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Early Options: Tech entrepreneurs looking for seed money have more places to turn these days

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Small Business (A Special Report)
Early Options: Tech entrepreneurs looking for seed money have more places to turn these days
By Jaclyne Badal
1368 words
30 April 2007
The Wall Street Journal
(Copyright (c) 2007, Dow Jones & Company, Inc.)

The world of dot-com financing is changing, and entrepreneurs are reaping much of the benefit.

While the competition for deals remains stiff, investors and researchers say tech entrepreneurs looking for seed money have more varied options these days. Indeed, some investor groups and venture-capital firms are giving companies that are still in the concept stage faster access to modest amounts of cash, and asking for less equity in return.

Seed money -- used to turn an idea into reality -- is among the toughest financing to secure for tech-related start-ups. Banks and professional investors are frequently reluctant to jump in at such an early stage. The few entrepreneurs who manage to cut deals with venture-capital firms tend to give up huge chunks of equity, something a lot of founders want to avoid.

But with the new approach -- driven in part by the falling cost of launching Internet start-ups -- some venture capitalists and so-called angel investors are writing smaller checks and issuing them faster, in return for either relatively small stakes upfront, or convertible notes that can be turned into equity under certain future conditions.

Angel investors -- wealthy individuals who fund companies and tend to take a hands-off approach to day-to-day management -- were the largest source of funding at the seed and start-up stages last year, backing roughly 23,500 such ventures, according to the University of New Hampshire's Center for Venture Research. Jeffrey Sohl, director of the center, estimates that roughly 35% of the $25.6 billion in angel investments last year went to early-stage companies.

Dr. Sohl says some 46% of angel deals were at the seed or start-up stage, a proportion that the center expects could grow to as much as 55% in the next several years.

Venture capitalists, meanwhile, invested in more than 300 seed and start-up deals in 2006, up from 184 such deals in 2005, the center says.

"There's tons of money around, and if you can't find it, you're not ready to start a company," says Kenneth Morse, managing director of the Massachusetts Institute of Technology's MIT Entrepreneurship Center.

Tech Coast Angels Corp., a network of angel investors started in Irvine, Calif., recently launched a "seed track" funding program to get earlier access to companies. Candidates who look good on paper are invited to a screening session and have 30 minutes to sell their idea to about 10 angels, with half the time used to field questions. If investors are impressed, the entrepreneur can get a check the same night, or a few days later, in return for as much as 10% or so of the company, depending on valuation and check size.

The Tech Coast network also offers more traditional funding for entrepreneurs, but that route, because it usually involves bigger investments, can require about 500 hours of due diligence.

Checks for $25,000 to $100,000 in seed-track funding are common, says Tech Coast Angels founder Luis Villalobos. In some cases, the angels won't take equity upfront but will issue a convertible note, which would be turned into stock if the company later provided equity stakes in a formal funding round.

On the venture-capital side, QuickStart Seed Funding Program at Charles River Ventures LLC, Menlo Park, Calif., offers loans of as much as $250,000 at 6% interest and takes no equity upfront. If the start-up does well and sells to venture capitalists, the debt -- plus interest -- converts to stock at a discount of as much as 25%. (A $250,000 loan, with interest factored in, would be worth up to $353,333 in stock a year later.) Entrepreneurs should note, however, that the firm wants to be an equal investor in any future funding round, so it could ultimately end up with a more traditional venture-capital-size stake in a company -- say, 20% or more.

Successful companies that never go for another round of funding but are bought out by another company, say, or go public, are expected to pay Charles River double the amount that they borrowed.

A Seattle-based start-up, BuddyTV.com, a discussion forum for television fans that also features original interviews with TV stars, is one of the first companies to get funding under the Charles River program. BuddyTV Corp. Chief Executive Andrew Liu says the $250,000 check came just five to seven weeks after his first meeting with Charles River.

The program was a "great thing for us because we didn't spend much time on fund raising and could focus on the execution," Mr. Liu says. The debt is currently outstanding. Mr. Liu hopes to have positive cash flow before trying for more funding for his company.

Seed-funding provider Y Combinator LLC, Mountain View, Calif., takes a slightly different approach. It gives out less cash than most seed-money investors -- a company with two founders gets a check for $15,000; one with three founders gets $20,000. But Y Combinator devotes more time to teaching young engineers with interesting ideas how to be entrepreneurs. About a dozen fledgling companies at a time attend 12-week programs in Mountain View or Cambridge, Mass., where experts speak at weekly dinners.

Then, at week 10, the start-ups make presentations to potential additional investors, with the last session drawing about 60 outsiders. Y Combinator usually ends up with about a 6% stake, but the range can be from 1% to 10%, depending on the company's initial valuation.

"It's much easier to get seed money than it used to be," says Paul Graham, a partner at Y Combinator. "Ten years ago a bunch of college kids starting a start-up had to go on hands and knees."

But seed funding is still by no means easy money. Mr. Graham says this year's winter session in Mountain View had 200 to 250 applicants, with the program accepting 13.

Charles River gets five to 10 submissions a day for its QuickStart program, but plans to fund only 10 start-ups this year, says George Zachary, a partner in the firm.

"If it takes us more than five minutes to understand what the product is, we are not going to fund it," Mr. Zachary advises.

Start-up hopefuls who don't get funding right away sometimes need to improvise until they do find capital. Some venture-capital firms, like Highland Capital Partners LLC in Lexington, Mass., will give free or reduced-rate office space to start-ups that they like but aren't ready to fund. This allows the start-up to work side-by-side with other entrepreneurs and investors. Almost the entire first floor of Highland's Lexington office is devoted to Highland-backed start-ups, says Highland Managing General Partner Paul Maeder.

Alternatively, entrepreneurs can recruit engineers and other experts to the team in an effort to do as much as possible without outside investment.

Daniel Marques couldn't get funding for his first Internet business, started as a freshman at Babson College, Babson Park, Mass. So he and his partner brought in a third person to help with the technical aspect. The trio kept expenses low and eventually gained positive cash flow and attracted an angel offer.

Finding the first risk-taker can be difficult, says the 22-year-old Mr. Marques, "but a lot of people want to be the second."

No matter how successful a start-up is at attracting capital, New Hampshire's Mr. Sohl advises researching the investor before accepting any of the money. Venture capitalists or angels with even a small chunk of equity can become a problem if their plans for the company differ from the founder's plans.

Make sure your visions align, Dr. Sohl warns: "Due diligence is a two-way street."

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Ms. Badal is a staff reporter for The Wall Street Journal in South Brunswick, N.J. She can be reached at jaclyne.badal@wsj.com.

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