Chapter 2
Bootstrapping and Self-Funding
Note: This article was originally written and published for DailyDAC as the second installment in a series of articles.
So, Brandon Smith has become his own boss. Brandon finally got enough nerve to give up his corporate job (or maybe he didn’t make his own choice as he might have been downsized from his struggling employer… doesn’t really matter!), but along with the loss of a steady income, he will now have to fund the start-up expenses for the business. Brandon came up with a great idea (at least he thinks it is!) to build an all natural coffee and yogurt chain – “Joe & Yo.” He brought together a qualified team, built out a business plan, visited and qualified suppliers, tweaked recipes, and is having advancing discussions with real estate brokers for the first store location. Brandon had been moonlighting some of the initial investigation and company formation activities while previously employed which helped, but the founding team has contributed $150K in cash, and has racked up an additional $75K in credit card debt. The business plan shows a capital need of $1.25 million for the next 12 months.
What does Brandon do now? How will he fund the business? As an entrepreneur(s) will very quickly find, no one is quite as enamored with the business idea as the founders themselves. And even if the founders find welcoming ears, a big ear does not necessarily fill up the bank account. At this early stage, the risks are high, and the founders of Joe and Yo are assessing their options:
- Self-Fund
- Family & Friends
- Angels
- Venture Capital
- Bank Financing
After several meetings with venture firms, they were politely told that the idea is interesting, but that they were too early, and that they should talk to them again after they launched the first store and when they were raising more than $3 million in capital. As we will explore in later installments, the structure of venture capital and private equity firms as well as the sources of their capital are important in understanding the investments they typically make.
Things went marginally better at the banks. Each of the banks were requesting at least two (if not three) years of income statements from operating history, which had no relevance to the start-up nature of the company. Even with personal guarantees (required from all founders), the company was only able to get approval for up to $250,000 in loans.
So, with this framework in mind, it is time to talk about bootstrapping. Bootstrapping is the act of building a business without external funding, capitalizing the company through founders & their close relations, utilizing internal cash flow, and minimizing expenses. Funding it through internal means can include: use of personal savings; taking out and using home equity loans or other personal debt obligations, proceeds from selling investment portfolio, withdrawals from retirement accounts, and even maxing out credit cards. Bootstrapping is typically done out of necessity; however, there are many reasons why CEOs of very fundable and bankable business still take this route, and we will explore some of these benefits below.
Benefits of Bootstrapping
- Delay taking equity capital until valuation of company is increased. Minimize dilution, and maximize ownership by founding team.
- Prove out the business. Operating in the “real world” reveals plan deficiencies, and the company can fix these, and make new improvements so that the business case is much stronger when approaching capital providers.
- Sets the tone for fiscal discipline, and the need for the company to achieve much with little.
- Eliminates the significant amount of time required when raising capital from outside parties. Founders can focus on building the business.
As a counter weight to the benefits of bootstrapping, there are some obvious disadvantages, with the biggest one being that the company may not have access to the sufficient amount of capital to execute the business. For businesses that require first mover advantage or rapid deployment, the slower growth trajectory may seriously jeopardize the long term potential for the company. In addition, the ability to bring on outside investors, whether it be angels or VCs, has strong potential given the rolodexes of these groups to open up business doors that might not be available to the founders themselves, as well as the providing of high quality advice.
To further explore bootstrapping methods, you could refer to the book “Angel Investing” by Mark Van Osnabrugge and Robert J. Robinson.
It is also very instructive to be able to review some commentary that Ron Conway (one of the most active angels), and Sequoia Capital (one of the largest and most highly success venture capital firm) had sent to their portfolio companies in the midst of the financial meltdown in 2008. Essentially, they called for start-ups to dramatically reduce expenses, including staff, marketing, and R&D expenses, and to essentially “do more with less.” At the same time, they painted a gloomy fund raising market, and that companies should be realistic on valuation, and raise ample capital for future needs if available. The virtues of bootstrapping can be very beneficial to a company’s future, not only during start-up, but even at a later stage, especially if on shaky ground.
Next installment: External Financing Options for Early Stage Companies
