Why don’t tech startups seek investment from their customers?

by Kraettli Lawrence Epperson in Capital & Valuations

I recently answered this question on Quora: “Why don’t tech startups seek investment from their customers?”

It is a very good idea for startups to seek investment from their customers. As other answers have mentioned, this can be a very important source of validation for the startup because it proves that customers value the products that the startup is providing.

For B2B (business-to-business) startups serving larger enterprise customers, there is actually a name for this: “strategic investment.” It is called a strategic investment because the enterprise customer-investor is not typically investing primarily for financial return but is instead investing with the aim of being involved with the company and product plan long-term and possibly even acquiring the company in the future. Making an early investment puts the enterprise company in a good position to influence and monitor the startup.

However, answering your question, there are good reasons why startups often do not and cannot raise money from their customers:

  • For B2C (business-to-consumer) startups, the startup is serving individual consumers or maybe small businesses. As a result, there is no available enterprise buyer with the capital available to make a large investment in the startup. With individual consumers or small businesses as a startup’s primary customers, the startup is unlikely to be able raise capital through its customers, no matter how eager or enthusiastic those customers might be.
  • Secondly, even for startups with large enterprise customers, the startup will often find that the enterprise customers are not prepared or interested in making high-risk venture capital investments. Even enterprises that consider making these kinds of investments do so very seldom and often cease after a few years due to the required overhead of making venture capital investments in other companies. VC investing is a particular business model that is typically run by professional investors and most companies do not perform this function in-house because it would be secondary to their primary business, can be very expensive over time, resource intensive and distracting. As a result, the startup often cannot find a customer able and willing to make an investment, even when an enterprise customer might have the available capital, in theory.
  • It is also important to keep in mind that accepting an investment from a large customer can come with strings attached. Large enterprise customers may have their own goals for a startup and its products, which may not align in the long-term with the goals of the startup’s founders. The investor may, for example, seek to gradually steer the company’s products to better serve the investor’s company rather than the needs of the industry as a whole. Also, competitors to the enterprise investor may decide to no longer deal with or purchase from the startup, which can be a significant problem. I have seen a variety of methods that startups use to manage these investor relationships, including having policies that separate their dealings with their investors’ competitors from the enterprise investor’s oversight. But any investment from a large customer will come with some overhead and cost to the startup.
  • Finally, there are a few large companies, in the energy industry for example, that operate either in-house or closely associated venture capital funds to make investments in promising and innovative vendors. These are companies that want to encourage innovation in their industries and that see startups in their industries being under-served by traditional venture capital. I know several of the managing directors of these in-house VC funds. This practice is currently more common in the industrial and manufacturing sectors and the large enterprises make these investments explicitly with the aim of improving access to particular products and improving the design and function of those products because they see them as useful to the future of their industry. They also perceive startups as engines of innovation and able to manage rapid development and new product iterations, as well as risk, better than the large enterprise can. And, eventually, acquisition of the startup may become a goal of the enterprise investor.

Startups often do not seek capital investments from their customers because these investments are difficult to obtain, infrequent, can be difficult to manage and definitely have long-term implications for the company’s strategy, direction, growth and exit plan.

How to Raise Money from Your Customers

In addition to explaining why startups often to do not ask for or receive investment from their customers, I also wanted to explain how startups can and do seek investment from their customers.

  • B2B startups should consider whether they want their larger business customers knowing that they are seeking investment, and what message this might communicate to a customer. However, if you decide to do it, then contacting your biggest customers to ask about investment is straightforward. Call the most senior person you know at the company and ask. Most will say that they’re not in that business and turn you down. Oh well. But, if you’re lucky, some will put you into a conversation with the right person at their company. Get a good startup attorney and go for it!
  • One caveat – Talk to your attorney about this topic: You want to be sure that you do not solicit investment from an individual small business owner who is not an “SEC accredited” angel investor. Your attorney can help guide you.
  • Again, for B2B startups, identify the large enterprises in your industry that have recently made investments in other companies. They are more likely to take your request for investment seriously. Google and Google News are your best friends. Check PitchBook as well. These investing enterprises likely have a strategy around these investments and are much more likely to at least enter into a conversation with you and possibly provide some guidance. If they do not want to invest now, maybe they will provide you a list of milestones to reach and then express an investment interest at a later time.
  • For B2B startups, look for large enterprises that have an investment office or who run or sponsor a seed fund, venture accelerator or full-blown venture capital fund. A surprising number of larger enterprises do have these operations specifically to help them identify tech trends and innovation early and to stay ahead of the curve. They will have a process for you to follow. Again, you need a good startup lawyer.
  • Also, keeping in mind the above caveats, I’ve seen companies raise money and/or enter into joint ventures with their bigger customers at trade shows. If you’re bold, you can ask around among your friendliest customers during trade shows and conferences, find the right CEO or VP for a quiet chat, and arrive home with an investment or at least a promising discussion.
  • Finally, an idea for B2C startups: Both early-stage and even larger, more established companies are testing out new products on crowdfunding sites focused on product launches, prior to bringing the new product idea to market or even manufacturing it. For B2C startups, particularly those with a physical product, product-based crowdfunding is the ideal way to both test a product idea and get development and production funded at the same time. I’ve been surprised at the number of established companies testing out new product ideas on Kickstarter before formally launching the product! Do some searches and you may get some B2C crowdfunding inspiration.

Good luck!

 

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Kraettli Lawrence Epperson

Managing Director at JumpPhase Ventures
This blog is dedicated to providing advice, tools and encouragement from one entrepreneur to another. I want to keep this practical and accessible for the new entrepreneur while also providing enough sophistication and depth to prove useful to the successful serial entrepreneur. My target rests somewhere between the garage and the board room, where the work gets done and the hockey stick emerges.