By Poornima Vijayashanker
This post is based on Chapter 14 from my latest book: How to Transform Your Ideas into Software Products
As the old adage goes, “It takes money to make money.” If your goal is to eventually build a business, then you’ll need to realize that this requires capital, and I want you to have a sense of how you can get this funding. I also think there are a lot of myths about how software products are built, and I want to present you with a number of financing options for working capital so that you can choose a realistic path forward.
In this post I’m going to outline some ways to think about funding product development and, eventually, your business with working capital. Before we dig into each strategy, here are some definitions of all the terms I’m going to use:
- Bootstrapping is building a business without funding from investors.
- Crowdfunding is taking capital from a group of people.
- Accelerators help you take your idea to the next level through programming + some investment.
- Angel investment is capital that you receive from a business angel or high-net-worth individual in exchange for an equity stake in your company.
- Venture capital is similar to angel investment in that you exchange equity (a percentage of ownership in your company) for capital. It is usually provided to companies pursuing high growth with exits like large acquisitions or IPOs. The source of the funds is typically large institutions like corporations, endowments, and trusts.
Just like people rush into building a product too quickly, I’ve seen people rush into fundraising. The result is that either they raise a lot of money and burn it quickly in a number of experiments, or they waste many months getting rejected from investors rather than building a real business.
Also, realize that there is a level of control that you have over an idea when you are self-funding. Once you take OPM (other people’s money), especially from professional investors, you are expected to do things like send them frequent updates on your progress, attend meetings, and solicit their advice. This can be beneficial once you know where you’re headed, but doing it prematurely will just pull you in directions that you may not like.
While it might seem like seeking outside investment is a guaranteed path to success, it isn’t. There have been startups that took $1M or even $40M and ended up just closing up shop. At the same time, other startups that hadn’t raised even $1 went on to build $100M+ businesses and even had IPOs!
Ultimately, it comes down to knowing the vision that you want to bring to life and which sources of capital can make it happen.
Begin with bootstrapping
Both Mint.com and BizeeBee were initially funded using personal savings. Aaron Patzer invested $50K of his personal savings to build out the prototype before reaching out to angel investors. I spent roughly the same when building BizeeBee’s prototype. However, I’ve witnessed founders who invested significantly less than that, so know that it is possible!
After building the prototype and generating revenue, I did take in some angel investment, but I went back to bootstrapping after a couple years.
When I started on the path to bootstrapping, I had little to no guidance. Most people I talked with who had bootstrapped had really just done it through savings or as a bridge before they received investment; there were very few who bootstrapped all the way to break-even and profitability.
Before we get into the nuts and bolts of bootstrapping, there is one concern I want to address: the feeling that you’re not innovating because you’re focused exclusively on revenue. I’m going to call a spade a spade and say that yes, it’s natural to have this feeling, and it’s OK. However, you’ve got to learn to put on the blinders.
The major benefit to bootstrapping is that it will give you the financial freedom and control that allows you to direct your company and innovate. The key to getting that freedom is to hit the revenue milestones that will let you switch from purely pursuing sales to doing creative work.
Basics of bootstrapping
The 3 most common ways to bootstrap while still scaling your business are as follows:
1. Build a simple version of a product, then switch your focus to customer acquisition. If this is the approach you take, then you’ll want to make sure the initial version of the product has the following:
- A simple way for customers to onboard themselves that gives them a positive first-time experience and provides enough value that they are willing to pay — this will keep churn low.
- Marketing baked right into the product for increased viral distribution.
- Enough money in the bank to support yourself while you wait for revenue to come in.
It might seem like this approach presupposes product-market fit. However, it can be done if you spend a bulk of time doing pre-sales by selling customers on the value proposition before the product is built. Or, if you have a product that’s been out there for a while — maybe as a free product — focus on getting people to become paying customers. Offer just a little value to get them interested and using the free version, but do your best to upsell them. The latter is the approach the company Olark took.
2. Initially offer services that are high touch while automating and productizing them. In this approach, you can start by doing work for an initial set of customers — essentially, consulting. This is tantamount to a concierge MVP. While doing this, you’ll need to figure out a way to automate some of the work you’ve been doing and productize it. You can then offer the product to your customers as a time and cost-cutting tool. When doing this, realize that you’ll be cannibalizing your service-based revenue stream, but eventually you’ll be able to recoup the losses because your product will appeal to a wider audience and be more scalable than your service offerings.
