June 2011

"If there were no bad speculations there could be no good investments; if there were no wild ventures there would be no brilliantly successful enterprises."

F. W. Hirst

Abstract

This article explores the current funding challenges facing technology startups and describes new models based on smaller investments and collective action. First, the advantages and disadvantages of traditional startup funding models are presented, with an emphasis on venture capital and angel investment. Next, an overview of existing seed funds, or seed accelerators, shows how entrepreneurs can leverage this approach to access subsequent rounds of funding and create successful ventures. Then, an overview of crowd funding is provided, including examples of companies that have adopted this approach to funding startups and their founders. Finally, the article presents the basis of a new approach that uses crowd funding as means of attracting investors to collectives. In these business ecosystems, startups are exposed to less risk and investors can benefit from attractive returns by investing in these promising startups.

Introduction

Technology startups can be financed in different ways. These include self-financing using the founder’s own money, loans from banks or other sources, government support through grants and entrepreneurial programs, venture capital (VC) investors, and angel investors. In this article, we will explore new alternatives means of investment that are designed to help entrepreneurs overcome the initial investment challenge and prepare their companies for subsequent funding and improved bargaining power. With the advent of crowd funding, new forms of startup financing have emerged that can turn seed companies into successful ventures. The article further proposes that, by leveraging collectives and the business ecosystems they participate in, it is possible to create a robust environment where startups can access funding, grow rapidly, and generate profits.

Traditional Funding Models for Startups

Today, the wide availability of affordable technology solutions has made it easier to turn ideas into well-developed concepts. These technologies include free/libre open source software and hardware, tools for remote teams, affordable hosting, and cloud facilities. As a result, early-stage technology companies need only small amounts of investments to either create a first version of a product or to create an early prototype in order to attract more investors or subsequent rounds of funding. Although VC money may become available in the early stages of a company's lifetime, it usually comes into play when a company is growing and ready to expand its operations. Moreover, VC investment is used more frequently to finance product manufacturing and commercialization or is used to reach an initial public offering (IPO) in which shares can be sold to the public (Lefton, 1998).

On one hand, venture capitalists provide strong support to startups. Aside from providing financial backing, executives of such firms have extensive experience of building businesses and usually provide the right level of guidance to put companies on track. On the other hand, VC firms invest in startups in order to get significant returns. Their clients are pension funds, hedge funds, and wealthy individuals who expect high returns. In order to achieve those returns, they want to reach the IPO or buyout stage as quickly as possible (Galbooni and Rouziès, 2010). Founders may lose control over their company and find they are forced to report to a designated CEO. Moreover, all actions and decisions made by the founders must be scrutinized and approved by the company’s board, who have a right to veto any decisions (Wadhwa, 2006). In most cases, venture capitalists negotiate aggressive contracts and may specify liquidation terms in which they receive two or three times their original investment along with other preferential terms (Ante, 2009). Therefore, in a case where startup liquidation occurs at twice the company value, it is possible that the entrepreneurs do not get anything in return, since they need to respect the liquidation clause of the contract.

In the current climate, it has become very difficult for venture capitalists to find companies in which to invest. Since 1997, the number of deals has decreased significantly to reach its lowest point in 2010 (Galbooni and Rouziès, 2010). VC firms have not been able to adapt their businesses accordingly and their value proposition to investors and entrepreneurs is being reduced significantly. Investors that back VC firms expect high returns, but regrettably these firms cannot provide the expected return because there are fewer promising startups and reaching the IPO stage takes longer. Because of this increased risk of illiquidity, investor preference may shift to other types of alternative investments that provide a better risk/reward ratio (Galbooni and Rouziès, 2010). For entrepreneurs, the VC value proposition is equally weak. Venture capitalists try to attract promising companies by improving their financing offers, but in the end many startup technologies need guidance and mentorship rather than large investments to get their businesses going (Galbooni and Rouziès, 2010).

Because of these challenges with VC funding, many entrepreneurs turn to angel investors, who offers greater attention and guidance to the business in addition to investment (Liu, 2000). Angel investors typically fill the gap between the original funding provided by the founders, relatives, or small investors and later VC investment. In other words, they usually finance startups up to $1 million (Liu, 2000). Angels provides a more flexible alternative to venture capitalists. Angels tend to require less information about the company and it takes them less time to make an investment decision (Champion, 2000). According to a survey conducted by the Ottawa Economic Development (OED) in 1998, it usually takes an angel six weeks to close a deal (Liu, 2000). As for the investment expectations, they usually require a 30-40% return on investment, which is much less than what a VC firm expects. Although angel investment looks attractive and more flexible, some due diligence is necessary to make sure that they have the shoulders to support a startup during its journey. The most common problems arises with abusive term sheets and agreements signed between the entrepreneurs and the angel, cash shortage when the startup needs it the most, and angels who have no prior experience of investing in startups (Zwilling, 2011).

