From Venture Made Transparent: How an entrepreneur finances his or her company is one of the most critical decisions that they will make during the course of their startup. The structure of their financing will be one of the key drivers of their financial return from their venture.
There are financing structures for companies that have small potential and structures for companies that have big potential. There is not a one-size fits all strategy for capitalising 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 in which 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 breakeven. While there are a number of other considerations, but I would argue that these are the first two dimensions to consider as they should help entrepreneurs more quickly find the right direction for their financial strategy.
The 2×2 chart below should help to illustrate how to think about which fundraising category that they are in.
If you have a big idea that can generate at least $50M in revenue and the business requires millions of dollars to get the company to a cash flow positive position, you should probably pursue venture capital.
If your business requires significant capital, but is not poised to become a large business you may not be able to find a viable funding source. You will either need to find dumb money 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 business 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 realise a meaningful payout when the sell the company.
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, then you may want to bootstrap the company in order to maximise 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 you should consider venture capital.
I frequently meet entrepreneurs that should be bootstrapping who are seeking venture capital or entrepreneurs that 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 is often building the business too slowly to capture the opportunity properly.
Picking the right fundraising strategy is often as significant of 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.
Mark Davis is a VC at DFJ Gotham Ventures.
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