How high-risk entrepreneurs fund their startups
High-risk entrepreneurs want to take their ideas and make them as impactful and valuable as possible, as fast as possible. Failing is not a big deal because high-risk entrepreneurs feel that failing gives them additional experience, which just improves their odds of succeeding the next time. While many entrepreneurs dream of going down the high-risk path, few actually do; as we mentioned in the previous sprint less than 3% of all founders wind up going the high-risk route.
A critical starting point for even considering the high-risk route is that you have to be prepared to give up control of your startup. Strangers that invest in your startup want their money back, so they only invest in startups with credible plans to either be sold or to go public within 5 to 10 years. They do not invest in startups that plan to stay private and pay dividends to their investors. They want to invest in ambitious founding teams who want to make as much money as possible in as short of time as possible. It doesn’t matter to them who is leading the startup just because they came up with the idea.
There are three main groups interested in funding the startups of strangers: angels, accelerators and VC.
Angels
Angels are wealthy individuals who take pride in their ability to help ambitious entrepreneurs start companies. They invest in entrepreneurs they like, and who are starting companies that they think they understand, and where their understanding tells them their investment can triple or more in value over the next few years. In the US, they tend to individually invest on the order of $25,000 to $250,000. Often angels invest together in groups, which can result in a group of angels investing up to one million dollars at a time. The latest data shows that the median angel round in the US is a modest $88,000. In other countries, these amounts are considerably less.
Less than 1 in 5 companies receiving angel funding go on to receive VC funding and more than 70% of all angel-funded companies fail. A small sliver of angel funded companies prosper having only received angel funding, where the angel winds up receiving dividends from their shares.
Angels are individuals to whom investing in startups gives them pleasure. For some it is just the pleasure of making money, but for most angels it is about feeling relevant and respected. Many angels accumulated their wealth as successful entrepreneurs and want to feel they are still part of the entrepreneurial ecosystem. This pleasure can come from investing alongside other angels in groups, or when they invest alone from getting to know and helping an ambitious entrepreneur.
When a founder receives money from an individual angel, they should expect that the angel will want to ‘feel’ involved and will require ongoing attention to make them feel appreciated and relevant. When you introduce yourself or describe your startup to a potential angel investor you want to make it clear how what you want to do is inspired by what the angel has done or is interested in. We will prepare sprints specifically on how to pitch to angels in the near future.
Accelerators
Accelerator is a general term for organizations that explicitly help founders start their companies. While some people use the term generically, you want to distinguish accelerators from incubators. Accelerators give space, training, some investment money as well as access to their commercial networks in return for an equity interest in the startup. All accelerators offer to introduce startups to potential investors, but they do not promise that any will invest. Prestigious accelerators, like Y Combinator, virtually guarantee their graduates will receive seed funding once the program ends. On the other hand, incubators do not invest and instead charge startups for providing space to work, where that space provides access to a local entrepreneurial ecosystem.
Accelerators are businesses who want to make money from helping startups succeed. Because they invest in and own equity interests in startups, they select their cohorts of participants based upon what they feel the chances are of the applicant getting sold to a bigger company, or perhaps going public, sometime in the not-too-distant future. Without fairly quick liquidity from their investments in the startups that they nurture an accelerator will run out of money and close, which happens to most of them.
Prestigious accelerators are very selective in whom they admit and they only accept teams and not individuals. They invest between $100,000 and $500,000 for 10 or more percent ownership stake. They also help put together post-graduation seed rounds of several million dollars. There are maybe a dozen prestigious accelerators in the world, and they greatly improve high-risk entrepreneurs’ chances of being successful. Most other accelerators offer to make a small investment and have spotty records of helping their graduates find seed capital.