3. Offer services that require a level of expertise that can only come from you, are hard to automate or replicate to experience the same level of quality, and can be a one-to-many offering.
Freelancing and consulting are the common ways people do this. However, I advise against this because you end up trading dollars for hours, which isn’t very scalable. Instead, I prefer the one-to-many model, which means servicing a number of customers at the same time.
The classic example of this is teaching. In this approach, you can eventually productize your curriculum, but you begin with a very high-value offering that people are willing to pay a premium for. You’re going to use that premium to build up reserves and possibly fund product development.
If you’d like more case studies of software products and companies that bootstrapped their way to profitability and even an IPO, then I highly recommend reading Sramana Mitra’s book Bootstrapping with Services.
There are two types of crowdfunding. First, there is traditional crowdfunding, which is raising capital from close friends and family. Second, there is the modern version, done through platforms like Kickstarter and Indiegogo.
Most successful crowdfunding campaigns that used Kickstarter and Indiegogo have been for consumer product goods rather than software. Platforms like Fundly are product agnostic.
Before you decide to go the route of crowdfunding, be sure to check what types of products are acceptable on the platform because the rules are often in flux.
The requirements for crowdfunding are similar to doing a pre-order campaign with a landing page:
- You need to have a clear value proposition for your product.
- You’ll need pricing tiers that appeal to people’s needs.
- If the product is still in development then you need to set clear expectations for when the product will be available.
However, unlike a pre-order campaign where customers are primarily concerned with a product that meets their needs, crowdfunders care more about why you are building this product. Hence, you’ll need to have a story that showcases your vision.
I also recommend figuring out how much you need to raise in order to hit your next milestone — and don’t forget to factor in the transaction fee you need to pay the platform provider.
The success of a crowdfunding campaign is contingent on how much setup work you do. Here are the basics:
- You’ll want to start by reaching out to your network to let them know you’re doing a crowdfunding campaign. Getting the support of these folks is a great way to seed the campaign.
- When the campaign kicks off, you’ll want to remind your network that it’s time to fund, and this is the ideal time to ask them to help spread the word!
- Toward the end of the campaign, you want to make one final marketing push in order to hit your goal amount.
After you’ve raised money, you’ll need to keep the people who funded you in the loop about your product’s progress. If you miss a deadline, communicate the reasoning behind it; people are forgiving as long as you’re upfront and honest with them!
Over the past few years a number of accelerators have popped up. Some have a vertical focus like financial tech or healthcare, but most are pretty general. The goal is to help accelerate a company’s growth (i.e., customer acquisition and revenues). Some others are earlier-stage, like incubators, and are focused on helping founders get products out of their heads. And finally, there are those that are really just glorified co-working spaces that may provide access to a number of resources, like technical talent and investor introductions.
If you’re considering an accelerator, take the time to do some research to understand if it’s right for you and for the stage you’re in. There are subtle nuances to each, so be sure to understand how a particular one can help.
If you live outside of Silicon Valley or just don’t have a strong network that can introduce you to angel investors, then you may consider applying to an accelerator like AngelPad, 500 Startups, TechStars, or Y Combinator.
There is no guarantee that you’ll get in, and even if you do, it doesn’t mean you’ll definitely be able to raise capital. However, a number of these accelerators pride themselves on having a network of angels that they can introduce you to, so you stand a better chance of getting introduced to angels than if you go at it alone.
Some will also give you capital in exchange for equity. Currently, 500 Startups and Y Combinator provide about $100K to each incoming company in exchange for equity. The range is usually 3–7% ownership, but it can vary.
Most accelerators have an application process that aims to understand what stage you’re in so that they know whether or not they can help you. They’ll want to know the following:
- Do you have a co-founder?
- What is your team composition (i.e., the number of technical versus business people involved)?
- Have you launched yet?
- Who are you customers?
- How many do you have?
- How do you acquire them (i.e., what are your distribution channels)?
- What is your pricing model?
- Are you currently making money?
- Do you have metrics like CAC (customer acquisition cost), LTV (lifetime value of a customer), or annual run rate (how much money do you make each year)?
Their goals in asking these questions are to find out if you know your business and your market, and if you’ve done enough work to show that you are committed to furthering your idea.
