Raising money in the 21st century, or: Why Zencoder raised $2M

Zencoder just closed on a $2M funding round from some pretty awesome investors. This is our second round of funding, though most of our first round investors participated again in the second round. Investors this time around include Andreessen-Horowitz, Ignition Partners, SV Angel, Lowercase Capital, Founder’s Collective, 500 Startups, Matt Cutts, James Lindenbaum, Orion Henry, Adam Wiggins, Wolfgang Buehler, Mike Bollinger, Neil McClements, and a few friends-and-family investors. Why did we raise this money, and how did it happen?

Zencoder plays Moneyball

Dave McClure, one of our investors, wrote an infamous blog post last summer that coincided with the launch of 500 Startups. The post is called MoneyBall for Startups: Invest BEFORE Product/Market Fit, Double-Down AFTER. Dave argues that startups are changing and technology is changing, but VCs are slow to adapt. Startups no longer need $3M to get a product out the door - products are cheaper and faster to build, marketing can be done inexpensively, and many startups can start making revenue on day one. When you think about it, it should be obvious that technology companies are easier to start today than they were 20 years ago. The internet, open source software, and (now) cloud services empower smart people to build amazing things with very little money. But venture capital in 2011 looks suspiciously similar to venture capital in 1991. Dave outlines a new model for financing startups, in three stages.
1) Product: $0-100K, 3-6 months to develop basic MVP that's functional & useful for at least a few customers. Get to small product/market fit. 2) Market: $100K-$2M, 6-12 months to test marketing & distribution channels, understand scalability & customer acquisition cost, conversion to some non-zero revenue event. Get to large product/market fit. 3) Revenue: $1-5M, 6-24 months to optimize product/market fit and get to cash-flow positive.
This is exactly - to the numbers - what happened at Zencoder, with the addition of a Step 0. 0) Bootstrap Zencoder spent two years as an unfunded side project. We built Flix Cloud during that period, but otherwise, like most side projects, we didn't get real momentum until we moved to the next stage. 1) Product. We raised $20,000 from Y Combinator, supplemented this with personal savings, and completed a working beta in 4 months (January-April). Zencoder launched in May of 2010. 2) Market: Just after launch, we raised a convertible debt round from Chris Sacca, Dave McClure, and others. We used this money to hire a team, get Zencoder to product-market fit, and start making meaningful revenue. After about 4 months, things really started to click. Customers now love Zencoder almost universally, and revenue and usage have been growing quickly. After this clicked, we began working hard on our sales and marketing alongside of continued improvements to the product. 3) Revenue: We just closed $2M in funding. We'll use this money - and I quote the Moneyball post - "to optimize product/market fit and get to cash-flow positive." Give 500 Startups credit: this isn't just talk. They first invested in Zencoder before product/market fit, and they doubled down after. So did a number of our angels. This approach to fundraising would have been difficult in the 20th century, or at least rare. But it's not unusual today, and it's only going to become more common.

The future of fundraising

Paul Graham has written a number of great essays with similar themes: see The Future of Startup Funding and The New Funding Landscape, amongst others. Four trends stick out to me. 1. The importance of convertible debt. It is expensive to raise money - a $25K bill is not unusual for an early equity round. When you're raising $500K, it's stupid to spend 5% in legal fees. We negotiated a $4K cap with our lawyers for our first round, and this one will come in under $25K. Beyond that, there is a reason that equity is expensive to raise: it takes time and money to negotiate terms, handle due dilligence, etc. It pays to defer these things. 2. Because startups need less money to get started than they did 10 or 20 years ago, angel investors are becoming more important. VCs are no longer the gatekeepers to building something awesome. Startups can get far down the road with half a million from a few angels, or $20K from YC, or even $0. 3. Fundraising can take less time. Raising money is difficult and becomes the top thing on your mind. It is in no one's interest - startup or investor - to make a founder a full-time fundraiser for 6 months. And successful fundraising is a full-time job, so the only way to save time is to make the cycle shorter. Ours took 1-2 months, depending on how you look at it. We had commitments for our entire round in a month, but took another month to close due to slow negotiations with one of our investors. (I won't name names, but they're great - just slow. And the delay is my fault as much as theirs.) Still, 1 month of full-time pitching followed by 1 month of part-time paperwork isn't terrible. 4. Startups can stay in control longer. For each of our rounds, we've tried to take exactly as much money as we need to get to the next major milestone, plus a little padding. We could have raised $5M this time around, but we don't need $5M to get to the next stage of our business. A smaller round means less dilution, more control, and no pressure to spend more than is necessary. This doesn't mean that venture capital is obsolete, of course. VCs will always be needed to help with growth; it is arguably just as expensive to build a big company today as it was in the past, and good VCs make fantastic partners in this endeavor. But startup financing is moving in the right direction: startups can make progress on less money, find money faster, and raise from a position of strength, not weakness. This is good for everyone.