11 Chapter 11: Financing a Startup

Chapter 11 Introduction

Securing funding is one of the first steps, and a very real requirement, for starting a business. Let’s begin by exploring the financial needs and funding considerations for a simple organization. Imagine that you and your college roommate have decided to start your own band. In the past, you have always played in a school band where the school provided the instruments. Thus, you will need to start by purchasing or leasing your own equipment. You and your roommate begin to identify the basic necessities – guitars, drums, microphones, amplifiers, and so on. In your excitement, you begin browsing for these items online, adding to your shopping cart as you select equipment. It doesn’t take you long to realize that even the most basic set of equipment could cost several thousand dollars. Do you have this much money available to make the purchase right now? Do you have other funding resources, such as loans or credit? Should you consider leasing most or all the instruments and equipment? Would family or friends want to invest in your venture? What are the benefits and risks associated with these funding options?

This same basic inquiry and analysis should be completed for every serious startup. First, you must determine the basic requirements for starting the business. What kinds of equipment will you need? How much labor and what type of skills? What facilities or locations would you require to make this business a reality? Second, how much do these items cost? If you do not possess an amount of money equal to the total anticipated cost, you will need to determine how to fund the excess amount.

Once you have considered this, it’s time to start thinking about startup financing, which is the process of raising money to launch a new business. Typically, those who can provide financing want to be assured that they could (at least potentially) be repaid in a reasonable period of time. An entrepreneur may pursue one or more different types of funding, which will be discussed further below.

Entrepreneurial Funding across the Company Lifecycle

Identifying the lifecycle stage of the business venture can help entrepreneurs decide which funding opportunities are most appropriate for their situation. From inception through successful operations, a business’s funding grows generally through three stages: seed stage, early stage, and maturity (see Figure 11.1).

A seed-stage company is the earliest point in its lifecycle. It is based on a founder’s idea for a new product or service. Nurtured correctly, it will eventually grow into an operational business, much as an acorn can grow into a mighty oak – hence the name “seed” stage. Typically, ventures at this stage are not yet generating revenue, and the founders haven’t yet converted their idea into a saleable product. The personal savings of the founder, plus perhaps a few small investments from family members, usually constitute the initial funding of companies at the seed stage. Before an outsider will want to invest in a business, they will typically expect an entrepreneur to have exhausted what is referred to as F&F financing – friends and family financing – to reduce risk and instill confidence in the business’s potential success.

Figure 11.1 Funding Strategies and Company Lifecycle Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license

After investments from close personal sources, the business idea may begin to build traction and attract the attention of an angel investor. Angel investors are wealthy, private individuals seeking investment options with a greater potential return than is traditionally expected on publicly traded stocks, albeit with much greater risk. For that reason, they must be investors accredited by the federal Securities and Exchange Commission (SEC) and they must meet a net worth or income test. Non-accredited investors are allowed in certain limited circumstances to invest in security-based crowdfunding for startup companies. Among the investment opportunities angel investors look at are startup and early-stage companies. Angel investors and funds have grown rapidly in the past ten years, and angel groups exist in every state.

An early-stage company has begun development of its product. It may be a technical proof of concept that still requires adjustments before it is customer ready. It may also be a first-generation model of the product that is securing some sales but requires modifications for large-scale production and manufacturing. At this stage, the company’s investors may now include a few outsider investors, including venture capitalists.

A venture capitalist is an individual or investment firm that specializes in funding early-stage companies. Venture capitalists differ from angel investors in two ways. First, a venture capital firm typically operates as a full-time active investment business, whereas an angel investor may be a retired executive or business owner with significant savings to invest. Additionally, venture capital firms operate at a higher level of sophistication, often specializing in certain industries and with the ability to leverage industry expertise to invest with more know-how. Typically, venture capitalists will invest higher amounts than angel investors, although this trend may be shifting as larger angel groups and “super angels” begin to invest in venture rounds.

Private equity investment is a rapidly growing sector and generally invests later than venture capitalists. Private equity investors either take a public company private or invest in private companies (hence the term “private equity”). The ultimate goals of private equity investors are generally taking a private company public through an initial public offering (more on that shortly) or by adding debt or equity to the company’s balance sheet, and helping it improve sales and/or profits in order to sell it to a larger company in its sector.

Companies in the mature stage have reached commercial viability. They are operating in the manner described in the business plan: providing value to customers, generating sales, and collecting customer payments in a timely manner. Companies at this stage should be self-sufficient, requiring little to no outside investment to maintain current operations. For a product company, this means manufacturing a product at scale – that is, in very large volumes. For a software company or app provider, this means generating sales of the software, or subscriptions under an SaaS model (Software as a Service), as well as possibly securing advertising or data revenue based on access to and/or knowledge about the user base.

