Episode Transcript:

ADAM MCGOWAN: : Welcome to episode six of Ventures in Tech, brought to you by Firefield. This is Adam McGowan and on today's show we're going to discuss the variety of options available to startups in their early stages when it comes to getting funded. I'm again being joined by my colleague from Firefield, Henry Reohr, who'll be guiding today's chat. And with that, I'll let Henry take it away.

HENRY REOHR: [00:31]: Adam, for many entrepreneurs, the world of venture funding can seem daunting for a whole host of reasons. Even the terminology can be hard to follow. Before we dig into the actual options for raising capital, could you decode some of the jargon related to the different rounds of fundraising?

ADAM MCGOWAN: [00:51]: Sure. You know, I think that over time this has become a little bit more complicated because it used to be pretty simple; a new startup with self-finance or they would get funded from friends and family and then as soon as things started to move and they got some traction they'd go for a Series A round. That was pretty much it. If it worked, they were off to the races, otherwise, they went home.

But I think there's been this concept that I could talk more to later but I call it Round Inflation and it seems like the target or the goal posts are consistently moving. So if you look today at a typical Series A round of funding, they tend to start around two million dollars in funding and, you know, that capital is today generally used for companies to be able to scale once they've really proven out their model.

Now we've got what's called the Seed Round which is going to happen typically before a Series A. These usually start around five hundred thousand and this is capital typically earmarked for what we call product market fit. So you put a product into the market, you're trying to assess how well you're actually going to translate that introduction of the product into true sales, into true traction. You know, how well does, technically, that product fit your market? And if doesn't it could be because of poorly conceived product, poorly conceived market or possibly both.

Now, prior to a Seed Round, given that they're starting at half a million, we've got what's being called Pre-Seed Rounds. And these are typically starting somewhere around one hundred thousand dollars range and this is often used as capital for early stage product development. So it could go towards minimum viable product creation or maybe beta launches to do some testing with users of your very early stage product.

And of course Friends and Family Rounds, if people use or rely on them, tend to precede all of these. But we've certainly seen this collection of rounds of capital and at least the targets for each of these dollar amounts have been ticking up and up and up over time.

HENRY REOHR: [2:54]: You mentioned this concept called round inflation. Can you dig a little bit deeper into that?

ADAM MCGOWAN: [3:00]: Yes. So this idea comes from the fact that I would describe money as; by money I mean investment, money being "relatively" easy to come by today, relatively is in quotes and that's very important. So it's not absolutely easy, it's still hard to get funded, it's just relative to the ease with which or lack of ease with which you could have get funded. Historically, it seems as though it's been a little bit easier to do so recently.

What that means is that more investors are piling on into deals, wanting to participate in investments and it's just pretty straightforward economics that the increase in demand from investors is going to result in driving up price and in this case the price is the valuation of these companies who are getting the funding. And so if you're an investor, you're now getting into a deal with the valuations going up and up and up, all else equal, if you invested the same amount of money, you're going to own less of the company.

And that's not what investors want. Because these investors don't want to have to make more and more and more investments to put their investors money to work as many of these investors are coming from venture capital funds for example. They don't want to double the number of investments they have to make to put their money to work. And so what they want to do is they want to try to drive up the amount of money that they're putting into deal so they can still own a meaningful chunk of companies. So prices are going up, valuations are going up, more money is coming into deals and investors want bigger chunks of the deals. So naturally, the size of the rounds inflate. That's where that language comes from.

HENRY REOHR: [4:37]: So, what does that mean for entrepreneurs who are out in the market trying to raise capital?

ADAM MCGOWAN: [04:42]: I think it means that all else equal more money means investors are going to expect… more money in means investors are going to expect more money out. So, you know, what that means is that for what I'll call a market, "market based investor", the dollars return for a Series A deal of the past just aren't going to cut it anymore. So we've got bigger valuations, we've got generally bigger deals and this means start-ups are going to need to start attacking bigger markets and trying to get bigger market shares of those markets and trying to do so with a higher likelihood of success. So even though investment money or dollars might be getting relatively easier to raise, because it's actually getting concentrated into these larger deals, an individual or emerging venture might actually find it harder to raise money. So I know it's somewhat paradoxical but money might be easier to be spent by investors but it might be harder for you to actually get it.

HENRY REOHR: [05:41]: What did you mean by the term market based investor? Are there other types of investors as well?

ADAM MCGOWAN: [05:49]: Well, to me, market based refers to the fact that an investor is operating using… they're using rational expectations for economic returns. So these investors would assess the risk and return profile of a particular investment and they would assess that relative the alternative and one alternative could be to not invest at all. So, what's in the market? What can I invest in? What's the risk? What's my return? And what does that mean relative to me doing nothing at all? That's what I mean when I say market based.

