Start-up Funding Ecosystem

Funding is a vital component of entrepreneurship, especially for tech firms which often require significant investment before reaching profitability.

In a tech start-up, you may burn through cash validating new ideas and insights. Consulting firms on the other hand have smaller setting up costs. Types of Investors and Investments include:

• Bootstrapping and Side-Hustles: Focus on minimizing costs and generating revenue quickly, often through freelancing or part-time work.
• Family & Friends: Early backers, usually without equity but sometimes involving personal debt.
• Credit Cards and Loans: Traditional debt financing, with potential conversion to equity under certain conditions.
• Start-up Studios, Incubators & Accelerators: Organizations that support start-ups through space, mentorship, and sometimes funding.
• Competition & Prizes: One-off prize money and exposure through pitch competitions and innovation challenges.
• Crowdfunding: Raising small amounts of capital from a large number of people, typically via online platforms.
• Business Angels & High-Net Worth Individuals: Individuals who provide funding and often mentorship, typically in exchange for equity.
• Grants and Subsidies: Non-repayable funds provided by governments or foundations, often with specific requirements.
• ICO (Initial Coin Offering): A decentralized way of raising funds by issuing a new cryptocurrency.
• Venture Capital: Professional investors focused on high-growth companies, typically for a share of equity.
• Strategic Partners & Corporate Venture Capital: Investment from larger companies in the same or related industry.
• Private Equity: Investment firms that invest in companies through equity.

These can be broken down into 4 categories:

1. Grants: : Non-equity funding from foundations or government entities, usually in return for reports and impact metrics.
   • Shell Foundation. Power generation start-ups for equity free money
2. Prizes: Funds obtained through competitions, offering both financial and networking benefits.
3. Debt: Bank or personal loan with no ownership; assets as potential collateral otherwise 9-10% interest
   • Convertible debt - loan converts into equity (and vice versa) after milestone (revenue or product targets or from seed to Series A round)
4. Equity: Selling a portion of the company in exchange for capital, often from venture capitalists or angel investors.
   • Risk capital investors that bet on a future return. They follow the spray-and-pray model.
   • Employment Stock Option Plan (ESOP) to incentivize employees and minimize HR cost for key staff

When looking for investment, keep the law of averages & sales in mind. To sell 1 product, you have to knock on 100 doors. If you're very good, you will sell 2 packages when you knock on those 100 doors. Build that thick skin of being told no. Keep doing it until you get that one that makes a difference.

Understanding the different types of investors and investments is key to navigating this complex ecosystem.

Investment Market

Capital investment available is on the rise. 2019, London Paris & Berlin were the top entrepreneurship hubs in Europe. There were over 6 million professional developers in Europe, with the number rising steadily, and over 34 billion have been invested. There's a similar picture in London, which is the frontier of the whole of Europe and the UK. Over 11 million has been invested this number steadily rises - there is more money available for technological innovation. There is a similar picture in the US, especially California.

Although, 90.8% of investment goes to all male teams. Only 4% of all UK deals go to all female founder teams. Less than 1% of investment money has gone to all female teams. There is a problem to see this asymmetry. In 2019, article said that start-ups with mixed gender teams performed better. Better for Global GDP, rising 3-6%. Race also plays an important issue. In 2019, the vast majority of investment went to white males. Little goes to black or coloured founders. Strong inequalities exist, but inclusivity brings benefits. This should be considered when building a team.

Funding wise, due to psychology, people trust and therefore are more likely to fund people who look like themselves. For example, I might seek out coloured investors. Now there are even clubs organizing social investment funds.

Bootstrapping and Side-Hustles

Avoid the need for external financing at all cost. Keep cost to bare minimum e.g. second-hand/lease equipment, home/co-working office space. Reduce 'burn-rate' - no employees or labour on contract basis. Reduce personal spending to absolute minimum. Begin to generate revenue as fast as possible. Bootstrapping as initiation ritual

Side-hustles-out-of-necessity supplement costs; accept related or unrelated gigs (odd jobs as freelancer or full time job) for cashflow generation. Entrepreneurship-as-side-hustle is when you test the waters before jumping in from full employment to entrepreneurship once traction kicked in.

Founders, Family & Friends

Parents, Uncles, Aunts as early backers. Potentially pool together a large sum e.g. £10k x 5. Usually no equity but personal debt (often informal). Signal of buy-in to investor. Personal savings (not all at once - in tranches over years). Credit Cards/ (Re-)Mortgage on assets are also sources.