Companies at the mature stage have different financing needs from those in the previous two stages, where the focus was on building the product and creating a sales/manufacturing infrastructure. Mature companies have reached a consistent level of sales but may seek to expand into new markets or regions. Typically, this requires significant investment because the proposed expansion can often mirror the present level of operations. That is to say, an expansion at this level may result in doubling the size of the business. To access this amount of capital, mature companies may consider selling a portion of the company, either to a private equity group or through an initial public offering (IPO).

An initial public offering (IPO) occurs the first time a company offers ownership shares for sale on a public stock exchange, such as the New York Stock Exchange. Before a company executes an IPO, it is considered to be privately held, usually by its founders and other private investors. Once the shares are available to the general public through a stock exchange, the company is considered to be publicly held. This process typically involves an investment banking firm that will guide the company. Investment bankers will solicit institutional investors, such as State Street or Goldman Sachs, which will in turn sell those shares to individual investors. The investment banking firm typically takes a percentage of the funds raised as its fee. The benefit of an IPO is that the company gains access to a massive audience of potential investors. The downside is that the owners give up more ownership in the business and are also subject to many costly regulatory requirements. The IPO process is highly regulated by the SEC, which requires companies to provide comprehensive information up front to potential investors before completing the IPO. These publicly traded companies must also publish quarterly financial statements, which are required to be audited by an independent accounting firm. Although there are benefits to an IPO for later-stage companies, it can be very costly both at the start and on an ongoing basis. Another risk is that if the company does not meet investors’ expectations, the value of the company can decline, which can hinder its future growth options.

Thus, a business’s lifecycle stage greatly influences its funding strategies and so does its industry. Different types of industries have different financing needs and opportunities. For example, if you were interested in opening a pizzeria, you would need a physical location, pizza ovens, and furniture so customers could dine there. These requirements translate into monthly rent on a restaurant location and the purchase of physical assets: ovens and furniture. This type of business requires a significantly higher investment in physical equipment than would a service business, such as a website development firm. A website developer could work from home and potentially begin a business with very little investment in physical resources but with a significant investment of their own time. Essentially, the web developer’s initial funding requirement would simply be several months’ worth of living expenses until the business is self-sufficient.

Once we understand where a business is in its lifecycle and the industry in which it operates, we can get a sense of its funding requirements. Business owners can acquire funding through different avenues, each with its own advantages and disadvantages, which we will explore further below.

Types of Financing

Although many types of individuals and organizations can provide funds to a business, these funds typically fall into two main categories: 1) debt financing, and 2) equity financing (Table 11.1 below). Entrepreneurs should consider the advantages and disadvantages of each type as they determine which sources to pursue in support of their venture’s immediate and long-term goals.

Table 11.1         Debt vs. Equity Financing

Debt Financing

Debt financing is the process of borrowing funds from another party. Ultimately, this money must be repaid to the lender, usually with interest (the fee for borrowing someone else’s money). Debt financing may be secured from many sources: banks, credit cards, or family and friends, to name a few. The maturity date of the debt (i.e., when it must be repaid in full), the payment amounts and schedule over the period from securement to maturity, and the interest rate can vary widely among loans and sources. All of these elements should be weighed when considering debt financing.

One advantage of debt financing is that the debtor (eventually) pays back a specific amount. When repaid, a creditor releases all claims to its ownership in the business. On the other hand, a disadvantage is that repayment of the loan typically begins immediately or after a short grace period – so the startup faces a fairly quick cash outflow requirement, which can be challenging.

One source of debt financing for entrepreneurs is the Small Business Administration (SBA), a government agency founded as part of the Small Business Act of 1963. The SBA’s mission is to “aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns.”[2] The SBA partners with lending institutions such as banks and credit unions to guarantee loans for small businesses. The SBA typically guarantees up to 85% of the amount loaned. Whereas banks are traditionally wary of lending to new businesses because they are unproven, the SBA’s guarantee takes on some of the risk that the bank would normally be exposed to, providing more incentive to the lending institution to finance an entrepreneurial venture.

To illustrate an SBA loan, let’s consider the 7(a) Small Loan program. Loans backed by the SBA typically fall into one of two categories: working capital and fixed assets. Working capital is simply the funds a business has available for day-to-day operations. If a business has only enough money to pay bills that are currently due, that means it has no working capital – a precarious position for a business. Thus, a business in this position may want to secure a loan to help see it through leaner times. Fixed assets are major purchases, such as land, buildings, equipment, and so on. The amounts required for fixed assets would be significantly higher than a working capital loan, which might cover just a few months’ expenses. As we will see, loan requirements made under the 7(a) Small Loan program are based on loan amounts.