For first-time founders, getting accepted to a credible accelerator program is a critical step on the path to getting significant outside funding. Accelerators give first time founders credibility because the former entrepreneurs that run accelerators basically vouch for the entrepreneurial savvy of some or all of their graduates. About one-third of all startups that receive series A funding graduated an accelerator program, with one-third of that total coming from just the top five accelerator programs in the US. When you consider that most series A funding goes to startups led by individuals who spun out of existing successful startups, or are serial entrepreneurs, or are individuals or teams closely mentored by a well-connected successful entrepreneur, it is clear that being accepted and graduating with the sponsorship of a credible accelerator, particularly a prestigious one, hugely increases the chances of a first-time founder being able to raise significant amounts of venture funding.
There are a couple hundred real accelerators in the US at this time and around 500 worldwide. But the majority of accelerators who invest money, space and networking time into two or three cohorts of teams per year are not successful at helping many of their startups get to series A. Many organizations that call themselves accelerators actually charge for their services; we would call them an incubator, and they are not very useful in helping entrepreneurs raise money. Aspiring high-risk entrepreneurs therefore need to investigate and verify the track record of any accelerator they consider joining. In a future sprint we will give more details on when and how to apply to prestigious accelerators.
VCs
Venture capital, or VCs, are organizations created for the purpose of investing in startups and non-public companies. While there are different flavors of VC, each with slightly different business objectives, the classic VC is a firm founded by an entrepreneur for the purpose of investing in startups with the goal to make a much greater return on investment for their investors than the investors could make in public equity markets. In return for getting higher than market returns for their investors, a typical VC firm charges 2% per year for managing the investors’ money and also receives 20% of the profit they make for the investor. Since giving money to a VC firm to invest on your behalf is expensive, successful VCs must have great rack records of investing in startups that get big fast.
The first serious round of VC funding is known as series A, and for the past 40 years in the US there have been around 1600 unique startups a year that receive series A funding. This number does fluctuate from year to year and the size of a typical series A investment has grown considerably over that time, but the count of unique startups getting past series A has not. Realizing that in the US there have been around 800,000 new business incorporations a year you see how extremely picky VCs are about whom they give substantial amounts of money.
How big you have to get fast, depends upon the VC. Commonly, VCs want to invest in companies that will get at least as big as half the size of the funds they manage. If the fund is managing a fund with one-hundred million dollars, they will want to invest in companies that can be sold for more than fifty million dollars in five or so years. And they will want the company to get that valuable with around five million of total investment. Furthermore, many of these hundred-million-dollar funds do not want to invest in risky startups, instead they invest their money alongside bigger VCs investing in already fast growing bigger companies. The universe of VCs wanting to invest in companies with the potential of becoming fast growing very profitable fifty-million dollar companies is small.
Investing in first-time entrepreneurs, particularly without relevant industry experience and connections is super risky, so scoring such an investment requires strategic cultivation of contacts with VC firms that might someday be interested in investing in your idea once you prove that it will be super-fast growing. That is what accelerators help you do. If you have industry experience and if you know your potential customers well, then it makes sense to introduce yourself directly to VCs that have experience in investing in related businesses of the size you aspire to get to in a few years.
The realities of high-risk entrepreneurship
The reality is that there are many people that dream about being a high-risk entrepreneur, but very few actually follow-through. Here are the underlying numbers:
There are over 36 million entrepreneurs running their own businesses in the US right now and another 12 million people working on their ideas and aspiring to be an entrepreneur. Thirty million are solopreneurs and have no employees, although many use contractors to support them with specific business needs. Close to six million different businesses with employees operate in the U.S. and 99% of those are run by entrepreneurs and not listed on a stock exchange.
There are about three million new businesses, including solopreneurs a year, and about the same number that close up shop or are sold. Of these new businesses, about 50,000 get some angel funding, of which approximately 12,000 or so will succeed in starting up and being sold and maybe a thousand will get to series A. Around 2,000 attend an accelerator, of which maybe 600 get to series A. The other 1,000 a year that get to series A do not go through an accelerator because they are started by individuals with specific industry expertise or by serial entrepreneurs, many of whom received some initial funding from an angel.
The reality is that it is a very risky to want to be a high-risk entrepreneur.