Venture Builder, Foundries, Start-up labs

Startup studio: A company that births startups. A business whose intent and primary activities are to spawn and launch new startups. The activities of these organizations include identifying the initial concepts, identifying attractive markets and taking concepts from inception to scale. Other terms used to refer to startup studios are company builders, venture studios, startup labs, and foundries. In short, a company that births start-ups. IDEO Futures (opens in a new tab) and Rocket Internet (opens in a new tab) are examples. There are even places like Founders Factory (opens in a new tab) that are a hybrid between a VC and a start-up studio.

Incubator: A co-working space that houses startups. Workplaces where early-stage startup companies work to develop their concepts from idea through the product market fit stage. These spaces can be part of an existing business, a standalone workspace, or be a virtual community. The incubator may provide funding, mentorship, services, and a support community of similar start-ups. Typically, there are loose guidelines for how long an entity can share the space including an approximate time period and/or size and scale of the team. In short, a co-working space for start-ups, such as Imperial white city incubator.

Even more is the Accelerator; a program that trains startups. Similar to an incubator, the program usually offers a shared space for start-up companies to work in tandem. In addition to working out of the same space, each startup team goes through a structured program over a defined time period, typically between 3 to 5 months. Typically the accelerator makes a seed investment for a small percentage of equity for participating. The intent is for start-ups to exit the accelerator space at the end when the startup has graduated from the program. In short, a program that trains start-ups. Y combinator etc. Strategically, brings them close to start-ups and innovation. Also, you have something they need

Crowdfunding

Donation is where nothing is expected in return, for charitable causes. Intangible benefits (JustGiving). A reward is when funding is provided for product development (validation, market testing for the start-up). Rewards e.g. be an 'innovator' (adoption cycle) plus what you opted for. Crowdfunding platforms even exist to get a small bit of equity; they become an investor and expect a return on investment if business does well. Kickstarter, Indiegogo, Crowdcube, Seedrs.

Business Angels and High-Net Worth Individuals

Hands on, face to face, close tie approach. Fund around £50k - £1m for minority ownership (10-40%). Quick and dirty investment realization. Within industry in which angel has experience. Often located within driving distance. Recommended by trusted business associates. Invest in people first (highly people driven), technology second

Invest at very early stage only (VCs still reluctant) and the exit is not as planned; more of a personal approach. Angle syndicates and networks e.g. London Business Angels, Indian Business Angel. Example: In 1998, Google co-founders Sergey Brin & Larry Page get 100k check in after 15 min pitch from Sun Microsystems co-founder Andy Bechtolsheim

Subsidies

Government funded R&D initiatives (national or European) as grant, loan, risk capital or tax exemption. Google's search algorithm supported by a grant from National Science Foundation, a US public grant-awarding body. Tesla has received a $465 million (£380 million) loan from the US Department of Energy. Elon Musk's Tesla, SolarCity and SpaceX had jointly benefited from nearly $4.9 billion (£3.9bn) in public support. Book on this topic: Mariana Mazzucato, The Entrepreneurial State.

ICO

Raise funds in a decentralized way by issuing a cryptocurrency token. Token may have utility in product or service or may represent stake in company. Unregulated, decentralized, independent and (kind of) hyped.

Extremely high risk, be aware of fraud. Offering works through whitepaper that details project and amount requested. E.G. Telegram Open Network raised USD 1.7 billion from January to March 2018

Venture Capital Investments

Venture Capital (VC) funding is a pivotal element in the growth of many startups, especially in technology. Understanding how VC funds operate and what they seek can significantly enhance an entrepreneur's chances of securing investment.

VC funds often specialize in specific verticals, such as logistics or green chemicals. They gather investments from limited partners like pension funds, large banks, and insurance companies. These investors contribute to the VC fund along with a management fee. The VC firm then allocates these funds to selected companies within their focus areas. The typical lifecycle of these investments spans 5-10 years, culminating in an exit strategy like an Initial Public Offering (IPO) or acquisition. Initial investment is returned to the limited partners plus whatever profit that has been made. It is demonstrated here from this diagram (Pearce & Barnes, 2006, p.9):

To make this more visible, imagine raising a VC fund for a 5 year horizon. Investment associates or partners at the VC fund source, assess and invest; they are in charge of the entire deal flow. They manage the information asymmetry. The problem is early stage start ups fail at a high rate. Roughly 50-60 percent after a few years. If the VC fund want to return the principal plus additional on top, some of the companies have to outperform all of the rest. The VC fund invests looking at companies that are Big Winners - startups with the potential for exceptionally high returns.

