Choosing your start up funding source

One of the things that drives me up the wall is hearing the local start up community complain that the venture capital market in Australia isn’t like the US. Of course it’s not, in Australia we’re a much smaller market, with a completely different culture.

The general complaint is that “venture capital is so risk averse here” because they wouldn’t invest in a business. The truth is, most American VCs wouldn’t invest in these businesses either because they are just not good enough, suffering from simply okay ideas, average people and a small market.

Having worked and observed the space for the last 0 years or so, I have come to the conclusion that the type of funding you should chase depends on two things: the type of competitive advantage your venture will have and the market risk.

Your competitive advantage is a continuum that has at one end a pure intellectual property play (eg. ResMed) to a execution-based business (eg. McDonald’s) at the other end, with lots of stops in between. A new drug is normally a pure IP play, because it simply has to work, and be patentable to attract investors’ interest. However a website that targets a hitherto unknown market segment, no matter how clever it is, is simply an execution-based model. You need to do it well to win.

Your market risk can be extremely high or extremely low. To have low market risk you can either have a product that will solve a clearly articulated and expensive problem (eg. a new anti-cancer drug) or it can have a proven market (eg. shoes). High market risk is the area for disruptive innovation (such as nanotech), or unproven demand for a consumer product.

I see the two areas intersecting as per the drawing below:

The Venture Risk Quadrant

Now once you start looking at the world this way, you can start to see that the traditional sources of funding gravitate towards the different quadrants.

Venture capital likes protectable IP and a low market risk.

If there is no market risk and your competitive advantage depends on how good a job you do, become friends with some high net worth individuals as potential private investors who will probably support you. But if you’re really confident, why wouldn’t you just see the banks and use a bit of debt to grow?

If you’re like the hundreds of aspiring entrepreneurs I meet over the course of an average year, and you have a solution to a problem but can’t keep competitors away, your options are really limited to finding an experienced hand to put some cash and guidance in, (angels) put the hard word on people you know for investment (family, friends and fools) or reduce your ambitions, tighten your belt, and get on with the job (sweat equity).

And if you’ve developed some really clever intellectual property, but have no idea whether it solves a problem that people would pay money for, the government grants are probably the only source of funding, as no one else is likely to put money in.

Populating it with sources of funding, the model now looks like this:

Seeing the world this way, it’s pretty obvious that chasing venture capital for your “kick arse” idea is more than likely to be a waste of everyone’s time.