The decision regarding how to finance a startup or otherwise fast-growing firm is a critical one. Of course, there are many sources of capital available in the market for different upstarts—some more well-known than others. Of these, venture capital tends to get most of the attention in both popular and academic settings; however, it is available to only the small number of firms that have a business model appropriate for it. In this post, I explore an alternative, bootstrap capital, which includes options ranging from personal funds to customer prepayments, vendor financing, and deferred employee compensation. Bootstrapping is not for all firms and/or growth strategies; however, it does fit the needs of many—especially those interested in maintaining ownership and control over their ventures.
A Few Preliminary Questions
Before pursuing capital from any source, dilutive or otherwise, several questions are in order:
- How much financing is required?
- Can I self-finance?
- Is raising more money better than raising less?
- Does starting a business with limited resources necessitate different growth strategies relative to well-capitalized ventures?
- Should I raise equity or debt?
How much financing is required?
The answer to this question is largely dependent on the scope of the proposed venture and the abilities of the founder(s). Consider, for instance, two particularly talented developers who collectively have the skills necessary to build an MVP. If they are able to code away during odd hours while holding down full-time jobs somewhere else, the financing needed to get to market might very well be negligible. A non-technical founder, however, with the same exact plan is in a different situation (unless he or she secures a technical co-founder or two) as money will likely be required to get to an MVP. Beyond first getting to market, funding requirements are largely dependent on the cost of pursuing targeted levels of growth—costs which are, of course, very difficult to estimate, but which can be fleshed out to a degree through robust planning. The literature is rife with examples of practitioner fallibility when it comes to making projections; however, this failure should not keep us from engaging in the process—it should simply be seen as a reason to take pause, temper our enthusiasm, and establish more conservative estimates.
Can I self-finance?
External capital comes with drawbacks—chief among them, in my opinion, being the additional opinions that come along with it. Many successful businesses are established without outside money—though they are usually dependent on the human capital of the founder(s). An IT engineer, for instance, can rather easily start a break-fix or managed services firm with little to no outside capital—especially, if he or she already has a foundational customer or two. In a similar vein, it takes little for a digital marketer to hang out an agency shingle and be in business. In such cases, external capital might help the firms to scale more rapidly; however, the additional overhead (and mouths to feed) will often reduce or destroy profitability and returns on investment and energy.
Is raising more money better than raising less?
Additional capital gives a firm more runway and flexibility; however, it often comes at the cost of both reduced upside, thrift, and urgency. When a firm raises money in its early days, it generally has no leverage in the bargaining process; therefore, it must give up an awful lot in exchange for very little. Under such circumstances, raising excess funds seems foolish—especially if subsequent funding rounds will be needed down the road. Of further concern is the reduction in thrift and urgency that so commonly follows capital raises. Thrift and urgency often beget organizational and financial success, but in the presence of excess, often fall victim to waste and lethargy. Though there are exceptions, less is generally more when it comes to capital.
Does starting a business with limited resources necessitate different growth strategies relative to well-capitalized ventures?
Growth is expensive: the faster a business attempts to grow, the more it usually is required to spend. Case studies abound of growing firms collapsing under their very own success in the early-stages as they overextend financially and/or operationally. With institutional support, growth plans can be more ambitious; without it, they need to be more restrained. I return to this point in the third section of the post.
Debt or Equity?
If outside money is required, the question becomes: debt or equity? For some entrepreneurs, debt is a non-starter. Given the ubiquity of the personal guarantee, this is somewhat understandable—especially if material sums of money are required. That said, non-convertible debt allows founders to maintain maximum upside exposure. Further, as a tool of corporate governance, debt drives urgency and focus—elements that are associated with success. On the flip side, equity is safer, but comes at the cost of reduced upside and control. In the end, the debt or equity decision depends on two things: personal preference and capital availability.
Bootstrap Sources of Capital
Bootstrapping, or bootstrap finance, is a term commonly referred to in entrepreneurial circles to describe a firm which avoids taking on external capital. Sources of bootstrap finance are numerous and include: personal funds from savings and loans; customer prepayments; vendor financing; and deferred employee compensation.