Statistically, a significant proportion of early-stage startups fail, so VCs hedge their bets across multiple ventures. The expectation is that a small number of investments will yield returns substantial enough to cover the losses from less successful ventures and provide a profit to the investors.

This also means there is a lot of pressure on each start up to grow rapidly. Roughly, 30% are outright failures, 40-60% make some money, 10- 20% are big winners. These are the ones that need to return the principal to the VC, plus pay for fees, plus give a nice return to the limited partners.

Andy Davis, in an interview, said that for him, if he had invested $1M in 10 companies for 10% equity, he expects 50% to fail. 2 to return some money, but still at a loss. He expects 2 to be somewhat profitable and return some money. And one massive outlier; 10% of the companies to knock it out the park. VC's need it to 40X for it to be a winner. So, when talking to an investor, think "Can I return to them the entire investment pool". If not, it wont be worth the investment for them, and they wont bother investing. Keep this in mind when you are pitching. You need to prove that your company will return the capital of all the other companies.

In general, where does Venture capital come from? Its emergence was in 1946 by Boston area elite worried by the economy. They thought they needed investment in new innovation and new companies as there was very little at the time. American Research & Development Corporation was the first organizational vehicle that can be labelled a VC firm, and it had the purpose of recycling idle societal savings. VC's acts as financial intermediaries providing sector-specific expertise and financing. They source, assess, invest in and monitor start-ups using their expertise.

Typically, they take a seat on the Board of Directors and manage the potential information asymmetry between the LPs and the venture and influence strategic decision making. This adds value through investment, network contacts, knowledge, follow-on funding and structuration of the organization.

The Investment Process

• Sourcing and Assessing Deals: Investment associates or partners at a VC firm are responsible for finding and evaluating potential investments. This process includes managing information asymmetry between the VC fund and startups.
• Diversification of Risk: To ensure a healthy return on their investment, VCs diversify their portfolio, banking on a few startups to provide high returns.
• Investment Allocation: Funds are usually allocated with a clear understanding of the high-risk nature of early-stage investments. The expectation is for a small percentage of investments to drive the majority of returns.

What VCs Look For in Startups

VCs typically (Birley & Muzyka) focus on several key aspects:

• Leadership and Team: The capabilities and track record of the lead entrepreneur and management team are crucial.
  • Investment in a product can be an idea as markets are very volatile. You want to make sure the team can adapt and execute in these situation
  • Industry expertise of management team
  • Track record of lead entrepreneur
• Market Potential: A clear understanding of the market, high growth potential, and a realistic pathway to long-term profit.
• Innovation and Competitive Edge: Startups need to demonstrate unique value propositions and a clear competitive advantage.
• Well-Structured Business Plans: Clear equity structures, intellectual property portfolios, and future cash flow projections are important. Not being over-diluted in equity is also important.
  • Don't say there is "no competition" because that is a lie or a problem.
• Sensible Projections: Overambitious claims can be a red flag for VCs.

Andy Davis said his typical investment pipeline looks as follows:

This is naturally really hard, so don't be disheartened by a 'no'. This is what you should expect. Talk to 120 investors instead. Understand that this is an uncertain numbers game. You also practice as you go, and you are optimizing your pitch and script. Write down any feedback, iterate, and try again.

What Should we Look for in a VC?

Do they have a good reputation and track record? You can look at sites like RateMyInvestor (opens in a new tab). You can talk to some of their past investee's to see who they have backed in the past. Check if they have additional funds for follow on investment. Often times it is a signal of trust if they dont only invest in one round, but if you raise a subsequent round they can also invest. Do they have strong ties to individuals that can unlock future growth for you? How involved are they?

Do they lead or follow finance rounds (not everyone leads)? The lead investor does all the due diligence, and a follow-on investor will just take whatever terms have been agreed by the lead investor; they don't do the heavy lifting. Are they a general good fit (i.e., vertical, portfolio, culture, personal)? Do they have international or other links? Can they grow you (do they know more than you and do you respect their opinion)?

Deals also don't look like they do on dragons Den. £80,000 for 40% is not a good deal; deals look more like £100,000 for 5%. You need to keep the entrepreneur incentivized, have enough skin in the game, to motivate the entrepreneur to keep running the business, if they only own a small part of it.

