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Launching a startup software company is like legal gambling:  The stakes are high, the odds are against you, but with persistence and good luck, you could strike it rich.  But as the saying goes, you have to spend money to make money, and software startups can burn through cash like a brush fire through Silicon Valley.  So the trick is to find enough capital to fund your startup until it can sustain itself with customer revenue, without giving up too much ownership and control to your investors.

There are four main sources of capital to fund a startup software company: yourself, friends & family, angel investors, and venture capitalists.  During my 25 years of software entrepreneurship, I have used each of these sources to fund my six software companies, to varying degrees of success.  But none of these options are bad, and I would consider any of these funding sources again, depending on the situation.  One lesson is clear: the more you take from others, the more you have to give in return.

Following are the pros and cons of the main sources of software company funding:
 

You

In a perfect world, you would fund your software startup completely from your own savings.  But building a company often requires you to leave your day job, cutting off your income and making it even more challenging to fund your company.  If you lack the cash, alternatives include a working spouse, credit cards (but watch those high interest rates), bank loans and small business loans.  Of course, the truly best source of funding is customer revenue.

Pros:

• You retain complete ownership and control.
• All profits go to you.
• It’s easier to keep spending under control when it’s your own money.
• Interest payments are deductible business expenses.
• You can tweak and validate your business model before exposing others to risk.

Cons:

• The entire financial risk falls on your shoulders.
• You may not have enough capital to adequately fund your company.
• You are not receiving outside expertise, advice and perspective.

Friends & Family

If you lack the cash to fund your company, friends and family may be your next best bet.

Pros:

• There is much less due diligence because the investors already know you.
• Return-on-investment demands are lower.
• You can usually trust friends and family.
• Friends and family are less likely to meddle in the operation of your business.

Cons:

• Mixing business and pleasure can range from tricky to disastrous.
• Friends and family typically lack the expertise and contacts to help your business.
• They may not offer enough capital to adequately fund your company.
• The regulatory burden is much higher if your investors are not accredited, which the SEC defines as having at least a million dollars in liquid assets or annual income of $200,000.

Angel Investors

Angel investors are rich individuals (often successful entrepreneurs) who invest their own money in private businesses.  Angel investments typically range from $25,000 to $250,000.

Pros:

• Angel investors who themselves are tech entrepreneurs will understand your situation and can provide expertise and business contacts.
• Angels may invest in early-stage companies with inexperienced founders and few customers.
• Angels are less likely to meddle in the day-to-day operation of your business.

Cons:

• You will lose some ownership and control of your company.
• Angels may not be able to provide additional funds as your company expands, forcing you to find other angel investors or venture capitalists.
• Angels may lack experience in your business domain.
• Angel investors may be dishonest or unethical.
• Angel investment contracts can be quite complicated and require legal help to decipher.
• Angels may require you to invest a significant amount of your own cash to prove your commitment.

Venture Capitalists

Venture capitalists (VCs) are companies that invest other people’s money in both new and established businesses.  VC firms are organized as funds, much like mutual or hedge funds.  VC investments average several million dollars, so they are more difficult to obtain and come with many strings attached.

Pros:

• VCs can provide millions of dollars to jumpstart your business.
• VCs also provide expertise, contacts and customers.
• Established VCs have a reputation to protect and are usually ethical and trustworthy.
• VCs provide instant credibility.  Customers–especially large corporations–are more likely to buy software from VC-backed companies.

Cons:

• You will likely lose majority ownership and control of your company.
• You could quite possibly lose your job.  Founder CEOs are often replaced in the first year after receiving venture capital.
• VCs are focused on receiving a ten-times return on their investment, and hence will make decisions based on what’s best for their return, not necessarily what’s best for the company, its founders or employees.
• It will take 6-18 months of dedicated effort to secure venture capital.
• VCs typically will not invest in inexperienced entrepreneurs and companies without established customers and revenue.
• VC deals generally come with adverse terms, such as the VC gets its investment back before any other investors.  So if your company is sold at a low price, you get nothing.
• Founders may be required to accept “vesting” where you surrender your stock and earn it back over the next few years.
• A large infusion of venture capital often shifts the company’s focus away from selling software instead to building staff and spending money.

Links

• How to Fund a Startup
• The Hacker’s Guide to Investors
• Beyond Venture Capital: 5 Funding Options for Startups
• Two Years of Real Numbers for a Startup
• 10 Reasons to Shy Away from Venture Capital

Article published on December 19, 2007

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Tags: Angel Investors, Funding, Software Startup, Startup Company, Startup Funding, VC, Venture Capital, Venture Capitalist