “give away” a huge chunk of the company to whomever puts the money in, especially if you’re a debut entrepreneur without star value to count as equity.  So great thing if you can just get a loan in the beginning – hello Charles River Ventures – and not have to decide the equity split until you’ve had a chance to attract zillions of daily visitors or develop the world’s best something or get a lock on incredibly valuable content (good luck!).

Also better to have plenty of equity left to “give away” in subsequent rounds which you need to build on your initial success.

But the most CRV will give you is $250K.  You might find similar terms for more money but not likely. It’s tempting to think this plus whatever you put in is all you need to build your initial value. Sometimes it is since you probably won’t have to buy much hardware and, even if you do, hardware’s pretty cheap for most applications. Viral marketing is “free” – if it works.

Most startups underestimate both how long it’ll take them to develop a great user interface (assuming that they need one) and how hard it will be to get the ball of viral adoption rolling. We all know stories of a few people who succeed on the strength of their idea with very little cash, no formal marketing, and no sales force. Not something you want to count on, though.

Let’s assume your idea is a good one. Once you expose it to the world, other people are gonna say “aha, I can do that too”. It’s very unlikely you can stop them with patents, especially if you’re selling a service. First mover advantage is really a misnomer.  The advantage goes to whomever gets to critical mass first. If your imitators are willing to spend much more money than you – maybe they “buy” customers, they may beat you to the left hand end of the long tail. If your imitators already have a position in an adjacent space or just have some way to reach lots of potential users, you could be toast.

The problem of insufficient startup funding is particularly acute if you depend on user input to create value in your service.  Remember the 1% rule: only one out each hundred people who find the content of your service interesting will be substantial contributors of content.  Even if you can launch with a wonderful writeup in TechCrunch, the first people who come won’t find any content to make them come back. You either have to spend money to seed content before you launch or be prepared for a lengthy campaign to keep people looking to at the site until the helpful 1% have had enough time to make it really interesting.

I ran into a version of this problem with the blook site for hackoff.com.  Thanks to my blogger friends, I attracted thousands of readers at a time over the months of serialization. There are still a steady stream of new readers.  I had set up a wiki and a user forum which I thought were ways to make a blook more interesting than a traditional book would be. But there were never more than a few contributors at a time to either of these (not counting spam).  There were lots of lookers but they didn’t find enough reason to come back to these parts of the site. With hindsight, I should have lined up early contributors pre-publication so that there would be a lively conversation already in progress when later visitors came. 

If your whole product plan depends on both participation and viral spread, you usually have to do a lot of work to make sure these things happen within a fairly narrow window of your launch. And before competitors do a better job and eat your lunch.

You’re better off raising enough money for an extended pre-launch period of content building and a post-launch period of fanning the fires ferociously than hoarding your equity. Obviously, 20% of something big (after a couple of rounds) is better than 100% of nothing at all.

Some related previous posts:

VC Primer from an Entrepreneur’s POV – Source of Funds

VC Primer from an Entrepreneur’s POV – The Funds

VC Primer from an Entrepreneur’s POV – What About Angels?

VC Primer from an Entrepreneur’s POV – Finding First Round VCs

VC Primer from an Entrepreneur’s POV – The Five Year Plan

VC Primer from an Entrepreneur’s POV – What to Show VCs

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