For technology entrepreneurs, it is important to nurture ideas that could turn into successful ventures while keeping a strong customer focus. In order to secure funding, entrepreneurs must have the ability to understand the market in which they are competing and be able to overcome the obstacles of creating a successful venture. Being able to create compelling business plans with a strong focus on cash flow management and time to revenue are essential elements to investors assessing an investment opportunity (Wehrum, 2009). According to the OED survey conducted in 1998, over 70% of business plans are rejected because of a poor initial impression of their financial merits and the abilities of the entrepreneurs to succeed (Liu, 2000); clearly many entrepreneurs would benefit from greater preparation when seeking significant investment.

Seed Accelerator Funding Models

To ease the process of startup funding, some companies offer a combination of mentorship and seed funding, which allows entrepreneurs to nurture and refine their ideas before presenting them to potential investors such as angels and venture capitals. This model is based on a lean approach to product development, which is more agile in nature and features shorter development cycles and frequent releases. These investment companies are called "seed accelerators" and they have demonstrated that an investment as low as a few thousand dollars can have a tremendous impact on the ultimate success of a startup company.

YCombinator is one example of a seed accelerator company that provides a simpler process than direct VC or angel funding. Initially, a business plan is not required; applicants need only describe the business opportunity. Applications are reviewed and promising candidates are selected to present their ideas in person. Once the candidate is approved, a round of seed funding and three months of intense development and training is initiated to bring the startup to a stage where they can present their business to a large audience of other investors. YCombinator has provided seed accelerator funding to 300 startups using this approach. An impressive 94.4% of participants received subsequent funding with an average pre-valuation of $10M (Geron, 2011). Notable success stories include Cloudkick (acquired by Rackspace for $50M), 280North (acquired by Motorola for $20M), and Heroku (acquired by Salesforce for $212M).

Crowd Funding Models

In addition to seed accelerators, further innovative solutions are required to help technology startups overcome the funding challenges they face. The crowd funding space is a good place to look for inspiration. Crowd funding is a fairly new concept that stems from crowd sourcing, which is the process of delegating tasks or problems to a group of people through an open call. Crowd funding embraces the same concept and puts out a call to the public to invest in ideas in the form of intellectual or monetary support.

An example of a crowd funding initiative is Kickstarter, which provides funding to projects "from the worlds of music, film, art, technology, design, food, publishing and other creative fields." It is based on an all-or-nothing funding model; the invested funds are released to the creator only once a certain threshold has been reached. If creator fails to attract sufficient investment interest to reach the threshold, the funds are returned to the investors. This ensures that creators have the necessary funds to develop their projects.

Another example is GrowVC, which relies on a community of startups, investors, and experts to provide investments for startups. The company charges its members a subscription fee, 75% of which is used to build a community fund and the remaining 25% offsets the company's operational expenses. The community fund is managed by GrowVC, but the community decides which startups receive investment. If there is a return on equity, the profits are divided between the “most successful decision makers” and GrowVC. The successful decisions makers are the ones that have first chosen to invest in a successful startup and have allocated a significant portion of their community fund to those startups. Furthermore sophisticated investors have the option of investing directly in the startups of their choice.

Towards a New Funding Model

In this article, a basis for a new approach to startup funding is proposed. This approach uses the force of the community (the crowd) to raise investments for startups and use an ecosystem (the collective) to provide a robust startup selection, mentoring, and investment process. The goal is to increase the chances of success and reduce risk by providing startups with the necessary tools to develop their businesses, access subsequent rounds of funding, and generate profits. At the same time, the intention of this approach is to help investors make informed decisions to satisfy their need for favourable risk/reward ratios.

While these suggestions need refinement and discussion before a comprehensive model can be developed, the purpose here is to stimulate thinking and debate about an alternative approach that builds on the existing crowd funding model and business ecosystem approaches. We propose an approach that has the following characteristics:

1. A trusted decision-making body. In order to provide a more robust crowd funding framework than is currently available in the market, there are numerous points of improvement that need to be considered. One of them is to define the limit of crowd sourcing in investment decisions and the other is to decide what extent crowd involvement is constructive without negatively impacting the startup's mission. Making investment decisions is not easy, even experienced investors get it wrong much of the time. Further complicating matters is that, compared to other types of investment, the crowd's decision-making is hampered by the relative lack of information because startups need to keep strategic information private at an early stage. An investor that does not have this information at hand is more likely to make a poor investment decision. Delegating investment decisions to a trusted body that works closely with the startup and keeps information confidential is a more realistic approach and promotes an environment of trust.

2. A governance structure. The involvement of the crowd can bring in important knowledge that can inform a company's strategic decisions. The idea is that the investors can become active in the venture and provide knowledge to build the business. However, it is important to be realistic; even the simplest project can turn into chaos as the number of stakeholders increase, reminding us of the old proverb: "Too many cooks spoil the broth." Large open source projects typically use a governance structure to ensure that the project does not diverge from its initial vision and mission. At the same time, contributors and committers are encouraged to have their say and, in most cases, if their comments and ideas are constructive there are accepted openly by the governance and community. Therefore, a collective investment model can benefit from this approach by improving products through constructive comments and suggestion, but it is important that governance is established to make sure the business evolves in an ideal environment.