For loans over $25,000, the SBA requires lenders to demand collateral. Collateral is something of value that a business owner pledges to secure a loan, meaning that the bank has something to take if the owner cannot repay the loan. Thus, in approving a larger loan, a bank might ask you to offer your home or other investments to secure the loan. In a real estate loan, the property you are buying is the collateral. In a way, loans for larger purchases can be less risky for a bank, but this can vary widely from property to property. A loan that does not require collateral is referred to as unsecured.

To see how a business owner might use an SBA loan, let’s return to the example of a pizzeria. Not all businesses own the buildings where they operate; in fact, a great many businesses simply rent their space from a landlord. In this case, a smaller loan would be needed than if the business owner were buying a building. If the prospective pizzeria owner could identify a location available for rent that had previously been a restaurant, they might need only to make superficial improvements before opening to customers. This is a case where the smaller, collateral-free type of SBA loan would make sense. Some of the funds would be allocated for improvements, such as fresh paint, furniture, and signage. The rest could be used to pay employees or rent until the pizzeria has sufficient customer sales to cover costs.

In addition to smaller loans, this SBA program also allows for loans up to $350,000. Above the $25,000 threshold, the lending bank must follow its own established collateral procedures. It can be difficult for a new business to provide collateral for a larger loan if it does not have significant assets to secure the loan. For this reason, many SBA loans include the purchase of real estate. Real estate tends to be readily accepted as collateral because it cannot be moved and holds it value from year to year. For the pizzeria, an aspiring business owner could take advantage of this higher level of lending in a situation where the business is buying the property where the pizzeria will be. In this case, the majority of loan proceeds will likely go toward the purchase price of the property. Both the high and low tiers of the SBA loan program are examples of debt financing.

Equity Financing

In terms of investment opportunities, equity investments are those that involve purchasing an ownership stake in a company, usually through shares of stock in a corporation. Unlike debts that will be repaid and thus provide closure to the investment, equity financing is financing provided in exchange for part ownership in the business. Like debt financing, equity financing can come from many different sources, including friends and family, or more sophisticated investors. You may have seen this type of financing on the TV show Shark Tank. Contestants on the series pitch a new business idea in order to raise money to start or expand their business. If the “sharks” (investors) want to invest in the idea, they will make an offer in exchange for an ownership stake. For example, they might offer to give the entrepreneur $200,000 for a return of 40 percent ownership of the business.

The advantage of equity financing is that there is no immediate cash flow requirement to repay the funds, as there is with debt financing. The drawback of equity financing is that the investor in our example is entitled to 40 percent of the profits for all future years unless the business owner repurchases the ownership interest, typically at a much higher valuation. Valuation is an estimate of what a business is worth, usually described in relation to the price an investor would pay to acquire the entire company.

This is illustrated in the real-life example of the ride-sharing company Uber. One of the early investors in the company was Benchmark Capital. In the initial round of (venture capital) financing, Benchmark invested $12 million in Uber in exchange for stock. That stock, as of its IPO date in May 2019, was valued at over $6 billion – which is the price that the founders would have had to pay to get Benchmark’s share back.

Some financing sources are neither debt nor equity, such as gifts from family members and friends, funds from crowdfunding websites such as Kickstarter and Indiegogo, and grants from the government, trusts, or individuals. The advantages and disadvantages of these sources are discussed in further detail below.

Special Funding Strategies

It’s important to recognize that not all startups are Silicon Valley tech companies. These companies create high-profile products, such as applications and websites, which can take years to become profitable or even generate revenue. Much more common are the small businesses founded by everyday entrepreneurs who seek to build local businesses and create value in their own communities.

Moreover, not all startups are founded with a profit motive in mind. Charitable organizations, or certain nonprofit companies, are often founded for altruistic purposes. This can include advancing the arts, education, and science (e.g., Metropolitan Museum of Art, Teach for America); protecting the natural environment (e.g., Sierra Club, Wildlife Conservation Society); providing disaster relief (e.g., American Red Cross); and defending human rights (e.g., Amnesty International, Human Rights Watch). In these organizations, altruistic goals supersede the profit motive that a traditional business would have. As a result, the funding strategies of these enterprises often differ quite dramatically from those of standard for-profit businesses. Without the emphasis on profit, it can be difficult to provide for the cost of ongoing operations. Thus, these organizations must develop a sustainable strategy – one that can maintain the organization’s financial stability.

In the United States, such organizations can qualify for tax-exempt status, meaning that if there is a profit from operations, it is not typically subject to taxes. Organizations seeking this exemption must apply to the Internal Revenue Service for tax-exempt status and provide information about what kind of mission the organization carries out – charitable, scientific, educational, and so on.

