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— A VPA Perspective

Funding Your Business: Bootstrapping vs. Venture Capital

  • Why bootstrapping is a great strategy for founders interested in selling on the private markets
  • The tradeoffs of taking venture capital money

One of the primary issues you’ll face as a founder is whether or not to bootstrap your company or take on venture capital money.

Having worked with many founders at the time they sell their businesses, we’ve seen how one route or the other can affect the final outcome in the sale of a business. Here are our thoughts on the trade-offs of bootstrapping vs. funding through venture capital.

Defined: Bootstrapped vs. VC-Funded

When we use the term bootstrapping, we’re not strictly referring to companies who have taken zero outside investment. According to our definition, a bootstrapped company is one that relies primarily on the company’s cash flow to grow the business, taking on little investment (less than $20m depending on the circumstances). The money raised mainly comes from FFF (family, friends, and founders) and angel investors, but could also come from a small VC round.

Our definition of a VC-funded company, on the other hand, is not dependent so much on the amount of money raised, but rather the dependency of a company on VC money to fund future growth, regardless if the company raised $15M or hundreds of millions.

Should You Bootstrap Your Business?

The default funding strategy is bootstrapping, so the question remains, should you maintain that funding strategy or take on VC money?

Some startups might take for granted that they have a choice between growing with and without VC money. In the general startup narrative, taking on VC money seems to signal prestige or success for the business. There is also that whole "smaller piece of a bigger pie" story that has been told thousands of times.

While these ideas aren’t necessarily false, they often focus on outlier success stories and lean in favor of taking on VC money, when there are other important variables to consider:

  • Control. As a founder, how important is controlling the outcome of your business to you?
  • Risk. How much risk are you willing to take on as a founder?
  • Potential size of outcome. How big can your pie reasonably get?
  • Competitive landscape. Do you need an insertion of VC money in order to reasonably compete in your space?

Before you resolve to take on VC money, consider the below thoughts.

Should You Take Venture Capital Money?

If your company is doing well enough to attract the attention of VCs, you have a business to be proud of. But before you start a Series A, you need to know what’s at stake.

The issues with VC money

Depending on the circumstances (your business model, industry, and product), a founder might be worse off taking VC money. Here’s why.

First of all, growing with a VC doesn’t necessarily mean a larger exit for the founder. Venture capitalists often use the pie concept to suggest that working with them will, almost by default, grow your business to a size large enough to counteract the significant dilution resulting from taking VC money.

However, raising VC money can actually result in a smaller exit for founders because:

The proverbial pie doesn’t always end up as big as anticipated. Your company has limits on how big it can grow, which a VC might not acknowledge. The larger your pie needs to be to make VC money worth it, the more difficult to reach that size. For example, you’re better off bootstrapping and exiting a $50M company owning 100% than taking VC money and exiting a $200M company at 20%—the $50M bootstrapped company makes you more money and is a more probable outcome than a $200M exit.

Venture capitalists take extra bites from the pie with minority protections. Venture capitalists go to special lengths to protect themselves in the case of downside. They will almost never accept common stock or be on equal footing with you as the founder, insisting on liquidation preferences, participation preferences, dividend rights, and other minority shareholder provisions. These minority protections enable VCs to take more than their percent share of the final sum upon exit, meaning less pie for founders.

In addition, VCs could damage your company’s future because their risk profile might not be aligned with yours. VCs take a portfolio approach to investing, putting their funds into 40-100 companies at once. Because they’re highly diversified, they demand ratcheting up the risk on each of their ventures because only one of them needs to work for the fund to succeed.

You as a founder, on the other hand, only have one company, and if it blows up, you’re in trouble. So when your VC suggests it’s time to spend a ton of money to rapidly scale sales and marketing or introduce a new product line or pursue another risky strategy, know that they are much less afraid of risk because they have another 100 companies backing their play.

A risky strategy can greatly inhibit your ability to reach a successful outcome. Many of our bootstrapped founder clients make a $75-250M exit owning 50-100% of the business. However, if you have raised $30-40M in VC funding, these outcomes aren’t as likely because the VCs are pushing to be a $1 billion company and the strategy to get there inherently takes these otherwise great outcomes off the table for founders.

Remember, VCs aren’t worried about sacrificing the outcomes of a few founders they’ll likely never work with again in pursuit of that $1B deal that makes their fund look appealing to even more founders.

