This post is a continuation of my series of key segments from my book, The Fundraising Rules.
Figuring out how to finance a company is easier for some founders than others. The choice is difficult when a business could make a great lifestyle business or a great venture-scale business. To clarify, this is a somewhat unique situation, as many startups are either not viable as small lifestyle businesses or do not have the potential to achieve venture scale. I call companies that could become either of these fringe companies. To clarify, by lifestyle business I’m referring to smaller businesses (typically less than $10 million in annual sales at peak) that the founders don’t intend to sell; rather, they intend to extract profits from the business in perpetuity. A venture-scale business is one that grows to much more than $10 million in annual revenue and has real potential to ramp to $100 million or more.
When faced with this dilemma, many entrepreneurs assume that they can simply raise venture capital in order to chase the bigger opportunity initially and fall back to the lifestyle business strategy if the company doesn’t scale. More money appears to create the most real options — the founder gets to chase the upside case and still benefit from the downside case if things don’t go as planned.
Here’s the catch — taking venture capital in this scenario has two key implications:
1. It is likely you will not be able to operate the company as a lifestyle business if it doesn’t scale (you’ll likely be required to sell the company), and
2. Your return when selling the company in the downside scenario may be smaller than if you had bootstrapped it to the same size.
Here’s why: Since venture capitalists must return invested capital to their investors, they need a method of exiting their investments. Typically, when a company stops growing, investors will work with the entrepreneurs to either seek more capital to explore new business opportunities that can stimulate growth (which usually means that the entrepreneur has a smaller portion of the pie) or find a buyer for the company. In either scenario, the company remains on the path to an exit, and entrepreneurs don’t get the opportunity to run the company as a lifestyle business. Simply put, raising VC and chasing the upside case typically eliminates the option to have a lifestyle business.
Furthermore, by taking venture capital financing, the entrepreneur’s ownership stake is diluted. The entrepreneur’s share of any sale proceeds is therefore lower than if he had not taken venture financing. This is a fair trade for a venture-scale business, which probably achieves an optimal exit value only through the benefit of relatively large, fast infusions of capital that venture firms can provide. In this instance, the entrepreneur is getting a “smaller piece of a much larger pie.” But for a lifestyle business, particularly one that might have become profitable without venture financing, the dilution entailed in venture financing is probably not a good trade for the entrepreneur.
While venture capital gives entrepreneurs the chance to make lots of money by building big companies, it’s generally not designed to make founders wealthy for starting small companies. Bootstrapping a small company, however, can make founders quite wealthy.
Here’s a simple diagram that illustrates the payout scenarios for fringe companies.
Founders with uncertain future market sizes are the most typical victims of this dilemma. In situations where the market is small today but expected to rapidly grow, the potential scale of a venture is more difficult to predict. At the heart of this issue is an information gap — if you don’t know how big a business can get, it is difficult to choose a financing strategy. You won’t understand the potential scalability of the company until after you raise venture capital and commit to go big or go home.
One way to unravel this issue is to wait on the decision to raise venture capital until knowing the extent to which the company is scalable. For many entrepreneurs, the timing of capital needs won’t afford this luxury, and for others, the prospect of delaying the capital raise is anxiety-provoking. If, however, you can test the market and better understand scalability before charting a financing strategy, this may maximize your return.
