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50 questions: What are the different types of early stage funder?

By on November 24, 2010
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Yesterday, I co-hosted (together with Paul Gardner of law firm Osborne Clarke) a roundtable discussion between VCs and a number of games entrepreneurs. You can read Nic Brisbourne’s thoughts on the event in a post entitled VC investment in the games industry on the Equity Kicker.

I was struck by how, even with only five investors in the room, we had a wide variation in attitudes to risk, the market and what makes an attractive investment.

So, as question #4 in off this series of 50 questions you should ask when raising venture capital, written jointly with Nic Brisbourne of DFJ Esprit, and as a follow-up to my post What exactly is an “investor”?, I wanted to write about different types of early stage funder.

Nic has already addressed the question “Is venture capital right for your company?” I want to go one step further: if VC is right, what type of VC is best; if VC is not right, what are your alternatives?

Revenue, revenue, revenue

Revenue is the cheapest form of finance. It requires you to pay no interest nor to give up equity in your company to an outside investor. It is, in many ways, the best form of finance. For most early-stage companies, it is also the hardest.

I haven’t got time to go into detail about how you generate revenues from a games company in this series (I cover it in detail in How to Publish A Game, which is on sale at a 50% discount until 7th December), but let’s go over the general idea.

You can generate revenues by boot strapping or calling in favours. You can do work-for-hire for game publishers (like most developers), for advertisers (like Fishlabs and nDreams), for education providers, for government (like Blitz), for television and entertainment companies (like the dozens of British game developers working for Channel 4).

Then you self-publish something – anything – in the gaps in-between projects. You learn, you prosper, you grow. Eventually, with blood, sweat, toil and tears – and quite a bit of luck – you will be able to wean yourself from pitching projects and become a self-publisher. It will be slow, and hard work, but it can be a viable alternative to external financing.

Other sources

if you are not ready to make revenue your primary source of capital (and for many startups, it is incredibly hard), there are alternatives:

  • Banks: if you just snorted into your coffee as you read this, I’m not surprised. For a games company to get money from a bank is very, very difficult. Our business (like most startups) is risky, uncertain and dangerously likely to default; games are even worse because they carry creative risk as well as business risk. Banks will typically ask for a business loan to be guaranteed by the directors personally. In the UK, the Enterprise Finance Guarantee provides government backing for 75% of the value of the loan – although even these are hard to get.
  • Government grants: These are often very specific by country, region and even city. It helps if you are in an area that is viewed politically as being in need of regeneration (it is easier, for example, to get a grant in Scotland or the North East of England than in London). The secret to securing these is to be in the regional networks that fund these type of projects. As you will discover throughout this series on raising money, networking furiously is your best chance of sourcing capital.
  • Funds: The games industry, in particular, is full of specific funds that want to put small amounts of money to work on games. Kleiner Perkins runs the $200m iFund and the $250m sFund. The developers behind World of Goo and Portal have launched an indiefund to help develop new and interesting games. Companies like Mochi, Sony (a very specific offering called the PubFund) and Channel 4 (through the now defunct 4iP) fund games directly. There is no easy way to find all of them – although I am starting to build a resource to list all the ones I know on GAMESbrief. Do let me know if you know of any others.
  • Sell your house: It worked for Sean Murray of Hello Games. He made Joe Danger with it. I’m not sure I would recommend it though.

No, really, I want VC money

If you’ve decided that you really do want VC money, you need to start understanding the motivations of the investors. Not only are there a lot of terms bandied about, but investors often all sound as if they are saying the same thing – until you’ve spoken to enough of them to understand the nuances. (I’m sure investors say the same thing about developers). There are a couple of key aspects you need to focus on.

What stage are they?

Angels. Superangels. Incubators. Early stage VC. Growth capital. Late stage growth.

Investors will describe their investment philosophy in many different ways. The crucial thing to identify is what level of risk they are comfortable taking:

  • Are they backing three people with an idea? (very early stage. Often angels or a handful of high-risk, high return funds)
  • Do they want to see a solid team and clear evidence that a market need exists, which is typically evidenced by the existence of paying customers? (early stage VC, growth capital)
  • Are they reluctant to invest until you have $2m of revenue and a clear growth strategy? (Late stage growth)

The only way to find this out is to talk to the investors. Worse than that, you have to keep talking to them: one VC I know has just made a decision only to invest in later stage companies at this stage in its fund, in direct contrast to its investment philosophy less than a year ago.

Risk/reward appetite

All VCs talk about wanting to invest in the next Google; few are actually prepared to take that level of risk. In the UK, in particular, investors look for clear evidence of revenue and financial growth, rather than following a strategy of “get big as fast as you can, worry about the revenues later”.

I’m not against this (I was an equity analyst during the dotcom boom and saw what happened when people stopped thinking that having a viable business model mattered at all). But if all VCs say that they are swinging for the benches, and then encourage you to take the safe path, you might be forgiven for thinking that they were saying one thing and then doing another.

How do I navigate this confusing maze?

I’m afraid that there is only one way. Get out there and meet people. It can be at conferences or at networking events. It can be via their blogs, twitter feeds and newsletters. It can be over the phone or in person.

If you are looking for funding, you need to be out looking for funding. Even better, you should start this process 6-12 months before you need funding. (Mark Suster has a great post on why this is true called Invest in Lines not Dots.)

