A decision that all entrepreneurs face is whether to fundraise or bootstrap their business. It’s a critical decision that can arise in all stages of a company’s growth. It’s influenced by many factors including the industry, founders’ vision, personal savings and type of lifestyle the founders intend to live while running the business. We’ll break down the main pros and cons to this complicated decision.
Fundraise from Investors?
Fundraising is raising funds from outside investors in exchange for equity in a business. Common sources of capital tapped during fundraising include venture capital, angel, or seed funding. Certain industries are more predisposed to need to fundraise than others. For instance, companies in the biotech and pharmaceutical space need to raise significant amounts of outside investment due to high costs associated with the R&D and government approval process. According to the National Venture Capital Association (NVCA) and PWC, the average amount invested per biotech deal was $15 million compared to $6 million per software deal in 2015.
However, despite the media attention, the vast majority of U.S. businesses don’t fundraise from professional investors, instead relying on savings, family and friends and debt financing. Fundraising reduces your ownership stake, as your company creates new shares to sell to investors. The investors shares will also usually have preference so that their money is more protected. They get their money out first in the event of a liquidation or sale. However, companies that can fundraise well will have an advantage in capital intensive industries where the first to reach scale achieves network effects and competitive advantages (e.g. Uber and ridesharing).
Bootstrapping is using mostly the founders’ own money to launch a business, then growing it using its own profits. Along the way it may receive informal investments from friends and family as well as debt from lenders. Bootstrapping uses limited capital to start a self-sustaining business without significant outside equity. Running a business in this manner requires more financial discipline but maintains full control for the founders. Most traditional small businesses are bootstrapped, including staffing companies, advertising agencies, distributors, contractors, services businesses, etc.
Without the support of fundraising dollars, startups rely on alternative forms of financing to augment their cash flow. One commonly used method is relying on trade credit, which is the payment terms your suppliers grants to you. The longer suppliers allow you to pay them back, the more cash your business has to cover other expenses. With many startups, particularly in the retail industry, trade credit is an essential tool for growth as the terms to pay back suppliers or manufacturers is extended for 30, 60, or even 90 days. This frees up cash to pay employee salaries, rent and take on additional orders. Unfortunately, for many businesses starting out, suppliers will demand net 30 or even collect on delivery (COD) terms, because they’ve been burned in the past by new businesses without a track record. It’s up to your company to prove them wrong!
Various types of loans are also available to bootstrapped startups over time. Bank loans are usually only available to startups with at least 2 years of operating history and profitability. Merchant cash advances are a quicker option, particularly for B2C companies, but they are incredibly expensive, with effective APR’s stretching well past 70%, and reaching 100%+ in some cases!
Invoice factoring can be a useful alternative for B2B companies (both bootstrapped or funded)
Invoice factoring converts accounts receivable into immediate cash. This changes the financial dynamic in industries where there’s a mismatch between customer payments and supplier payment demands (e.g. industries such as advertising, hardware, distribution, government services, tech, staffing, etc). It’s a fast, tidy solution for companies that need money now and aren’t quite bank eligible yet.
In addition, invoice factoring is not debt, and as such, has no limitations on the use of funds. Because the invoices are purchased outright, the ultimate entity owing money is your customer on invoices you’ve already sent to them. Your business is left with a clean balance sheet and cash on hand to fund growth.
