How would you respond? 

• Smart money, of course!
• Dumb money, that’s why I’m talking to you.
• Which kind can I get from you?

The question is ridiculous, yet the issue comes up a lot.  Money is inanimate, and is neither smart nor dumb in and of itself.  The way entrepreneurs or investors manage and invest money can be smart or dumb, and this gets more to the heart of the matter.  But before delving into this issue and its implications for entrepreneurs, let’s take a quick look at some definitions. 

The term “smart money” is often used to describe investment capital from sources that also provide valuable expertise and contacts that will enable businesses to become more successful.  This sounds like a smart idea, and I believe the principle is a good one.  But the term is also used in other less useful ways, and not always explicitly.  For example, a venture capitalist or angel investor may deem their investment as smart money, and infer that others who invested in your business at an earlier stage on an informal basis provided dumb money.  

There are many elitists in the capital markets.  But ultimately this doesn’t matter, and I’ll tell you why.  I’ll also tell you what’s far more important as an entrepreneur looking for capital. 

First, many of the “smartest” financial people in the world helped create the current global economic meltdown.  And even today, whenever they talk about the future, the only truth is “we don’t really know . . .” 

Second, $18 billion (the same amount angel investors and venture capitalists each invested in 2009) was entrusted to Bernie Madoff by thousands of smart people. 

Third, let’s compare the failure rates of companies that received angel investment, those that received venture capital, and the whole gamut of U.S. start-ups that survive at least 5 years. 

 
While different studies report varying failure rates, these numbers reflect a reasonable average.  

What does the data indicate about the value of so-called smart money? 

Taken on the whole, it doesn’t seem to make much of a difference. 

So what does matter for you, the entrepreneur? 

YOU being smart. 

Here are some tips to help guide you along.  

Smart entrepreneurs surround themselves with advisors, strategic partners, board members, employees, subcontractors, customers, vendors, etc. who bring expertise and contacts to the business.  When you look at the big picture, you can get vastly more support from these resources than you are likely to get from your investors, though good participating investors can be very helpful members of your team.

Investors who are also well-known and successful figures in your industry could be very helpful, if they take an active role in supporting you.  There are many anecdotal tales of high profile experts that promised to help for a premium, but never did.  Find out how active such investors will really be for you (check their references) before you take their money.

Don’t take money from investors that are likely to become a problem for you later on.  You can conduct due diligence on them by asking to talk to the owners of other companies they invested in.   

If investors are too “smart” you could end up in a dangerous situation where they can take over your business if you don’t meet certain performances on schedule.  While this a a major concern for entrepreneurs, the reality is that it doesn’t happen very often.  Most angel investors don’t want your business, don’t have time for it, and would rather support it with help from time to time rather than taking it over.  Onerous terms and conditions proposed by an investor should flag you to perform due diligence on the investor, and talk to your trusted business advisors before committing to do a proposed deal.  This is the path of the smart entrepreneur.

Develop a strong financial model of your business built on leading indicators that will help you manage the business from the beginning of the marketing and sales cycle.  Show it to experienced advisors you trust.  Refine it until you completely believe in your ability to achieve these numbers.  Don’t start trying to raise money until after this has been accomplished.

Expect that you’ll have to do a major overhaul of your business model within a few years in order to ultimately succeed. 

Know that a smart entrepreneur can make just as much with so-called “smart money” as can be made with “dumb money.”  So focus on being a smart entrepreneur.  That’s something you have a lot more control of.

Don’t be a smart aleck, that’s not the same thing as being smart.  You’re unlikely to succeed with Tip #1 if you’re a jerk.  I’d like to be able to say that jerks are also more likely to fail, but I haven’t seen any reliable numbers on that issue yet . . .

Data Sources:

SBA Office of Advocacy FAQ updated September 2009; Kauffman Returns to Angel Investors in Groups study 2007; 2005 Sand Hill Econometrics Report by Susan Woodward; http://www.reuters.com/article/idUSTRE58Q2SE20090927; http://knowledge.wharton.upenn.edu/article.cfm?articleid=2397

Here’s what I mean.

High profile angel investors and venture capitalists are focused on high growth businesses, those that can grow to $30-100 million within a few years.  This is not necessarily based on greed, but more often on the realities of the financial world where they live.  They have compelling reasons for this focus.  And so for the most part, they ignore smaller companies. 

There were about 600,000 new businesses with employees that started in 2009 in the U.S.  Angel investors funded some 13,000 start-up deals, and venture capitalists funded 312.  Statistically, angels funded 2 percent of the new companies, and venture capitalists a tiny fraction of 1 percent.  The SBA reports that nearly 70 percent of start-ups survive at least 2 years, and more than half survive for 5 years. One other statistic of interest is that the average person born in the later years of the baby boom era held 10.8 jobs from age 18 to age 42, according to the U.S. Department of Labor.  This equates to changing jobs every 2.2 years on average.

From these numbers, we can conclude that your odds of starting a business that succeeds on some level for at least 5 years are better than staying with the same employer for 5 years.  While many millions of people do stay at their jobs more than 5 years, most don’t. 

So how successful are those businesses that survive?  According to the IRS, 81 percent have net income of less than $1 million per year, 16 percent have income from $1 million to $10 million, and just 3 percent have income of more than $10 million.  By the way, only 0.5% have income greater than $50 million annually.  

One other statistic is useful to consider.  Of all the small business funding provided during 2009 – a year of economic turmoil – just 7 percent came from angel investors and venture capitalists.  All the other small business funding came from somewhere else. 

Most small businesses, whether start-up or well established, will never receive a nickel from sophisticated angel investors or venture capitalists.  Yet there are more than 5 million households in the U.S. that have a net worth of more than $1 million.  Most did not inherit their wealth – they earned it from small businesses that they found some way to start and fund and grow.  Small business owners have a much higher probability of success in this world than in the realm where angel investors and venture capitalists live, all due respect to those at the top of the food chain. 

And so while we aspiring entrepreneurs can learn much from angel investors and venture capitalists about getting funded, we should remember that 93 percent of small business funding comes from somewhere else.  Somewhere that shares key viewpoints of high profile investors, but also takes many other issues into account.  Things that are often more favorable to you.

Learning to successfully navigate in the world of the 93 percent offers your best chance for success in funding your company. 

Data Sources:
SBA Office of Advocacy FAQ updated September 2009; Center for Venture Research – The Angel Investor Market in Q1Q2 2009; National Venture Capital Association and PriceWaterhouseCoopers (January 22, 2010); U.S. Department of Labor News Ref. USDL-0860 dated June 27, 2008; U.S. Internal Revenue Services, Statistics on Income, Corporation Income Tax Returns – 2006; Federal Financial Institutions Examination Council Fact Sheet (August 2009); GEM 2008 National Assessment for the USA; GEM 2009 Executive Report