This is my 18th article on startup funding and my most important. Because somewhere around 2/3 of the startups I work with are building business that aren’t suitable for venture investment.
The venture model is simple — investors put in cash in exchange for a cut of the payout when the company is acquired or goes public. Since venture investors get nothing until the exit, no surprise that’s their only goal. And since startups are valued by revenues and revenue growth rates, accepting venture investor money is a promise to focus exclusively on explosive revenue growth.
This venture model works well because your interests are aligned with theirs – the senior team gets paid mostly in equity. When investors get their big payout, you get yours, too. Until then, it’s instant noodles and sharing a studio apartment with three roommates. Venture investing has made some founders outrageously wealthy. But just because you have a great business does not make it a great venture business.
This model doesn’t work if it’s unlikely to have a 25x acquisition within five years. As my previous article detailed, that means at an absolute minimum, you’ll need to reach annual revenues of at least $25M; below that threshold, acquisitions are difficult and multiples are low.
In addition to the $25M revenue minimum, there are other reasons your business may not be a great fit for venture capital:
- You don’t intend to sell the business as soon as possible.
- You don’t want to kill yourself for instant noodle wages for the next five years in the hopes of a huge payout later.
- You want to dedicate your efforts to solving a problem instead of focusing exclusively on increasing revenues as fast as possible.
What I find most frustrating is that most good business ideas—products that are needed, things that ought to get built—often don’t fit the venture model. Niche products for a specialized audience are far easier to build than venture rocketships that have little margin for error. And good, solid, profitable (often wildly profitable) businesses can make the founders rich. But there’s the little complication of funding. If the VCs won’t write you a check, how can you build it? Fortunately, there are many alternatives, so let’s dive in.
Bootstrap: Many businesses, software and services in particular, don’t require much cash to start. A small team working nights and weekends can build an MVP that you can take to a few forward-thinking customers and make initial sales. You use that revenue to pay part-time contractors and maybe do a little marketing. As your revenues grow, the team comes on full time and you begin to add people to fill critical gaps. This is the way most small businesses are built, and tech startups need not be different. The founding team owns 100% of the business, makes all the decisions, and keeps all the profits. If you stay scrappy, run lean, and keep your costs to a minimum, even $5 million in revenue could mean $1 million or more in income.
Personal Funds: Rather than being beholden to outside investors, invest in your own business and truly work for yourself. If you’re married or in a stable relationship, one partner can work a traditional job to pay the mortgage while the other builds the new business. If you have savings put aside for a rainy day, this is the time to use it. If you own a house, it’s time to do a cash-out refi and make the equity work for you. More successful businesses have been built on home loans than venture funding, and a startup built on credit card debt is as much a part of Silicon Valley lore as the parent’s garage.
Friends & Family: If you can’t afford to bootstrap the business on your own, reach out to people around you who can help. You can structure their funding as a loan or an equity investment; it doesn’t really matter. Unlike venture investors who care about nothing but potential returns, friends and family just want to help you succeed.
Cofounder/Business Partner: Find a cofounder who can not only help build the business but contribute capital. This works especially well for technical founders who have already spent considerable time building the MVP. You need a partner who knows how to run the business anyway, and to match the time you’ve put in developing the product, your cofounder can contribute capital to make you 50/50 partners.
Grants: If you’re building a technical product, especially one that solves a societal need like clean energy or a better medical device, or helps the military in any way, there are billions of dollars in SBIR grants available from the U.S. government. Other countries often have similar programs. The grants usually focus on research and development rather than commercialization, but can pay for you to build and test your product while providing validation. Many states have their own grants programs, as well as private institutes.
Small Business Loans: In the US, the Small Business Administration guarantees billions of dollars in loans to small businesses. They tend to focus on loans to buy existing businesses or build factories and offices, but they do offer some loans to help founders get started.
Customer Pre-Sales: If your product is as useful as you think, convince a few launch customers to pay you now for delivery later. Sign up a few customers and you’ll have enough to build it.
Customer R&D/NRE: If you have expertise the customers don’t possess in-house, they may pay you to develop the product rather than trying to build it themselves. They may have unique requirements for features or integration with their existing systems that makes the idea of a custom solution attractive to them. Once you’ve delivered to your launch customer, you can extend the product for use by a general audience. Be careful to make sure the contract specifies that you own all the intellectual property and is not a work for hire.
Consulting/Contracting Projects: Work with clients as a consultant or contractor to implement what they need by hand, automating the process as you go. That automation then becomes your product. Other companies can then use your product instead of continuing to work manually. By engaging with multiple clients, you end up building a tool that meets the needs of a wider variety of uses and requirements than you’d think of on your own.
Indigogo and Kickstarter: If you have a consumer product, Indigogo and Kickstarter are a great way to fund development. This is similar to customer pre-sales for B2C rather than B2B products. Not only are customer pre-orders paying your costs, but they provide validation when you approach traditional retailers later.
Shark Tank: If you watch Shark Tank (and don’t we all) you might think Mark, Barbara, Daymond, Robert, Mark, and Lori are venture investors. They aren’t. They’re what I call operational investors. They’re not handing over a big check and saying call me in 5 years when Google buys your company. They mostly invest in small consumer products. Rather than a big acquisition, they’re looking for an ongoing revenue stream. If you take their deal, they become not just investors but operational partners. They have large teams that work with you to manage your business, get your product into retailers, build your distribution, professionalize production, or take over your marketing. This assistance doesn’t come free: their deals often include complex structures with repayment terms, royalties, and management fees in addition to an ongoing share of the profits.
Operational Investors: The Shark Tank crew may be the best-known operational investors, but they aren’t the only ones. There are other investors who work in a similar way. Operational investors will work with you daily, and their team may take over finance, operations, and other roles to help build the business while watching every penny spent.
The venture model is simple. The interests of the entrepreneur and investor are aligned – neither gets anything until the company is acquired, and any profits are plowed back into growth. But for operational investors where splitting a share of the profits is the goal, the investor needs to know all the details of the business. How much should the CEO be paid? Is he flying coach or business class and staying at the Four Seasons or Motel 6? How much staff is really needed and how much should they be paid? Is the fancy office in the World Trade Center necessary to win customers, or is that for the CEO’s vanity? Do the employees need a personal concierge and a Michelin chef to keep them from defecting, or is that a wasteful perk? In other words, if the profits are going to someone else, there’s plenty of other ways to spend the money. Only by being part of the operating team, usually as CFO, can an investor protect her investment.
Because an operational investor needs to oversee daily operations, she can’t take on many investments. A VC fund will typically make 10 investments per year, an operational investor makes 1 or less, maybe only one or two ever. Since helping you run your business requires specialized expertise, unlike VCs, they have to focus on very narrow specialties where their experience and connections are of the most value.
A business built for long-term profitability needs to be run differently than one for short-term revenue growth. Even the corporate structure is different: a venture business needs to be a C-corp to facilitate investment and acquisition; a profits business should be an LLC or S-corp to eliminate taxes on those profits.
So consider carefully now and don’t let the tail wag the dog. It comes down to the product – if the product can’t be built without dozens of developers and requires a huge sales staff and millions in advertising to reach the audience, but will generate a billion dollars in revenues eventually, keep working on that pitch deck and engaging with VCs. But if in your heart of hearts you know you have a fantastic product for a specialized audience, find a way to fund it yourself. You’ll save yourself years of aggravation. You’ll become CEO of a respected business and an industry leader. It may not make you a billionaire, but multi-millionaire is not too shabby.
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