Personal Funds from Savings and Loans
It can be scary to invest personal funds in an entrepreneurial venture; however, if available, personal resources should be used: they are quick and easy to access and their deployment signals confidence in and commitment to the entrepreneurial effort. Different sources include:
- Cash on hand in checking and savings accounts
- Loans backed by automobiles, real estate, securities accounts, or other assets
- Personal credit cards
- Loans from friends and family
Whenever money is being borrowed, the risk naturally magnifies as the funds have to eventually be returned, regardless of the firm’s success or failure. If the lender is a family member or close friend, this creates an additional type of risk—with the potential for severe emotional consequences if things go wrong. Risk aside, personal funds are easier and quicker to obtain, cheaper, and generally a pre-requisite to significant external participation.
Customer prepayments are a very effective way to generate the positive cash flow needed to establish and maintain a business. In the IT service space, for instance, it is standard to charge a customer between 50-100% upfront for equipment purchased as part of an installation project (only the labor is billed with terms). Taking it a step further, resource-rich customers (who tend to be large) have been known to fund the development of partners (and their respective offerings) that they deem to be strategically valuable through non-dilutive prepayments. True dropshipping strategies yield similar benefits as customer orders generally yield cash within 1-2 days which can, in turn, be utilized to acquire the pre-sold inventory.
Vendor Financing (Extended Terms)
Establishing extended terms with vendors yields the same thing as customer prepayments: positive cash flow. Of course, it can be a challenge to get a vendor to take a material risk by offering terms to a startup; however, it is surprisingly common—especially when the gamble offers to open up a new and exciting market. Naturally, trust, confidence, and transparency are critical.
Deferred Employee Compensation
For many firms, employee compensation is the single largest use of cash in the early stages (and beyond). It is sometimes possible to defer some or all employee compensation—thereby mitigating or eliminating a firm’s cash burn when it can least afford it. For instance, if an employee (or partner) is financially stable, he or she might be willing to defer compensation until a later date. Further, in many instances, employees (or partners) are often able to maintain full or part-time employment elsewhere while they work on the project during off hours on a deferred compensation basis.
Managing a Bootstrapped Firm
Firms which employ bootstrap financing have to be run differently than those which have institutional support. Amar Bhide’s Harvard Business Review article, “Bootstrap Finance: The Art of Startups,” highlights several axioms of interest that are very briefly touched upon below: get operational quickly; keep growth (and costs) in check; focus on cash, not on profits, market share, or anything else; and cultivate banks before the business becomes creditworthy.
Get operational quickly
In a bootstrap setting, resources cannot be wasted in a deliberate attempt to find the perfect opportunity: the sooner that revenue is generated, the better. Successful operations create a track record for subsequent external investment and/or bank financing; build the confidence of customers, vendors, employees, and founders alike; and open up additional opportunities for new, profitable extensions of the business which in the absence of operations would have remained undiscovered.
Keep growth (and costs) in check
For most entrepreneurs, growth is a primary focus (and likely an obsession); however, growth comes at a substantial cost which cannot always be afforded. When bootstrapping, growth needs to be kept in check to maintain cash and stability. Absent adequate resources, firms need to keep overhead in check, delay unnecessary expenditures (even if the additional assets would be very valuable in the long-run), and pass up on profitable opportunities that will materially reduce working capital.
Focus on cash, not on profits, market share, or anything else
Interestingly enough, profits are not always friendly to firms—at least, not in the short-run. Profitable work which absorbs working capital for weeks or months beyond what can be afforded could easily put a resource-constrained firm out of business. The same is true of market share which almost always costs money to capture. With bootstrap finance, maintaining cash is the core concern. Everything else is secondary until stability and mature financing are realized.
Cultivate banks before the business becomes creditworthy
Bankers and entrepreneurs tend to be radically different types of people; however, sooner or later, a traditional banking relationship is going to be a necessary step in the evolution of an entrepreneurial venture. Getting a bank comfortable enough to lend money takes time and patience. Getting to know your bank and exploring others is a time-consuming process and should be started as soon as possible.
Bootstrapping is a viable method of financing for a large number of startup and fast-growing firms; however, it does set limitations which need to be carefully heeded.