Funding New Emerging Ventures

R&D in a new venture relative to a corporate program is a very different animal, primarily due to the financial constraints.

Corporate R&D seeks to develop product offerings that address a market opportunity and contribute revenue to the business.  Funding and risk are understood components of the corporate R&D equation, with varying thresholds for both.  Corporations have varying philosophies about what percentage of revenue they should invest in exploring next-generation products, and the expectations for desired margins achievable vary as well.  In successful technology-related industrials, R&D spending is often in the range of 10-15% of revenue. Margins of 30-40% are typical targets to definition a successful product.  This is in general and when averaged across all firms in a sector it varies considerably.

When entrepreneurs explore an R&D project in a start-up venture, there is invariably a wealth of energy and enthusiasm, but the funding to carry it through is often the most challenging piece to solve.  As a new venture, one cannot linger too long in the R&D phase. The path is usually to find and demonstrate a solution for a specific, well-articulated market need, prototype the solution, then commercialize it to get to revenue before one’s ability to fund the work wanes.runway 615399_engizs_runway The metaphor is invariably finding enough runway to take to the air.

There is no shortage of content on the Web about funding paths, schemes and strategies. Often those lists exclude a few common options, or gloss over a few risks that I might have chosen to emphasize.   Hence this is a brief overview with some thoughts from my perspective.  These are common paths to funding a project forward towards profitability.  I have had some small experience or exposure to each of these from whence my opinions have been formed.

  1. Venture Capital
  2. Angels
  3. Friends and Family
  4. Bootstrapping
  5. Government Assistance
  6. Bank
  7. Strategic funding
  8. Crowd-sourcing

Here is a look at each of these in turn.

1) Venture Capital.  I’ll say a little bit more about this funding source, as it is often the one that first-time start-up projects tend to think about as the first stop.  Venture Capital or “VC” funding is based on high-wealth individuals seeking to lessen the load of finding investments, yet still seeking to tap into markets in which they may personally have poor depth or understanding.  They pool their money behind venturesuits 1012552_business_world_4 funds raised from diverse sources, and those funds are in turn directed by savvy managers employing subject matter experts toward target sectors perceived to be rife with potential.  They have the resources to perform the ‘due diligence’ required to engage ventures that they hope will show explosive growth.  They accept a substantial failure rate – most quote a number like nine out-of-every-ten expected to fail.  They expect, then, that the tenth will yield enough to compensate for those other losses.

In exchange for equity in your venture, a VC will theoretically provide funding towards specific goals that bridge between initial concept and customer engagement, to firm revenues, and the holy-grail of profitability.   Or at least that’s how it was originally conceived.

VC funding was arguably the engine behind the late 90’s explosion in funding that pushed the technology world into a financial bubble.

In the period, large pools of investment capital and exciting emerging technologies coincided fortuitously. There was a fertile batch of ideas coming out of the nascent Internet/Web ecosystem hungry for a rain of equity to enable a crop of world-changing companies.   So many ideas emerged so fast, that it became a sellers’ market for ventures.  Soon the stories were rampant of new ventures getting tens of millions of dollars based solely on a compelling idea described in PowerPoint slides, and a couple of good resumes.

With the crash after the turn of the millennium, VC’s moved to a brief period of throwing good money after bad – while they tried to shore-up failing concepts rather than engage in fresh ones.  After that played out, most VC’s became extremely risk averse.  Most continue to explicitly seek to invest in ventures that are not only established, but most seek only ventures that have customers and revenue in hand.   For many ventures, however, the chasm between early prototypes and commercial, revenue-generating product is their biggest barrier to success.  With that chasm to cross, once customers and revenue are in hand, the last thing they are interested in is relinquishing large chunks of ownership in their operations.

The VC risk-aversion is also played out in the sectors selected for investment.  VC’s are much less likely to lead a new emerging space now, and usually wait for traction in a space before turning their attention in that direction.  This is partly driven by their source of funds.  It’s much more engaging to tell your high-wealth individuals that you are going to get them involved in firms chasing the exciting markets of which they have heard much in the press, than it is to convince them to put more money into something of which they are unaware.

There are exceptions to any rule, and some VCs will have a bit more of an appetite for risk, or earlier stage ventures.  It’s also likely that if the market shows a period of big hits on the venture front, pressure will emerge for VC’s to take more chances to pass those big gains on to their fund contributors, and in that scenario we’ll be prime for another pass through a potential 90’s-style investing bubble.

VC Goal: High value exit event to return capital with a significant premium to compensate for the many projects which will fail.

