“Pre-seed is the new seed.”
“We need to see traction before we can write a check. Come back when you have a product and customers.”
“We don’t do sub-500K rounds anymore. If you want less than that, talk to your friends and family.”
There’s a growing gap in the funding market, and early-stage companies are finding it more and more difficult to raise the money they need to get their products off the ground. Those that do spark investor interest face constant pressure to think bigger, ask for more money than they need, and commit to accelerating their company’s growth before they’re ready. None of this is healthy.
I’ve seen this trend in the Boulder/Denver market over the past couple of years and I’ve confirmed it with friends and peers in Boston and the Bay Area: VCs and angel investors are moving up-market, de-risking their investments by waiting until a company has already proven its viability by releasing a product and winning its first few customers. Meanwhile, most entrepreneurs’ friends and family haven’t gotten any richer, leaving a growing gap between “I have a great idea” and first launch of a product. What’s an entrepreneur to do?
Traditionally, entrepreneurs have filled this gap with individual equity transactions — “sweat equity” for early employees— or by building the first version of a product themselves. As engineering salaries continue to go up, though, fewer engineers are willing to work for equity alone or for a reduced salary with a large equity component. And why would you, if you can make $150K or more working at a slightly larger startup or get Silicon Valley salaries and all the perks by joining the Googlesoftazon development office that just opened down the street? The competition for engineering talent keeps heating up, and there’s no end in sight. Again, this leaves many entrepreneurs at a disadvantage as the price tag for getting to Minimum Viable Product continues to rise.
“So go find a technical cofounder,” reply the Silicon Valley traditionalists. “Investors won’t talk to anyone who doesn’t have a technical expert on the founding team.” Interestingly, this traditional approach has a curious side effect: it decidedly tilts the playing field for early-stage companies in favor of engineers. If you’re an engineer who has an idea for a new product or technology-enabled service — and aren’t all services tech-enabled at this point? — then you can start building tonight. If you’re a business person with a great idea and a deep understanding of the market opportunity, you’re still crippled until you can find an engineer to build the tech. Hence the roving bands of business people roaming from technical meetup to technical meetup searching for a “technical cofounder,” when what they really need is any engineer who believes enough in their idea to work for free until they can raise enough funds to pay them. Even companies who have their first engineer struggle to find the second and the third, unless they have friends willing to moonlight.
There’s a hidden bias here, too: despite the “diversity initiative” whitewashing in the VC market, minority and women-owned businesses are still getting the short end of the stick from investors, meaning that the playing field isn’t just tilted in favor of engineers: it’s tilted in favor of white, male engineers. And within my admittedly small sample size of the 5–10 women-owned companies that I’ve mentored this year, women in particular are offered extortionary terms from the engineers they ask for help.
I’ve already talked about the risks to your company of seeking a technical cofounder when you really need an engineer, but what about the risks to the market? How many great business ideas are dying on the vine because their owners don’t know how to code? How many engineering-led companies are hammering the market with brilliant solutions to the wrong problems? We need a better solution.
One solution would be for investors to stop swinging for the fences with every investment. Instead of asking how this new company can be a unicorn in three years — and potentially forcing a healthy young company to accept an unhealthy amount of risk in exchange for your money — how about looking for investments that return 5X returns with lower risk, or investing in companies that provide a healthy cash return with greater potential upside than your average index fund? What if we treated startup investments with the same diversification strategy that we apply to the rest of our investment portfolio?
Of course, if you’re already diversified elsewhere, then your startup investments start to feel like house money, where high risk/high return is the most reasonable investment strategy, so maybe we can’t look to investors to close this gap. Maybe we need to look around, instead.
Why does an early-stage company need money? To get that elusive traction: to build a product and get people to buy it. So what if we cut out the middle man? What if you could find a group of development shops, designers, and sales firms who were willing to invest some of their idle capacity in getting young companies off the ground? Idle capacity — “bench time” — is the bane of every consultant’s existence, and we always struggle to make it worth the money we’re spending. What if these companies and freelancers could put that time toward building and selling a company’s first product, in return for reduced rates and a piece of equity in the company? Could we make that work?
I see a lot of benefits in this approach, as well as some complications:
- It invests idle capacity in something other than busywork.
- It creates an early relationship between entrepreneurs and service providers, which becomes more profitable as the company grows and gets funding.
- It lets non-technical founders separate “I need a cofounder” from “I need something built,” giving them the time to find a real technical leader for their company rather than hiring the first engineer who will work for free.
- It builds a community around these young companiess.
The challenges are:
- Securities law limits how equity is granted, sometimes in challenging ways.
- Many helpers = many names on the cap table, a negative for investors.
- Cash is always less risky than equity, so a service provider has to have a higher risk tolerance if they want to sign up to help early-stage companies.
I don’t have all the answers for this one, but we have a gnarly problem that needs to be solved if our entrepreneurial ecosystem is going to stay healthy. Fortunately, solving problems is what we do best. What do you think, intelligent reader? How do we close this gap?