“Bootstrapping vs Raising Capital” are the binary terms that many people view the continuum of fundraising options. In my many years of experience, this is a gross misunderstanding of what lies ahead for new founders. Money doesn’t usually fall from the pockets of the well informed investor like rain in a storm. A more likely title should be “you are going to be bootstrapping because most people won’t give you a lot of money for a long time.”. Not quite as appealing of a title? Ok, sarcasm aside here are some practical things to consider when deciding if you want to raise capital and what kind of capital.
What is capital?
Broadly speaking, when we talk about “capital” in this book, we are referring to money that you can potentially access in order to help grow your business.
One very common misconception when first time founders think about capital is that they only think about venture capital.
Venture capital is only applicable to a very small subset of businesses that have the right, high growth profile where the risk-reward profile makes sense for that type of investor. More on that later in the chapter.
There are many other types of capital available to founders and new business owners. Loans, crowdfunding, other types of equity investments (maybe with a profit share, etc).
It’s important to understand all of the different types of capital out there and identify those that might make sense for your business. This leads us to the next question.
Why do I need capital?
Some first time founders think that raising money is just part of the process of building a new company. An end in itself. That’s not true. You should have a very clear reason why you need capital to grow your business. If you are profitable and can grow without external capital, that may be something you want to consider. Unfortunately, much of the time that early stage founders want capital is because their business intrinsically doesn’t work and it needs to be subsidized. That is not a good reason to want money. You should consider this question explicitly.
One tip to help think about this would be to make a financial model of your business. Even though they tend to be very wrong at this stage, that doesn’t mean they aren’t helpful tools for analysis or thinking through different scenarios. It will also make you more prepared to talk in concrete terms with an investor.
What kind of business do I have and what are my ambitions? If you have decided you need capital…
This question will help you determine the types of capital that are viable for your business (if at all). For example, if you open a coffee shop and your goal is to become profitable and then operate your coffee shop for years, you won’t want to or won’t be able to get venture capital (whichever of the two happens first). But you might want a small business loan to buy more inventory or hire more employees to stay open longer each day, etc. However, if you launch a company to bring satellite internet to Africa, you’ll probably need and be able to access venture capital (if you have any business traction at all) because of the market size and possible outcomes of your business.
There are no “official rules” for any of this. For example, Blue Bottle coffee started out as an individual coffee shop but decided its ambition was to become a large brand and scale rapidly. So its business profile changed from one of being more well suited for a small business loan to one that might be appealing to a venture investor.
If you take anything away from this section, it should be that you need to consider what types of capital make sense for your business because of its profile.
Do I have traction?
Traction can mean a few different things depending on the industry you are operating in. In a small business it might mean that you have enough revenue to underwrite a loan; in a venture business, it could be that you have enough growth and user engagement to justify an investment.
This is probably the holy grail in terms of figuring out whether your business will be appealing to capital sources or not. There are certainly other factors at play depending on the type of capital you are seeking like “market size” and your personal relationships, but anyone savvy will immediately jump to questions about traction.
As a rule of thumb, if you don’t have any traction and you are as first time founder you can ignore the title of the chapter. There are basically 3 scenarios:
- “FFF”– You have rich family, friends or know fools who are going to give you money.
- You are going to be bootstrapping until you have traction.
- You have done something almost exactly the same thing before in a larger company and are considered an expert. In this case, you may be investable without explicit traction.
Are you willing to give up some decision making authority and are you willing to sell your business eventually?
There isn’t too much that needs to be said about this question. In a sense it’s self explanatory. But a few points to help you think about it. The amount of decision making authority you’ll need to give up to secure investment is generally inversely proportional to how much leverage you have- if you have a lot of traction in a big market, you’ll probably have the upper hand. If not, you’ll probably be giving up a lot of control if anyone will invest in you at all. These specifics regarding decision making control, board seats etc, vary from fund to fund and also often change based on the stage of the investment.
Also, if you aren’t willing to sell your business, you aren’t getting venture capital. The reasoning is simple. If you aren’t willing to sell your business, the investor would essential be counting on you to give them some enormous dividend of profits large enough to far exceed the reward profile of a later stage investment or the public markets (to compensate for the increased risk). That is just not going to happen 99.9% of the time. Your odds of failure are extremely high and to compensate for having a high likelihood of losing all your investor’s money, there needs to be a possibility of a very large return. Generally speaking, a liquidity event is the primary way to achieve this from an early stage company.