Consider a museum. What is its purpose? Traditional companies provide a product or service to their customers in exchange for payment, and typically fill a need their customers have. A grocery store sells food because human beings need to eat food to survive. Although viewing paintings and sculptures is not a physical requirement for life, this experience arguably enriches our lives and helps educate and shape our society. That is why museums are founded. This is a different goal than that of most small businesses (providing a product or service in exchange for a profit) and, as a result, requires different financing strategies, such as a combination of program services, donations, and grants.

Program Services

Program services are the basic offerings that a nonprofit organization provides that result in revenue. Typically, program services are not enough to cover the overall cost of running the organization. These services most closely resemble the revenue-generating customer interactions of a traditional business, in that the organization provides a product or service in exchange for a “customer’s” money.

In our museum example, program services could take a few different forms. First, the museum likely charges a fee for admission to view the artwork and artifacts. The individual ticket price multiplied by the number of museum visitors equals the museum’s ticket revenue. An established museum will have a good sense of how many visitors it has on average and can use these data to create a budget.

Another source of program service revenue for a museum could take the form of hands-on educational activities or events with guest speakers or presenters. Often museums will host local artists, or their own employees might conduct art classes or special-topic tours. These events and activities typically have a charge (revenue) beyond the regular admission cost.

Despite these revenue-generating activities, nonprofit organizations still face many funding challenges in covering all the operating costs of a normal business, such as employee wages, facility costs, and advertising. Thus, they typically need many different sources of income. To illustrate, 2018 program service income for the Metropolitan Museum of Art (the “Met”) only accounted for 2.3% of its total funding for the year.[3]

Donations

One benefit to a business with a charitable mission is inherent public support, which can foster community involvement above and beyond patronage. For nonprofits, this can translate into a willingness to donate money to the organization. A donation is a financial gift with no expectation of repayment or receiving anything in return. A traditional business must provide something valuable to create a customer exchange: Their customers demand value in exchange for their hard-earned money. The benefactors of a charitable organization want to help further the mission of the organization. This type of entity – whether it’s a museum, a hospital, or the Red Cross – relies on the goodwill of community supporters. For the Met, with such a low percentage of revenue generated by program services, it’s clear that donations and charitable gifts are vital to the organization’s financial viability.

Grants

Another source of funding for nonprofit organizations is grants. A grant is a financial gift given for a specific purpose by a government agency or a charitable organization, such as the Gates Foundation. Like a donation, a grant does not have to be repaid. Unlike with donations, both nonprofit and for-profit organizations can compete for grants. Whereas donations are typically given without restriction to offset the general operating expenses of the organization, grants often specify how the funds are to be used. Most grant-providing entities have an agenda or purpose behind their funding. For example, the National Institutes of Health (NIH) provides grants “to support the advancement of the NIH mission to enhance health, extend healthy lives, and reduce the burdens of illness and disability.”[4] This federal organization invests over $32 billion annually for medical research.

Grants can be very competitive, requiring a rigorous application process. Usually, multiple organizations apply for the same grant, and the organization issuing the grant reviews the many competing applications to make its selection. Grantees generally must submit audited financial statements and are required to update the grantor subsequent to the grant award to ensure proper intended use. The NIH awards almost 50,000 grants annually, most of which are competitive. Although that is an enormous number of projects to fund, only 20% of applications submitted to the NIH in 2018 actually were accepted.[5] In other words, the NIH rejected four out of every five applications. For entrepreneurs, this means that when you identify a grant that is specific to your organization’s mission, you should weigh your chances of being awarded the grant when considering it as part of your funding strategy.

To understand grants in practice, let’s further examine the National Institutes of Health (NIH). The NIH Small Grant Program provides funds for activities such as the development of new research technology. This specific grant can be awarded for up to a two-year period, with funds of up to $50,000 in direct costs per year. A grant like this could provide vital support to a nonprofit startup.

Some business ventures fall somewhere between organizations completely committed to charitable work and traditional small businesses with entrepreneurs focused on social entrepreneurship (which we previously learned about). Social entrepreneurs develop products and services as solutions to societal problems. For example, the TOMS shoe company was able to create a business model through which the company gives one pair of shoes to children in need in developing countries for every pair of shoes that a customer in a developed country purchases. This practice pioneered what they refer to as the “One for One” model.[6] The company’s website describes the origins of both the company and this model, which are based on the experiences of its founder, Blake Mycoskie.

Given its emphasis on pursuing revenue-generating activities, social entrepreneurship offers the ability to effect positive change in the world without simply relying on donations. It pairs a profitable, sustainable business model with a good cause. This combination often creates positive word of mouth. It can give potential customers a good feeling about the product beyond just its style or function.