Accelerators have varying batch sizes and run their programs periodically throughout the year. AngelPad takes in about a dozen companies twice a year (one batch in San Francisco and another in New York City), 500 Startups accepts about 30–40 companies across four batches a year (two in San Francisco and two in Mountain View, CA), and Y-Combinator takes in about 60–80 companies across two batches (all based in Mountain View, CA).
Many people also benefit from the camaraderie of being with other founders who are facing similar challenges of building their products and scaling their businesses.
Getting rejected from an accelerator isn’t the end of the world and doesn’t mean your idea sucks! Often it means that it’s not yet time to accelerate your growth. You need to run more experiments on your own first. Some even encourage you to reapply once you’re further along.
Fundraising from investors
I’m going to provide a brief overview of fundraising from investors. Please realize there is more research to be done if you do indeed want to go the path of fundraising. I highly recommend checking out the following resources to get a deeper understanding of investment, how the investment community operates, and what they are currently concerned with:
The landscape for fundraising is in constant flux. It used to be that having a bright idea and pitching it to the right investors could get you investment capital. While there are more angel investors today than in the past, the bar for garnering investment has gone up. Therefore, you have to be careful about how you approach the process. Don’t jump right into it otherwise you’ll end up wasting time that you could have spent building your product and business.
However, even after I say this, I know people try to approach investors with nothing but an idea. Unless you’ve previously sold your company for millions of dollars, investors will not want to risk investing in an unknown person until you have some traction.
Traction today means:
- at least having a prototype built out, and preferably one that is being used by paying customers; as well as
- a solid team of seasoned technical people, along with business people who are doing sales or marketing to help with customer growth.
Finally, you need to have a BIG idea, which means that it needs to expand to service a large market segment. This is often where many people get tripped up. Just having a technical product doesn’t mean you have a big idea. It’s OK if you are operating in a niche market if you can show how you’ll expand to other market segments or how you’ll grow the market.
An example of a company that has grown the market would be AirBnB. Initially, investors thought, “Who would want to rent a room from an unknown person?” Turns out it was a behavior that was already prevalent, but it was just being done in a limited social context. To do it at scale would require a few things, including building up trust and awareness, while still focusing on a market segment that enjoyed travel or hosting people in their homes. Hence, as AirBnB was building, it was also responsible for growing the market and increasing awareness.
The difference between angels and venture capitalists
Angels are individuals who have a high net worth and are investing their own money. Venture capitalists are professional investors who raise capital from limited partners (LPs), like corporations, high-net-worth individuals, and endowments.
In the early stages you’ll want to approach angels, who are willing to take a bigger risk, rather than venture capitalists, who are concerned about providing returns to their LPs.
A typical angel investment would be $10K to $1M.
An initial investment round, also known as a seed round, can range from $50K-$2M, and come from a combination of angels and VCS or either one exclusively.
As I mentioned before, if you don’t have a strong network, you’ll either need to take the time to cultivate one that is composed of angel investors, or you’ll want to consider an accelerator program. While there are a number of services that provide a directory of angels, like AngelList, there is still an element of trust and relationship building that needs to take place before someone feels comfortable enough to invest.
When to consider venture capital
One of the reasons many entrepreneurs come out to Silicon Valley is to raise capital from venture capitalists. While tech media makes it seem like everyone here raises capital — and a lot of it — fairly easily, the reality is that it is still pretty hard to get investment from VCs.
If you are going to go the route of seeking capital from VCs, then realize you’re going to need to find an investor who is interested in your market, because some (though not all) have a thesis around the types of ideas and industries they like to invest in. You’ll also need to be willing to give up a larger portion of equity in your company, anywhere from 15–30%. You’ll need to give them a board seat, which means that they now have a voting right when it comes to major decisions related to your company. You also need to have to have a plan in place for taking in and using a large amount of capital, because investors are giving you growth capital. Once again, the market is in flux, but currently most VCs want to invest a minimum of $2M-$3M.
In exchange, VCs will give you a valuation (i.e., what they think your company is worth). The valuation is tied back to the amount of capital they invest. For example, if a VC wants a 20% take in your company, they might give you a $2M investment and value your company at $10M.
Ultimately, you need to be ready to grow your business and convince the VC that your idea can scale to a large market.
This post is based on a chapter from my latest book How to Transform Your Ideas into Software Products, learn more about the book here.