How you finance your company is one of the most critical decisions you will make in the course of your venture. The structure of your financing will be a key driver of your financial return.
There are financing structures for companies with small potential and structures for companies with big potential. There is not a one size fits all strategy for capitalizing a company. Ultimately, financing a startup properly boils down to aligning the financing structure with the business opportunity and capital needs. In other words, the way you elect to finance your company should, at a high level, be determined by 1) how big of a business opportunity it presents and 2) how much capital is required to break even. There are a number of other considerations, but I would argue that these are the first two dimensions to consider and will help entrepreneurs more quickly find the right direction for their financial strategy.
The chart below should help to illustrate how to think about the fundraising category that one is in.
If your business requires significant capital, but is not poised to become a large business, you might not be able to find a viable funding source. You will either need to find alternative sources of capital or trick savvy investors into believing your company has bigger prospects. If your company falls into this category, you should probably go back to the drawing board and find another opportunity to pursue.
If you have the potential to build a small business — one that generates single-digit or low double-digit millions in revenue — while requiring little capital to achieve breakeven, you have a lifestyle business. In my opinion, lifestyles businesses are best financed when the founders take as little outside capital as possible. These are companies where it’s really only exciting for founders if they own a large percentage of the equity. Additionally, by raising less capital, entrepreneurs will be able to avoid accruing a large amount of liquidity preference. If there is a significant amount of liquidity preference in the company, it may be difficult for the entrepreneurs to realize a meaningful payout when they sell the company.
If you have a big idea that can generate at least $50 million in revenue and the business requires millions of dollars to get the company to a cash flow positive position, you should pursue venture capital.
Depends On Barriers
If your company has the potential to become a big business and requires little capital to get there, the decision between bootstrapping the company and raising venture capital generally boils down to your expected barriers. If there is little risk of a competitor beating you to scale and taking the opportunity, because you have a unique approach, protected IP or otherwise, you may want to bootstrap the company in order to maximize your ownership of the company. If your barriers are limited, however, and additional capital can help you capture market share more quickly, securing the opportunity, then consider venture capital.
I frequently meet entrepreneurs who should be bootstrapping but are seeking venture capital or entrepreneurs who should be seeking venture capital when they are bootstrapping. The former could limit their returns by loading too much liquidity preference into the business; the latter are often building the business too slowly to capture the opportunity properly. Picking the right fundraising strategy is equally an indicator of the founder’s payout as selecting the right business strategy. Take the time to understand what type of company you are building and finance it properly.