Bikchandani talks about the importance of bootstrapping (for the uninitiated, here is a formal definition of bootstrapping) one's venture. Athough, he makes convincing arguments, the article dangerously borders on providing general advice to budding entrepreneurs to most certainly bootstrap without actually understanding ground reality. As sooner or later everybody finds out, there are no certainties - bootstrap! don't bootstrap! is all an illusion. Heck, even scientists can't be completely certain if F = m * a or F = m1.01 * a.99 or F = m.99 * a1.01 where F is Force applied to a mass m causing it to accelerate with a (that is Newton's second law of motion for the uneducated). The models we build are only as precise as our decision-making requires. To tackle uncertainties we rely on frameworks, a structured way of discovering reality, when it actually happens.
Bootstrapping is an option among several others. The choice of funding a budding entrepreneur should go for, will depend on several factors. By the way, I can speak authoratively about it, because:
* I have worked with one startup (Quetzal) for nearly couple of months (awesomest 7 weeks of my life)
* I am presently giving some MBA insight to a friend who is starting a new venture.
* I did actually start a small venture when I was 16
As I said, there would be several considerations while making a choice of funding. Some key considerations would be:
1. What does the entrepreneur want to do with the business?
Now there could be 2 generic type of answers in this context:
* I want to create & sustain something of my own and I want to be make as much money as I can while I do it. For these bunch of people, their business would form their primary source of income (unless they are living of the proceeds of their earlier business or inheritance). Somewhat like a lifestyle entrepreneurs. Money is inevitably tied to ownership i.e. equity. And so is control.
* I want to create something, sell it out (and invest the proceeds or join a consulting firm or something like that). These are the guys for whom starting a business is not the end, but a means to something else. Making money would be important but secondary to other important things person wants from life.
2. Has the idea of the product or service been proved?
This is a no brainer. Only two broad answers possible.
* Yes - there is a clear demand of the product in the market.
* No - the product or service is going to take off slowly, and market may need to be created.
3. What is the competitive environment for the product or service?
Three broad scenarios possible.
* New entrepreneurs but no well-established existing players
* Existing players are serving the need(s) of customers
* Zero or little existing players in the field
If we combine all these options, we end up with 12 scenarios. The following image defines the twelve scenarios.
Firstly, couple of observations: Where ownership is important, the founder needs to hold as much equity with him/herself – in fact, it is best not to allow the equity to fall below 51% – to retain control of the organization. When however cashing out is important and controllership is not important, equity can be allowed to fall to 26% the minimum required to protect one’s stake (from Indian point of view). Not that it will protect the founder fully, but some amount of protection is offered. However, in this case typically the founder will have a returns expectation over a period of time. I would think that one would ideally want to beat the highest returns that can be obtained from the stock market. But that is what I would think. Somebody else might think something else.
Secondly, there are three broad financing choices open to startups:
1. Bootstrap
2. External equity – this is the VC route. It doesn’t come with many strings attached, but results in loss of equity.
3. External debt – this is the loan route from banks or otherwise. It comes with a lot of strings, most important of which is interest payments. However, there is no equity loss.
With this background, let me discuss what could be the relatively appropriate financing strategy in each scenario.
A – In this case, where demand is proven and several others are in running after the same pot of gold, you would want to be first to develop a quality product, sell it, establish your distribution presence, etc (what could be called leveraging first mover advantage). Assuming the founder does all other things right (pricing, costing, etc); the right amount of funds will help you attract premium talent, penetrate market faster, etc. If one has sufficient funds with oneself, then bootstrapping is obvious. But if more funds are required, it is better to opt for debt (loans from banks). Ideally some amount of debt might also help in raising the Return on Equity for the founder, plus interest payments do force a discipline in fiscal matters in the organization.
G – When cashing out quickly is more important, the aim is to bring the business to a position where it fetches value significant to get returns. Secondly, it would be necessary to find a buyer. In India, right now the secondary market for business is not very developed. Angel Investors can help looking for buyers through their network. So bringing in external equity might serve well. This equity would help in growing business quickly, if the product is good. This will increase value of the business. Having excessive debt on the balance sheet would be a hindrance when selling the business. Some combination of debt and equity can be used effectively here, to raise value of the company and preserve enough equity to quit the business with very expected returns.
B – In this case, typically nobody understands the customer requirements clearly – including the customer. So the product evolves over several iterations involving the customer. First mover advantage will only be helpful if one gets the right product bang on the first time. But that will happen rarely. Also, risks of failure of business will be high. In this case, ideally one would want somebody else to give money to setup the business. Well, if one is lucky or if one has contacts in the investor circles or if one is really good, then chances are one might get other people’s money to play with. But most likely, neither of the three will be true. It would be even more difficult to raise debt. So, one will be forced to bootstrap. In a way, this would be the real test of one’s risk-taking abilities.
