How to solve the chicken and egg conundrum in startup financing

You need to get the financing to create the product. Investors want to see customer traction first. What can you do?

I especially enjoy advising startup founders in their early stages.

They are full of drive and enthusiasm, and more than a touch of naivety. Most founders assume that developing the product will be their biggest challenge. A few recognize that finding customers willing to pay for their wonderful invention will be much more difficult. But almost none of them seem to understand that financing will be their biggest challenge.

Lured by stories of successful founders who started out with big checks from venture capital firms, there is an enduring myth that a brilliant vision and a great presentation can land you a $2 million investment to get your idea off the ground.

Too many people, from accelerators and mentors to venture capital firms themselves, sell the idea that they invest in visions. Yes, a vision of how you are going to conquer an industry and generate hundreds of millions of revenue is essential, but so is a product that works and is already in the hands of customers.

This is the crux of the chicken and egg problem that startup founders face every day: you need $2 million to create the product. Venture capitalists tell you to come back when you’ve built the product and demonstrated customer traction.

You think: «Oh, I’ll get an angel investment instead.”. Unfortunately, angel investors, at least the kind of angel investors who call themselves angel investors and look for good investments, don’t help either. Angels invest before VCs, but typically still require an MVP with some level of validation from clients.

There are, of course, notable exceptions that we have all read about. If you are a Nobel Prize winner, inventor of the lithium-ion battery, or co-founder of Tesla, you can walk into any venture capital company and walk away with a check. For the remaining 99.9%, we have to find another way to finance our dreams.

In most cases, that means doing as much as possible with as little as possible until we have a basic version of the product in customers’ hands.

Ideally, we can build the product on nights and weekends with minimal out-of-pocket expenses. In that sense, software is easy, and that’s why the vast majority of venture capital goes into software. But many products, especially hard-tech and industrial ones, will need a significant amount of financing to reach viability, and often quite a bit.

It takes money to build the product. Investors do not want to invest until the product is built and tested. It’s a difficult problem, the classic chicken and egg problem. How to break the egg?

A startup is not a job. You don’t work for investors. You work for yourself. Which means that the first place to go for financing is your own bank account.

Creating a startup means raiding the savings account, the retirement fund, taking out a second mortgage on the house. It means asking your grandmother for an advance on your inheritance or your rich uncle for a big favor. If you are not convinced that it is the best investment ever and that it is worth investing everything, it will be difficult to convince others that you are fully committed to the project.

But even that is usually not enough to start your rocket engine. Where else can you get the financing you need to build the product and bring it to market?

Where will you find the money you need to build your product and get the customer validation that venture capital unlocks?

Friends and family: Yes, it’s time to ask everyone you know for help. They will contribute, not because it is a big investment, but because they believe in your vision and want you to succeed.

Grants: Are you working on a better battery? A cure for cancer? Quantum computing encryption? The government will support you. If you are in the United States and do something related to climate or medicine, SBIR grants are your salvation. Many other countries have similar programs.

Do you work in cybersecurity? The military will be your friend. Do you fight forest fires? Call the Department of Agriculture. Do you remove space junk? NASA has funding for it.

Most SBIR grants are $250,000 for Phase 1 development, followed by $1 million for Phase 2 commercialization. Multiple grants, of $1.25 million each, can be stacked to develop different use cases for the technology. It is not uncommon to see hard tech companies with $5 million in non-dilutive funding before raising money from investors.

In addition to federal SBIR grants, many states and cities also have their own grants. Many large companies and private foundations offer grants to support innovation and sustainability, or to help build the local community of underrepresented founders.

For hardtech startups, grants should be the first source of funding, along with personal funds.

Accelerators: Y-Combinator will invest $500,000 in each startup accepted into its program. Techstars invests $120,000. Most for-profit accelerators invest in their cohorts, although in return they take a considerable portion of the capital.

The most useful accelerators are industry-specific programs that can provide useful information and insights while connecting you with potential clients. These accelerators are usually connected to specialized investors who focus on your sector and are usually willing to invest at an earlier stage than generalists, who need to see results sooner.

Customers: If you solve a problem important enough for your customers (and if you don’t, you might want to rethink the viability of your business) they may pay upfront for your product. They may give you NRE (non-recurring engineering) to develop specific features to their specifications. Perfect. Just what you need to get detailed customer requirements and feedback for your MVP.

Once you have an MVP, push for paid pilots. Not only does it generate a small amount of revenue, but a paid pilot provides far more validation to potential investors than free trials, which are easy to sign up for and leave on the shelf.

Additionally, some clients might be open to investing in the company in the early stages. Large companies are unlikely to do this, although it does occur, but medium-sized companies, especially those owned by founders or a family, may be interested in investing in a startup in their sector where they can add value.

Suppliers and resellers: Your suppliers, distributors, and resellers can also be your financial partners. They have a vested interest in your success. Even if they don’t write a capital check, they may offer free materials, lab space, engineering assistance, trade show space, or attractive credit terms that can reduce the amount of capital you need to raise.

Many vendors and distribution partners are mid-sized, family-owned companies looking for new opportunities but lack the team and capabilities to develop products on their own. They know your industry, they know your customers, and they understand the value you bring in a way that venture capital never could. Some may be willing to invest early on. Strategic investors who know the customer and the industry also provide validation for financial investors.

Sector network: From the beginning of your journey, you should develop a network of industry experts who can offer you ideas, advice and feedback. Some may introduce you to potential clients, others may be willing to invest or introduce you to their investor friends.

Especially look for retired executives from giants in the sector and founders and first employees of successful startups in the sector who have left. They may be looking for ways to give back and will have a great experience to offer.

Consulting and part-time work: If all else fails and there is no way to develop the product without more money, the last resort is consulting. The company as a whole or the founders individually can take on external projects on a part-time basis while still working on the startup.

Many great products were developed over nights and weekends until the founders were advanced enough to dedicate themselves to the startup full time.

The ideal is to only accept projects that benefit the startup, either by establishing relationships with potential clients or developing parts of the product.

In the end, you will have to do what it takes to build the product, even if it is not the ideal path.

To create a startup you need to be brave. You will have to scrimp, save, and find a way to get a product to market on a minimal budget. Many founders ask for $2 million in the first phase, which is unlikely to go down well with a company that doesn’t have a product yet. It’s best to find a way to raise a little to get to the next major milestone in 12 to 18 months.

Then you can get a bigger round with a higher valuation.

So before looking for investors, review your funding needs to see not how much you want, but how much you actually need to complete the product and get customer validation.

The first round of financing is the most difficult. Once you have clients and the business grows, the revenue will speak for itself. Until then, however, it may be an arduous task.

Ideally we would like to raise $2 million or $10 million early on to hire a full team and start marketing, but for most of us that’s not going to happen. So review the plans and calculate the minimum you need to build the product.

You can try pitching the product to venture capitalists and angel investors. It’s good practice. Learn about the landmarks they would need to see before becoming interested, so you know where to go. But don’t go all out because the chances are slim.

Instead, look for alternative funding sources, such as grants, industry insiders, and strategic partners to help you get over the hump. Not only will they provide you with much-needed money, but they will also be able to guide and support you to help you in the right direction.

But above all, remember to take a deep breath and relax from time to time. No one said startups were easy. Be flexible and resilient to find a way to achieve the impossible. And make sure you enjoy the ride.