The Funding Gap

The resources required to start a company vary significantly, depending on the type of company and growth rate anticipated by the entrepreneur. An experienced software engineer, for example, can develop a new mobile app with his or her own resources and market the product on the web with very little capital. A medical device company, on the other hand, may need cash resources to pay for FDA testing, designing the prototype, manufacturing the product, establishing an inventory of the devices and establishing marketing and sales channels for the products. Most high-impact companies need substantial cash resources to sustain their rapid grow.

There are several important sources of capital for entrepreneurs starting their businesses, depending on the stage of development of the company. The following table shows these sources:

CAPITAL SOURCES ANNUAL US $$$ REFERENCE TYPICAL STAGE OF DEVELOPMENT
Friends and Family (F&F) $50 billion GEM Studies Idea, pre-seed, startup
Government Grants $3 billion US Government Pre-seed, startup
Angel Investors $20 billion Center for Venture Research Most for startups and growth stages
Super Angels $0.2 billion Estimate Startup and growth stages
Venture Capital $20 billion MoneyTree© Most for startups and growth stages

It is clear from this table that Friends and Family, Angel Investors and Venture Capitalists provide 95% of the capital for new ventures. Friends and Family typically invest a few thousand to perhaps $10,000, and only a small number of investors provide more than $50,000. Angel investments range from $100,000 to $1.5 million with a small fraction below and above this range, while venture capitalists fund rounds of investment from $4 million to $100 million with a few above and below this range. So, generally, these three major sources of capital are complementary, not competitive.

The figure below shows the number of investors by investment size for startup ventures. This graphic shows that the distribution of funding is not uniform across the spectrum of rounds size in dollars.

Copyright BillPayne.com 2011

Clearly, there is a funding gap between $25,000 and $100,000, and another capital gap between $1.5 million and $4 million. This simply means that there are fewer investors who are willing to provide investments in these two capital gaps than for rounds of investment larger and smaller than these two ranges. To elaborate, seldom can entrepreneurs accumulate $50,000 from Friends and Family, while angels are infrequently willing to provide as little as $75,000 for new ventures. In the gap between $1.5 and $4 million, angels only occasionally fund rounds larger than $1.5 million, while VCs are hardly ever interested in investing less than $4 to $5 million in startup companies. In fact, we estimate that less than 200 investors in the US are routinely investing $2.5 to $3.5 million in entrepreneurial ventures.

So, how should entrepreneurs use this information? Clearly, new companies need to design their achievement milestones with the capital food chain in mind. For example, entrepreneurs who anticipate needing $4 million to achieve positive cash flow need to carefully plan to hit important milestones with perhaps $1 million, and then plan to raise two additional rounds of $1.5 million to eventually achieve positive cash flow. What might these milestones be? Milestones are accomplishments that demonstrate the viability of the business; hence, they increase the valuation of the company. Depending on the company, important milestones may include being granted a patent, receiving a 510k FDA approval, completing a prototype, receiving positive customer feedback on a beta test, achieving first revenues, hitting the goal in annual revenues of $1 million, etc.

The funding gaps can create a bumpy fundraising road for entrepreneurs. It is important that the management team of new companies understand the capital food chain, acknowledge these gaps in capital sources and design fundraising strategies accordingly.

 

 

 

All opinions expressed are those of the author,  and do not necessarily represent those of Gust.

Bill Payne , Angel Investor , Frontier Angel Fund
December 6th, 2011