The Funding Gap

January 20 2011 2 Commented

Startup entrepreneurs need to be aware of The Funding Gap between angel investors and venture capitalists.  It is quite well-known that startup entrepreneurs first use their own capital and then seek funds from friends and family in the process of productizing their innovation.  Only when customers have been identified who have at least beta tested the product will angel investors be interested in looking at the company.  And, normally VCs come along later, when larger sums are required to rapidly grow the enterprise.

Entrepreneurs are expected to invest their net worth in their new ventures.  Friends and family are often good for $5000 to $100,000.  Angel investors usually invest between $200,000 and $1 million.  A decade ago, entrepreneurs could expect venture capitalists to invest sums above $1 million.  But, at the time of the Internet bubble, the threshold for venture capital increased significantly.  Today, very few VCs will invest in deals seeking less than $4 million.  VCs need to invest much more money in a smaller number of deals; consequently most VCs now invest sums above $4 million in later stage companies.

Let’s look at some numbers:  Hundreds of thousands of friends and family invest an estimated $50 billion or more in startup companies every year in the US.   It is estimated that more than 200,000 angel investors fund 50,000 companies with $20 billion annually.  And, the 1000 or so VC firms also invest about $20 billion in 1000 new companies every year.  But, I estimate that less than 200 (and probably less than 100) investors provide funding in the gap between angels and VCs, that is, rounds of investment between $1 million and $4 million.  Finding investors is always difficult, but finding capital in The Funding Gap is like seeking a needle in the proverbial haystack.

So, armed with this information, what’s an entrepreneur to do?  My advice is design your milestones accordingly.  If you need $2.5 million, raise $500K and demonstrate increased value by hitting key milestones and raise $1 million, both from angels.  And, once you can demonstrate real traction in the marketplace, you will likely be able to raise another $1 million from those angels.

What if you need $3.5 or $4 million?  I would then raise $500K to $1 million from angels with the understanding that you will need more money, but you can hit key milestones and create a company that VCs will be interested in funding with an additional $4 – $5 million later.

And, what if you need $3.5 million to build a prototype, before any customers will see the product?  Frankly, in today’s startup funding environment, unless you are a serial entrepreneurs with an exceptional track record, it is virtually impossible to find investors who will fund such ventures.

The key issues for entrepreneurs are (1) understand the realities of capital sources available to entrepreneurs today and (2) design key milestones around building sufficient value in your enterprise to attract the capital necessary to grow your business.

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