From the Field

Friends, family, and fools. That’s who usually funds very early startups. After all, who in their right mind would invest money in an unproven product with an unsubstantiated market, often with a single inexperienced person at the helm? Think about it: Would YOU give hard-earned money to a stranger?

I am often contacted by startups who know I’ve been an angel investor and think if they email me a pitch deck and ask me if I want a follow-up meeting that I will enthusiastically reply in the affirmative.

I never do. And here’s the reason. I only invest in people I know. Why? Because that slightly minimizes the risk. Only slightly, however. When I make an investment in a startup, I kiss the money good-bye. I might as well have lost it in Las Vegas gambling, for the number of times I get a return on my investment, and over time I have come to know this. Every person (relative, friend, or just random risk-taker) who invests in your venture should be aware of this.

There are three risks every early-stage investor must know, and every entrepreneur should ignore: the product risk, the market risk, and the people risk. If entrepreneurs focused on the risks, they’d never start companies. But if investors didn’t focus on risk, they’d be broke and on the street.

The product risk consists of the unknowns surrounding whether the proposed product can be created or built at all. Think virtual reality, which has been announced for two decades without becoming a product accessible for the average user. To make virtual reality accessible would mean making the glasses look like real glasses, and not like something only a dork would wear. And making the focus good enough so ordinary people don’t get sick after a half hour. And bringing the price down to an affordable number. For most of us, $2,500 for a fast computer and another $1,500 for glasses is not affordable for an entertainment device.

Then there’s the market risk. Let’s go back to the highly-touted virtual reality. Suppose we could afford $4,000 for the setup. What would we actually DO with it? With every product, there must be a product market fit. We must need the product for something to make us overcome our desire to save our pennies. Food is one of those products.

And last there’s the people risk:

• Will this founder be able to make a go of this business?
• Will she stick with it when the chips are down?
• Will this product scale enough to make a return on investment?
• Will a competitor come out of the woodwork before I, the investor, make the 10x return on investment that I want to make?
• Will the founders continue to get along well enough to be able to work together? Will the product become a business and the business become a company?
• Will the founder create a corporate culture that develops and nurtures new employees?

I always invest in someone whose capabilities for business I think I know well. My first investment, in one of my former students, was because I knew how tenacious this guy was as a student, and also how ethical he was as a human being. That investment paid off about 50 to 1. That’s extremely rare. But the next time he started a company, I invested in him again. That’s why experienced investors seem to invest in experienced entrepreneurs.

These three risks — product, market, and people–together constitute the investment risk. Since you can’t minimize the product and market risk involved in an as yet untried product, the only one that can be minimized is the people risk.

And that’s why investing in strangers almost never happens, and as a startup, you should only look to people who know you and would bet on you no matter what you did. That’s where your family comes in. Moms want their children to be successful, so they’ll gamble where others will not. Sometimes friends are like that, too. The third group are fools. They don’t realize all the risks, and the problem with taking their money is that they’re likely to contact you every day to see if their investments are getting more valuable.

That is unless they are a special kind of “fool,” an early customer. A customer is someone with a pain so intense that she’s willing to take any kind of risk to have it relieved, even the risks described above. Early stage companies just aren’t appropriate for other kinds of investments beyond friends, family, and fools. Or beta customers.

Truthfully, customers are the best people to fund your startup. They’ve already got the need, so you don’t have to prove the market to them. And their need is so intense that they’re willing to take a chance on an unproven technology. You can sell them an early version of the product and they will appreciate it so much that they’ll pay for it in advance, which generates the funds for product development. Kickstarter works this way. People who contribute to Kickstarter campaigns aren’t looking for a 10x return on their investment. Instead, they want the product. That’s why crowdfunding took off—because people truly interested in products like home robots and fitness watches were willing to take the gamble that an entrepreneur they didn’t know could deliver those products.

When I teach my classes, I make my students all start a business during the semester. And I ask them to find an investor—even if it’s a parent and a miniscule investment, just so they learn how to pitch and what a great responsibility it is to take another person’s money. Or I ask them to find a customer: someone who will pay for the product. They panic. But they produce. Which ultimately is what real entrepreneurs must do.