There are many decision points to weigh when making this important decision for your company. We’ve outlined some of the key pros and cons of both below…
The Game of Life: Startup Edition Source: FundersandFounders.com
- Product or service that can be sold profitably. This may sound like a no-brainer, but some venture-backed startups are losing money on a GROSS PROFIT BASIS (*on demand food delivery*) in the name of growth… which means every time an order is made, they’re losing money before factoring in operating expenses! Unlike funded companies, bootstrapped ones have to generate money from the start in order to stay alive. There needs to be near immediate product-market fit or there won’t be a business for very long
- Maintain control. No investors forcing the business in a direction the owners don’t want it to go
- Growth at a reasonable pace. Business will grow based on the market and execution. There will not be a race to scale too quickly that has come back to bite many venture-backed companies (e.g. Zenefits, Lending Club)
- Focus on execution. Fundraising is tremendously distracting. It can take up to a year to raise money from professional investors and the process starts over again every 18 months or so. Founders can focus completely on running their business instead of preparing for meetings with investors
- Financial discipline is always required. All spending decisions must be carefully assessed. There needs to be a purpose for every expense. Does the spend generate a positive ROI in some way, short term or long term? For example, an executive assistant may seem like a luxury but the time they free up for an executive to focus on more valuable tasks may be worth many multiples of his / her compensation
- Aggressive goals. Armed with fundraising rocket fuel, entrepreneurs can really point their company at the Moon. Near term profitability can be sacrificed (with investor buy in) for the sake of disruption, fast growth and market domination
- More advanced initial products. Multiple features can be built early on with outside funding. Life sciences companies often need significant fundraising just to reach a testable prototype
- Bigger budgets = faster growth. More resources compared to bootstrapped businesses. This allows your company to sink money into marketing and sales and acquire customers rapidly. However, this can be terrifyingly expensive at first with Long Term Value / Customer Acquisition Cost ratio dipping near or below 1.0x when starting out, meaning it costs more to acquire a customer than they will be worth over their lifetime…
- Expanded network and expertise. Investors provide helpful advice (if they have industry operating experience), support and connections (with suppliers, talented employees, customers and the next round of investors)
- Venture-backed startups have the funding and cache to hire the best engineers and researchers, especially early on
- Great marketing and PR. Immediate credibility as a “VC-backed” company, particularly if top tier VCs are involved. All the tech news publishers will give you the time of day now. Helps with selling to corporate customers that question startup’s short history and with hiring employees
- Capital constraints limit growth. Profits must be reinvested to fund growth. These are often thin at the early stages of a business. There can be limitations on growth based on available cash flow
- All spend must be carefully assessed. This is not necessarily a bad thing, but if positive ROI projects must be turned down due to lack of funds, then capital constraints are a limiting factor to a company’s growth
- Missing out on branding / halo effect. Outside investors, in particular venture capital, creates a positive branding effect for young companies. VCs are masters at marketing and PR – just take a read through TechCrunch and you’ll see an industry that doesn’t hesitate to sing its own praises. There is value in that for young companies looking to build awareness and brand. Also, it will be tougher to gain credibility early on, unless the founders have an established network or reputation within an industry
- Lack of network and guidance. Certain investors who are former entrepreneurs are truly impressive individuals with tremendous operational track records and deep rolodexes. Taking money from them can mean access to these resources
- Certain companies won’t work without funding. Some companies simply cannot be bootstrapped due to the capital intensive nature of the business model and industry
- Dilution of ownership and economics. Startups that require significant fundraising to achieve scale, will have founders owning only a small portion of the business. Aaron Levie, founder of Box, owned 5.7% of the company at IPO. His VC investors made way more money than he did on the IPO.
- Less control. Do directors elected by investors control a company’s board? If so the founder could be fired from their own company. It happens more often than you think, though it’s often not publicized or covered up as a resignation. Make sure your vision for the business aligns with your investors
- Less flexibility. Ability to change directions is more difficult as investors’ interests must always be accounted for. They’re not interested in moving to a smaller market or a slower growth business model. Entrepreneurs may be okay with a 5x outcome (which is great by normal standards), but investors may want to shoot for a 20x outcome. Under constant pressure from investors to run the company for a large exit, founders are forced to take moonshots
- Fundraising is a full time job. Fundraising ties up tremendous amounts of founder time and resources and can take up to a year. If not careful, the fundraising process can quickly impact the actual running of the business and burn out key individuals
- Race against the clock. Once money is raised, it is a race against the clock to hit milestones that will allow the company to raise the next round. Starting a business in any manner is incredibly hard, but the deadlines of a venture backed start up are a pressure cooker
- Need for an exit. Professional investors, in particular VC and growth equity funds, have a ticking clock that starts when they invest in a business. They need an exit, usually within 5 years, to produce desired returns for their limited partners. Does this timeline fit with your company’s growth trajectory? Or will you be forced into a premature exit? Certain sectors, such as equipment, have long development and sales cycles. The exit timing is often out of sync with the realities of the business, which can result in a fire sale. In this situation, the founders and employees are the ultimate losers as investors get paid out first…