Following my post on the absence of a Lean Funding Movement, I thought I ought to at least try to come up with some lean funding concepts, put a bit of thought in. After all, high-concept business models are what MBAs are supposed to be good at devising, right?
The primary constraint on the solution is obvious: sufficient money needs to come into the startup basically before the startup needs it – but the issue is about whether it should all come in while the startup is iterating and learning. After all, it usually takes some time (in Mike Maples’ Jr’s terminology) to carry out “business model discovery”, and so the notion that the startup must have already identified the correct opportunity at the start (as well as its achievable share of that opportunity and its optimal path to achieve that share) in its business plan (Lord ‘elp us all!) goes against the grain of actual startup experience. It’s typically an 80-20 thing: even though knowing 80% is normally enough to take action, it doesn’t mean that you have the other jelly-like 20% nailed to the wall yet (if indeed you ever do manage this).
So, as a startup builds, tests and develops, it zigzags (and occasionally leaps) towards its product/market fit and its market position, both of which it knows only imperfectly at the start: conversely, the problem with business plans is that they almost always gloss over this zigzagging – after all, a typical startup narrative (i.e. repeated failure and delays tempered only by persistence and bloodymindedness) would not be hugely helpful in a business plan, which (after all) is an idealised process towards an idealized end line. So, the question is: how can the contract between angels and startups be made more honest to reflect this?
Firstly, because raising a single round is hard enough in the real world (whatever anyone tells you), let’s try to base a first attempt at a corporate structure for Lean Funding around a single round but with a modified shareholder agreement and modified shareholder behaviour. For the sake of argument, let’s consider a Lean Startup that thinks it needs to raise $500K. But (of course), it doesn’t really know that: for all its spreadsheets, plans and timelines, $500K is still no more than an educated guess – let’s say the figure is broken down into $250K for development, $100K for marketing and $150K of ‘sh*t-happens‘ contingency fund, all based on a post-money valuation at $2M (just because it puts the equity at an easy-to-work-with 25%).
As it develops, however, the startup’s knowledge of what it needs should iteratively converge on more realistic numbers as it moves towards product/market fit: however, what also changes is its “company/angels fit”, i.e. how well the company’s situation sits with its angel backers. It is surely rare to have a Borg-style level of accord amongst your backers – a pivot from (say) a niche strategy to a mass market strategy may leave one or more backers in an uncomfortable place, even if other backers think that it’s a good move.
Let’s say the round raises $500K, but the company puts $300K of it in some kind of escrow – as a ‘lean startup’, it wants to use the first $200K for product development and customer development, and to then give itself the option of making a pivot based on what it has learnt. My suggestion is that the company should then make a matching funding pivot. But what would a ‘funding pivot’ look like? Here are the five basic options I can see:-
- “Abandon ship”. If it becomes clear that it’s never going to work, the whole lean startup idea of “Fail Fast” should be backed out to the angels. At least they’ve collectively only lost $200K and 8 months rather than $500K and 24 months: as losses go, this is a big win.
- “Stay on course”. Of course, sometimes it so happens that customers really like what you’re doing. So, just carry on as planned. And why not? Release 50%-100% of the cash in the escrow account and take it to the end line.
- “Slow down”. OK, this is for when there’s turbulence ahead. Development is going OK, but other confounding market factors are in play. Release (say) $100K to get to the next pivot (renegotiating where possible), and we’ll see how it develops.
- “Speed up”. The startup’s big development risks are passed, and the market opportunity is significantly larger than we thought. The startup now clearly needs (say) $800K to go big, whereas there is only $300K in the escrow account. The startup needs a new funding round, but having $300K in the bank is surely a much better point to be looking for more money than if you have $0K in the bank.
- “Change direction”. The hardest situation of all – but probably the most honest, because it’s based on much more information than the initial funding round could ever have been. Some backers might want out, others might want to double up, while some might want their share converted from equity to some kind of debt. You can think of all this as a ‘lean’ internal re-funding round, to try to find a better company/angel fit in light of what has been learned.
(…I’ll leave the issue of how such decisions should be made to another post entirely…)
Note that I don’t have all the answers, these proposed “funding pivots” are just my tentative reachings towards a better (and arguably more transparent and financially honest) way for angels and entrepreneurs to do business. If startups iterate, why doesn’t startup funding iterate too?