Sunday, September 9, 2007

Dangers From Friends&Family Money

There is one truism in the startup business. The more an entrepreneur can reduce the technical and market risk in their startup before seeking outside money, the better valuation they will get, and therefore the more ownership they will retain. VCs and angels will value a startup by the size of the opportunity and the inherent risks in that opportunity. An entrepreneur can only clearly describe the size of the opportunity --- it is what it is, but he/she can definitely reduce the technology risk by building a proof of concept demonstration, or reduce the market acceptance risk by signing up pilot customers.

These early risk reduction efforts typically require some seed capital. Entrepreneurs often self-finance this seed stage, or they turn to “Friends & Family” angel investment. In general, this is a good idea, and it helps a startup get later financing if the idea has been better validated, and if the entrepreneur seems to have some “skin in the game”. However, I want to discuss some aspects of F&F seed financing that may be under-recognized and hurtful to the entrepreneur’s efforts.

Here is a great saying that I have always respected for its wisdom:

“Reasonable people adapt themselves to the world. Unreasonable people attempt to adapt the world to themselves. All progress, therefore, depends on unreasonable people." -George Bernard Shaw

Entrepreneurs almost have to be unreasonable, even irrational, to try to start a business around a new idea. They have to visualize something that doesn’t exist, create it out of thin air, and sell it to others, particularly VCs and early adopter customers. If it was obvious, everybody would be doing it. Instead, it is usually obscure and often seemingly crazy. Who will invest in such a raw idea?

Mom and Dad, ... your best friend… that’s who. They trust you for reasons unrelated to the idea you are promoting. In fact, in the case of parents, biology drives them to support their offspring, even irrationally. In the case of friends, it can be payback for that time you bailed them out of a DUI in college, or any number of pre-existing debts, or irrational friendship.

I’m going to ignore the argument that parents investing in their kids is an unwise concentration of assets. I’m concerned with the hazier issue of irrational seed investors not giving the entrepreneur unbiased feedback. There is danger in F&F seed funding.

If for no other reason, subsequent investors will be looking to see who has invested before them. They will be looking for previous validation. Mom’s money is weak validation.

It’s a tough balance to strike --- you want some seed money to validate the idea, but you also want unbiased input on whether you are drinking too much of your own KoolAid. And believe me, after an unreasonable, irrational entrepreneur fixes on an idea and throws their weight behind it, it is hard to be convinced otherwise. The danger is that calling on the easy money, may delay getting a cool, rational dose of reality.

So I guess my advice is to validate that idea before seeking VC money, but test it both with F&F money and with unbiased, “tell you the honest to God truth” advice that a family member or close friend cannot give you. Don’t just labor away in stealth mode, eating up your parent’s money. Find “seed advisors” you can trust who know the space and the technology, and continually test your idea and fine-tune your pitch on them.

VCs have a phrase for Friends and Family money. Sometimes it’s just called Friends, Family and Fool’s money. Don’t trust the F's to validate your idea, and definitely don’t trust them to Value your idea. They love you and love is blind.

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