Dec 19


Launching a startup software company is like legal gambling:  The stakes are high, the odds are against you, but with persistence and good luck, you could strike it rich.  But as the saying goes, you have to spend money to make money, and software startups can burn through cash like a brush fire through Silicon Valley.  So the trick is to find enough capital to fund your startup until it can sustain itself with customer revenue, without giving up too much ownership and control to your investors.

There are four main sources of capital to fund a startup software company: yourself, friends & family, angel investors, and venture capitalists.  During my 25 years of software entrepreneurship, I have used each of these sources to fund my six software companies, to varying degrees of success.  But none of these options are bad, and I would consider any of these funding sources again, depending on the situation.  One lesson is clear: the more you take from others, the more you have to give in return.

Following are the pros and cons of the main sources of software company funding:
 

You

In a perfect world, you would fund your software startup completely from your own savings.  But building a company often requires you to leave your day job, cutting off your income and making it even more challenging to fund your company.  If you lack the cash, alternatives include a working spouse, credit cards (but watch those high interest rates), bank loans and small business loans.  Of course, the truly best source of funding is customer revenue.

Pros:

  • You retain complete ownership and control.
  • All profits go to you.
  • It’s easier to keep spending under control when it’s your own money.
  • Interest payments are deductible business expenses.
  • You can tweak and validate your business model before exposing others to risk.

Cons:

  • The entire financial risk falls on your shoulders.
  • You may not have enough capital to adequately fund your company.
  • You are not receiving outside expertise, advice and perspective.

 

Friends & Family

If you lack the cash to fund your company, friends and family may be your next best bet.



Pros:

  • There is much less due diligence because the investors already know you.
  • Return-on-investment demands are lower.
  • You can usually trust friends and family.
  • Friends and family are less likely to meddle in the operation of your business.

Cons:

  • Mixing business and pleasure can range from tricky to disastrous.
  • Friends and family typically lack the expertise and contacts to help your business.
  • They may not offer enough capital to adequately fund your company.
  • The regulatory burden is much higher if your investors are not accredited, which the SEC defines as having at least a million dollars in liquid assets or annual income of $200,000.

 

    Angel Investors

    Angel investors are rich individuals (often successful entrepreneurs) who invest their own money in private businesses.  Angel investments typically range from $25,000 to $250,000.

    Pros:

    • Angel investors who themselves are tech entrepreneurs will understand your situation and can provide expertise and business contacts.
    • Angels may invest in early-stage companies with inexperienced founders and few customers.
    • Angels are less likely to meddle in the day-to-day operation of your business.

    Cons:

    • You will lose some ownership and control of your company.
    • Angels may not be able to provide additional funds as your company expands, forcing you to find other angel investors or venture capitalists.
    • Angels may lack experience in your business domain.
    • Angel investors may be dishonest or unethical.
    • Angel investment contracts can be quite complicated and require legal help to decipher.
    • Angels may require you to invest a significant amount of your own cash to prove your commitment.

     

      Venture Capitalists

      Venture capitalists (VCs) are companies that invest other people’s money in both new and established businesses.  VC firms are organized as funds, much like mutual or hedge funds.  VC investments average several million dollars, so they are more difficult to obtain and come with many strings attached.

      Pros:

      • VCs can provide millions of dollars to jumpstart your business.
      • VCs also provide expertise, contacts and customers.
      • Established VCs have a reputation to protect and are usually ethical and trustworthy.
      • VCs provide instant credibility.  Customers–especially large corporations–are more likely to buy software from VC-backed companies.

      Cons:

      • You will likely lose majority ownership and control of your company.
      • You could quite possibly lose your job.  Founder CEOs are often replaced in the first year after receiving venture capital.
      • VCs are focused on receiving a ten-times return on their investment, and hence will make decisions based on what’s best for their return, not necessarily what’s best for the company, its founders or employees.
      • It will take 6-18 months of dedicated effort to secure venture capital.
      • VCs typically will not invest in inexperienced entrepreneurs and companies without established customers and revenue.
      • VC deals generally come with adverse terms, such as the VC gets its investment back before any other investors.  So if your company is sold at a low price, you get nothing.
      • Founders may be required to accept “vesting” where you surrender your stock and earn it back over the next few years.
      • A large infusion of venture capital often shifts the company’s focus away from selling software instead to building staff and spending money.

