I wrote in an earlier post in this series that friends and family is the most common form of startup financing. If you are talking explicitly equity investments, then that is probably true. But the most common way that startup businesses get money to get going is they sell something to someone. In this context, someone means customers.
Customers are a great way to finance a business for many reasons. First, customer financing is typically non dilutive. They want something from you other than equity in your business. Customers also help you fit your product to the market. And customers will help debug and improve the quality of the product. An early customer will give you credibility with other customers. And an early customer may spend more with your company down the road.
The most common way customer financing is done is you sell the customer on the product before you’ve built it or before you’ve finished it. The customer puts up the money to build the product or finish the product and becomes your first customer. Usually the customer simply wants the product and nothing more. At times an early customer might ask for some exclusivity on the product or even some free equity in the business, but most of the time the early customer simply wants the product from you and nothing more.
So why not take this approach with every startup? Well, it isn’t always possible to find a customer who will put up money in advance of the product being complete and ready to use. It takes great salesmanship to convince a customer to buy something from you that isn’t built or isn’t finished. But even if you can convince a customer to do this, there are some negatives.
First and foremost, building a product explicity for one customer often makes it less applicable to the market as a whole. An early customer who provides funding to build your product will want the product tailored specifically for its needs. And a highly tailored product is often not well suited to a broader market.
Second, you risk building a “fee for services culture” in your company with this approach. Some companies build products for customers for a fee. Other companies build products and sell them “as is” to customers. The latter is the scalable model for building valuable companies. If you use customer financing, you risk being pulled into the former.
And customer financing is much more difficult, if not impossible, in consumer facing services. It is much more applicable in business facing services.
Those are the pros and cons of customer financing. If you can convince a customer to put up significant capital in advance so you can build or finish your product, you should consider it very seriously. Many great companies got their start this way.
From the comments
Avi Deitcher added:
Great point about fee for services, but there is a middle ground between fee for services and product-oriented which can be more insidious. I am all for sales (who doesn’t want revenue), but I have seen a number of cases where companies become sales-driven (or more correctly deal-driven) than product-driven.
As you said, product- and market-orientation make a scalable company. But it is oh-so-tempting when there is one big deal to make “just that one tweak” to the product to fit the deal, even though it distracts from the product goals. Sure, sometimes that “just one tweak” is the customer insight for the market as a whole, which is great, but too often it becomes another distraction in the rat race after current revenue instead of growth.
Insidious: because you *think* you are product-driven, when you are really deal-driven.
To which fredwilson replied:
i see this all the time, both in our portfolio and outside of it
This article was originally written by Fred Wilson on June 20, 2011 here.