But I talk about them as their own category because I believe there's also some investors where that's not their primary motivation and when they're not relying solely on the market. I describe those as what I would call affinity investors. And there can be many reasons why somebody would have a non market based or an affinity based approach. It could be they want to get some learning or experience out of making the investment, they might want some brand or some name recognition, if it was a company making the investment maybe they want access to some customers or opportunities or maybe some other non-financial assets and some cases it could just be pure emotion, it could be a feel good nature, it could be more of a social component, do you want to make the investment? But, yeah, I think it's in stark contrast, the affinity, to the market based investor.

HENRY REOHR: [07:13]: So you've got market based investors and affinity investors, what types of investment options fall into each of those two categories?

ADAM MCGOWAN: [07:24]: So there are quite a few options. I'm going to run through them somewhat rapidfire. So, you know, listeners can feel free to kind of pause and go back because I will read through these relatively rapidly. But I'll start with the affinity group and I think that there are three categories or three investor types in that bucket. The first one will be pure friends and family, that's pretty straightforward.

The second would be what I'd call truly an affinity investor. So this would typically be high net worth individual, someone who's accredited, and you know that's a definition that we could maybe talk about in a future episode, but they're accredited, have the means to be able to make early stage investments in companies, but they have a particular reason why this investment is interesting to them personally. So maybe it's in the same industry that they were in where they sort of made a lot of their success or maybe they're trying to make a difference in a particular industry. So they know something keenly and deeply about an industry and they want to be able to put that knowledge base to work and they often would act like an angel investor who I'll mention in a second but they do so without necessarily the market based approach.

The third category of investments I see in the affinity group would be true crowdfunding, so the traditional type Kickstarter or Indiegogo type campaigns. For the market bucket, there are number of different investor types. One would be the pure angel investor, individuals, typically high net worth, they are accredited, they want to make investments with a good risk return profile. When those angels band together, they can form angel groups and they make investments in packs, if you will. You then have the traditional venture capital fund and the VC fund typically has a collection of its own investors and they are investing money on their behalf. You then got the incubators and accelerators, so they're acting in a market based way because they're looking at hundreds maybe thousands of different applications to pick those that are going to have the best return for their investors. And then lastly you got the equity type of crowdfunding. So it's different from traditional crowdfunding in that you have investors who are expecting a return. So that's a very important distinction.

And then lastly I'd say that there is a bucket of hybrids which are combos of market based and affinity investing. The first one would be what I'd call strategics or strategic investor. These would be companies that are making investments that might not necessarily only be market based because they want to get something else out of it. Maybe they want to get some new customers, maybe they want to get some brand recognition, maybe there's some intellectual property they want to capture, so there's reasons beyond simply the risk return.

And we've got the corporate version of venture capital. Corporate VC doesn't have the same constraints as traditional venture capital because it doesn't typically have a collection of investors in its own funds, it's usually the company itself, and as a result even though they're looking for a return they might act more like a strategic in that they can have some affinity based concerns or interest when they make investments.

And then lastly would be an initial coin offering. So, very buzzy at this point, crypto currencies we can definitely go into this in another collection of episodes of the podcast but the reason I label it as a hybrid because certainly people look at it from a market based approach, trying to figure out the economics of the risk return profile, but also there's something very hip, very trendy, very interesting, about this cryptocurrency space for a lot of people and I think all else equal, some people might choose an ICO or a cryptocurrency based investment over an alternative investment simply because it's new, it's fresh, it's exciting and so it starts to lean a little bit more affinity than to be exclusively markets based.

HENRY REOHR: [11:06]: It's quite a lot to unpack in that list and I'm sure that we can fill multiple future episodes but for today, as listeners try to make sense of all those options, are there a few key things that they should be thinking about?

ADAM MCGOWAN: [11:19]: Well, I think you're right that we are definitely just skimming the surface here and I also think that each funding option we talked about could warrant one or more episodes on its own. But I think there's a couple of key things or frankly more misconceptions, I think, that would be important to point out. So the first one would be the idea that I oftentimes see people confusing the appropriateness of traditional versus equity crowdfunding for their venture. So a lot of people default to this idea that a Kickstarter type campaign or a traditional campaign makes a ton of sense for them. What we need to keep in mind is traditional campaigns are generally to find customers whereas equity campaigns, I would argue, are more geared to find investors. And so that distinction might seem not to be a big deal but it is because usually when you're looking for customers, it means you have a product, it's pretty clearly defined, you know what it is, you have something to give someone, they give you currency, you give them something back, and it's typically not a service, That's typically a product.