No-Loan Financing Strategies

As you’ve learned, many startups come into being through the extensive use of debt. Although borrowing is a legitimate source of funding, it can be risky – especially if the entrepreneur is personally responsible for repayment. In practice, some entrepreneurs max out credit cards, take out home-equity loans against their primary residences, or secure other high-interest personal loans. If the entrepreneur fails to repay the loans, the result can be repossession of equipment, home foreclosure, and other legal action.

We will now examine some funding strategies that may be attractive to many startups because they do not require going into debt or exchanging ownership of the business for financial support (i.e., debt and equity financing). The financing methods described here are more creative funding strategies, including crowdfunding, bartering, and other methods (see Figure 11.2).

Figure 11.2       No-Loan Funding Options

Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license

Crowdfunding

When the founder of Oculus turned to Kickstarter in 2012 to develop its virtual reality headset product, he quickly blew past his $250,000 fundraising goal.[7] The company went on to be acquired by Facebook for $2 billion in cash and stock just two years later. This example, though not common, shows the potential for crowdfunding sites like Kickstarter and Indiegogo.

Crowdfunding involves collecting small sums of money from a large number of people. The people who contribute money are typically referred to as backers because they are backing the project or supporting the business idea. Browsing these crowdfunding websites, you will see many different kinds of ventures seeking financial backing – from creating new board games to opening donut cafes. Each project identifies an overall specific funding goal in terms of a dollar amount. Some crowdfunding websites, such as Kickstarter, implement an “all or nothing” model, in which projects do not receive any funds unless their overall funding goal is met. The amount can be exceeded, but if it is not met, the project receives nothing.

For an entrepreneur utilizing this resource, selecting an attainable funding goal must be a core part of their strategy. The funding goal must also be appropriate to the scale of the project. For example, setting a goal of $50,000 may be reasonable for launching a food truck (which could be a prototype for a full restaurant), but it is a mere fraction of the cost of constructing an entire table-service restaurant, which would come closer to $750,000. An entrepreneur seeking to enter the culinary world should consider which target would be most achievable as well as most beneficial in meeting both short- and long-term goals. Also, remember that meeting the funding goal does not ensure success of the business.

Entrepreneurs vying for crowdfunding usually employ some common tactics. First, they often post an introductory video that explains the project goal and the specific value proposition. For example, a chef might seek $75,000 to open a food truck specializing in a relatively unknown cuisine. Second, the entrepreneur provides a more detailed written summary of the project, often including specific items that the funding will pay for, such as $50,000 for a vehicle, $10,000 for graphic design and vehicle decals, and $15,000 for kitchen equipment for the truck. Last is the reward structure, which is what entices visitors to the site to fund the project, offering a return beyond their own passion for the venture. The reward structure establishes different levels of funding and ties a specific reward to each level. For example, for a contribution of $5, the chef might thank the backer on social media; for $25, the backer would get a t-shirt and a hat featuring the food truck’s logo; for $100, the backer would get five free meals when the food truck opens. Fees for these crowdfunding sites vary from 5% to 8%. Kickstarter now requires physical products or prototypes for some startups, as well as a short video to help represent and “sell” the product.

Although this financing source offers a lot of flexibility, businesses utilizing crowdfunding can run into trouble. Certain funding levels and rewards may have limits. For example, a reward structure might offer backers contributing $1,000 a trip to the grand opening of the food truck, including airfare and hotel. These top-tier rewards can generate a lot of excitement, but the expense of flying people around the country and providing accommodations could become unmanageable. In fact, one research study found that 84% of Kickstarter’s top projects delivered their rewards late (and sometimes not at all).[8]

The advantage of crowdfunding is that the business receives cash upfront to launch. The downside is that the reward requires a future payment to the backers. This payment may be in the form of branded merchandise, meals, or even events and travel, so it is important for entrepreneurs to set aside part of the investment money to fund the rewards. Depending solely on generating the reward funds out of future sales is a risk that might result in upsetting the very fans who made the business possible. Since crowdfunding is managed online, another risk is upsetting the project’s vocal supporters. Crowdfunding usually only provides a “kick start” for a startup, so most seed-stage companies will need additional funding from other sources to get to their first commercial launch.

Although social media can backfire, entrepreneurs can take advantage of benefits too. Crowdfunding can allow an entrepreneur to build a community around a product before it is even sold. Like-minded fans of a product can connect with each other over the internet, in the feedback section of a website, or in shared social media posts. Additionally, backers of a project can become cheerleaders for it by sharing the idea—and their enthusiasm for it—with friends, family, and coworkers. Word-of-mouth marketing can lead to more backers or future customers after launch. Dozens of crowdfunding portals exist, including WeFunder, SeedInvest, Kickstarter, and Crowdcube.