It is not as bad as it sounds. But you should expect to invest as much time in learning about the world of the funder as you expect them to invest in learning about you. If you don’t, you are likely to be very disappointed in the outcome.

Hungry for more? Go to the 50 questions homepage for more insights into venture capital.

About Nicholas Lovell

Nicholas is the founder of Gamesbrief, a blog dedicated to the business of games. It aims to be informative, authoritative and above all helpful to developers grappling with business strategy. He is the author of a growing list of books about making money in the games industry and other digital media, including How to Publish a Game and Design Rules for Free-to-Play Games, and Penguin-published title The Curve:
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  • Anonymous

    Yes, that growth=risk argument is exactly how UK investors tend to interpret pure growth. It’s also, on the whole, the wrong way to look at it, and why their history of funding online successes (games or otherwise) is miserable.The problem that that attitude has is simply that it’s not interested in ideas which scale. In order to achieve scale, you need growth, and the most common way that any online company does that is through free distribution. Whether the revenue is to come through ads, virtual goods or subscriptions, the point is growth first, revenue second is the strategy needed to prioritise.If you go at it the other way, which is perfectly doable, the results tend to be very small scale. 37Signals is an example of a company that thinks revenue first, growth second, and that’s worked out for them because their core product (Basecamp) has such a compelling use case that it encourages use. And yet even with that, it took 37 Signals 4 or 5 years after the launch of Basecamp for revenues and subscriber numbers to build up to the point where they could stop doing client web design work. The reason why money-now businesses usually don’t scale online is because money is a huge hamper to any kind of virality. So charging businesses don’t really manage to spread fast enough to then turn on paying customers quickly enough. The thing is: Most investors will not invest in a 37Signals either, because the anticipated scale is nothing like what they want. Instead, what they want is make-believe businesses where money is not an issue and scale happens magically, and product is developed for free. It comes from a simple lack of expertise in the field. What a lot of investors outside Silicon Valley don’t have, in short, is any sort of engineering or technology background. Instead what they have is business backgrounds. So they prefer to believe in safe bets or ideas that they can understand (like insurance comparison) and ideas that will achieve scale through blunt advertising (because they don’t trust virality really).For games specifically, it gets worse because every company that walks in with a “i’ve got a game idea” style of plan is treated the same. Idea=risk=no invest. But we all want to invest in games right? Wrong. What they want is to invest in what they consider to be a proven type of game because the risk is long gone.The problem with that is that investing in game types that are already made is usually a losing proposition. That virality that happened with the breakaway hit that defined the genre (this does not mean first-mover, actually it often means the second-mover that solves the big problems of the first-mover) does not accrue to me-too games that follow after. That leads to USP-thinking (i.e. trying to create a third-mover) which also almost invariably never works because the market isn’t buying games for features, it’s buying them for outcomes.Entertainment as a sector has always been unique in its volatility and reliance on timing because as an industry it has more power than any other to form tribal communities of fans who give their undying loyalty. The reason why entertainment industries have often been so reliant on publishers as a result is that a publisher is like an investor who actually gets that. It’s not so much about tactics and business models and so on (although those do matter), as it is about understanding taste and timing.Regular investors really don’t understand that at all, and so they stay away in droves, believing that ideas are risk and risk is bad. What amazes me is why any of them ever want to take a look at the gaming sector at all. I suppose, like film investing, it seems romantically attractive for a while before they get their usual cold feet.You know, a great idea for your second book would be “How to Invest in Games.” You speak the language of business a lot better than most games bloggers (certainly more than I at any rate). There might be a real market for such a work among angel communities and the like.Just a suggestion.

  • I agree with some of your points, but not all.
    I wonder if by “pure growth” you really mean “pure risk”? i.e. pre-revenue, pre-product, based on an idea.
    The problem with that, particularly within games companies, is that VCs are taking all of the usual product/market/team risk, and the financial risk. But they are also adding creative risk. And they know that they have no ability to evaluate the market potential for a single game. WHich is terrifying for them.

    I go back to my point that investors want to back *companies*. And companies have to be more than just and idea. They need traction.

  • That’s a very good point. I got seduced by the word “fund”.
    SOme of them (like the pub fund) don’t take equity. Some do. Some are looking for investments that are more operational than financial in data.
    But I agree that the KP funds are just a branding for a VC investment

  • Hey Nicholas – nice post, and nice re-design! I generally read your posts via an email feed and haven’t seen it before.

    My comment: a lot of the institutions you describe under ‘funds’ are in practice VCs, in fact Kleiner Perkins is in every way a VC.

  • Anonymous

    Agreed on the “Want Google, won’t invest in it” point most especially. Investors are a very hard bunch to understand, but my read on them is that the ideal business that UK investors want to see is a two-man eBay or Groupon, already showing revenue and scale, but which needs some amount of growth money.

    The real problem that they have is that none of them really ascribe any value to pure growth. This is why most UK sites that get any investment of any kind tend to things to do with financial services, insurance comparison etc: Investors understand the idea because it’s close to their heart and area of expertise (who hasn’t gone looking for a better rate on their insurance).

    Alas, this makes game investment in the UK very difficult, because in the main the investors are not from the game industry itself. That said, I do that know that Phil Harrison is attempting to set up a boutique fund for games, and some other small investment companies are prospecting (such as Tenshi) so maybe there’s some opportunity?