2) Angel funding is a simpler version of the above.  High wealth individuals are still involved, but  they typically wish to get closer to the investments.  Sometimes this is because they don’t play well with others, and want more control. Sometimes it is because they have a love for a specific sector and wish to be involved at a detailled level.  Sometimes they bring no subject matter expertise yet seek to satisfy themselves based on founder relationships and financial structure and hope that the technology pieces take care of themselves.Angel 473926_cheesy_phil_1

In most cities and regions there are loose associations of Angel funders who will mix and match partnerships to engage a venture together, and spread the risk somewhat.

The Angel-funding landscape is more diverse and as such there are both better situations and worse ones.  Some Angels will meddle and micro-manage a venture, seeking to exert too much control, while others can do just as much harm by providing no guidance or structure for an inexperienced start-up team.  Indeed many angels are the lottery winners of the business world, having had a company in the right place at the right time, and sold it in a windfall.  The wealth and apparent success may not indicate any particular ability or depth of ability.

Of course, angels might also be solid, proven entrepreneurs with a track-record of success. They might be satisfied with a smaller potential market opportunity due to an enthusiasm for the business idea.  With the right match, an angel can be the second best thing that happens to venture.

Angel’s Goal: High value exit event to recover funds, but possibly also a high-value idea in which the funder(s) can participate (for better or worse).

3) Family and Friends funding is as it sounds – collecting investments from those people you know around you.  These can be a few individuals with deep pockets, or many friends and relatives with small investments.   In general, my advice is to avoid this situation.   Perhaps your family circle includes established successful business people who align with your venture direction.  That exception is an easy one to manage.  But otherwise the challenges are many.FriendsFam 422094_equipo

In most cases the investors are naive about the subject matter and business fundamentals.  In the best case they have money they can afford to lose, and know how to apply some rigour in their expectations.   In the worst case they will have inflated ideas about their ability, or yours, and may wish to meddle.  If a venture turns out poorly, the reactions can be aggressive demands to pursue other random strategies by ill-informed people.   Fundamental life-relationships are put at risk.  Focus can be challenging, and people may invest beyond their ability to lose.

There may be situations where family and friends desperately wish to invest, and to participate in something that is doing well and is well on the way to succeeding.  They may interpret a lack of will to accept investment as a personal slight as well.   And eventual success may further put up some backs.  It’s certainly possible and common in many cases to have a ‘friends and family round’ at some stage of the business.  Timing it to a lower risk profile, and capping the participation rate might be a good strategy to manage risk to your sanity and life beyond the venture.

In the event of any investments from this group, the best guidance is to ensure there is just as much structure around the investment as if you were dealing with a stranger.  Protect both parties with formal documentation of the outcomes, including the worst  (and most likely) case – total failure.

Friends and Family Goals: Partly to support a friend or loved one, partly to become fabulously wealthy from what is obviously a brilliant person.

3) Bootstrapping is a tough road, but for many ventures today it is also very rewarding one.  The barriers are much higher, the learning is much more intense.  For many ventures it is not an option, as the capital costs are too substantial to cross from concept to commercial product.   But in a wide range of markets, there can be low capital cost opportunities where small customer engagements may create the trickle of initial revenue that allows a skeleton founder’s group to emerge slowly into the market.bootstrap 1136536_old_scummy___

Young entrepreneurs, or those with a good nest-egg may be able to work without pay for an extended period of time.  Partnerships may solve some near-term issues.  Co-working spaces, of which there about 1000 world-wide, provide for functional environments for networking and collaboration.

The path to success is certainly more difficult, but the basics learned about controlling costs, pride of workmanship and work-ethic are invaluable.  Out of this culture of bootstrapped business has come a philosophy that many report to be effective.  Rather than labouring towards the perfect product and a huge introduction date, the mantra is now to fail quickly and often.   This is particularly well suited for software and web-based services, but can apply to more physical products as well.

It’s a little tongue-in-cheek, suggesting failure quickly and often. Obviously everyone secretly hopes to introduce the perfect product on the first try, but it is essentially a call to recognize that if a market is large enough, you can get a very minimal product in front of your initial customers, and even if the product fails, you will find additional customers on your next try, or some will stick around if they see the promise of the concept.  Customer tolerance for roughness-around-the-edges will be higher with a product from a bootstrapped venture.   The company can learn a lot in a short time, making product revisions rapidly.

The founders get something out of the process too, in that they retain much more ownership going into an equity event where a payoff is possible.  They also retain much more leverage in such a situation.

BootStrapping Goals: Get product out to market before founders starve or have to abandon the project and get ‘real’ jobs.

5) Government Assistance is often available in areas where there is some political will to support innovation and small business growth.  The challenge with many of these programs is that they require substantial cash-on-hand to take advantage of them.   Much has been learned from poorly managed government programs that were abused in the 80’s (e.g. Canada’s SRTC), without actually fostering much R&D or new business development.  Thus the most common approach now is matching funds for a described R&D or commercialization project, or newer tax-credits after the fact for spending that fits into one of those categories.government 1383653_parliament_hill_ottawa

These can be very lucrative for ventures that have reached the stage of having funds to spend on new exploratory development, but they have less value to very early-stage businesses.

