Funding Your Startup: Deciding the Best Fit for You
As a tech entrepreneur, securing funds to bring your idea to life is a significant step in the journey toward success. You may have heard the terms “bootstrapping” and “venture capital” thrown around. But what do they actually mean? And, more importantly, how do you know which one would be the best fit for your company?
For this article, we sat down with Jay Rhind, Partner at Rhino Ventures, to unravel these concepts and to help you make an informed decision about what type of funding would work best for your startup.
Venture capital (VC) has become an integral part of the tech startup ecosystem. It provides founders with the financial resources required to turn their innovative ideas into successful businesses. So, what exactly is venture capital funding?
VC funding involves receiving investment from venture capital firms or institutional investors. In exchange for their investment, venture capitalists receive equity in the company, allowing them to share in the potential future profits.
One differentiating aspect of VC-backed companies compared to bootstrapped ones is how VC-funded companies typically depend on venture funding throughout the various stages to fund future growth.
All this being said, VC funding has its own distinct advantages and disadvantages, and we go through the pros, the cons, and if taking VC might make sense for your company:
The Advantages of VC Funding:
- Mentorship and Expertise: The right venture capitalist can offer you valuable industry insight, guidance, and mentoring through their experience, which can help entrepreneurs navigate challenges and make informed decisions as they scale up.
- Access to Capital for Rapid Growth: Venture capitalists can give you access to substantial capital to fund R&D, product scaling, marketing, and expansion into new markets.
- Validation: Startups with professional investors backing the company provide a layer of trust and reputation, and services as a signal of validation to potential customers and partners.
- Network Expansion: Venture capitalists often have extensive networks in the business world. Working with a venture capitalist can open doors to potential partnerships, customers, and strategic alliances that might otherwise be inaccessible.
Jay talks about how Rhino supports their portfolio companies by aligning with the founders’ vision through their journey and acting as mentors. “Rhino first and foremost believes in the Hippocratic Oath of do no harm” – knowing that entrepreneurs drive the value of the startup and the importance of funder and founder alignment.
“We do our absolute best to be the most knowledgeable group on the CAP table about the business and market, being the person to call when you’re thinking through challenging business problems.”
The Disadvantages of VC Funding:
- Equity Dilution: In exchange for funding, startups give up a portion of ownership to venture capitalists. This leads to founders having less control over strategic decisions, less share of the profits, and likely a lesser portion of the final exit proceeds if the company sells.
“If you do the whole “alphabet soup” Series A, B, C, etc., one, that’s a lot of dilution, two, control that’s lost, and three, the destiny of your business is progressively pulled further out of your hands because every subsequent round is looking for a different kind of return profile.”
- High Expectations: Venture capitalists expect a strong return on their investment. This pressure can lead to short-term decision-making focused on rapid growth at the expense of long-term sustainability to achieve milestones and get to the next raise.
- Pressure to exit: Venture capitalists often expect an exit strategy, such as an acquisition or IPO, due to the timeframe of their fund and investment strategy. This can force startups into decisions they might not be ready for such an early exit.
- Competitive landscape: In the post-pandemic area, VC funding has become more competitive, and not all startups are a good fit for the VC’s investment criteria. The process of finding the right VC can take away a lot of time from founders as they prepare from one pitch to the next, impacting their focus on operations.
“A lot of companies try to raise money and spend 8-12 months trying to do it as opposed to building the business (shipping the MVP, closing one marquee customer, etc.). The more value-creating thing for them to do would have been focusing on building the business, the product, and do founder-led sales.”
When you should take Venture Capital investment:
While venture capital can be advantageous for many tech startups, it is particularly well-suited for those with the following characteristics:
- Large Addressable Market: When the market opportunity is substantial, there is the ability to grow to a large enterprise-value company, leading to success for both the VC and the founders even after equity dilution.
“Before you go down the venture path, ask yourself if you think there is an addressable market and opportunity that is several hundred million of enterprise value creation potential.”
- High Growth Potential and Scalability: Startups positioned to scale rapidly in the market likely will need an infusion of cash from a venture capital investor to do so.
- Innovative Technology and Costs: Companies with innovative or disruptive technology in their verticals attract VC interest, and when the capital costs for innovation are high, your startup may require VC investment to make headway.
- Reliance on network effects: Startups with products that rely on network effects for success, such as building to be the first to market, or ones building in a highly competitive space, will find that the right VC can help gain traction to enhance the network effect.