Current SEC guidelines for issuing and investing limits granted for Title III Crowdfunding include the following:

• A company can raise up to $1 million in aggregate through crowdfunding offerings over a twelve-month period;
• Over a twelve-month period, individual investors can invest in the aggregate across all crowdfunding offerings up to:
  • – $2,000 or 5% of the unaccredited investor’s net worth or yearly income if they make less than $100,000/year;
  • – 10% of the lesser of their annual income or net worth, if both their annual income and net worth are equal to or more than $100,000. [9]

Bartering

Startup companies often don’t have a lot of cash assets on hand to spend, but they often have offerings that may be able to provide value to other businesses. Bartering is a system of exchanging goods or services for other goods or services instead of for money. Let’s consider the case of Shanti, a website designer who wants to start a business. She may want to have her business formally incorporated or may require other legal help, such as review of standard contracts. Hiring a lawyer outright for these services can be costly, but what if the lawyer needed something that a website designer could provide?

Whether the lawyer has just started their own business or has been established for several years, they may need a website created or have an old website redesigned and updated. This website overhaul could prove costly for the lawyer. But what if there were a way that both the lawyer and the web designer could get what they wanted with a resulting net cost of zero dollars? Bartering can achieve this. It should be noted that there are accounting and tax implications involved with bartering that can prevent a net zero offset of costs.

In a barter scenario, Shanti could create a website for the lawyer at the expense only of her time, which in the startup phase is often more abundant than actual cash. The lawyer could provide incorporation services or contract review in exchange, requiring no cash outlay. For many entrepreneurs, this type of exchange is appealing and enables them to meet business needs at a lower perceived cost. Although more mature firms can also use bartering, the opportunity cost is much higher. If a mature company is unable to take on a new paying client because it is doing too much free (barter) work, it may lose out on future revenue, which could potentially be a big loss. Startups, in contrast, often have excess capacity while they develop a customer base, so taking on barter work is often a low-risk, beneficial funding strategy.

Other No-Loan Funding Options

Beyond crowdfunding and bartering, startups have other options to help them get off the ground, such as funding competitions and pre-orders. First, many organizations hold entrepreneurial finance competitions or contests that provide financial awards to the winners. These prize funds can be used as seed money to start a new venture. For example, the New York City Public Library holds an annual business plan competition called the New York StartUP! Business Plan Competition.[10] Applicants must complete an orientation session, attend workshops that develop skills related to the creation of a business plan, and submit a complete business plan. The first-place award yields $15,000 in prize money, which can be a great start toward turning an entrepreneurial idea into a business reality.

Another way for startups to gain financial traction is to solicit pre-orders. Consider the launch of a new book or video game. Retail stores will often solicit pre-orders, which are advance purchases of the product. Customers pay for the desired item before they even have access. This approach is not limited to existing, well-known franchises – startups can use it as well. Although established novel and video game franchises have big fan bases and often large advertising budgets, startups can still find effective strategies in this space. For example, entrepreneur Mitchell Harper raised $248,000 in funds before his product launched.[11]

Companies with a prototype of their product or a first manufacturing run can showcase the new product to potential customers, who may be interested enough to place an order. The company can use the funds received from these pre-orders to pay for the inventory. In addition to having sales staff make sales calls, new companies can attend trade shows and exhibitions to garner interest in the product. Many new products are launched in this fashion because it allows access to many potential customers in one place.

Why Bootstrapping Hurts, Then Helps

The process of self-funding a company is typically referred to as bootstrapping, based on the old adage that urges us to “pull ourselves up by our bootstraps.” It describes a funding strategy that seeks to optimize use of personal funds and other creative strategies (such as bartering) to minimize cash outflows. In recent years, this strategy has been the fodder for shows like Shark Tank. These shows may make entrepreneurs think that being on TV is glamorous, or the shows may glorify the financial backing of millionaires and billionaires. We have seen that for many entrepreneurs, the reality is that there are drawbacks to bringing in outside investors to launch your venture. These drawbacks include loss of future profits and possible loss of control of the company, among others. Potential business owners must weigh the advantages and disadvantages – both short and long term – for funding their specific dream.

You’ve learned about financing strategies predicated on finding a willing investor or lender, but many small businesses simply don’t have access to large amounts, or any amount, of capital. In these cases, aspiring business owners need lean business strategies that will yield the greatest benefit.

Bootstrapping requires entrepreneurs to shed any preconceived notions of the popular-culture image of startups. Most startups don’t have trendy downtown offices, foosball tables, or personal chefs. Bootstrapping reality looks more like late nights spent clipping coupons. It involves scrutinizing potential expenses and whether each cost is really worth the investment. It can be a difficult and trying process, but without any angel investors or wealthy family backers, bootstrapping is often an entrepreneur’s only option. The good news is that this approach can pay substantial dividends in the long run.

