SAN FRANCISCO (Reuters) - Claude Burns, who just earned a degree from MIT's Sloan School of Management, hatched what he thought was a great startup idea: a subscription business peddling craft beers. But how to come up with the half-a-million to fund it? He figured he'd target the usual suspects: family, friends, angel investors, maybe even a local bank.
What he didn't expect was that one of his classmates would step up. Victoria Gutierrez liked the idea so much that right before graduation, she promised to invest $25,000 in Nobel Brewer.
“Not only did I think it should work, but I’d always wondered why it didn’t exist,” said Gutierrez, who before MIT had helped run a boutique Napa winery.
Welcome to "the classmate round."
There is no national data. But entrepreneurs and professors from Harvard to Stanford to the University of Pennsylvania report that the classmate round is gaining traction. For example: At MIT, where 30 graduating MBA students reported starting companies this year, five told Reuters they lined up funding from fellow students. A few years ago, such cases would have been one-offs, said Professor Edward Roberts.
Stanford Graduate School of Business lecturer Jim Ellis attributed the increase to “a confluence of things.” For one, he said, more students are starting companies while in school or upon graduation. In addition, more people are comfortable with investing at a company’s earliest stages.
As in the case of MIT's Burns and Gutierrez, students also have an opportunity to become familiar with business ideas that have been refined in classes. “You really get to see if there’s potential (and) the warts," said Patrick FitzGerald, a lecturer at the University of Pennsylvania’s Wharton School.
But where do the students get the cash?
Some have family money or entered graduate school after, say, lucrative consulting jobs. Some even go to graduate school to find a potentially hot start-up.
“One of my goals coming into Stanford was to find a classmate founding a business,” said Steven Looke, a former Lehman Brothers analyst and Madison Dearborn associate.
Locke caught the online-retail bug during an e-commerce course. Then he found his start-up at a student dinner where classmate Ilana Stern discussed her idea for a bridesmaid-dress start-up, Weddington Way. But Locke, still an analyst at heart, wasn't about to hand over $10,000 until she ran through the details.
“I hope we’re not getting into Webvan territory here,” he recalled saying, referring to a legendary failure of the dot-com bubble. But she "had the numbers, the customer acquisition cost, why this was scalable,” Locke said. He gave her the money on graduation day in 2010. Stern has gone on to raise around $11.5 million in capital, including $750,000 from classmates.
Terms of these student deals vary. Most invest using convertible notes, meaning they sign agreements to invest a set amount. But precise valuation terms aren't typically set until the company wins its first institutional funding round.
Some student investors hope such investments can lead to success as venture capitalists. Will Galvin, who graduated from Stanford's MBA program in June, has already sunk funds into three Stanford companies with his nascent fund, Three Fish Capital.
There are a few downsides of course. Start-ups have a notorious failure rate. And friendships are sometimes at risk.
Stern felt wary when then boyfriend, Jeff Enquist, asked in on Weddington Way. “I just figured, that was one relationship that shouldn’t mix,” she said.
She's now married to Enquist, so he's got a piece of the business by default thanks to California's community-property laws. “He’s married to me,” Stern added. “Technically, he’s invested.”
Reporting by Sarah McBride. Editing by Hank Gilman