GenuineVC David Beisel's Perspective on Digital Change

June 21, 2005

A friend of mine is currently in the process of bootstrapping to start an ad-supported internet content business. However, she doesn’t have very much seed capital to fund the initial development of the basic functionality of the product, and is now trying to determine how to fund the business. One option that she considered is granting not-so-insignificant options and/or founder’s equity to a few software engineers in order to compensate them for getting the product up and going. Another would be to approach select angels for an initial seed round of investment. Sounds like a typical situation that we’ve all seen before. However, she is not following this path, and her reasoning is a follows.

Her perspective is grounded on the fact that a significant information asymmetry that exists between an entrepreneur and his or her constituents, especially extremely early in company formation. No matter how much she communicates her vision of the opportunity, prospective employees/contractors and angel investors alike are not going to be as fully informed about the situation as she is. Only she fully knows the market opportunity and has complete confidence in her ability to execute on it. Because of this differing level of information among each party, her constituents are going to perceive her venture to be riskier than it actually is. And investors and employees are going to want a higher compensation-level for that added perceived risk. Consequently, she doesn’t want to give up more equity than she believes is a “fair price” for investment or services, as these other parties have an inherently different viewpoint than she does.

So this entrepreneur is forgoing granting equity to prospective employees and raising angel seed money. Instead, she is going to work on a consulting basis to an unrelated business to generate cash on the side. This cash will be used to directly pay contract programmers for their time at cash market rates – without a premium for the information asymmetry. Her belief is that once she has a demonstrable product up and going with significant revenue, the information asymmetry will be reduced (though not eliminated) and her company’s equity will be more fairly priced by the market (prospective employees and investors).

Of course, one could make counter arguments. Is she being paid a fair amount for the opportunity cost of her time for the consulting gig? If not, perhaps a different imbalance exists. Or one could contend that granting options factors in the risk involved with the venture, as an option’s value increases with volatility. And perhaps by working on two different projects at once, she runs the risk of losing focus and/or exposes herself to time-to-market risk.

Regardless of the above issues, what is clear to me is that this entrepreneur’s perspective is very thoughtful and deliberate about her approach to bootstrapping a company. And her view about the information asymmetry that exists early in a company is both insightful and real. Do others have additional thoughts?

UPDATE: There are a number of good comments on this post that are worth reading.

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