Many young companies with innovative ideas face a fundamental financing question. Should they bootstrap their business or take on equity investment? Bootstrapping vs. venture capital is a critical question to resolve for several reasons:
- Equity investment is usually the “most expensive” source of financing for your business if it ends up being as wildly successful as you hope (see “Debt vs Equity Risks and Rewards“).
- There are other strings attached – like sharing your important decisions with investors, and needing to provide investors a return by selling your company – that aren’t associated with other types of financing.
- Raising equity is difficult, time consuming and far from certain.
- It’s not at all clear that bringing in venture capital increases your chances of success.
- Even if venture capital might make sense and be accessible some day, you can dramatically increase your negotiating leverage with investors by successfully bootstrapping your company in the early years.
So even if you are in a technology business it’s worth going through the exercise of asking some important questions about whether or not you should pursue equity investors now or (continue to) bootstrap your company. It’s helpful to think of these questions in three categories:
- How much access to other cash do you have?
- Does your particular product, business or market push you towards needing equity?
- Is your business a fit for angel investors or venture capital firms?
Access To “Other” Cash
1. How much of your own capital do you have?
If you have accumulated savings from previous jobs, investments, or inheritance, or you have a very healthy equity cushion in your house, it could well be that you can fund all of your startup business needs with your own financial resources. I used my own capital when I started my a cappella music business. It allowed me to run my own show. Plus, the business wasn’t a fit for venture capital (see below).
2. How likely is it you can raise funds from friends and family?
3. Can your product support a Kickstarter style campaign?
Consumer product companies now have an opportunity to raise funding from future customers with the help of Kickstarter and other rewards based crowdfunding options. If you are developing a game, producing a movie, or creating an electronic consumer gadget it’s more likely you will see financing success early on from Kickstarter than from venture capitalists. And if your Kickstarter campaign really goes huge, you can expect VCs to start calling you!
4. Will customers pay you well in advance of you delivering your product or service?
Kickstarter style crowdfunding is an extreme case of customers paying you before you deliver what you promised. There are plenty of other businesses in which customers typically fork up the cash in advance of a company expending cash to deliver the product or service. A few examples include:
- Sports contests, including expensive extreme sports, require advance registration often months ahead of time.
- Dell Computer famously required upfront online payment for its custom-built computers, which then allowed the company to use that cash to purchase the necessary components and labor to build the computers.
- Fruit of the month clubs often get some upfront payment, and can then collect customer cash via credit card charges before paying suppliers for the regularly scheduled deliveries.
5. Does your technology, product or business qualify for a grant?
Business grants are certainly not available to all types of businesses. But some government and private grant providers target business grants to meet their missions. You should check to see if:
- Your technology can help a federal agency
- Your business is or could be located in a place where local, state or federal agencies want more businesses like yours to be
- You or your co-founders are in a population that grantors want to help, such as disadvantaged minorities, young entrepreneurs, female STEM business founders, veterans, or particular school students or graduates.
Increasingly grants are available through business plan competitions. Not only can winning a competition lead to cash, you can learn a lot from the process, and become visible to potential future funders.
6. Do you know when your business might be bankable, or if your planned growth will make you unbankable?
Sometimes young businesses assume they won’t qualify for bank credit for years, if ever. The answer you get from your local community bank may surprise you. Every banker I’ve met likes to encourage young companies to at least come in for an introductory meeting. It’s worth an hour of your time to see if one of the many types of loans, lines of credit or other financing options has a chance to be part of your company’s not-too-distant future.
On the other hand, if your business plan projects very rapid growth that in turn requires lots of cash for working capital, marketing or customer support scaling, you won’t be able to pay back a conventional bank loan every month. There may be specialized debt that can help – revenue based loans and Small Business Investment Companies – but sometimes the cash needed for rapid growth is simply not a fit for debt financing.
7. Are you pricing your products appropriately so that they generate profit and cash?
Product pricing challenges many businesses, and not just young firms! If you are in business and trying to grow, start by taking a look at your pricing and competitive positioning. Do your prices reflect the value delivered to customers? Or are they some multiple of cost? If it’s the latter, you may be “leaving money on the table.” And that money could be used to fund your growth.
Product, Business and Market Considerations
Sometimes your choice of business or product, or the dynamics of the market that you are targeting, will have an enormous impact on whether or not you need to pursue equity investors.
8. Do you think it will take more than $100,000 and/or longer than one year to develop your product or service to the point that it is generating revenue?
There are many businesses that don’t take an enormous amount of cash to get started because of the nature of the products or services. Examples include selling other people’s products (such as Scentsy or other multi-level marketing products), landscaping services, and making jewelry.
The good news about these “low barrier to entry” markets is that you can get up and running without risking lots of capital or relying on investors’ money. The bad news is that lots of other people can, and do, get into these businesses.
On the other hand, if you are designing medical devices that require tens of millions of dollars and many years to get through approval by the FDA (Food and Drug Administration), it’s almost certain you will need equity investors to help get you through what is unfondly referred to as The Valley Of Death.
9. Does your business have “network effects,” where only one or two companies will end up with 80% to 90% of the market?
Facebook, LinkedIn, Google search, Microsoft, and some other technology businesses are the surviving winners of a “land grab.” Customers, technology partners, and ultimately investors like to focus on a small number of platforms because that’s where everyone else is that they want to connect with. City newspapers and national television networks used to be that way.
