From Friends & Family, to Angels to Venture Capital

If you start a business that is a good fit for outside capital, it’s natural to celebrate whenever you manage to land any financing — regardless of the source. But perhaps no aspect of the startup company has more potential to mislead the founder than early stage financing. The same investors that are vitally important early on are usually not the right ones for later.

It’s hard for startup entrepreneurs to be honest with themselves as they take their idea out to market. After all the odds against them are daunting — confidence and drive are essential to beating them. So it’s pretty common for entrepreneurs to react with something like, “they just don’t get it” when receiving negative feedback about their business or idea. Listening to customers, accepting that there are flaws in your ideas and adapting is a hard thing for anyone to do.

Still, according to some recent research work by CB Insights, 42% of startups fail because there is no market need for their product, and another 29% because they run out of cash. Logic suggests that if there was a strong market need, they likely would not run out of cash, because they’d attract both more sales and/or more investment. So I’ll argue that this statistic really says 71% of startups fail because of no market need for their product.

That’s stunning. How could it be so? Well, if you spend a lot of time around startups — which I do — it isn’t too surprising. We humans are inherently prone to confirmation bias. Not only will an entrepreneur ignore negative market signals, it’s also common for the people around them to be “supportive” rather than honestly critical. Non-professional investors can be a dangerous source of such bias.

When the venture is first launched, the first place to look for investment is friends and family. This is natural and good. We support each other and believe in each other — it’s how we move forward. But the entrepreneur has a duty to these early investors to seek out professional capital to fuel the business as it grows. This is because professional capital is far more likely to be tuned in to the full spectrum of market signals and help avoid the missteps of confirmation bias. Professionals are unlikely to invest in a company serving a weak market need.

You need the less demanding investors early, because you’re still getting your business model pulled together. But you need the pressure of more demanding investors as you grow.

Of course — professional investment is no guarantee of success — there’s still that 29% of startups that fail for other reasons (like plain old competitive pressure.) But once your venture can pass the rigors of venture capital due diligence it has crossed a big hurdle. It likely means you understand your customers, your market, and have a workable business model.

From the day you cash the first friends and family check, your focus should be on building a business which can appeal to discriminating professional investors — whether or not it ever needs them.

The next rung up the ladder from friends and family are angel investors outside your personal circle. You might find these folks at local angel investment meetings or seminars. Groups of angels might pool their efforts on due diligence but make individual investment decisions. Here you will experience a greater level of scrutiny than you likely experienced with friends and family who were probably happy to bet on you because they know and support you.

But the psychology and motivation of angels is still fundamentally different than that of professional venture capitalists. Angels want to make money on their investments of course, but they aren’t under contract with other people to invest on their behalf and make money for them like VC’s are. Angels are not likely to hire outside experts to examine your business and product like VC’s will. Their decision will rely more on their own judgement.

Venture capitalists typically have a particular focus area, deal type, and size they target. They will have knowledge and a network that helps them critically evaluate opportunities in an objective light. They will likely help you bring in other VC’s alongside them to both spread the risk and get more professional input. Angels are more likely to use a combination of instinct and emotion to make their decisions. This is fine, but you won’t get the really hard questions. You need those hard questions to drive the focus to avoid the mistakes about markets and customers that so often kill startups.

In short — friends, family and angel investment can often create a “tender trap” for a startup. They provide critical resources to get the venture launched but rarely force it to answer the hard questions and usually don’t have the right kind of experience to help as directors or advisors.

The founding entrepreneur must make an effort to be mindful of the fact that while the support from these investors is great — essential — they must push themselves to outgrow it.

There are sometimes exceptions, but usually once a new venture has been through one or — at most — two rounds of non-professional investment, it’s time for the pros to step in. Of course, if you never need additional capital that’s great. After all, you’re not in business to raise money, you’re in business to make money. Ideally, the early investment launches a company which can fuel growth with profits.

Often though, a venture with the potential to get big will not be able to grow from self-funding alone and will need outside investment. It should be a clear sign that something is wrong if the only money you can get to invest in your business is the money that doesn’t ask hard questions. If you do two rounds with friends and angels and still can’t get the time of day from a VC, better take a hard look in the mirror.

This is a time when you might need to consider looking around for startup incubator or accelerator programs in your area. This is a great way to get professional insight and constructive help to make your business more attractive to the pros. Typically, an incubator or accelerator will require you to apply. That process alone will make you better. You need to know your business pretty well to get through the screening process. Incubators don’t have time to waste on businesses that don’t at least have some of the basics about product and market figured out.

And if you apply and they don’t accept you — listen very very hard to the feedback they give you. Did they tell you that they’d be interested if you fixed X or Y? If so — fix X or Y and give it another go.

Almost without exception, new entrepreneurs spend way too much time talking about how great their idea is in excruciating detail. They often fail to focus on the simple message of exactly why, how and when the business will actually make money. This can be fixed, as long as the entrepreneur can listen to feedback and adapt. Outside professionals like those in a good incubator will help you do exactly that.

Startup business competitions can also be helpful for the same reason. They put you in front of a professional audience who give frank feedback about where the business does and doesn’t hold appeal for investors. Often the feedback can be discouraging. Don’t let it. You take your nice shiny idea in and it comes out all bumped and bruised. But if you listen to that advice, it will almost certainly make you better and the appeal of your business stronger.

And that brings us back to the tender trap. Investors that don’t feel the pressure themselves don’t do a good job of putting healthy pressure on you. VC’s invest for others — often pension funds and foundations. They make money themselves and grow their reputation if and only if they make money for their clients. For that reason, they work hard to make sure that as many risks as possible are understood and addressed in the companies they fund. The most important one — the 71% risk — is market need.

Less critical investors don’t really do you any favors beyond the initial round or two. After that, they’re making you comfortable. By continuing to put money in without the hard pressure, they make it easy to coast along, always out of reach of critical mass.

Perhaps one of the hardest things a person can do is take criticism well, but startup entrepreneurs need to do so in a big way. Your aim is to build an opportunity so good that you get to pick the investors you want. It’s rare, it’s hard. But it can be done.

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