The Basics of Bootstrapping

When entrepreneurs risk their life savings, they must stretch every dollar as far as possible. Having a limited amount of capital to work with requires optimizing creative strategies to get the business launched and keep it afloat. This creativity applies to bringing customers and sales in the door as well as to managing expenses.

Understanding the ongoing costs of the business is key. In an interview on NPR’s show How I Built This, Barbara Corcoran, one of the investors on Shark Tank, shares her humble beginnings in real estate brokerage.[12] One of things she touches on is being constantly aware of how long her money would last, given her monthly expenses. If she had $10,000 in the bank and the cost of her rent and employees was $2,500 per month, she knew that the money would last her four months. (In other words, she knew her burn rate and runway!) Such constant information and vigilance are required when bootstrapping a business for success.

Employee costs are typically one of the largest expenses facing a business. Hiring traditional full-time employees can be costly; onboarding them too early can be fatal to a business’s bottom line. Creative approaches to minimizing labor costs can be enormously helpful. One strategy for controlling these costs is utilizing independent contractors (freelancers) and other part-time employees. They do not work full time for the business and may serve other companies as well. Their compensation is generally lower than that of a full-time, salaried employee, often in part because these positions do not usually come with any benefits, such as health insurance or paid time off. Using these workers to fill resource needs can help minimize costs. Once operations have begun to stabilize, it may be possible and ideal to offer full-time employment to these individuals.

Marketing is another key area for new business investment – but billboards, web ads, TV ads, and radio spots can be expensive. TV and radio ads can also be ineffective if they are aired during low-volume times, which is typically all that startups with lower budgets can afford. Fortunately, there are many low- or no-cost marking opportunities, such as word-of-mouth marketing. Doing a good job for one customer can easily lead to referrals for more business. Some social media efforts can also provide a strong return for minimal investment, although typically it can be difficult to gauge an effort’s potential impact or success.

A new enterprise that is bootstrapping must also carefully manage operational expenses. At the beginning of operations, an entrepreneur can often minimize unnecessary expenses – even if that means forgoing an actual business location. Working out of a home office or a co-working space (e.g., WeWork, Impact Hub) can lead to significant savings. Renting office space can cost hundreds or thousands of dollars a month, whereas a home office typically requires no additional investment. Depending on the location, co-working spaces can provide a single workspace and technology access for as little as $50 to $100 per month, yielding substantial savings over a dedicated office suite. In larger cities, or in locations with more amenities, the monthly costs can run between $100 and $500 per month.

The Boston Beer Company, which today produces the Samuel Adams line of beers, provides a classic example of minimizing these costs in its early days. When this company first started, it owned no office space – or even a brewery. It employed other breweries as contract brewers to manufacture its beer. Its founder, Jim Koch, invested most of his time in selling to bars and restaurants, working from his car and phone booths (this was during the 1980s). His lean strategy was a successful application of the bootstrapping mindset. From its humble beginnings, the Boston Beer Company has become one of the largest American-owned breweries, ranked second based on 2018 sales volume by the Brewers Association.[13] Whereas traditional thinking may dictate that a company must have an official office or headquarters, a bootstrapping mindset evaluates what the space would be used for and the trade-offs for its cost.

How Bootstrapping Hurts

The process of bootstrapping is not an easy one. It is fraught with tight budgeting and sacrifice, which can take its toll on an entrepreneur. One of the simplest bootstrapping strategies is to start a business by moonlighting, or treating your business venture as a second job. Employing this strategy, the entrepreneur continues to work at their regular job, say from 9:00–5:00, and then dedicates the rest of the evening and weekends to working on the business. Whereas this strategy has the obvious benefit of maintaining a comfortable level of income, this approach has a few drawbacks (see Table 11.2 below). Moonlighting entrepreneurs cannot dedicate 100% of their time and energy to their new business. In addition, the time that they can dedicate to it may be less efficient. After working all day at another job, a person may feel tired or burned out, so it can be difficult to change gears and press forward with full productivity. Beyond the exhausting time investment, moonlighting can exact tolls on personal relationships. This strategy is easiest when an entrepreneur is in a life stage with few commitments. It may have an adverse effect on friendships, but in other life stages, this impact can be more significant. For example, it can detract from relationships with a partner/spouse or children, in both a decrease in focus/investment in these relationships and day-to-day challenges in work-life balance and household management for all affected. Additionally, at some point, to attract serious investors, a founder will have commit to the project full-time.

