Raising venture capital to fund product development and operations is a great way to grow a startup. But it’s not the only way. And raising money from VCs comes with tradeoffs.
Receiving an injection of capital in exchange for equity can make it feel like you’re playing with “house money” because there’s no corresponding repayment obligation. And there’s the rub. Many startups run into trouble because their funding doesn’t impose constraints on them that serve as a forcing function to move faster toward product-market fit, financial discipline and operational excellence.
Particularly at times like these, when VC money is less available and it’s more important than ever to acquire customers and generate cash flow, startups should consider alternative financing, such as what some perceive as “old-fashioned” loans.
Related: Five Easy Ways Startups Can Manage Debts From Day One
Moving beyond the mindset that raising equity financing equates to success
When a startup raises a big round, it results in headlines and accolades in the press. As a result, some startup founders understandably believe that fundraising is a proxy for success — that VC dollars in the door validate everything about the business.
But founders commonly look past the corresponding tradeoffs. For one, raising money takes a lot of time and effort. It can become a full-time job. And when that happens, the performance of the business invariably suffers. While the business may secure a short-term lifeline in the form of new funding, building the business gets neglected, resulting in its eventual failure.
Another problem that’s often overlooked is dilution. When a founder raises money for an early-stage startup (especially one that’s not generating revenue yet), the business valuation is typically low, which means the amount of equity that must be relinquished in the process tends to be proportionally high.
A common mistake we see early-stage founders make is raising more money than they reasonably need from the start based on the often erroneous assumption that early dilution will have little impact because future rounds will always be raised at higher valuations. As we’ve seen recently, many former high-flying startups have been forced to raise additional capital via “down rounds,” leading to further founder dilution.
Finally, it’s important to remember that VCs have their own expectations and obligations to their investors. The VC business model is to make 100 bets and hope five to 10 of them pay out in the form of a $100 million+ exit or IPO. That means they’re going to push the companies they invest in to grow like crazy—even if a slower march toward profitability would help ensure the long-term viability of the business. Every startup a VC invests in is, from the VC’s point of view, a chip on the roulette table.
Related: Why Small Businesses Should Look for Alternative Capital Financing
Debt: a reasonable alternative
Over the last few years, the idea of taking on debt versus raising equity capital was anathema to most founders, given how freely venture capital flowed. We all kept hearing about how too much money was chasing too few startups. Times have changed (obviously).
In some ways, I think they’ve changed for the better, although that’s probably hard for some to recognize right now. Sure, it will be hard for some companies to survive now that the VC spigot has been turned down. But for many startups, the resilience, grit and innovativeness developed during these challenging times will be the foundation for their long-term success. It’s often said that the best companies get started during a downturn, largely because they must dial in on building a great business instead of spending excessive time raising money.
There are viable alternatives to equity financing that startups can and should focus on, including bootstrapping and taking on a management amount of debt. Many successful technology companies, not to mention countless non-tech businesses in the broader economy, bootstrap to success by using cash flow from the business to fund operations. Some use loans, such as Small Business Administration loans, to fill in the gaps.
In certain instances, startups that bootstrap and take on debt ultimately raise equity financing, but only after their business model is proven, allowing them to raise at a higher valuation and leading to less dilution for the founder. In the interim, these startups build products that address customer needs, start to generate revenues and profits, and, in the process, their teams develop valuable skills that help take the company to the next level.
Related: Why Venture Debt is Gaining Popularity
Whether by choice or out of necessity, more startups are taking on debt because equity financing is unavailable. Bloomberg recently reported that “venture debt volumes in the US hit $17.1 billion in the first six months of 2022, up 7.5% from the same period in 2021. VC funding is down 8% over the same period to $147.7 billion.”
One of the objections I hear from founders when I raise the prospect of taking on a loan instead of equity financing is that, essentially, they’d rather use someone else’s (i.e., a VC firm) money. I understand this temptation, but as we’ve discussed, raising venture capital comes with significant risks, although often unrecognized and unacknowledged. And, yes, taking on loans comes with risks and obligations, too, including the need to pay back the loan or be in default.
But generating profits with a business requires taking smart risks, and if you’re not willing to put some skin in the game to pursue those profits, then the startup game may be the wrong one to play.
Don’t conflate fundraising with success. Don’t assume equity financing comes risk-free. Don’t be afraid to take on reasonable debt to preserve your equity and impose some discipline on your business. There’s no single path to startup success.
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