What Is Dumb Money?

by Mark Peter Davis

In my post, Should You Tranche Your Fundraising?, I described the potential challenges associated with trying to raise a large sum of money from VCs in one round.  In sum, if the capital raise is too large you will most likely give away too much ownership in your company, or scare off the VCs because they can't meet their ownership requirements.  There's not enough of the company to go around.

There is another way.  You could raise "dumb money". 

I generally hate the name "dumb money" - it is a bit insulting after all.  As my mom would say, "It just isn't nice."  There are, however, two reasons why it has that name.  First, the phrase "dumb money" is first-and-foremost used to imply that the investors will not be able to add any value to the business beyond providing capital.  They can't offer relevant advice or connections.

Second, dumb money is often invested in atypical structures that can both 1) reduce the odds of the investor generating a risk-adjusted return and 2) mitigate the entrepreneur's ability to raise subsequent capital.  Put another way dumb money can leave your company overvalued, scaring away future investors.

A bit of irony:  dumb money rarely comes from dumb people.  More often than not the investors who fall into this category are very successful business people who simply made their money outside of the venture community (they aren't entrepreneurs, venture lawyers or early-stage investors).  As a result, they're not as connected to the venture community and don't understand how to structure early stage investments so that the entrepreneurs are poised to "stay in the system", meaning raise capital from investors that participate at various stages in the startup life-cycle.

Note: Here is a comments from Eric Wiesen

Mark's posts are usually helpful to his entrepreneur readers, but this one is more important than most, especially since this is a very topical issue a lot of companies are facing. Raising money has gotten harder than ever, and professional investors (i.e. VCs) have raised the bar and are generally paying lower prices today than they were during the go-go market. So it's natural that founders will look for sources of capital that are, frankly, less discerning than those investors who invest in startups for a living. There are obvious reasons to do this - you typically get a higher valuation and better terms. But there are some very good reasons not to, some of which Mark touches on.

1. Passive capital is just that, and won't work with you to build the business.
2. It will often over-value the company, which feels really good but hits you hard when you need to do a followup financing.
3. These investors rarely follow on by themselves, so you wind up in front of the institutional investment community having done an overpriced round with non-standard terms. VCs are going to reset the terms at that time, and the dilution is likely to hurt you, the founder, more than your passive capital investor(s).

Entrepreneurs should take money where they can get it, but be aware of the tradeoffs. Good post.