Venture Capital and Investing in Business Start-Ups

Startups Must Choose Financing Models Wisely: Bootstrapping versus Angels versus VCs

When a Startup decides to expand using Bootstrapping, Angels, or VCs, it is incorrectly assumed that this choice has to do solely with money. Many advise founders to take the best deal and get the process over with as soon as possible.

However, it must be noted that the type of financing Startups receive determines the company’s strategic direction and probability of success.

Finance Models have numerous tangible strategic implications. When early stage Startups choose a Finance Model, they are confining themselves to a limited range of strategic options. When choosing a Finance Model, I think it is best to momentarily forget about money and focus sensibly on strategy.

To make the best possible decisions regarding your financing and de facto strategic direction, Startups have to place themselves in the best possible situation from day one.

Every Startup should end a series of successful prototyping with an analysis of which low-cost, high-impact business models, revenue models, pricing models, and sales strategies are suitable for their solution [problem-solving product or service] and its Users.

The next step is for Startups to assess the cost of implementing and executing particular business models. Startups may choose to self-finance these costs, receive funds from Angels, or use a pay-as-you-go strategy where you use a small base of sales to generate free cash flow which in turn funds additional sales efforts.

Finally, when moving into Alpha and Beta testing, it its critical to simultaneously test well-thought out business models, revenue models, pricing models, and sales strategies alongside your solution. If you decide to chase market share, forget about business models, and give your product away for the interim, then it is still a good idea to enable Users to purchase upgrades, subscriptions, or ancillaries. Otherwise, you may never know how many Users are committed or passive.

The Bootstrap Finance Model necessitates laser beam focus on product development, cost control, sales, and profits. Bootstrapping is akin to the concept of intelligent design. You are building a company from the bottom-up and are willing to allow a naturalistic growth cycle to occur. You’re interested in keeping your company very malleable, ready to shift directions in accord with market demands. You are opportunistic. Bootstrapping has lower initial risks, but higher long term risks since you may lose significant market share while other companies choose to Go Big. Bootstrappers risk being relegated to a sub par market position even though you probably have hip solutions, the coolest brands, and a cult-like User base.

The Angel Finance Model requires smooth investor relations, a high User growth rate, and a strategic direction that leads towards a highly probable merger or acquisition. Angel financing is similar to evolutionary theory. The Angel’s funds act as a propulsive agent to thrust a Startup upon an evolutionary cycle towards a probable Series A round or additional infusions of capital by Angels.

Despite opinions to the contrary, Angel investors are not charities, repositories of free money, or blind speculators panning for gold in quicksand. Angels need to make successful investments to sustain their investment activity. Angel financing has medium short term and medium long term risk.

The biggest dilemma in the Startup/Angel relationship is a misunderstanding of roles and responsibilities. Angels essentially invest in early stage conceptual renderings of solutions. Angels have to avoid getting involved in day to day management. Their only concern should be the completion of a workable solution [problem-solving product or service] that is ready to grow from prototype to Alpha tests/Beta tests. With Angels the clock is ticking slowly, but it is ticking. There is an expectation of multiple rounds of financing and merger or acquisition within 3-5 years. An Angel usually expects to earn a post-dilution return on investment of at least 200%.

The VC Finance Model can be simplified and best understood as a troika comprised of Seed Stage VC Funding, Early Stage VC Funding, and Late Stage VC Funding. Seed Stage VCs invest after evaluating an early prototype or hearing a particularly interesting pitch. Early Stage VCs invest with the sole intent of maximizing the value and market position of a Startup in anticipation of future rounds of financing. Late Stage VCs invest in Startups seeking additional funding while preparing for an eventual IPO or M&A. At each stage of a Startups’ evolution, VCs invest with the expectation that exponential growth and a successful M&A or IPO will substantiate the risks incurred.

The VC Financing Model compels a startup to grow at an ever accelerating pace. Such growth comes at considerable risk and entails the development of a costly labor, advertising, and technology infrastructure. Over the short term the risks involve technology and labor. The Startup must scale quickly to ensure quality user interactions, while priming their web sites and customer service systems to handle an exponential increase in Users. The Startup has to also deal with potential shortages in highly skilled programmers and project managers. Long term risks are market based. While managing such a fast pace of expansion, the Startup must stay grounded in the marketplace and respond proactively to shifts in the tastes and need of their Users.

Under this scenario, the focus is placed on expanding market share and brand identity. Typically, VCs expect to net a return on investment of at least 600%-1000%. Startups funded by VCs are always expected to become market leaders. A VC funded software company surviving multiple rounds of financing and heading towards a M&A or IPO can easily spend $50,000,000 or more over a two year period.

It is important to note that while there are innumerable examples of surviving and thriving Bootstrapped and Angel financed companies, successful Large-Scale VC investments are short in number in the Web 2.0 Era. Startups don’t require that much money to fund operations. And there is a more patient attitude on the part of Startup Founders who appear to be committed to running their companies for long periods of time before seeking VC funding.

Many Startups will become sustainable using all three Financing Models in the near future. A number of Startup Founders will decide early on to exclusively rely on one Financing Model throughout the embryonic period of their company. For example, it is possible that a Startup could reach a successful M&A or IPO exit by the sole means of Bootstrapping. To the contrary, numerous Startups will solely utilize several Angel investments or multiple rounds of VC funding to reach success.

Furthermore, others will undoubtedly find success by mixing and matching Financing Models. For example, a Startup may initially secure Angel investments then choose to Bootstrap or accept VC funding to facilitate further expansion and progress towards exit.

It is best to remain free of any preconceived notions or biases. When the time comes to make a Financing Model decision, just remember you’re making a compulsory strategic decision. Just make the best decision possible relative to the market conditions and fiscal circumstances that face your company at that time.

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