Government programs are best considered later in the cycle, when funds are already secured, and these programs can provide supplemental aid in covering a portion of a contributor’s salary, or recovering some spending that meets R&D tax credit criteria.

The other caveat in government programs to consider is that there is often a very high administrative burden.  If it takes a dedicated contributor’s full time attention for weeks to apply and follow-up the application and subsequent reporting,  it might turn out to be a zero-sum game.  The same effort invested in a revenue-generating task would have been as (or more) valuable to the venture than the funding program.

Government Funding Goals: Gain political points for government in power by showing successes in the market place from taxpayers’ money. But more dominantly, run a funding program without abuse or corruption scandals. All the documentation and paperwork seek mainly to avoid such risks.

6) The use of bank financing is only appropriate for a certain class of ventures, and almost never suitable for emerging technology ‘R&D’ type businesses.  The funding is loan-based and tbank 1415802_bank_loan_concept__2hus a bank will seek some asset-based protection of the funds, and require repayment.  The criteria applied to secure the funds are based on assets evaluation and cash flow.  In some cases, loans can be secured with customer commitments and projected accounts receivable, but the personal risks are greater in the case of venture failure.

Bank Financing Goals: Get money back with a specific interest rate on a rigid schedule, with little-to-no risk to the funds.

7) Strategic funding.  This path is an attractive one as it can offer the best of both worlds – the guidance and structure of a big player in a relevant market, and the agility and creativity of a start-up team.   In this scenario, a large established strategicFund 1198017_silhouetteplayer expresses interest and financial support for your idea and guides your path forward.   In some cases, motivation can be that the company desperately needs your product to enable part of their business.  In other cases the company may recognize that they cannot within their internal corporate culture assemble a team as agile or as inexpensive as yours to address a certain market opportunity.

Long term scenarios can be either the eventual acquisition of your venture into the business, or perhaps a prolonged customer/vendor relationship that makes the business a going concern.  There are sometimes multiple equity events as a company moves towards acquisition at a cautious pace, or instantaneous purchases outright.

Strategic investment is not without risks as well.  Without a structured relationship, the company may develop their own internal capability and eliminate their need for your product.  Internal decisions in which you have no say may suddenly result in an exit from your engagement all together.  In a worst case scenario, a heavily bureaucratic and slow-moving company may weigh you down and export a non-functional culture into your venture making it unable to address a fast-moving opportunity.

Strategic Funding Goals: Create a product or market that the company cannot do inside due to culture, bureaucracy, risk-exposure or talent deficit.  Ultimately likely to pull the venture inside if it succeeds.

8) Crowd-sourced funding is emerging as an exciting new path for entrepreneurs.  Prominent sites like Kickstarter, RocketHub and Indiegogo are changing the venture landscape.  Founders pitch their ideas to a broad audience and if they are able to create a compelling story with wide appeal, thousands of individuals provide small investments toward a specific product goal.  Often a portion of the funds invested are put towards the purchase of the target product, creating an immediate path to getting product into the market.Crowd 1370392_crowd

There are challenges in this environment as well.  An idea has to have mass consumer appeal to get attention, and often those who are able to create a compelling YouTube pitch may not be well suited to implementing it.  A non-viable product can result from a poorly funded group of enthusiastic but inexperienced founders, and interest can wane quickly.

However, even with a poorly implemented final product, sometimes a crowd-funded product can be an impetus towards gaining traction on other forms of equity.  The initial funds may provide the learning curve that teaches founders that they need some specific skills added to the team and may bring deeper pockets forward towards a next step

There have been some challenges on early funding sites, in that visitors were beginning to think of the engagement much more like a shopping process than an investment process.  They might then raise unreasonable displeasure with the path to delivery of the product they thought they had ‘bought.’

There have also been questions raised that need more attention regarding taxation of crowd-sourced funds.   It appears that in some cases tax authorities will see a portion of the investment raised as simple revenue from sale of a product.  If founders use up all of the funds for development and production of initial prototypes that get sent out to investors, they may suddenly find themselves owing associated retail sales tax without having the means to pay it.

Crowd-funding Investor Goals: Participate in the innovation people always hear about but which is typically beyond their reach.  Acquire a product that is compelling, visionary, revolutionary or simply neat.

That’s a quick overview of venture funding options and a few caveats for each.  Many ventures will find themselves traversing a few of those categories along the way to success.  Many more will touch on one only before a quick departure.  In either case those involved will learn a lot and have a shot at changing the world.