Is the investor the correct stage for you? Is he in the right sector, give you enough money, do they have the correct experience/network.

How much should you give away? Have an attitude like "Here are some milestones we want to get to. I don't want to give away too much because I need enough skin in the game to motivate us long term". Always under promise and over deliver. If i give away 10-15%, when I need to raise more capital in 2-3 years, I will need to give away again. Who else can invest? Not much left in the tank. I will only be left with so much. Balance is in not fearing to say no. If you can get it take it, but don't over dilute the company too early on. Raising money is not an accomplishment; growing is an accomplishment. Don't give away too much equity too early.

How to reach Investor

Here is a DM that Andy Davis shared:

Entrepreneurs should expect to engage with a large number of investors and be prepared for rejection. Persistence and the ability to iterate based on feedback are key. Direct messaging through platforms like LinkedIn or Twitter can be effective ways to initiate contact.

Investment Cycle

These are a couple key stages.

• Due Diligence: VCs conduct thorough research to verify the investment, the team, the technology, market, competition, business model etc. to ensure a sound investment. This follows pitching and negotiation.
• Syndication: VCs (or angels) often collaborate with others to share risks and insights.
• Term Sheets and Tranches: Investments are typically structured with clear terms and milestones. Investment may be tied to certain stages for example, post clinical trial etc.
• Post-Investment Relationship: VCs may require regular updates and often play a role in strategic guidance.

Due Diligence

Common Initial Due Documents Requested include:

• "Cap" Table (list of current stockholders with shareholdings, options, warrants, or notes)
• Financial Projections (model in .xls format)=
• Last (previous) term sheet

They will also require sample of additional information (requested in final due diligence):

• Annual and quarterly financial information for the past 1-3 years
• Tax filings (2-3 years)
• Bank statements for last 6-12 months
• Sales and gross profit by product type
• Summary of all debt instruments/bank lines with key terms and conditions, and off balance sheet liabilities
• List of top customers
• Current customer pipeline / backlog
• List of top suppliers
• Invoices
• Key personnel
• Summary biographies of senior management
• Articles of incorporation
• List of intellectual property (IP) - patents, copyrights, licenses, and trademarks
• Letters of intent (LOIs), Memorandums of Understanding, and Contracts

Essentially the whole DNA of the company, so keep the books from the first day in a good state. This is the level of detail that investors go to.

Quick how-to guide

• Empathy: Put yourself into their shoes (what do they care about; what is the fund team passionate about)
• Distinctiveness: Each person and each fund is different. Do your in-depth background research on each investor. Call up previous investees.
• Code-Switching: Talk their language and change your language depending on investor type. They are invested in ROI, in how you think, opportunities, how you deal with critical feedback. Take that serious
• Realness: No BS but authentic talk of what you have done and are prepared to do
• Build: Strategic techniques to break into their network (extended network, conferences, pitching). Cold-calling via LinkedIn only with compelling note. Self-organized events are a good way.
• Make emotional connection: Invite to self-organized events. Build personal relationship.
• Feedback: Ask for feedback. Take feedback. Implement feedback. Send note on progress. Great way to keep people involved.
• Maintain: Once contacted always follow-up. Even if not interested, keep them in the loop on progress (network maintenance)

Corporate Venture Capitalists

These are subsidiaries of larger firms and usually invest in later stages e.g. Shell, Google. Later stage investments of £2 - 20m are normal here. They seek strategic alignment with the parent company’s goals and offer valuable networks and potential exit routes.

Accelerators and Incubators

The Top 10 accelerators that you can apply at a super early stage (Source: Yurii Rebryk):

1. Y Combinator (opens in a new tab): Pre-Seed, $500k for ~10%
2. Entrepreneur First (opens in a new tab): No team, $250k for ~9%
3. South Park Commons (opens in a new tab): Pre-Idea, $1M
4. Antler Global (opens in a new tab): Pre-Seed, $250k for 9%
5. Sequoia Capital (opens in a new tab): Pre-Seed, Seed $500k -$1m
6. HFO Residency (opens in a new tab): Pre-Seed, $500k uncapped + 3%
7. Pioneer Fund (opens in a new tab): Pre-Idea, $20k for 1%
8. Pear VC (opens in a new tab): Pre-Seed, $250K -$2M
9. Techstars (opens in a new tab): Pre-Seed, $100k for 6%
10. Andreessen Horowitz (a16z) Start Program (opens in a new tab): Pre-Seed, $500k -$1m