Dangerous Games Startups Play

taken from "Leveraging Ideas", Feedblitz:

Do entrepreneurs now live in a new age where the lowered costs for development and marketing (theoretically) mean that a company can be launched without having to take traditional venture capital financing?!? Let's discuss...

For entrepreneurs this idea seems great because they can keep more of the company, rather than needing to sacrifice a big hunk of equity in exchange for a million bucks. However, this also means that many startups have begun to play dangerous games. In particular, many a young startup is seeking an angel(s) to provide a seed round, more akin to a bridge loan, that will see them to a Series A. The idea being that during a Series A, the valuation with have doubled or tripled and the amount of equity that will be given up will be at a considerably better valuation than if the same amount of money had been taken during at the seed round.

However, please consider a few things:
1. The Economy. This ability for startups to acquire a bridge loan getting them to a Series A is most effective during a strong economy. If you only raise $300,000 and the economy caters you’re in double trouble. You’re stuck with a minimal amount of money and the prospect of a) a tougher/longer lag time needed to close the next round and b) face prospect of having to accept a lower than expected valuation.

2. Competitive Landscape. A startup hoping to get ‘just enough’ money to bridge them to a Series A also runs the risk that the competitive landscape might change during that time. I’ve been told that the minimum amount of time need to close a Series A is 120 days. Three months. More likely thought it will take a company six months. If during that time a better funded, or higher profile competitor launches a similar product, what will that mean for the Series A? It means it’s going to take a lot longer, which means more money will be needed.

3. Whacky Valuation Principle. Although it is a dangerous game for the reasons suggested above (due to the economy and competitive landscape threats) risk-taking startups do stand to benefit from the "whacky valuation principle" (I’m making this term up). Whacky valuation principle is the idea that raising a small amount of money, or taking a small amount of money from ‘smart money’ will double or triple a startup’s valuation for really no good reason. Yes, raising even a small amount of capital is business model justification, but really it changes nothing intrinsically. Bottom line, why raise $1M on a valuation of $2M when by raising $250,000 your valuation is likely to jump to $5M overnight?

4. Level of Involvement. If a VC does decide to do the type of deal mentioned above, it’s important that entrepreneurs understand that the VC’s involvement will be limited. A VC can’t afford to spend time with a company that it has so little invested in. This is a good reason why taking money from an Angel (who might only have a couple of investments and to whom $300k likely means a lot more since it’s personal money) might in fact be better than a VC. In theory having the VC be hands-off is good, but in reality, the more time they spend with (or at least thinking of you), the better.

5. Credibility/Distribution. On the plus side for VC firms, getting in with the right high-profile company can be instant credibility in the eyes of the PR and Blogger Illuminati. How do you find them? Try TheFunded for starters. Such credibility goes a long way since possible the biggest concern for any new startup is in fact not funding, but distribution.

Conclusion: In my opinion, the best situation for a startup right now is to find at least one well-known angel and supplement him/her with either a convertible note loan, or money from dumb angels. Having at least one smart money person is key to making introductions and for the person’s experience hopefully in the space. Yes, dumb money supplemented by having a smart advisory board, but it’s not the same. You want your most influential supporters hugely incentivized to help you succeed. Also based on the concerns of folks I’ve talked to in the Valley and here in New York, looking for a minimum of $500k bridge money seems like the safe bet in these ominous economic times.