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The Reality of Fundraising and How Most Entrepreneurs Get Capital

Rebroadcast: Published November 20th, 2019

Original: Published October 3rd, 2018

Most founders will never raise a single dime from investors. This has nothing to do with your capabilities as an entrepreneur. It’s simply the reality of venture economics and the fact that most businesses don’t fit the requirements of a professional investor. The good news is that 95% of business are able to find capital through other means.

In this episode we describe how most entrepreneurs raise capital through four main channels – credit card loans, bank loans, money from friends and family, and good old fashion side hustles (aka contract work). Yes, in 2017 alone VC firms invested $61 Billion in capital, but everything is relative. This money was deployed across 5,948 deals – virtually nothing (1%) compared to the 500,000+ businesses that were started that year.

To help clarify the reality of fundraising, and to provide some data from those that are bullish on raising venture money, we also dive into the true motivations behind angel and venture investors, and what actually makes an entrepreneur fundable – a track record (previous exits), domain expertise, defensibility, a large market opportunity, and tangible go to market execution.

Show Notes

1:30 A lot of founders ask us about raising money from investors.

2:00 Today we’ll talk about whether you should raise outside money for your venture

2:24 According to Fundable, only 0.91 percent of startups are funded by angel investors, while a measly 0.05 percent are funded by VCs.

3:12 In contrast, 57 percent of startups are funded by personal loans and credit, while 38 percent receive funding from family and friends.

3:23 So by default almost every company you hear about is funded either by friends and family or through a bank loan or credit card

4:00 We don’t recommend getting into credit card debt. If you have a career where you’re very certain you can always go back and make a big salary again, then the risk could be justified.

4:15 Vadim and I funded our last startup initially with credit cards, and some contract work.

5:25 Even amongst those who do raise VC, up to 75% of them end up failing anyway because they run out of money

6:00 It only seems like everyone raises capital easily because you’re only reading about the success stories in the news

6:45 You only read about companies that raise a lot of money, or those who fail. Unless they truly have something newsworthy to share, you won’t hear about them

7:10 There are a few key requirements you need before considering raising VC.

7:33 One assumption people make is that raising capital means they will finally have the freedom to run their business.

7:45 The opposite is often true. Once you raise money then you’re working for that person until they get their money back

8:30 It takes a minimum of 3 months and often up to a year or longer to raise money

8:42 Once you raise money and you do well, you’re going to have to go out to raise more money because investors push you to spend as fast as you can

9:05 If you still want to know what it takes to raise money, we’re going to explain the motivations of investors, and who is better positioned to raise money from them.

9:30 Another way you can lose freedom by taking on investors is that some investors will bug you constantly about when you will get their money back. And VCs, if they have a board seat, could even fire you if they don’t think you’re doing a good job.

10:22 It’s important to vet the investors you bring on.

10:58 Typically early stage companies look for seed investors – angels and VCs who invest at the seed stage which is usually the first money in. They specifically look for early stage companies.

12:28 To clarify, an angel investor invests their own money, and a venture capital fund invests other people’s money. So their motivations slightly vary. But they all want a big return on their investment.

13:14 Let’s talk about their motivations. Angels usually want to feel helpful. They want to be able to help with their expertise or networks.

13:20 Often Angels make investment decisions more emotionally. If you’re looking for angels, look for people in the industry or those who invested in similar types of companies.

14:17 VC’s on the other hand usually have a thesis behind their investments. They invest on behalf of mutual funds and other funds so they have to report on how they make these investment decisions.

15:03 So if you’re going to raise from venture investors, find funds that invest at the stage that you’re in and an industry that matches their thesis.

15:20 Investors need to have a big return on their investment because of the fund economics. Something called the 2 and 20 rule.

15:40 Funds take 2% in annual fee of the whole size of the fund, and 20% of the returns. Since most investments fail, every investment has to have a chance at being a huge return by definition, to be worth their risk, because of the economics.

16:10 We’ve seen it happen many times with even friends, who raise a few million dollars and a year later get an acquisition offer for $20 million and the investors don’t want to approve that because it’s too small of an acquisition for them.

16:50 The risk of waiting for a bigger exit is worth it for an investor because they know they’re going to lose most of the money anyway. Might as well wait for a bigger exit opportunity.

17:40 So if only <1% of companies raise money from investors, who are they?

17:50 There are 4 core things a company should have to be attractive as an investment opportunity

18:00 First one that most people don’t meet is having a track record, in other words having other exits under your belt. This makes it much less risky for funds because data shows that founders who successfully sold businesses before can do it again.

18:55 Anyone that you read about that raises money on an idea is able to do so because they have experience building companies successfully before.

19:15 The other way to be attractive to investors is having deep domain expertise in the area in which you’re building a business

19:43 If you watch Shark Tank you’ll notice a lot of the investors like Daymond John only invest in businesses they understand. It’s for this reason.

20:13 If you can get customers, partners etc. more easily, it derisks the investment for the investor

20:52 The third thing that’s important to have is defensibility. How easy is it for someone else to copy you?

21:46 The way to build defensibility is through legal ways like patents/IP, or ways like network effects where if you build a big enough network it’s hard to copy you.

22:06 Having penetration in the market is the best way to build defensibility.

23:00 You can also build defensibility as a brand

23:35 Another way is having a team member who has some knowledge that most people don’t

23:44 The last of the four things you need to have is go to market execution. Proof that you can actually get customers.

25:37 Some companies raise money on crowdfunding platforms like Kickstarter to prove they have market potential. We know a few companies who raised from $50k to a few hundred thousand on Kickstarter who then raised funds successfully from investors because they proved that there’s potential.

25:56 If your product has a long sales cycle but high contract value, showing you have commitments from huge businesses is a way to prove potential in the market, that you could get sales.

26:40 One misconception is that having a product is enough, even if it’s very technical. If no one is using your product, no one will care.

27:26 Growth and engagement are also important to show. If you have had 20k users, but you’ve had that for the past year, that’s not exciting. But showing fast growth with even fewer users, is more exciting.

28:10 If you’re making a bunch of revenue but it costs you a ton of money to make it, then it’s not as interesting. The math needs to make sense for the investor.

28:50 We’re not trying to dissuade you from fundraising. You know we’re proponents of taking risks, but we also want you to take calculated risks, which is why we want you to understand who you should raise from and when.

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