Episode Transcript:

ADAM MCGOWAN: : Welcome to episode six of Ventures in Tech, brought to you by Firefield. This is Adam McGowan and on today’s show we’re going to discuss the variety of options available to startups in their early stages when it comes to getting funded. I’m again being joined by my colleague from Firefield, Henry Reohr, who’ll be guiding today’s chat. And with that, I’ll let Henry take it away.

HENRY REOHR: [00:31 ]: Adam, for many entrepreneurs, the world of venture funding can seem daunting for a whole host of reasons. Even the terminology can be hard to follow. Before we dig into the actual options for raising capital, could you decode some of the jargon related to the different rounds of fundraising?

ADAM MCGOWAN: [00:51 ]: Sure. You know, I think that over time this has become a little bit more complicated because it used to be pretty simple; a new startup with self-finance or they would get funded from friends and family and then as soon as things started to move and they got some traction they’d go for a Series A round. That was pretty much it. If it worked, they were off to the races, otherwise, they went home.

But I think there’s been this concept that I could talk more to later but I call it Round Inflation and it seems like the target or the goal posts are consistently moving. So if you look today at a typical Series A round of funding, they tend to start around two million dollars in funding and, you know, that capital is today generally used for companies to be able to scale once they’ve really proven out their model.

Now we’ve got what’s called the Seed Round which is going to happen typically before a Series A. These usually start around five hundred thousand and this is capital typically earmarked for what we call product market fit. So you put a product into the market, you’re trying to assess how well you’re actually going to translate that introduction of the product into true sales, into true traction. You know, how well does, technically, that product fit your market? And if doesn’t it could be because of poorly conceived product, poorly conceived market or possibly both.

Now, prior to a Seed Round, given that they’re starting at half a million, we’ve got what’s being called Pre-Seed Rounds. And these are typically starting somewhere around one hundred thousand dollars range and this is often used as capital for early stage product development. So it could go towards minimum viable product creation or maybe beta launches to do some testing with users of your very early stage product.

And of course Friends and Family Rounds, if people use or rely on them, tend to precede all of these. But we’ve certainly seen this collection of rounds of capital and at least the targets for each of these dollar amounts have been ticking up and up and up over time.

HENRY REOHR: [2:54 ]: You mentioned this concept called round inflation. Can you dig a little bit deeper into that?

ADAM MCGOWAN: [3:00 ]: Yes. So this idea comes from the fact that I would describe money as; by money I mean investment, money being “relatively” easy to come by today, relatively is in quotes and that’s very important. So it’s not absolutely easy, it’s still hard to get funded, it’s just relative to the ease with which or lack of ease with which you could have get funded. Historically, it seems as though it’s been a little bit easier to do so recently.

What that means is that more investors are piling on into deals, wanting to participate in investments and it’s just pretty straightforward economics that the increase in demand from investors is going to result in driving up price and in this case the price is the valuation of these companies who are getting the funding. And so if you’re an investor, you’re now getting into a deal with the valuations going up and up and up, all else equal, if you invested the same amount of money, you’re going to own less of the company.

And that’s not what investors want. Because these investors don’t want to have to make more and more and more investments to put their investors money to work as many of these investors are coming from venture capital funds for example. They don’t want to double the number of investments they have to make to put their money to work. And so what they want to do is they want to try to drive up the amount of money that they’re putting into deal so they can still own a meaningful chunk of companies. So prices are going up, valuations are going up, more money is coming into deals and investors want bigger chunks of the deals. So naturally, the size of the rounds inflate. That’s where that language comes from.

HENRY REOHR: [4:37 ]: So, what does that mean for entrepreneurs who are out in the market trying to raise capital?

ADAM MCGOWAN: [04:42 ]: I think it means that all else equal more money means investors are going to expect… more money in means investors are going to expect more money out. So, you know, what that means is that for what I’ll call a market, “market based investor”, the dollars return for a Series A deal of the past just aren’t going to cut it anymore. So we’ve got bigger valuations, we’ve got generally bigger deals and this means start-ups are going to need to start attacking bigger markets and trying to get bigger market shares of those markets and trying to do so with a higher likelihood of success. So even though investment money or dollars might be getting relatively easier to raise, because it’s actually getting concentrated into these larger deals, an individual or emerging venture might actually find it harder to raise money. So I know it’s somewhat paradoxical but money might be easier to be spent by investors but it might be harder for you to actually get it.

HENRY REOHR: [05:41 ]: What did you mean by the term market based investor? Are there other types of investors as well?

ADAM MCGOWAN: [05:49 ]: Well, to me, market based refers to the fact that an investor is operating using… they’re using rational expectations for economic returns. So these investors would assess the risk and return profile of a particular investment and they would assess that relative the alternative and one alternative could be to not invest at all. So, what’s in the market? What can I invest in? What’s the risk? What’s my return? And what does that mean relative to me doing nothing at all? That’s what I mean when I say market based.

But I talk about them as their own category because I believe there’s also some investors where that’s not their primary motivation and when they’re not relying solely on the market. I describe those as what I would call affinity investors. And there can be many reasons why somebody would have a non market based or an affinity based approach. It could be they want to get some learning or experience out of making the investment, they might want some brand or some name recognition, if it was a company making the investment maybe they want access to some customers or opportunities or maybe some other non-financial assets and some cases it could just be pure emotion, it could be a feel good nature, it could be more of a social component, do you want to make the investment? But, yeah, I think it’s in stark contrast, the affinity, to the market based investor.

HENRY REOHR: [07:13 ]: So you’ve got market based investors and affinity investors, what types of investment options fall into each of those two categories?

ADAM MCGOWAN: [07:24 ]: So there are quite a few options. I’m going to run through them somewhat rapidfire. So, you know, listeners can feel free to kind of pause and go back because I will read through these relatively rapidly. But I’ll start with the affinity group and I think that there are three categories or three investor types in that bucket. The first one will be pure friends and family, that’s pretty straightforward.

The second would be what I’d call truly an affinity investor. So this would typically be high net worth individual, someone who’s accredited, and you know that’s a definition that we could maybe talk about in a future episode, but they’re accredited, have the means to be able to make early stage investments in companies, but they have a particular reason why this investment is interesting to them personally. So maybe it’s in the same industry that they were in where they sort of made a lot of their success or maybe they’re trying to make a difference in a particular industry. So they know something keenly and deeply about an industry and they want to be able to put that knowledge base to work and they often would act like an angel investor who I’ll mention in a second but they do so without necessarily the market based approach.

The third category of investments I see in the affinity group would be true crowdfunding, so the traditional type Kickstarter or Indiegogo type campaigns. For the market bucket, the