Getting Funded

Dan Allred - Senior Relationship Manager, Silicon Valley Bank

There has been lots of talk lately about how innovation will be the means by which the economy starts growing again. We hear this from politicians, from academics, from economists, and most importantly, we hear it from the entrepreneurs and investors who are taking the inherent risks associated with the business of innovation.

However, those risks have been evolving. Traditionally, entrepreneurs have taken on a lot of technology risk in their attempts to bring new products to market, and angel and venture capital investors provided the capital needed to develop such technology. The premise was such that if entrepreneurs could solve a very hard technical problem that met a market need, then there would be lots of customers, often large enterprises, ready to buy the product made possible by the entrepreneur’s technical breakthrough. In short, the technology risk was very high, but the market risk was relatively low. In such a scenario, there were large amounts of capital needed early on in a company’s life to hire advanced engineers and to develop very complicated and often unproven technology. This dynamic set-up well for venture capitalists who had large funds to deploy and were willing to bet on high-profile, experienced technologists, scientists and entrepreneurs. The VCs knew they were taking on lots of technology risk, but they could rest assured that there was market demand for the products if these teams of entrepreneurs could pull it off.

Of late, I have seen the model shifting to a dynamic where the technology risk is relatively low but the market risks are high, just the opposite of what I describe above. Open source software, cloud infrastructure and distribution platforms such as the App Store and Facebook have changed the way that entrepreneurs are thinking about innovation, and as a result, the way they are thinking about risk. They are able to leverage established technologies and established infrastructure to build out products much quicker and much cheaper than the entrepreneurs described in the paragraph above. Also, they are leveraging the Internet as a distribution platform for reaching the masses, the proverbial long tail. They are less concerned with Fortune 500 clients and their many demands leading to long product development and long sales cycles, and more concerned with consumers and SMBs who are not likely to pay as much for any particular product but offer a hugely scalable business should the product be adopted. And product adoption is the key question. SMBs and consumers are notoriously difficult to predict, especially where innovation is concerned. Thus, technology risk is low, but market risk is high.

So, if you are an entrepreneur, and you are pursuing a start-up that you need to finance, you should ask yourself which of these is the predominant risk that you are taking on – technology risk or market risk. If you are developing proprietary technology that will be the core of your product, that will offer your business significant barriers to entry and will be protected by a strong IP defense, then you are most likely taking on a lot of technology risk, and you would be well served to find deep pocketed investors, likely VCs, that understand your business and are accustomed to longer product development cycles, complex engineering projects and partnerships with larger companies such as OEMs, joint development agreements, etc. which may help you in bringing your product to market. Chances are you will need to take on more capital (probably in the millions of dollars) early on to be able to hire the right team and to develop and protect your technology.

If however, you see a relatively short path to market that will only require a few months and a few developers and you already know how you will distribute your product (through an app store, through social media, SEO, SEM, inbound marketing, etc.), then you may be a better candidate for a seed financing (probably in the hundreds of thousands of dollars). Such investors are likely to be angels who know your market well or who like to work with early-stage companies and founders. Micro-VCs or super-angels (many of which are raising micro-VC funds) are also candidates for such a financing. These companies are likely to raise money on lower valuations as there is little value in the their IP; however, the amount raised will be much lower than in the “technology risk” scenario, so dilution to the entrepreneur will not be significantly different.

In the “market risk” scenario, it is important to understand that you are likely to need larger dollars eventually, once you prove out your concept (thereby overcoming, or at least mitigating, the market risk). At this point, you would probably want to raise a larger round (again, in the millions of dollars), perhaps from your existing investors if they have deep pockets, or from VCs or strategic partners. Keep in mind, that you would theoretically be raising this money on a higher valuation now that you have mitigated the market risk in your company and are taking on execution risk, a risk that is typically easier to handicap, account for and manage.

A final note: I know that I am speaking in generalities here, but there is a very clear trend that I am seeing in the market. Sure, there are still plenty of IP-centric companies that are undertaking huge technology risks and solving big problems, and we should be very excited about these companies as they are very important to our region and our economy as they tend to be high profile companies and larger employers. We should also embrace this newer class of companies that want to leverage technology, versus creating it, in order to reach new customers and to innovate on old business models. If they are successful in doing so, they have the potential for serious economic impact as well.