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If you believe the blogosphere, the venture capital model is broken. If you don’t believe that, there’s no arguing that VCs are more cautious than ever.
Angels have pulled back too: Angel investments in the first half of 2009 fell by 27 percent compared with last year’s first half. And banks, their balance sheets in disarray, aren’t writing new loans — heck, with the real estate market the way it is, a desperate entrepreneur can’t even get a second mortgage to fund a wild idea.
In this environment, investors and entrepreneurs are devising creative ways to fund startups that look nothing like the traditional venture finance model. If you’re an entrepreneur at the end of your financial rope, don’t let go of that big idea before you’ve read this.
Pay for Play
The back of Chris Hurley’s business card reads, “funding the unconnected.” In Hurley’s vision of startup finance, which he hopes will bear fruit in January, you don’t need to have your deets in a venture capitalist’s Blackberry to get funding. All you need is $5,000.
That’s the price you’d pay to present to Hurley’s Revolutionary Angels. Half business plan competition, half angel group, the nascent startup-funding organization plans to pool cash from as many as 100 entrepreneurial applicants and distribute up to $250,000 to the startup that its board of entrepreneurs and executives pick as the winner at an event in January. In exchange, Revolutionary Angels takes up to 10 percent common equity in the business.
“We want to pick winners, just like everybody else does,” said Hurley, a former business development executive at Sun Microsystems Inc.
If the program is successful, some of the pooled entry fees will go toward funding next year’s program, he said.
So-called ‘pay-for-play’ angel groups have come under scrutiny, after blogger and Mahalo founder Jason Calacanis trashed the practice in an incendiary post in October, but Hurley is unapologetic.
“Right now we need to look at this as being able to build out the team to make this accessible to as many people as possible,” he said.
Debt funding
To come up with their new startup debt funding structure, the investors at Cambridge’s LaunchCapital LLC threw out everything they knew about venture capital, said Elon Boms, founder of LaunchCapital.
The young venture capital firm wanted to fund good startups regardless of whether they fit the VC profile, Boms said. “Not every great idea has an exponential growth model.”
To that end, the evergreen fund, backed by a private family office, is writing loans worth up to $150,000 in exchange for a stake of 2 percent to 10 percent common equity. A loan’s grace period and interest rate, which ranges from 10 percent to 15 percent, varies based on the percentage of equity ownership.
The debt-and-equity structure is similar to that used by venture banks like Square 1 Bank and Silicon Valley Bank — except that venture banks typically are constrained from lending to companies that don’t already have institutional venture backing. “We were meeting a lot of great entrepreneurs who were doing businesses that in a traditional equity model we couldn’t finance fairly,” he said.
“We needed to find a more effective way to fund these businesses.”
Customer financing
With the cost of starting a software company lower than it has ever been in the history of information technology, more and more entrepreneurs are cutting out the middleman and going straight to their future customers for the funding that gets them off the ground.
That’s what Sonian Inc. did, working from a virtual office in Needham funded by friends and family until the e-mail archiving software startup was able to put together a product and land commitments with distribution partners. Rackspace Hosting Inc. bought its licenses in advance in exchange for warrants to buy shares later on, said Greg Arnette, co-founder and CTO of Sonian.
“That early strategic involvement propelled more seed investment,” Arnette said — which in turn brought in more customer involvement. “It kept kind of bopping back and forth.”
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