Source: saunderslog.com

Ian Graham writes frequently from his soapbox at Blogmatic about startups — especially funding, hiring, business plans and so on.  His blog is a bit of a startup CEO handbook in many ways.

He asks "Is Startup funding broken in Ontario", inspired by a StartupNorth piece about Brightspark’s new incubator model.  Brightspark 3.0 is a company that will build web 2.0 businesses, not a fund. The lads at Brightspark have returned to the model they started with in the late 1990’s; assemble a team around an idea and fund it.

Ian points out that today’s VC model is broken because it requires as much due diligence to do a seed round as it does a Series A or B, but the risk is higher at the seed round.  I’d add to that that once beyond the term sheet, the VC solution is over engineered.  To raise $500K an entrepreneur can easily be staring at a legal bill of $100K.

Do you really need $500K?  Depending on the kind of business you’re in, maybe not.  In a cloud computing environment, it doesn’t cost much to open an EC3 or Joyent account, and simply start building. There are plenty of Web 2.0 startups being built using tools like Ruby on Rails that are being created for far less than $500K. Many entrepreneurs simply choose to finance their pet project as a sideline, or by running up the credit cards.  It doesn’t take long to create an early stage product, throw it out there, and see what happens. 

So who needs the VC?  Well, come stage 2, which is refining that prototype into a commercial product, we all probably need additional sources of capital.  And that’s where it gets tough in Ontario.  You won’t get a fully fleshed out business plan from an entrepreneur who’s just maxed credit cards to build an exciting prototype.  So let’s scratch all those government programs that require one.  There aren’t sufficient VC funding sources available to fund even a fraction of those prototypes in growth mode either.  Moreover, when VC’s delay buying into the seed round, they price themselves out of the market for follow on rounds. Let’s face it, everyone wants a deal, but as soon as there’s any success, the price to buy into a later round increases.

The formal angel networks offer a potential solution.  However, the taste of the 2001 era cram downs hasn’t left their mouths yet.  Most are looking for business plans that won’t require a follow on round. 

It’s a mess, and it’s no wonder that funding is down over 60% this year in Ontario.  I’m not sure that the Brightspark 3.0 model is for everyone, though.  They have the potential to be a competitor or an employer, but probably not a financial partner. 

For answers, I’d look south.  Two models I like are YCombinator and FoundersFund.

The YCombinator model is efficient in that it allows entrepreneurs to raise very tiny amounts of money in return for a small equity bite using cookie cutter terms.  In one stroke they’ve eliminated most of the due dil and legal expenses.   If the prototype is successful, YComb is ready to add additional funding themselves, and bring more money to the table. 

FoundersFund is a different model.  They do seed stage financing, and they’re attractive to entrepreneurs because they offer a somewhat controversial early partial exit to the entrepreneur.  Buy allowing the entrepreneur to crystallize value at later rounds, they’re putting themselves firmly in the partner camp, rather than the adversary camp.