Table 11.2         Bootstrapping Advantages and Disadvantages

Other bootstrapping strategies include negotiating the terms for payments on expenses. Often when businesses sell to other businesses, the vendor allows the customer to buy on credit. This means that the buyer does not have to pay at the time of purchase. Although retail customers are required to pay at the register during checkout, purchases between businesses can work on different terms, sometimes extended up to thirty, sixty, or ninety days. This extra time to pay for purchases can be a real advantage for businesses. When a business buys inventory on credit, it has the opportunity to begin selling it before it has even paid for it. For example, a clothing retailer could sell its product in stores or online and receive cash before it had to pay its vendors. Unfortunately, when a business’s cash becomes tight, an ethical dilemma can arise. When a business has more bills to pay than money to pay them with, the owner will need to make tough decisions. It can be easy to forget about or ignore amounts due to vendors, but this problem is compounded when it occurs with more and more vendors. Ultimately, it can get to the point where vendors will no longer sell to you on credit, or even at all. When a company can no longer buy inventory to sell to customers, it won’t be long until it’s out of business. An ethical entrepreneur will be alert to this concern and resolve it with aboveboard business decisions.

How Bootstrapping Helps

Although bootstrapping can be painful in the early years of a business, it yields significant benefits for the business owner in the long term. One of the most valued benefits of bootstrapping a business is the fact that the founder can maintain control of the company and typically retain 100% ownership. Although it can be easy to give up ownership in an idea (because ideas come freely and don’t require financial sacrifice), entrepreneurs who accept an equity financing opportunity and give up a significant portion of ownership of the business may not realize the potential detrimental outcomes. What seems glamorous on Shark Tank may cost a business owner more control than desired – and once you give up any amount of equity in a business, it can be difficult or expensive to get it back. Once the deal is accepted, the investor is entitled to that percentage of the profit every year the company is in business, even if that person never lifts a finger to support the enterprise. Entrepreneurs usually make those financing deals because of the benefits of the money and access to the investor’s contacts. It’s unlikely that Kevin “Mr. Wonderful” O’Leary is going to roll up his sleeves in your food truck when things get tough. If you can avoid outside financing, you will maintain complete control and full ownership of the business, and you should weigh this benefit in your financing decisions.

Another benefit of bootstrapping is avoiding taking on debt. Whether it’s in the form of credit cards or personal loans, repayment of debt can take a serious toll on any business and can be especially burdensome for new businesses. Considering that some of the debt financing sources available to entrepreneurs can bear higher-than-average interest rates, digging yourself out from underneath this financial burden is no easy task. Also, delaying outside investments allows your business to grow not only in revenue and profit, but also in market value. When potential investors do come along, they will consider a higher contribution for a smaller percentage in the business.

Startup Accelerators[14]

Over the past two decades, a new organizational form has emerged in the entrepreneurship ecosystem to support early-stage entrepreneurs. Paul Graham launched Y Combinator in 2005; shortly after Brad Feld founded TechStars. These organizations and others like it are collectively referred to as accelerators.

Accelerators essentially function as a “bootcamp” for entrepreneurs. For a short period of time (typically 3-6 months), accelerators provide entrepreneurs with access to mentors, training, workspace, and other valuable resources to “accelerate” their traction and growth. Many accelerators also offer a small amount of equity funding upfront, usually in the $10,000-$50,000 range. Then, they work to prepare participating entrepreneurs, their product, and their company for seed stage investment. Accelerators are usually “cohort” programs, with a group of entrepreneurs being accepted and participating during the same timeframe. In this way, they are able to learn from each other as well. This also enables the startups to “graduate” at the same time. In fact most programs end with a “demo day” event, where ventures pitch to a large audience of qualified investors.

Because of the investment that accelerators make in entrepreneurs, the criteria for being selected for an accelerator tends to be highly competitive. Startups and entrepreneurs first apply and then go through intensive vetting processes. Often, an accelerator will have a preferred type of company that they are looking for (e.g., health care ventures, mobile app ventures, etc.). Some accelerators are focused on entrepreneurs living in a particular geographical area, whereas others may recruit entrepreneurs from around the world.

Accelerator funding can be very attractive for early-stage startups (or founders with a new idea), but it can take a lot of work to prepare and apply. Furthermore, the funding from the accelerator is typically designed to only last as long as the program – so founders are usually expected to drop everything to participate fully for the 3-6 months. The aim is that when the program is over, a startup will be much better positioned to attract traditional angel or venture funding – but of course, there are no guarantees.

Chapter 11 References

[1] “Whole Foods Market: John Mackey.” How I Built This (NPR Podcast). May 15, 2017. https://www.npr.org/2017/06/30/527979061/whole-foods-market-john-mackey