A VC in Vacationland

About half of the entrepreneurs who approach me about investing in their ideas should not (yet,or perhaps ever) be speaking to a venture capitalist. I know, the conventional entrepreneurial wisdom is get an idea, draft a short business plan, then find a vc to fund it. And believe me, I am always pleased to see a great new concept with an experienced management team show up on my doorstep.

But is my investing in your start-up always the right answer?  I often have to resist the urge to get a great idea on the cheap, as the premoney valuation for "ideas and concepts" is pretty minimal.  But, more importantly, I hate to have young entrepreneurs realize too late that they have chosen the wrong funding path for their idea.  So, the question is: "Do you want to give up the ownership rights to 50% or so of your idea for a few hundred thousand dollars in seed money?"  Surprisingly, many savvy players have not thought this through and think that expensive vc money is the key to "validating" their proposed idea.

What really validates your idea and bolsters your premoney valuation is an enthusiastic customer or two willing to pay money for access to the technology, product or service you are proposing. I realize that many vc’s bet on the idea and the team without having any signed customers. There are also many good reasons for doing this, especially if you need to get your idea to market quickly and need the high level of funding to accelerate development.  Even in these situations, vc’s like pilot site customers for the new technology or product within the first few months of operations.  None of us likes to see our money used for development without significant market input.

So, what’s an entrepreneur to do to both fund early stage development and maintain control over ownership of their ideas?  First, hit up the friends and family for loans.  You have to be willing to live with Uncle Ralph reminding you for years about losing his money if the idea fizzles, but I personally prefer someone who has put up the first $250,000 or so in seed money from second mortgages and family loans.  Second, remember that, beyond friends and family, angels are the fastest growing source of early stage funding and your local community probably has a number of potential investors.  Check out angel associations like the New York Angels to see when they are meeting to consider new investments.  In both cases, have your lawyer structure the investments as early stage loans with conversion rights to common stock (with warrant coverage) to protect initial investors from cram downs (that’s when a vc reduces early stage investor ownership levels as a precondition for new investment) if the start-up later goes after venture money.

There is a lot of venture money chasing innovative technologies and products at the moment.  You may find that it is easy to attract a lot of venture interest.  But think about stepping away from the term sheet and increasing your valuation by using early stage loans to land some benchmark customers to use and endorse your idea before looking at venture money.  Your management team and your early stage investors will profusely thank you for your astute management of funding as your idea proves itself in the marketplace.