So you still want to raise venture capital. How will an investor vet and value your startup?
There are many different approaches taken to both vetting and valuing a startup company.
Typically, an investor (or investment firm) will have some thesis or lens through which they view the world of investments available to them.
This is often a function of their own experience in certain industries, people they have worked with before, past investment data, etc.
A few examples might be:
- “We invest in B2B companies in XYZ industries with a revenue run rate over $ABC”
- “We only invest in consumer software and place a high emphasis on customer validation”
- “We are most focused on the founding team and look for a total addressable market over $ABC”
- “We are social impact investors and care about social good”
Each investor may have their own answer to the question above and usually they are happy to share this information. There are definitely people who invest more opportunistically and don’t stick as dogmatically to such specific criteria.
The second piece of the puzzle which works in conjunction with the criteria listed above is the risk-reward profile the investor is interested in. This can vary greatly from angel investors to VCs at different stages of the company life cycle.
Many early-stage investors are most interested in “home runs” (ie a Facebook, Uber, Snapchat, Dropbox, etc) and are willing to place bets that are to some degree binary.
These companies need to have the potential to grow VERY fast and have access to a large addressable market. To quantify this, they are not looking for companies that are likely to give them a 5x return (over a few years), but more interested in ones that provide a 100x+ return even if that means a greater risk of company failure.
Of course, this is not universally true.
There are other investors who are more interested in higher probability “doubles” or “triples” and may not be willing to take huge risks on consumer applications that are much less predictable than the types of companies they invest in. They may be more focused on current revenues or sales process, etc.
I would say there are two universal areas of interest for most investors:
- The Team. If they don’t trust the people, it ain’t happening.
- The Customer. If they can’t see very clear value to a customer, then it’s unlikely the company will receive investment. Some investors even insist on interviewing a large set of customers as part of their diligence process (which makes a lot of sense to me).
The nuts and bolts of “vetting a company” once investor interest has been expressed would mostly be verifying that all the information that has been shared is true (financial, user analytics, etc) and that the technology is real.
NOTE: This answer is very generalized and the investment parameters can vary greatly from investor to investors, so my best advice is to ask them directly.
This is definitely more art than science. There are a few key considerations, but beyond that, it’s very hard to place a value on something that is more “potential” than “realization” (if we are talking early stage companies).
The main considerations tend to be:
- Market comps — In cities with a lot of ventures investing, there tend to be widely accepted ranges. This simplifies the process because it brings some level of uniformity to a highly uncertain question and narrows the discussion.
- Investment vehicle — It’s very common for early-stage investors to use a SAFE or convertible note because that allows them to punt the valuation question down the road to some degree (rather than a priced equity round where a valuation is explicitly stated).
- Competition for access — If a company has a lot of prospective investors who are interested, not all of them will get to participate. This will cause the investors who most badly want to be included to improve their terms.
- Investor goals — If an investor is looking for companies that can one day be worth a billion dollars, they may not be as concerned about whether the valuation at a very early stage is 3MM or 5MM. They will be more concerned about keeping the founders motivated. If its a different type of investor with different goals, they may be more sticklers on the valuation.
- Founder motivation — I mentioned this before, but I’ll say it again because it’s important. If you are investing in a business, you need the people in charge of it to be motivated. If an investor cranks the valuation down too much (and still manages to get a deal), there is a very real concern that the founders will be much more comfortable walking away if things get tough.
More explicitly, from founders I have spoken to the early stage SAFE/convertible note cap range tend to be in the neighborhood of $2MM-8MM.
Even though there aren’t really great methods for determining these numbers, you should still be prepared to defend whatever you decide.
The most common methods I have seen are:
- Accept what is the market in your area (as noted above).
- Use an expected value approach; to do this you would probably make a financial model going a few years out and then assign odds of reaching various performance levels in your model. Do research and make assumptions on how companies in your space are valued (ie what business metric drives their value) and then calculate a valuation for your company at each performance level in your model. Multiply each valuation by your estimated odds of reaching that level. Sum the results, and you have an expected value approximation that is at least somewhat rooted in logic (hopefully).
- Start out at $6–8MM and then adjust based on how aggressively you are rejected (this is a pretty half-assed way to do it, but we live in a crazy world).