The “friends & family” chasm in the startup funding journey

Despite the inventiveness that permeates the world of tech startups, the fundraising roadmap dispensed to founders just starting out has not changed much over the last few decades. That’s a problem, and not just for startup founders, but for early-stage angels and VC firms.

Fundraising is seen as a pipeline.

All advice material meant for startup founders, from the last couple of decades, chart the fundraising steps as “love money / friends & family” → “angel investor(s)” → “Pre-Seed” (though rarely cited until more recent years) → “Seed”, “Series A”, etc.

A startup journey is rarely a straight line; even non-tech entrepreneurs are keenly aware of this. Fundraising is part of that non-linear adventure, a roller-coaster even, so models and advice are just guidelines. However, one thing is pretty clear: Unless you have a very large bank account (maybe from an inheritance, or a past startup exit), there will be a need for outside capital. [While certain startups, especially software-only ventures, can bootstrap their way, the vast majority will need to seek additional investment.] Just like a real fair ride, not everyone can get on. That first gate, a first investment, is that ticket to get onboard. But in many cases, despite doing everything right — making a strong case for the vision and the founder-product fit, validating the opportunity through research and/or a rudimentary prototype, demonstrating commitment, skin in the game, etc. — a friends & family round is rarely going to be possible given one’s family background, geographic region, previous occupation, or all of the above.

Despite a lot of love, the money may be absent.

Not everyone has wealthy friends or family. So, what happens when raising funds from one’s entourage is not possible?

• ⏰ Missed opportunities: Slower progress, potentially by continuing to work at a regular job full-time (or trying to work two jobs to accumulate savings to invest in the business) and advancing on the startup part-time. 🏃‍♀️ One of the largest advantages of startups is the ability to move fast; working part-time is a huge headwind, slowing things down so much that opportune market timing could be missed.
• ⌛️ Time wasted: Filling out tortuously long grant applications in hopes the square peg of the startup venture fits in the round gate of the funding agency’s requirements. This is rarely a solution as in many jurisdictions grants are doled out on a matching cash basis or on a refund basis, meaning that one still needs to somehow have money upfront!
• 😰 Founder fatigue: Being a startup founder requires a lot of energy and perseverance, but without that early financial and confidence boost that comes from a friends & family round, stress is amplified, escalating the likelihood of burnout, and giving up on a potentially successful venture.
• 🛑 Premature end: In some cases, there are no other options. Without the presence of patient love money, a venture will have to stop dead in its tracks.

Founders whose entourage doesn’t permit for a friends & family raise are clearly at a big disadvantage! They’re often unable to get their business off the ground, let alone be able to perform tests, adapt, and grow their business as quickly.

A friends & family round: Signal or noise?

I’ve listened in on many founders pitching angels and early-stage VCs, both in private and in public, at pitch events I’ve organized. I’ve also had numerous pre-investment analysis and diligence discussions with potential co-investors considering participating in the Pre-Seed round of various startups. In a high proportion of these interactions, there’s a noticeable sense of comfort when it’s discovered that there’s been a prior friends & family round. It’s normal, knowing there’s been some prior investment, even if it’s not smart money, is somewhat reassuring; it’s human nature not to want to go into a dark tunnel first.

Though love money is not explicitly a requirement for angel investors and “early-stage” VC firms, it is a source of judgment if absent; questions might come to mind as to the capability of the founder at pitching and selling the vision of the venture. There’s a chance these seeds of doubt could lead to passing on investing. That’s unfortunate, as the mere fact of having had a successful friends & family round might simply indicate a founder’s privileged background, rather than anything pertinent about the startup’s potential future success.

This surely limits diversity downstream.

It is well known that, collectively, the population of successful startup founders lacks diversity. Could it be that this lack of diversity is aggravated, if not originated, with the situational luck of privilege that facilitated a friends & family round in the earliest days of those startups? Sadly, the magnitude of the problem has not been rigorously quantified (I was not able to find any study of the socioeconomic diversity of friends & family-funded founders), but it seems like the venture funding system, as it is now, is heavily skewed to support those with well-to-do, well-educated families and the social circles that come with that.

Putting aside the moral implications, one must ask if, both as investors and as a society, we’re potentially missing out on world-changing, impactful startups?

Solutions?

I don’t claim to have “the” answer, but the unmerited disparity in access to friends & family startup fundraising should certainly be alleviated by an increase in risk-tolerant external investors, investing at the very earliest stages of a startup’s life. There is potentially a great opportunity to invest in previously overlooked ventures, where a friends & family round just wasn’t possible.

About me: I’m the founder of Badhouse Ventures, a nano-VC firm in Vancouver with a concentration on the very early stages of startup development (aiming to invest first in software-focused ventures), combined with a geographical focus on Western Canada. A central thesis of Badhouse is that the existence of an active institutional investor, investing earlier in startups compared to other investors in a region, should contribute to increasing the socioeconomic diversity of funded startup founders.