So if you're a software as a service venture, the product is pretty nebulous and much harder to deliver in a traditional crowdfunding manner than many… for example if you built a game with or you built a piece of hardware or a watch or a wearable or something else like that, so that's one thing to be keep in mind. And, you know, on the equity front, the idea of trying to bring in more investors, frankly, it should be treated like more market based driven investing. So you're going to have to put out an offering, you know, offering documents, and may you provide all your financials. So it's a very different animal. So when you're looking for working capital to grow your business, that's where equity crowdfunding comes in. If you need customers and you want them to help fund the building of product for them, that's where a more traditional crowdfunding approach comes in.

I think the second misconception would be the idea that oftentimes an angel group is viewed merely as just a collection of angel investors. And I think that that's a bit of a miscalculation because as a group angels tend to start acting more like a fund or more like a venture capital fund than they do like individuals. And so when that happens, you're going to see any opportunity for an individual angel to start taking an affinity type approach, will start to disappear. Very unlikely would you see a group of angels band together and do anything other than taking a very market based approach to the way they make investments.

And then last thing I mention as a misconception is this notion that ICOs or initial coin offerings make sense in lots of different cases. They do not. They make sense in typically very specific sets of circumstances. This can get very muddy and the perspective can skewed because the headlines and success stories have a huge impact on public opinion, you hear about people raising tens of million dollars overnight or faster and it sort of seems to be a get funded quick scheme, that's not how things play out typically in real life. One thing to keep in mind is that, this is a really good measuring stick, if the coin using the offering didn't exist, if the venture loses its actual DNA, so the essence of what the venture is, if it can't do what it's supposed to do to the level it should do it without the coin being part of them, again this could be fodder for many future episodes, then ICOs doesn't really make a lot of sense. We've seen examples of people wanting to do ICOs for companies were just has nothing to do with cryptocurrency. There's no benefit to actually creating a currency or a coin for the purpose of their venture, the coin doesn't… you can't leverage its inherent characteristics like acting like a smart contract. When you can't do that, that seems to be people are trying to ride the wave rather than actually using the ICO for what it's intended to be used for.

And then lastly, even if you do have an idea where the ICO makes really really good sense, it's typically the case that when ICOs have a huge amount of success, it's because the people behind it have an unbelievable amount of credibility in the space already; because you're not typically investing in a track record of the existing coin because it's the initial coin offering. You have to go on some gut feeling or some sort of track record that the people behind it are going to make good on their promises. And so the idea that you're a first time founder without a ton of background in the industry that may not be perfectly aligned with the coin offering, it's probably not a good fit for you. So I think that's another really important thing to keep in mind.

HENRY REOHR: [15:55]: For an entrepreneur at a very early stage, what's one piece of advice that you would share when it comes to raising capital?

ADAM MCGOWAN: [16:03]: This is a difficult question to answer because I would argue that my answer would vary a lot based upon the individual entrepreneur circumstances. But what I'll do is I can make a bunch of assumptions that are consistent with probably the most common cases that we see and then based on that example I'll share some advice.

So the conditions; first, the venture hasn't yet proven its product market fit, the second would be that the venture doesn't have any really material traction or revenue yet and the third will be that the product has some element of it that's technical but yet the founders aren't particularly technical. So this is a very common scenario and in that case the most important advice I would give would be to truly be honest with yourself about your ability to raise the "market based investment". And If I should break that down a little bit, the first thing I'd say is, try to do as much as you can with the skills and capital you already have readily available. So the need to go out to raise should be an absolute necessity once you've exhausted all the other options. So focus on your own strengths, be very self-aware about, maybe, what holes you have in your team, be willing to expand your team and share maybe a piece of the pie or some equity with other people to figure out how you build that appropriate team that can help build the right product, build the early traction, build the early excitement, before you need to go out and raise some of that market based money.

And also, put a real emphasis on the, kind of, lean startup approach to validating your market; so, measuring the market's interest, affirming that the problem you think is out there is really shared by lots and lots of people and that they really care and they really need it solved, and then also do a lot of interviews, a lot of testing of hypotheses. And I'll also argue that in that stage, if you do need capital, try to go affinity based first. It typically doesn't sort of pop up into people's consciousness as been that obvious, these investors don't put out a sign in neon lights that suggests, "hey, affinity money here," it's a little hard to uncover, but I think with the right amount of research and thoughtfulness, you can find people in your space who might be really really great angel type investors, who might not expect as market based, the return, as some other people might at a very early stage. And then the last thing I'd say and just sort of a reiteration here of what I just mentioned, but really focus on looking inward, thinking about what kind of skills and frankly what kind of holes you've got your team and augment that team to the best of your ability with those key skills that you're missing and I think you'll probably get a lot further on a very limited amount of capital than maybe you thought you could otherwise.

HENRY REOHR: [18:52]: Well, thanks Adam. That's all we've got for today. I'm Henry Reohr at Firefield and you've been listening to another episode of Ventures in Tech.