Today I begin a series of posts on Angel Investing. Over the last several months I have enjoyed attending several events around Vancouver, networking with angels and entrepreneurs. At these events, I find that I get asked a lot of the same questions from young entrepreneurs looking to raise seed money from angel investors. If I get to the heart of their questions, the questions can be reduced to two, which I paraphrase below:
- I’ve got a great idea that I am working on; how can I raise money to get my “work in progress” product/service ready to take to market?
- What is the process of raising money from angels/angel investing groups?
The intent of this posts is to answer the first of the two questions above. In my next Angel Investing post (scheduled for June 16th) I will answer the second question. In future posts, I will also post about deals from the perspective of an angel (e.g. what is an angel looking for in a startup company? what are the motivations of an angel investor?). However, from recent experience, I feel there is still a requirement to educate young/first time entrepreneurs on some of the basics of fundraising for early stage start-ups (covered in this post) and on the process of raising funds from an angel investor and/or angel investor group (to be covered on June 16th).
Sources of Funding for Early-Stage Startups
The graphic below is a free to share communication tool developed by startup commons to “help understand the startup journey, identify key stages and to help develop startups from ‘idea to business’ and from ‘founding team to organization’.”
I have taken the liberty to use this graphic and to overlay the typical sources of funding at each stage:
Stage -2 Ideation to Stage -1 Concepting
The primary source of funding for a startup at inception (the Ideation Stage) will be the own resources of the founder(s). Expenses at this stage are minimal: usually, cups of coffee and doughnuts while the founder(s) fleshes out their idea on their laptop. If you haven’t had them already, I recommend Lucky’s Doughnuts. The salted caramel and bacon maple syrup doughnuts are superb.
Stage -1 Concepting to Stage 0 Committing,
From Stage -1 Concepting to Stage 0 Committing the expenses start to add up quick. There will be incorporation costs as well as other legal costs associated with the incorporation (e.g. the Shareholder’s Agreement). Fortunately, the Vancouver startup ecosystem is blessed with several outstanding legal firms who can assist with this. A few are specialized to serve startups exclusively. A startup legal package starts from around CAD 1,250 – CAD 1,500. However, the bulk of a startup’s cost at this stage will be incurred in building a prototype product/service to get to a Minimum Viable Product that can be put out into the market.
By way of example, if the product/service is a mobile app, or a mobile platform, or an online two-sided market, a non-technical founder would have to hire a developer to produce the prototype. The median pay for a mobile app developer in Canada is CAD 60,000 per annum. An independent contractor hired for 3 months to build a prototype puts the founder out by at least CAD 15,000. Many entrepreneurs differ this cost by bringing in the developer as a technical co-founder and compensating the developer with equity. This is not considered best practice (see my tip below).
So where does a founder get CAD 15,000 from to build a prototype? The primary sources of funding for this are a founders own money and/or money raised from F&F (Family and Friends); the vast majority of angels will not touch deals in this space.
Remember those young entrepreneurs who asked me about financing for their idea for a product/service that is under development? My answer to them is always the same. It is up to them to beg/borrow/steal (ok not the last one) capital to get to a Minimum Viable Product. The first set of people to approach are the people who know you best, your Family and Friends. And it is vital to inform F&F investors that they are more likely to lose their money than to get their money back let alone make any money. But for many F&F investors, they are will to take the risk (of total loss of capital) because they want to invest in you, not your product/service. Usually, F&Fs provide funding in exchange for a convertible note.
Tip: Best practice is to hire a potential technical co-founder on a contract basis with the intention to bring them in (i.e. compensate them with equity) after a reasonable trial period. This way, the founders get to know each other and make a decision on whether to deepen their relationship on an informed basis. Founders have a relationship akin to a marriage. It’s quite possible an entrepreneur will spend more time with their co-founder than with their spouse, at least for the first few years of the life of the startup. In the same way that most people wouldn’t commit to marriage without a significant period of dating, consider the initial contract work as a date. An additional benefit is that the entrepreneur may be able to get better deal terms from the developer on the contract (e.g. propose to pay CAD 7,500 for the contract; if the developer is not brought in as a technical co-founder at the end of the contract, the fee reverts to CAD 15,000). Don’t get me wrong, getting the right developer to commit as technical cofounder is vitally important – having the technical cofounder leave while your MVP is under development could kill the start-up before it is even born – but it’s worth taking a few months to ensure the co-founders are aligned.
Tip: Crowdfunding (especially reward and donation crowdfunding models) are a good source of “alternative” funding at this stage. With a rewards model, the entrepreneur is in effect preselling product/service in addition to providing rewards to the early backers. A successful crowdfunded campaign also provides important social proof that the product/service (as described in the campaign) addresses a market need. Crowdfunding is a huge topic and deserves its own post at some stage.
Tip: Another source of funding at this stage is the Government; there are some grants available, but usually these are competitive/hard to get. However, there are tax incentives available for R&D (e.g. your mobile app does something unique and novel) and there are grants/subsidies available for hiring certain types of workers (e.g. the NSERC Experience Awards is a CAD 4,500 grant for hiring science/engineering undergrad students for 16 weeks). The National Research Council of Canada provides an awesome “Concierge” service for entrepreneurs where a dedicated Innovation Advisor can guide you through what Government funding (Federal and Provincial) is available for your startup. The Innovation Advisor for BC is Neil Gibson.
Don’t count on Government funding as your sole source of funding to get you to your MVP; what Government funding, through grants, subsidies and tax breaks can do is stretch that CAD 50,000 you raised from Family & Friends to feel like CAD 75,000 – 100,000.
Stage 0 Committing to Stage 1 Validating to Stage 1.5 Early Scaling
Funding in this stage is the domain of Angels. The Minimum Viable Product is complete and is being validated by the market. The bulk of angels tend to come in once product-market fit has been established and market traction can be demonstrated. Angels ideally want to see revenue coming in and growing exponentially. If not revenue, then users. The graph needs to be going up and to the left with a nice steep line (a concave curve is even better). I will blog about the process of raising money with angels on June 16th.
Stage 2 Scaling to Stage 3 Establishing
Funding during these stages is provided by VCs in the form of Series A, B, C rounds.
Ultimately, the goal is to raise funding from the public markets in an IPO. Details on VC funding and IPOs are outside the scope of this post.
Tip: Funding for certain types of companies with healthy and growing revenue streams (e.g. SaaS companies with subscription/membership revenues) may be available from alternate sources of financing such as revenue finance providers (e.g. Timia Capital; Disclosure: I own financial products sold by Timia Capital including warrants on Timia Capital shares). Revenue financing is a type of debt funding where the startup will receive funding which will then be paid back through a percentage of revenue each month. This type of funding tends to be more expensive than traditional debt (which the startup may not be able to raise without collateral; that being said, Vancity has some loan facilities worth checking out). This may be a better option for certain companies than raising money through angels and VCs. Remember, equity is the most expensive form of funding so revenue funding is worth considering.
I hope the above is useful to any young/first time entrepreneurs who read my blog. Generally, please don’t ask angels for money if you are still in the early stages of prototyping.
My next post on Angel Investing (on June 16th) will be devoted to how a startup goes about raising funds with angels/angel groups. The process I describe will be based on the VANTEC angel group as well e-Fund (another vehicle through which I invest in startups).