Funding your startup – target family and angels, not VCs.

Basil Peters is a Techvibes Guest Contributor.

It’s surprising how often first time entrepreneurs will set out to find a ‘venture capitalist’ to fund their startup. These days, fewer than 1% of startups are funded by VCs. In the early 90s, about 20% of US venture capital was invested in startups and seed stage companies. For the past several years, that number has been less than 2%. In the US, only 200 companies per year receive seed/startup investment from venture capitalists. In BC, depending on your definition, there are probably about two startups funded by VCs each year. Successful entrepreneurs will eventually figure this out, but they can save a lot of time targeting the investors most likely to fund their startup. Over 90% of successful startups are funded in the same way:

  • First by Friends and Family, then by
  • Angel Investors, and then by
  • VCs or Public Venture Capital

Friends and Family are most often the first source of financing for a startup because they already know and trust at least one of the entrepreneurs. The challenge with most friends and family financings is that the total capital available is only in the range of $10k to $100k. This can get a startup going, but won’t let it get very far.

It’s a common misconception that VCs fund startups. I didn’t really appreciate this myself until I had been a VC for a few years. The problem with VCs funding startups is that to be economically viable a VC fund has to have at least $100 million. (I didn’t really appreciate that either until I had been the CEO of a VC fund for a couple of years.) A typical partner in a VC fund can only manage 5 to 7 investments. A $100 million fund might only have four or five partners. These constraints and some simple math mean that a VC has to invest about $4 to 5 million in each portfolio company. Even if they invest over multiple rounds, the first cheque should be $1 to $2 million. Even if a startup thought, “No problem, I’ll take $2 million”, the math still doesn’t work. To be able to reasonably accept that much capital means the startup would have to be valued at above $5 million.

Today, reasonable valuations for startups are much lower (unless they have very extensive patent portfolios). That’s why over 90% of startup funding comes from angel investors (excluding government programs). Angel investors are high net worth individuals who have often made their money by being entrepreneurs. Individual angels typically invest $10k to $100k in a company. Angels usually syndicate, or co-invest, which means that companies can raise amounts from $250k to $2 million from angel investors. This is usually enough capital to fuel the successful companies to valuations above $5 million and be reasonable candidates for VC or public venture capital financing. Angel investors are not as easy to find as VCs. The good news is that there are a few efficient ways to introduce your startup to angels. This link provides a good summary of best practices for entrepreneurs looking for angel investors in Vancouver.