If your industry has strong network effects – customers strongly prefer a dominant player – it’s likely you will need to raise equity investment. The marketing battle will be brutal and expensive. You can’t win without a big war chest.
There are plenty of other industries where small individual companies are treasured. Craft brewing, high end restaurants, marketing agencies, and real estate firms are but a few examples of industries in which there is no pressing need to raise millions in equity for a big marketing battle for dominance.
10. Do you have large capital equipment or other fixed investment needs that aren’t debt financeable?
Software companies no longer require huge investments in computers to get started. On the other hand, plenty of young manufacturing firms face the financing challenge of buying the equipment needed to produce their innovations. Or, they may need to start with a large production facility in order to achieve the low cost of goods necessary to be competitive.
Sometimes these investments can be funded using long term debt or equipment leasing. But, securing such debt is difficult to impossible for very young companies. The only remaining option is often equity.
11. Do you need access to absolutely top tier talent and corporate relationships to realize your vision?
Innovative new businesses often depend on creative employees to build and sustain competitive advantage. In some sectors, that top talent is extremely expensive because it is rare. A good case in point today is tech talent with experience in data science or machine learning.
Some of the top people have built relationships with larger corporations during their careers. In some business models, key corporate relationships are essential to success long term.
When people are expensive, essential to success and not immediately revenue generating, equity investment may be necessary. Artificial intelligence companies, not law firms, often raise venture capital.
12. What does the cash flow cycle look like in terms of payables, inventory and receivables?
In some industries a young firm can not exert any control over what large suppliers or large customers demand for payment terms. The first option for such working capital needs is usually debt from banks or alternative finance companies. But sometimes the existing choices are slim and grim. Equity may be necessary in some such cases.
13. Do you have potential customers that will see your small size as a risk, e.g., a potential “career limiting decision?”
Large corporate customers are often risk averse. If you serve such customers, you know that it’s a struggle to convince them that they should trust you with their business. Sometimes, raising equity can help significantly in convincing such prospective customers to finally buy. This can become especially important if you have an innovation that you want to scale to the point that the “early majority” will be customers (see the graphic below if you aren’t familiar with the term “early majority”).
Are You A Fit for Angels or VCs?
14. Will your business support growing sales by 50% to 100% annually for five to seven years? Will annual sales reach $15M to $50M in that timeframe?
Equity investors are looking for companies that can earn them extraordinary returns on their investment. To support those returns, the companies need to grow rapidly over a long period of time. And, they need to achieve a critical mass in terms of total revenue. Both are needed in order to attract a corporate acquirer, which is the typical way equity investors achieve their returns.
Very few businesses achieve this kind of sustained growth. And many never even have the potential. You need to be able to convince yourself, and potential investors, that your company can grow fast and get “big enough” in order to be a fit for angels and VCs.
“Big enough” for venture capitalists is much bigger than what angels need, since VCs typically have 10 times or more the amount of money to invest than angel investors. Many VCs need a company to be worth at least $1 billion in order to make their $20 million investment valuable, while angels can be happy with smaller exits if your business can go a long way on their $50,000 investment.
15. Are you comfortable selling your business in order to provide investors their return in five to seven years (or maybe earlier for VCs)?
Speaking of exits, this is the big “fork in the road” with equity investment. They usually want a return in five to seven years. If that is incompatible with your personal vision of the future, then equity investment may not be a fit.
16. Are you comfortable sharing control of and decision-making for your company with investors?
One of the many reasons entrepreneurs start their own companies is that they like to run the show. Some might be “control freaks,” but many others have been burned by the bad decision making of previous bosses, company owners, and industry leaders.
This is another “fork in the road” with equity investment. You are no longer the sole decision maker. Although, arguably, if you are hiring great employees and giving them room to grow they will be making some decisions on their own, and many of your decisions will be in collaboration with them.
Some entrepreneurs excel at surrounding themselves with great investors and advisors, and synthesizing their input, even around tough decisions. But that’s not the path for everyone.
17. Is your team, plan and pitch in the top 10% of companies seeking financing in your region?
Few companies that seek equity investment are successful. We haven’t seen any reliable statistics, but it’s likely that somewhere between 1% and 10% of companies seriously pursuing equity are ultimately successful within 12 months of the process beginning.
You need a highly competitive team, and plan, and pitch in order to have a reasonable chance. Do you know where you stand competitively? If you aren’t willing to put in the time and effort to be one of the best, equity is not a fit.
18. Do you have traction?
Equity investors look for traction – increasing momentum with revenue, customers, channels, product, talent, and advisors. Different investors will measure traction differently but ultimately they are looking for Big Momentum.
If you are “just” making steady progress, we think that’s awesome! But that may not – yet – be enough to tip investors towards choosing your company from among hundreds of others competing with you to attract their cash.
19. Are you ready for the equity investment process?
Equity fundraising is long, grueling, and foreign territory for most entrepreneurs. Depending on your location it can take 6 to 12 months from initial introduction to money in the bank. Lots of investors will tell you “no” and many might just say nothing at all. And, the process of due diligence and term sheet negotiation is quite different from any other type of financing.
Until you are fully prepared, plan on bootstrapping. And even while you are equity fundraising, plan on bootstrapping! In general bootstrapping is Plan A until you know for absolutely sure you have other, better options.
We hope this list has been helpful for you. Please let us know if we missed a question!