The advantage of raising money from friends and family is that they're easy to find. You already know them. There are three main disadvantages: you mix together your business and personal life; they will probably not be as well connected as angels or venture firms; and they may not be accredited investors, which could complicate your life later.
The SEC defines an "accredited investor" as someone with over a million dollars in liquid assets or an income of over $200,000 a year. The regulatory burden is much lower if a company's shareholders are all accredited investors. Once you take money from the general public you're more restricted in what you can do. [1]
A startup's life will be more complicated, legally, if any of the investors aren't accredited. In an IPO, it might not merely add expense, but change the outcome. A lawyer I asked about it said:
When the company goes public, the SEC will carefully study all prior issuances of stock by the company and demand that it take immediate action to cure any past violations of securities laws. Those remedial actions can delay, stall or even kill the IPO.
Of course the odds of any given startup doing an IPO are small. But not as small as they might seem. A lot of startups that end up going public didn't seem likely to at first. (Who could have guessed that the company Wozniak and Jobs started in their spare time selling plans for microcomputers would yield one of the biggest IPOs of the decade?) Much of the value of a startup consists of that tiny probability multiplied by the huge outcome.
It wasn't because they weren't accredited investors that I didn't ask my parents for seed money, though. When we were starting Viaweb, I didn't know about the concept of an accredited investor, and didn't stop to think about the value of investors' connections. The reason I didn't take money from my parents was that I didn't want them to lose it.
Another way to fund a startup is to get a job. The best sort of job is a consulting project in which you can build whatever software you wanted to sell as a startup. Then you can gradually transform yourself from a consulting company into a product company, and have your clients pay your development expenses.
This is a good plan for someone with kids, because it takes most of the risk out of starting a startup. There never has to be a time when you have no revenues. Risk and reward are usually proportionate, however: you should expect a plan that cuts the risk of starting a startup also to cut the average return. In this case, you trade decreased financial risk for increased risk that your company won't succeed as a startup.
But isn't the consulting company itself startup? No, not generally. A company has to be more than small and newly founded to be a startup. There are millions of small businesses in America, but only a few thousand are startups. To be a startup, a company has to be a product business, not a service business. By which I mean not that it has to make something physical, but that it has to have one thing it sells to many people, rather than doing custom work for individual clients. Custom work doesn't scale. To be a startup you need to be the band that sells a million copies of a song, not the band that makes money by playing at individual weddings and bar mitzvahs.
The trouble with consulting is that clients have an awkward habit of calling you on the phone. Most startups operate close to the margin of failure, and the distraction of having to deal with clients could be enough to put you over the edge. Especially if you have competitors who get to work full time on just being a startup.
So you have to be very disciplined if you take the consulting route. You have to work actively to prevent your company growing into a "weed tree," dependent on this source of easy but low-margin money. [2]
Indeed, the biggest danger of consulting may be that it gives you an excuse for failure. In a startup, as in grad school, a lot of what ends up driving you are the expectations of your family and friends. Once you start a startup and tell everyone that's what you're doing, you're now on a path labelled "get rich or bust." You now have to get rich, or you've failed.
Fear of failure is an extraordinarily powerful force. Usually it prevents people from starting things, but once you publish some definite ambition, it switches directions and starts working in your favor. I think it's a pretty clever piece of jiujitsu to set this irresistible force against the slightly less immovable object of becoming rich. You won't have it driving you if your stated ambition is merely to start a consulting company that you will one day morph into a startup.
An advantage of consulting, as a way to develop a product, is that you know you're making something at least one customer wants. But if you have what it takes to start a startup you should have sufficient vision not to need this crutch.
Angels are individual rich people. The word was first used for backers of Broadway plays, but now applies to individual investors generally. Angels who've made money in technology are preferable, for two reasons: they understand your situation, and they're a source of contacts and advice.
The contacts and advice can be more important than the money. When del.icio.us took money from investors, they took money from, among others, Tim O'Reilly. The amount he put in was small compared to the VCs who led the round, but Tim is a smart and influential guy and it's good to have him on your side.
You can do whatever you want with money from consulting or friends and family. With angels we're now talking about venture funding proper, so it's time to introduce the concept of exit strategy. Younger would-be founders are often surprised that investors expect them either to sell the company or go public. The reason is that investors need to get their capital back. They'll only consider companies that have an exit strategy-- meaning companies that could get bought or go public.
This is not as selfish as it sounds. There are few large, private technology companies. Those that don't fail all seem to get bought or go public. The reason is that employees are investors too-- of their time-- and they want just as much to be able to cash out. If your competitors offer employees stock options that might make them rich, while you make it clear you plan to stay private, your competitors will get the best people. So the principle of an "exit" is not just something forced on startups by investors, but part of what it means to be a startup.
Another concept we need to introduce now is valuation. When someone buys shares in a company, that implicitly establishes a value for it. If someone pays $20,000 for 10% of a company, the company is in theory worth $200,000. I say "in theory" because in early stage investing, valuations are voodoo. As a company gets more established, its valuation gets closer to an actual market value. But in a newly founded startup, the valuation number is just an artifact of the respective contributions of everyone involved.
Startups often "pay" investors who will help the company in some way by letting them invest at low valuations. If I had a startup and Steve Jobs wanted to invest in it, I'd give him the stock for $10, just to be able to brag that he was an investor. Unfortunately, it's impractical (if not illegal) to adjust the valuation of the company up and down for each investor. Startups' valuations are supposed to rise over time. So if you're going to sell cheap stock to eminent angels, do it early, when it's natural for the company to have a low valuation.