The solution for funding startups building profitable businesses instead of venture rocketships

After 15 years as an angel investor and startup mentor, my biggest frustration has consistently been that the vast majority of startups don’t fit the moonshot profile of venture capital.

My own experience building smaller but successful startups has proven that generating a few million dollars in profits year after year is a far easier path to wealth than the venture lottery. Building a business to meet the needs of customers, employees, and founders instead of conforming to the accelerated timelines of venture capital is not only more sustainable, but also more personally satisfying.

But for most founders, reaching scale is impossible without access to seed capital. And seed capital usually means venture capital.

So over the past few months, I’ve been working with a team of other startup builders and investors to create a funding model for startups that can generate sustainable, long-term profits instead of a giant exit. We’re calling this new startup funding model operational capital.

Why Most Startups Aren’t a Fit for Venture Capital

If you’re building a startup destined to become a unicorn — the next Uber or AirBnb — but need tens of millions in investment to get there, venture capital is the way to go.

The venture model relies on startups reaching $100M in revenues within 5–7 years, then quickly being acquired for $1B or more or preparing for a big IPO. To make up for the fact that 90% of their investments fail, VC funds look for startups with the potential to generate 100x returns.

If you’re building a venture moonshot, great. That path is well worn. I even invite you pitch to my angel investment groups.

But of the startups I mentor, this moonshot model fits perhaps 10%. The other 90% of founders are stuck. If you pitch to my angel group with a 5-year revenue projection less than $100M, your application will be immediately rejected by the interns.

Taking venture capital when you don’t fit the venture model only dooms the founders to years of misery and eventual failure. The investors will push, push, push for growth at all costs, and when growth plateaus at $10M or $20M, they’ll desert the startup to die.

The Only Alternative (Until Now): Bootstrapping

If you’re building a business unlikely to grow to $100M in just a few years, the only choice is bootstrapping.

Bootstrapping requires building the business with your own money. It’s great for consulting or service businesses where you can scale up from a single employee (yourself) as you build your revenue. It’s great for licensing technology to other companies instead of making your own products. It’s the only choice for opening a small business like a bakery or cookie shop.

If you’re able to bootstrap your startup, that’s the way to go. The challenge, though, is bootstrapping requires using your own capital.

Of course, there are government grants and customer NRE that can help get the product off the ground. There’s working spouses, second mortgages, and credit card debt for cash. And if you have a rich uncle Bob, an inheritance from Grandma, or a big pot of gold from a lost leprechaun, congratulations, you have the flexibility to bootstrap your startup.

But in most cases, though, bootstrapping requires more cash than the founders can afford.

Too Small for VC, Too Big to Bootstrap

Most of the founders I work with fall into this difficult middle ground — their startups are too niche for venture capital, but require too much capital for the founders to fund it themselves.

These are the frustrating startups. Many of them are building important products that fit a critical need for a specialized market. It’s easy to see the business reaching $10M — $20M a year in revenues, and generating millions in profit year after year.

But they need perhaps a million dollars to get started. That’s a million dollars they don’t have. They need an experienced team to bring the product to market, but it’s difficult to find employees willing to work for equity without the unicorn upside.

For this wide gap between easy-to-bootstrap small businesses and venture rocketships, we need a new and better funding model. A funding model appropriate for startups focusing on profitability rather than growth at all costs.

Operational Capital — a Better Funding Model for Profits-Based Startups

A group of startup founders turned angel investors turned startup mentors, have been commiserating about this problem with me for years. Now, with shrinking early-stage funding options and the hiatus of the SBIR grant program, finding a solution has grown even more urgent.

So we borrowed ideas from venture capital, but more from private equity. We stole ideas from the restaurant industry where speciality hospitality investors pair with chefs to build new restaurants. We cribbed off the commercial real estate industry where the focus is always on cash flow and tax efficiency. And surprisingly, we copied the most from Shark Tank, where the sharks usually invest in modest products where they’re able to add value with their personal networks.

Combining them, we came up a new startup investment model we call Operational Capital.

The concept is simple. Make money from an ongoing stream of dividends instead of a single outsized exit.

But that only works if we can reach a success rate of 90% instead of the 10% of venture capital. Otherwise, the modest stream of profits from one business will be overwhelmed by losses from others.

So we focus on startups building useful niche products that with a modest amount of capital, can quickly reach sustainable profitability. And instead of simply providing capital, we bring our expertise, our experience, and our own networks.

We don’t just make occasional phone calls or attend a quarterly board meeting; we join the startup’s executive team as full-time or part-time employees. We work at the startup on a daily basis, filling in gaps, and helping bring the product to market.

In other words, rather than just investors, we become co-founders, combining our skills as startup leaders with our capital.

Investment terms will be different from the lottery ticket approach of venture capital. It will be closer to negotiating share ownership with a co-founder who brings capital to the startup while the original founders bring an early version of the product. Returns won’t be from selling the equity to an acquirer but a combination of dividends, salary, bonus, and interest.

Borrowing from the venture studio model, instead of each of us joining one startup, we’ve assembled a small group to apply our expertise in marketing, finance, engineering, HR, supply chain, and other functions across a handful of startups in our portfolio.

Is Your Startup a Fit for Operational Capital?

Like venture capital and bootstrapping, operational capital fits a specific startup profile:

  • Expectation of high profits margins at scale
  • Requires a modest amount of capital
  • Able to reach break-even quickly
  • Structured as a LLC or S-corp instead of a C-corp for tax efficiency
  • Has not already raised outside capital
  • Fits within the industry expertise of the partners
  • Existing founders are willing to take on a co-founder

The trickiest part, of course, is finding operational partners who understand your industry and bring value beyond capital to your startup. And like any other cofounder, there has to be an alignment of values and personality, and a clear split of responsibilities from the start to avoid a blow-up later.

This makes the process more complicated that simply pitching for investor dollars. But with the right partner, the chances of success will be far higher.

Building Unventure Capital

Together with my partners, we’ve set up an operational capital group called Unventure Capital.

If you’re interested in learning more, please take a look at our very rough website at https://unventures.net.

We’re hoping not only to find the right startups for us to invest in, but that other investors will adopt this operational capital model, bringing both capital and expertise to help build profit-focused startups.