H/J/L – The create market scenario is ill-suited for entry of time-bound returns focused entrepreneurs. Because, creating a market is a trial and error process. As such predictability of future cash flows in such a case is almost zero. If founder has something that gives him/her a distinct advantage over his/her peers, then it can be leveraged and external debt/equity can be raised for growth. Size can be accumulated enough to cash out of the business. Otherwise, cashing out quickly is really a dream. Pumping any amount of money would not make the business success, if market is not proven. It would be better to look for other opportunities which will give the kind of returns the entrepreneur is looking out.
C – There is an existing market and you are trying to make a dent by serving some (niche) under-served or unmet need of the market. In such a situation, one of the most important things to be considered would be the reaction of existing players’ reaction, if they are few. And if there are many then their reaction would need to be considered, but may not be most critical. Also, in such a market price would probably be the only basis of competition. As one would expect, unless the founder’s value proposition is strong enough or there is proven room enough for at least one player to grow, VC’s won’t be very bullish on such a venture. The returns will be always under competitive threat. And if the competitors are few and big, expect them to spend obscene amounts of money to defend their turf. Raising debt would be advisable, but to a limited extent. Margins in such market may already be thin and interest burden would reduce them even further. So, forced to bootstrap!
I – The prospect of cashing out with super returns in the “Existing Players” scenario is dim unless one has a magic product or service to meet the proven demand and competitor reaction will do little harm – a combination which is very less probable in reality. Bootstrapping is preferable if investment is low. If externals funds are needed then it is a choice between debt and equity or its combination so the founder gets expected returns. If it can be done easily and cheaply, debt should be raised. As long as, founders’ returns expectations are not impacted, limited external equity can be raised too. Revision of expectations can be done, but that means lesser cash when exiting.
D – There are existing players and you are trying to create a market. This is typical when one is coming up with a new product to meet an existing need. Again, a strong competitor reaction is expected, when they are big and few and they would employ several tactical measures to delay the absorption of your product (not ruling out unethical practices, remember Virgin - British Airways). Getting external equity funding may not be difficult, if the product/service is good. However, to fight off the competitors, considerable funds may be required and that would imply a giving up considerable equity. A mix of external debt and external equity can be adopted to meet funding needs though in that case external equity investors are going to want to buy equity cheaper.
If competitors are many and small, then quickly penetrating the market with the new product/service is important, for their reaction would not pose a great threat. The best way forward, would be to develop right sales strategy and focus on selling, instead of competitor reaction. After bootstrapping initially, next strategy would be to raise debt (short-term or long-term depending on needs). If switching costs are high and customer acquisition process lengthy, then long-term debt would be needed otherwise, short-term should be fine, unless there is arbitrage possible.
E – When there is little competition to worry about and a proven demand, the best strategy is to establish and grow oneself as quickly as possible. Bootstrapping is obviously preferable. Quick growth and expansion would likely need a lot of capital. So, some debt/equity infusion can be sought at the beginning. Equity is better for the lesser hassles. But debt brings discipline which helps in long run. But discipline can prove to be an obstacle to growth. And undue freedom may compromise the long term prospects of the company. A balanced view should be taken before deciding the preferred route. Once an IPO-able size is attained, then external equity infusion is best sought from the market – hot market, if possible. The first mover advantage should be leveraged to the extent possible.
K – This situation is similar to E, except that one may choose to exit early by selling off to investors and not necessarily in an IPO.
F – This is usually the case with a highly innovative product or product for niche market. The problem in such a case for the first mover is – s/he may be able to create a market and not exploit it later – once the demand is validated. In such a situation, initially it might be very difficult to find cheap funding from VCs. The strategy should be to raise capital with short term point of view. Getting good valuations, at first go, would be very difficult. One has to be able to raise capital by bootstrapping during initial period, and later in small tranches to meet needs in short-term through external equity. It will not expose too much capital to excessive risk in one go. As the demand is validated, the risk will go down and the cost of capital will be cheaper. Of course, you would need to have or develop good contacts amongst the investor circles, so that capital can be easily obtained, when needed.
The following table summarizes what strategies (will) could fit best in the scenarios.
Of course, the beauty of the business world is that there are hardly any singular models which can be followed to make decisions. The challenge and excitement is in drawing one's own theories, hypotheses and then validating them. I asked some questions after reading Bikchandani's article and this post is the answer.
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