       

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      Article published on December 19, 2007




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      13 Responses to “Funding a Software Startup”

      1. Michael Says:

        This is the clearest comparison chart I’ve seen thus far on funding options for Startups and which consequences we can or can’t live with. The hardest part is making those initial decisions as they’ll set the course for your long haul. One decision that’s worth making is to take advantage of the various programs that are designed with startups in mind. My favorite one is Sun Microsystems’ Startup Essentials Programs. You get discounts on x64 servers, free tech support and become part of a community that can grow with you. If you decide not to bootstrap and go the VC route, they’ll be happy to see you’re up and running with a scalable solution! I don’t think you can go wrong with this one: http://www.sun.com/startup

      2. Michael Kennedy Says:

        Did you know that your posts are being stolen by SpotGnome? Your content is being stripped of your name, and posted on their site as your own. Here’s your post on their site, with their copyright.

        http://www.spotgnome.com/2008/03/19/FundingASoftwareStartup.aspx

        I’m writing to you because this is happening to me as well, and I don’t like one little bit. See the comments at the end of my stolen post:

        http://www.spotgnome.com/CommentView,guid,c672cf17-39dd-4abd-a263-6f0c78537daf.aspx#commentstart

      3. Basil Peters Says:

        Great article. As an angel investor, I regularly see companies that have only been funded by friends and family.

        In many cases, the investability of these companies has been seriously impaired by mistakes made during the Friends and Family financing. Often, the entrepreneurs have unintentionally been unfair to their friends and family by selling shares at unreasonably high valuations.

        To help entrepreneurs, and their friends and family, avoid the common pitfalls, I have been working on a series of posts in my blog on Best Practices for Entrepreneurs and Angel investors at http://www.AngelBlog.net/ An overview of the legal requirements of Friends and Family financings is also included. I hope this is helpful to your readers. Basil

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      7. Finance Tips Says:

        I think the trick is not giving up too much of the company, but that is usually what everyone wants for a reasonable investment. I am in the process of starting an online business and have found it easier trying to raise smaller amounts and being smarter about what it gets invested in, than trying to raise a big amount from one investor. Personally I’ve managed to raise $15,000 in small amounts and have only had to give up about 4% of the company. The $15,000 is enough for me to get running and generate profit that allows me to self finance the $45,000 I needed.

      8. Website Design Service Says:

        So which is the most successful way… any hint??

      9. Chinedu Obi Says:

        I have plans of establishing a software company in the nearest future and would very much like to fund it myself. But I would like to know the estimate amount that would be required to start a medium scale software company, and also if obtaining a degree from the university is necessary.

      10. Nhard Aradillos Says:

        I was looking for a partner at first but hard to find one. Then got my first client at the same time doing consultancy work for other companies. Now I am on my almost 5th year in this business and already full time since 2007. Got more Small to Medium clients and the software is becoming bigger and bigger as they request for customizations.

        But just like a dream, I want to see my software competing with big companies. And I know that my software has good potential since I used to evaluate others. The problem is that I still dont have enough capital to expand. Although my income is bigger compare to being an employee, but its more like I only have a job and not with business and I am still alone, no programmer, tester and marketing. I am doing all the work.

        The market is good because my target is from small Lending companies, Financing, Cooperatives, Microfinance upto Rural Banks. I am willing to sell 50% of my share but what is important is that I could find someone to help me expand to cater more clients.

      11. Geo Says:

        Hello,

        I am willing to fund your project as long as it is worth it. And I would like you to forward a comprehensive information regarding

        your proposal and funding opportunity for review. I would also like you to outline your investment preferences, the financial

        information, the potential yield, interest rate and the optimum return on capital.Get back to me with more details so we can move on.

      12. Nhard Aradillos Says:

        Hi Geo,

        Thanks for the reply. Let me prepare your requirements but for the meantime feel free to visit my website at http://www.marsean.net to see my software and clients. Although I can design a better website but mostly for now my focus is more on the software customization and also marketing and demos and implementations.

        I am still busy up to next week but I will try to provide what you need little by little. Please give me your email address or you can also email me at http://www.marsean.net.

        Thanks.

      13. Nhard Aradillos Says:

        Hi Geo,

        Oh sorry my email is ntaradillos@marsean.net or ntaradillos@yahoo.com

        Thanks.

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