I was talking to a friend from my mentoring group at Stanford who works closely with both students and startups, Glenn Winokur, and he told me about some useful blog posts at the FreshBooks website written by Mike McDerment

In particular, he mentioned a post about when to raise capital, one that I am being asked a lot lately, so I visited and thought it was great, you can see it on this link or below.

Mike McDerment: I meet lots of web entrepreneurs who tell me they want to raise venture capital. Most of these people are first time entrepreneurs and they just assume that once they’ve got an idea, the next thing to do is raise venture capital. That’s naive. I always ask myself is, “is this person/company ready to raise money?” and 99 times out of 100 the answer is “no”. I’m writing this post in an effort to explain what goes through my head at those times and when it is right to raise institutional capital.

So, when is the time to raise Venture capital?

When: you don’t need the money

This may seem counter-intuitive on a whole bunch of levels, but the time to raise money is when you don’t need it. What I mean by “don’t need it” is you can carry on without it, or you have alternatives (like other people who want to invest, or a house you will mortgage). Many entrepreneurs don’t understand the value of finding their way without VC money, or they think they need the money more than they actually do, or they think they need it sooner than they do, or all of the above! (READ: the 7 ways I’ve almost killed FreshBooks) The result is they spend a lot of time too early in their business’s lifecycle focused on serving VCs instead of serving their customers. Raising money is a negotiation. You need options when you are sitting at the bargaining table – you need a path without capital, a legitimate path.

When: you have a product

Don’t talk to a VC until you have a product. There are exceptions to every rule, but unless you have built a successful business before, or your business requires millions and millions of dollars to build V1 of your product (think microchips), don’t talk to VCs before you have a working product or prototype.

I’ve met entrepreneurs who tell me, “I’ve got this great idea, I’m going to start shopping it around to VCs.” Thanks to the web, it’s incredibly cheap to build a business. VCs know this too and their role in building businesses has changed since the first internet bubble. Back then entrepreneurs with ideas needed VCs to pay for infrastructure and servers and bandwidth – these things used to be expensive –today they are not. As the consequence, VCs have no incentive to fund ideas…they can wait till later in the process of building a business. And it’s important that they do because they want to be sure…

When: You know your customer better than anyone

I personally believe this is the most misunderstood milestone on the path to raising Venture Capital for both VCs and entrepreneurs – the “I know my customers better than anyone” stage. If you know your customers, or perhaps you’ve scratched your own itch and you ARE your customer, you are now enormously valuable to yourself and anyone who is going to invest in you. The difference between VCs and entrepreneurs is customers: entrepreneurs have them, VCs don’t (though I’d argue their LPs are their customers, and the best of the VCs know that entrepreneurs are their customers and they serve them accordingly…but I digress). Knowledge of your customer is what is going to make you a better strategic decision-maker and product designer than your VCs could ever hope to be. Remember Facebook Beacon? From what I gather Zuckerberg was against it because he knew his customer, the VCs…well, let’s just say Beacon looked great on paper.

Knowing your customer better than anyone is valuable. You should use it as a bargaining chip when it does come time to negotiate, but you have to invest in it. You need to phone your users, take them out to lunch and surveys are not enough. It doesn’t come fast or easy. So build your product and get to know your customers – I’d suggest 100 conversations (not emails!) is a good start. And don’t try to tell me they won’t talk to you on the phone. Have you asked? Email them an invite to speak with the founder of the service they are using about their experience. Your early adopters will be all over that. And if you have enough early adopters…

When: You have traction

If you have a product and you know your customers better than anyone, you are on your path to traction. But if people don’t become repeat users of your site or service, then you need to make sure they do. Do your customers refer you? Do you have early adopters who champion you? Do people write you up in blogs or on Twitter of their own free will? Repeatedly? Do people actually pay for your service?!! Those are signs of traction. VCs have enough good opportunities in front of them that they can choose from companies that have traction – you better make sure you do, and your friends using the service does not count.

Finally, when: you know what you’re getting yourself into

Don’t raise money if you think it means you’re going to stay in control. Raising money is the first step on the path to loss of control – know that. It starts with equity and a board seat. It’s my belief that if you raise money once you’ll raise money three times. If that’s the case…you might like the terms at round one, but have you thought about the terms at rounds two and three? If you have and you like your place at that stage of the race, proceed. If not, don’t. Really…you should be asking yourself, do I want to build something big, or do I want control. IF you want control, you’re going to be very unhappy with the VC path, so do the gut check before you proceed.

Mike McDerment Disclaimer: I have never raised Venture Capital and FreshBooks has no institutional backing. That said, I have raised money and I do spend a lot of time thinking about capital, and I handle a lot of calls from VCs who would like to invest in FreshBooks. Bottom line: take my advice as you will.