Even if you speak out against your VC’s risky strategies, you might not have the deciding vote because you’ve lost control of the direction of the company. Venture capitalists can exert control in your company whether or not they own a majority stake. As we stated before, VCs do their best to protect their interests. As preferred shareholders, they can exert power as a minority shareholder that feels an awful lot like a majority shareholder.

In the end, as a founder you need to stay tuned into:

  • How much control of the company you can retain
  • How big your share of the company remains

There are times you should and shouldn’t take venture capital money. Evaluate your own company and objectives based on the below criteria.

When you should take venture capital money

Taking on VC money might make sense for your company if:

The market opportunity is massive (like Salesforce massive). When the market opportunity is large, there is enough space for your business to grow to a multi-billion-dollar company, in which case a smaller piece of a bigger pie is worth the trade-offs.

Innovation costs are high. When initial innovation is costly and requires an infusion of capital to get off the ground, VC money might be your only option.

The market is highly competitive and product differentiation is difficult. When competing products aren’t intrinsically different, companies rely on sales and marketing to differentiate the product for customers. Scaling sales and marketing for rapid growth will likely require capital.

Network effects are key to success and require speed to market. If the first to market wins the entire market due to the value of the network, then a VC can help you gain customers quickly and strengthen the network effect.

The founder has valuable yet underutilized skills. If the founder has special skills that currently aren’t being used because they’re having to focus on other aspects of the business, venture capital can help expand out the management team and give that founder more time to focus on core aspects of the product/business.

When you shouldn’t take venture capital money

Venture capital money won’t make sense for your company if:

You’re a software company focused on a specific vertical with reasonable development costs. In verticals where product-market fit is the ultimate determiner of success, then you don’t need the resources of a VC to market or develop your business.

Profitability is attainable in a short period of time. If you can reach profitability relatively quickly, then you will shorten the time to sustainable growth and use retained earnings to grow the business.

Your business model has high margins. Businesses with high margins (such as internet businesses with low overhead) can use their own cash flow to fuel growth as well as provide founders with enough liquidity via distributions to de-risk their personal finances.

If you’re interested in taking out shareholder distributions at some point in the company’s future, then VC is not the route for you. VCs will not allow you to take dividends, as they’d rather spend that money on any initiative with even measly ROI than have shareholders take out a dividend.

If you’re interested in growth through capital, then you might consider growth equity as a solution further into your company’s future.

The founders want to maintain control of the business and have decisive authority about the future of the business. Even if the founders maintain majority ownership, the preferred shareholder status of venture capital investors gives them extra power in strategic decision-making.

If you don’t want a VC investor sitting on your board making decisions, mandating you delay or expedite a sale due to their 3-5 year holding period, or requiring you maintain your business plan despite fluctuations in the market, then don’t take VC money.

Your company has a low total addressable market (less than $1B). If your TAM is relatively small, then you likely don’t need VC money to maximize the value of your company.

Your company and founders have a local following and you want to maintain that image intact. When your local customers connect strongly with a founder and the company’s mission, bringing on external, "Silicon Valley" investors can fragment that image and damage customer relationships.

You’ve already reached scale and are still growing at a significant rate. Lots of VCs will target companies that are already growing at 30-50-70% and suggest that they (the VCs) can help the company grow at an even faster rate.

But growing at a faster rate doesn’t guarantee a larger final valuation, just that you’ll get there faster, which isn’t necessarily worthwhile if you’re giving up a significant amount of equity and accepting the trade-offs of working with a VC.

Growth Equity as an Alternative to Venture Capital

Many successful companies will completely forego the venture capital stage and will instead bootstrap until they’ve developed a proven and scalable business model.

At that point, they will instead take on investment from a private equity firm, either in the form of primary capital that goes into the business and helps them grow, or as secondary capital, which goes directly to the founder to help them de-risk their personal finances. Some of the benefits of this approach include:

  • Providing high liquidity to founders and early shareholders
  • Enabling founders founders to be more aggressive in how they grow the business moving forward by taking some chips off the table
  • Leveraging the playbook of institutional investors to grow the business faster but still maintain significant control

Regardless of the intended goals for your company, considering all your options for selling a portion of or your entire business will reveal the full universe of potential outcomes. In any case, if the circumstances are right and you’re in a position to bootstrap, do it. This path gives founders the most control over their business and the ultimate exit.

Modified on Jun 22, 2020