Are there better choices for funding than venture capital?


venture capitalist

venture capitalist

Venture funded startups have been some of the greatest sources of wealth in human history – for venture capitalists. For many of the other participants, not so much. Venture capital funding has a place in the startup funding sphere but it is not a panacea. Here I talk about why you shouldn’t and just maybe when you should use VC funding.

The type of funding that you should pursue depends on what the goal of starting your company is and the type of company that it is. If you want to massively grow your company and get acquired, you are going to have to behave a lot differently than if you are creating a company for long-term growth. In the former case, you are going to have a burn a lot of money to acquire the skills, people, and traffic necessary to get large – this can be a viable option in some cases but is essentially a lottery. This sort of growth->visibility->acquisition model depends on a vast number of factors, of which luck, timing, and culture play no small part. On the other hand, building a longer-term company can fail but the amount and rate of money expended is usually much less – often by an order or two of magnitude.

Venture capital funding is often not a bad idea for companies with high capital requirements that need to spend a lot of money very quickly – for example, manufacturing, people-intensive work (localized news reporting), and other such startups. Venture capital can and should be used for these sorts of large investments. For your startup, unless you are planning on simultaneously opening 10 offices nationally or servicing all industries at once, you should consider other types of funding. I have listed them below in increasing order from less desirable to most, as well as the considerations for each sort of funding.

  1. Venture capital (VC) funding
  2. The only real uses for this sort of funding are the lottery model – growth then visibility then acquisition – and capital-intensive businesses. Using VC funding for building a long-term company is challenging, as the VC people will be pressuring for a cash out and will thus press you to make decisions that may not be in the best interests of the long-term company growth. These will be things to help spike traffic, cultural interest, or other factors affecting saleability. If you want to sell the company as well, then great! If not, VC funding comes with increased loss of control in your control of the company. If you don’t care about this, then VC funding; however, even if you do not care much of this, understand that getting paid out 20% of the total value of a company is much different than cashing out 100%. Accepting VC funding dramatically reduces the eventual payout that you will receive – on the plus side, the payout may be orders of magnitude higher.

  3. Bank funding (hard money lending)
  4. This is the old standard – take out a bank loan, mortgage the house, this sort of thing. This has the benefit of NOT diluting your control of the company, which means that you will receive more money if you get paid out, and you will not be subject to interruption of your company control. This funding has massive drawbacks, however, in that business failure will often have extremely dire personal consequences, up to and including bankruptcy and loss of your home. If you are looking at building a company for acquisition, I would recommend VC funding over this; if you are building a company for longer term growth, I would suggest hard money funding. In any case, be very careful doing this and ensure that you have a valid, active market segment that is willing to pay for your services or product before using hard money.

  5. Friendly funding (soft money lending)
  6. This type of funding is a vast improvement over hard money lending for several reasons, albeit with some issues of its own. Soft money lending can have a different meaning for many financial people – for them, it means unofficial lenders that often charge high rates and short payback period; this is not the meaning that I am using. This type of funding is typically from friends or family – they will lend money to you based on your enthusiasm and (hopefully!) business plan. The main drawback for this sort of funding is that if your company fails, you can have a huge amount of personal blow-back. While this may not seem critical to you, remember that we are building companies to support our lives, not building lives to support our companies. This type of funding can work for both acquisition and long-term growth, although you probably will not have enough friends or family to get enough for the acquisition (if you do, please let me know – I would love to marry into that family!)

  7. Angel investment
  8. This is the best type of non-customer funding; Angel investors are superficially similar to VC funding but they do not incur the same type of control and payout dilution. The main drawbacks for this sort of funding are that they are often very hard to find, they are often focused on a particular industry or technology type, and the amounts are typically a lot lower than for VC funding. For the first point, in Calgary, not only are there few Angel investment organizations and individuals, the ones that exist tend to focus on energy and oil/natural gas technology plays. This makes it quite hard for Calgary startups not in the oil and natural gas sector to get Angel investment funding – this is one of the factors that is standing in the way of making Calgary a technology hub like San Francisco, Toronto or even Vancouver. The amounts are also lower than available for VC funding and are thus probably more suited for long-term company growth. It can be used for acquisition plays but it is harder to get enough money to make this model work for the truly large payouts.

  9. Self-funding/bootstrapping
  10. This is the summit of all funding types. It uses sales to customers to drive the company growth and ensure that both your cash-flow and profits will allow this. This type of growth is sustainable and will actually improve your desirability for acquisition as you have a proven model, market segment, and audience. The main drawback to this sort of model, if there is any, is that it is hard to work in a capital- or inventory-intensive business. This model is best for services or information technology products that do not incur these large upfront costs.

I would strongly encourage you to pursue the self-funding/bootstrapping model. This funding type has added benefit of validating both your business model and audience. If people are paying for your services or product to the point that you are making a profit, then by definition you have found an active market segment that is willing to pay for your services. This model is so useful, in fact, that you should do much more research than you think before starting your company – you should maximize your chances of success by validating your ideas and ensuring that there is actually a market hungry for your offerings.

How about you all? What successes or, more importantly, failures have you encountered with each of these funding types? Please share your experiences below.
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Image courtesy of adkorte / flickr.com

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