A governance body would make the final decisions, but in case investors are not satisfied with the decision-making process, there should be policies in place to ensure they can express their opinions through syndication or voting. Other forms of governance are also possible, through which other parties would have the ability to influence decisions.

3. A board of experts. For this investment process to be viable there is a need for a board of experts who have sovereign status and diverse skill sets. This board is assigned the role of selecting startups for investment and mentoring. Members of the board should represent a diversity of backgrounds, but it is particularly important to have a strong representation on the board from members who have experience owning or operating successful startups or have experience in the financial sector. They can be contractors or permanent employees hired by the company operating the startup investment process.

The board would oversee the startup evaluation process on a regular basis. New startups would be selected from a pool of new candidates by applying predefined selection criteria based on market trends, customer demand, novelty, and growth potential. Startups that are already in the system should be evaluated on a periodic basis as well. This process ensures that investors are informed about progress and that the startups are delivering to agreed product milestones.

As the number of startup grows, a good approach would be to leverage a collective, or business ecosystem, by borrowing expertise from previously launched successful startups. Since these startups are part of a collective, the members of the startup can, in turn, sit on the board to assist other startups. This has the effect of increasing the size of the ecosystem by bringing new startup businesses that can provide added value to the ecosystem in the form of expertise and complementary products. At the same time, the company operating the investment process reduces its costs by borrowing expertise from the collective and not contracting or hiring new experts.

4. A diversified portfolio. To reduce the level of risk, a certain level of diversification is needed. First of all, the investment amounts are small and one investor alone does not bear the whole risk of investment, but rather the risk is divided among many investors. The potential gains may be reduced if the investment is spread thinly, but it is up to the individual investors to decide how much they want to invest. Secondly, for less experienced investors, there would be an option to invest in a fund pool which provides a natural level of diversification. This is similar to a VC firm's value proposition to its investors, but the difference here is that any investor can participate and there is no lock-in or minimum investment amount. The investment decisions are made by the board of experts according to the need and growth potential of the startup.

Using a fund pool and accepting money from investors implies that the company running the fund should be registered with a financial regulation body or should have the status of an accredited investor. This ensures compliance with the financial laws of the country where the company is registered. In the US, the company must comply with rules and regulations set by the Securities and Exchange Commission; in Canada, the company should comply with the securities legislation of the jurisdiction in which it is registered.

5. An agile approach. It is important to adopt a lean and agile approach both on investments and product development; this ensures that opportunities are meeting market demand and that entrepreneurs are responding to feedback appropriately. Adopting an open business environment where members can freely collaborate and trust each other provides a natural level of agility where products are constantly tested and feedback is provided through the ecosystem. Concerning investments, startups and investors have the advantage of failing cheaply. Investments are provided in small portions, each round of investment serves a specific purpose in the product life cycle.

6. A pathway to further investment. If a startup is unable to attract customers, corrective actions can be taken quickly to cut losses by either deciding on a new strategy or abandoning operations to avoid further losses. If a startup is successful, when the venture has reached a certain level of maturity, it can access larger investment opportunities through venture capitalists or angel investors, or it can be acquired by other players. In either case, seed investors would get their dues based on their percentage of equity participation. Note also that ventures can still be part of the ecosystem while generating revenue. A portion of the revenue would go back to the investors and the ecosystem to nurture other startups. When the company has reached the product commercialization stage and is generating profits, it has the option of remaining in the ecosystem or seeking other investment opportunities. At this stage, the bargaining power of the startup is very high and can reach high valuations to the benefit of the ecosystem and its seed investors.

7. A strong collective. As described in the April issue of the OSBR, collectives harness diversity to achieve outcomes that participants could not achieve on their own. As part of a business ecosystem focused on refining business opportunities and attracting investment, a collective of technology startups can showcase their successes, build trust among members, add connections, and learn from each other. By showcasing success stories of startups and the forces of the business ecosystem, it would be much easier to attract individual investors to the collective.

Conclusion

This article reviews the current funding challenges facing technology startups, describes innovative solutions for funding startups, and suggests a new approach to funding that combines crowd funding and collectives to both provide funding and nurture technology businesses in their early stages. The key takeaways from this article are:

  1. Accessing VC or angel funding is an increasingly difficult task, especially for an initial round of funding. Alternative funding models such as seed accelerators, crowd funding, and collectives can be more effective in supporting early-stage companies and preparing entrepreneurs for subsequent rounds of funding.

  2. Investment opportunities are no longer limited to large-sum transactions; investors and startups can both benefit from new approaches.

  3. By leveraging collectives in strong entrepreneurial ecosystems, participants can benefit from diversity, more effective investment, and greater likelihood of success.

Share this article:

Cite this article:

Rate This Content: 
5 votes have been cast, with an average score of 5 stars