How to Fund a Startup

[How to Fund a Startup]

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| Want to start a startup? Get funded by
Y Combinator. |

November 2005

*(This
article is meant to be a complete summary of funding options
for startup founders. In effect we're open-sourcing the kernel of
what we tell founders about funding at Y
Combinator.)*
-->
Venture funding works like gears. A typical startup goes through
several rounds of funding, and at each round you want to take just
enough money to reach the speed where you can shift into the next
gear.

Few startups get it quite right. Many are underfunded. A few are
overfunded, which is like trying to start driving in third gear.

I think it would help founders to understand funding better—not
just the mechanics of it, but what investors are thinking. I was
surprised recently when I realized that all the worst problems we
faced in our startup were due not to competitors, but investors.
Dealing with competitors was easy by comparison.

I don't mean to suggest that our investors were nothing but a drag
on us. They were helpful in negotiating deals, for example. I
mean more that conflicts with investors are particularly nasty.
Competitors punch you in the jaw, but investors have you by the
balls.

Apparently our situation was not unusual. And if trouble with
investors is one of the biggest threats to a startup, managing them
is one of the most important skills founders need to learn.

Let's start by talking about the five sources of startup funding.
Then we'll trace the life of a hypothetical (very fortunate) startup
as it shifts gears through successive rounds.

Friends and Family

A lot of startups get their first funding from friends and family.
Excite did, for example: after the founders graduated from college,
they borrowed $15,000 from their parents to start a company. With
the help of some part-time jobs they made it last 18 months.

If your friends or family happen to be rich, the line blurs between
them and angel investors. At Viaweb we got our first $10,000 of
seed money from our friend Julian, but he was sufficiently rich
that it's hard to say whether he should be classified as a friend
or angel. He was also a lawyer, which was great, because it meant
we didn't have to pay legal bills out of that initial small sum.

The advantage of raising money from friends and family is that
they're easy to find. You already know them. There are three main
disadvantages: you mix together your business and personal life;
they will probably not be as well connected as angels or venture
firms; and they may not be accredited investors, which could
complicate your life later.

The SEC defines an "accredited investor" as someone with over a
million dollars in liquid assets or an income of over $200,000 a
year. The regulatory burden is much lower if a company's shareholders
are all accredited investors. Once you take money from the general
public you're more restricted in what you can do.
[1]

A startup's life will be more complicated, legally, if any of the
investors aren't accredited. In an IPO, it might not merely add
expense, but change the outcome. A lawyer I asked about it said:

When the company goes public, the SEC will carefully study all
prior issuances of stock by the company and demand that it take
immediate action to cure any past violations of securities laws.
Those remedial actions can delay, stall or even kill the IPO.

Of course the odds of any given startup doing an IPO are small.
But not as small as they might seem. A lot of startups that end up
going public didn't seem likely to at first. (Who could have guessed
that the company Wozniak and Jobs started in their spare time selling
plans for microcomputers would yield one of the biggest IPOs of the
decade?) Much of the value of a startup consists of that tiny
probability multiplied by the huge outcome.

It wasn't because they weren't accredited investors that I didn't
ask my parents for seed money, though. When we were starting Viaweb,
I didn't know about the concept of an accredited investor, and
didn't stop to think about the value of investors' connections.
The reason I didn't take money from my parents was that I didn't
want them to lose it.

Consulting

Another way to fund a startup is to get a job. The best sort of
job is a consulting project in which you can build whatever software
you wanted to sell as a startup. Then you can gradually transform
yourself from a consulting company into a product company, and have
your clients pay your development expenses.

This is a good plan for someone with kids, because it takes most
of the risk out of starting a startup. There never has to be a
time when you have no revenues. Risk and reward are usually
proportionate, however: you should expect a plan that cuts the risk
of starting a startup also to cut the average return. In this case,
you trade decreased financial risk for increased risk that your
company won't succeed as a startup.

But isn't the consulting company itself a startup? No, not generally.
A company has to be more than small and newly founded to be a
startup. There are millions of small businesses in America, but
only a few thousand are startups. To be a startup, a company has
to be a product business, not a service business. By which I mean
not that it has to make something physical, but that it has to have
one thing it sells to many people, rather than doing custom work
for individual clients. Custom work doesn't scale. To be a startup
you need to be the band that sells a million copies of a song, not
the band that makes money by playing at individual weddings and bar
mitzvahs.

The trouble with consulting is that clients have an awkward habit
of calling you on the phone. Most startups operate close to the
margin of failure, and the distraction of having to deal with clients
could be enough to put you over the edge. Especially if you have
competitors who get to work full time on just being a startup.

So you have to be very disciplined if you take the consulting route.
You have to work actively to prevent your company growing into a
"weed tree," dependent on this source of easy but low-margin money.
[2]

Indeed, the biggest danger of consulting may be that it gives you
an excuse for failure. In a startup, as in grad school, a lot of
what ends up driving you are the expectations of your family and
friends. Once you start a startup and tell everyone that's what
you're doing, you're now on a path labelled "get rich or bust." You
now have to get rich, or you've failed.

Fear of failure is an extraordinarily powerful force. Usually it
prevents people from starting things, but once you publish some
definite ambition, it switches directions and starts working in
your favor. I think it's a pretty clever piece of jiujitsu to set
this irresistible force against the slightly less immovable object
of becoming rich. You won't have it driving you if your stated
ambition is merely to start a consulting company that you will one
day morph into a startup.

An advantage of consulting, as a way to develop a product, is that
you know you're making something at least one customer wants. But
if you have what it takes to start a startup you should have
sufficient vision not to need this crutch.

Angel Investors

Angels are individual rich people. The word was first used
for backers of Broadway plays, but now applies to individual investors
generally. Angels who've made money in technology are preferable,
for two reasons: they understand your situation, and they're a
source of contacts and advice.

The contacts and advice can be more important than the money. When
del.icio.us took money from investors, they took money from, among
others, Tim O'Reilly. The amount he put in was small compared to
the VCs who led the round, but Tim is a smart and influential guy
and it's good to have him on your side.

[...]

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