- Perseverance: Startup founders taking venture capital should be prepared to embark on a long journey to truly build their business and scale it up. This can be a long venture, and commitment is required once you partner with a venture capitalist.
“Founders [pursuing venture capital] need to have perseverance and have to ask themselves questions that are too frequently left until they are in the thick of it: Why are you starting this business, why are you and your team the right people to solve this problem, what is going to give you sustaining energy to see through a 5+ year journey?”
Bootstrapping: Self-Funded Growth
A bootstrapped company is one that has started by using personal funds and resources and has grown by relying on the company’s revenue and cash flow generated. Later in the lifecycle, the company may have access to credit facilities such as business loans to fund further growth strategies.
With bootstrapping being the default strategy for startups, the decision to continue this self-sustaining process will depend on the circumstances and there are important variables to consider:
The Advantages of Bootstrapping:
- Full Ownership and Control: The most significant advantage is that founders retain full ownership and control of their startup due to not giving out equity to VCs. This allows founders full autonomy around strategic decisions and core vision as the company grows, which potentially could have conflicted with external investors.
- Profit Retention: As equity is not diluted through external investment, founders will reap the rewards of the net profits for themselves. Additionally, if you successfully sell your company, the founders will be able to get the full value of the exit price.
- Focus on Long-Term Vision and Operations: Founders can prioritize long-term sustainability and the operations of the business, without the pressure of meeting short-term milestones imposed by investors.
According to Jay, bootstrapped founders build accountability and strong financial discipline as they are growing their company, which can be lost in the venture route. You do not have this idea of unprofitable unit economics or negative gross margins being backed up.
“There is a purity of bootstrapping where you are accountable to the performance of the business.”
The Disadvantages of Bootstrapping:
- Limited Resources: Bootstrapping typically means limited access to capital, especially during the early days. With resource constraints, you might face challenges in scaling your business as you will not have the funds to invest in initiatives such as marketing.
- Slower Growth: Bootstrapped startups often experience slower growth compared to their VC-backed counterparts. Entering new markets or expanding rapidly is more challenging without the financial cushion provided by external funding.
- Competitive Disadvantage: If your startup is building in a highly competitive space, bootstrapped companies may find it difficult to compete against well-funded companies.
“There are limitations as you can’t invest ahead of the curve on either the product, sales, or marketing side. However, it is a much more methodical building block approach to value creation, which brings a level of accountability and discipline to a company that can be lost very quickly on the venture treadmill.”
Is Bootstrapping the better fit for your startup?
There are multiple factors to consider if you are better suited to bootstrap your company such as control, risk, and competitive landscape. Let’s dig into if bootstrapping could be a better fit for your startup:
- Niche Market and Vertical: Startups with product market fit in niche markets and verticals will find there may be less competition and could realize success in generating revenue without the resources of a VC.
- Low Total Addressable Market: Startups operating in a low TAM likely will not need VC funding to grow and capture enough market share to maximize the value of the company.
- Control: Founders who prefer to have control over strategic decisions rather than having VC investors on their board mandating decisions will find bootstrapping the better fit. This is further the case if the founder has the expertise and relevant skills in the industry the startup is operating in, reducing the reliance on external resources required.
- High Margins and Short Period to Profitability: Startups with a clear path to generating profitability early on are well-suited for bootstrapping as the cash flow can be used to fuel growth.
A Hybrid Approach:
Your approach to how you will be funding your startup through its lifecycle is not a restricted one. A successfully bootstrapped company that finds itself in a situation requiring resources from a VC can move on to finding external funding. Founders with a proven, scalable business model, sustainable growth, and traction, would be appealing to future investors.
“The nice thing about [a bootstrapped] business is they know exactly why they’re raising, and they have a clear reason for it. They have revenue and can demonstrate how the capital will be put to productive use” and this is appealing to VCs.
Jay notes these bootstrapped companies can explain why, for example, raising $5 million could be productive, while their alternative could be simply running a cash flow generative small business. “It shows a certain amount of discipline into the reason why you’re raising money that’s more heightened for that stage of a business.”
Determining the right funding strategy for your business requires a clear assessment of various considerations. The timing and reason for a raise need to be well thought out. If you would like to discuss how these issues relate to your specific circumstances, please contact one of our experts in our Smythe Technology Industry Group.