Back in 2010, when Tom Lauwers took the dive and spun out his research at Carnegie Mellon University into a new STEM education company, BirdBrain Technologies LLC, he didn’t exactly have the personal wealth to fund his operation.
“Some people do credit cards or take out loans,” he said. “I was fortunately able to avoid that.”
At that early point, Lauwers didn’t have an office or any fixed costs in excess of about $50 per month. He needed about $30,000 to produce the first 1,000 units of his Hummingbird robotics kit, which helps students bring their own robotic creations to life.
Luckily, Lauwers was able to secure the funding from CMU through a small loan provided by its technology transfer office. It’s a unique proposition—Lauwers didn’t disclose his interest rate—but not something that most entrepreneurs will ever see. Instead, most founders will ponder whether they should start fundraising from venture capitalists or begin pestering their family and friends for cash to bootstrap the company. The whole thing can be frustrating, especially for the first-time entrepreneur, because it’s not always so clear which companies would benefit most from bootstrapping and which should cozy up to VCs.
In addition, fundraising is multifaceted, and it doesn’t always make sense to reach out to a venture capital fund when there are other places to find that much-sought-after cash.
“I find that a lot of people have some familiarity with what venture capital is, but they don’t necessarily know if they as an entrepreneur should fundraise…and they assume it should be venture capital,” said Zak Slayback, a principal with Peter Thiel-backed 1517 Fund, a San Francisco-based VC fund that supports early-stage startups. “The reality is that there is a very, very, very, very small slice of companies that should do that.”
Slayback, along with Aaron Watson, founder and CEO of the Station Square-based digital media company Piper Creative, hosted an event last month to educate the Pittsburgh startup ecosystem on this hairy problem: Should you bootstrap or fundraise? And if you fundraise, whom do you ask for money? In case you missed the event, these two shared some valuable information on early-stage startup funding with StartNow. We’ll help you understand why companies like BirdBrain Technologies and Piper Creative did well through bootstrapping and what kind of fundraising might make sense for your company, whether it’s venture capital or something else altogether.
How can you tell if your company should raise funding from a VC?
To answer this question, according to Slayback, the primary thing you should focus on is scale. While high-net-worth individuals—like the Sharks on “Shark Tank”—are angel investors that are happy to see a 2-3X return on investment, venture capitalists are a whole different animal, he explained. These people typically invest others’ money, often from universities, banks, government funds, and, yes, even high net-worth individuals; they’re outsourcing the decision-making power to venture capitalists and expect to see higher returns for that trouble. For example, a VC fund may have $100 million to invest. If you’re writing $1 million checks to companies that you’re funding, that’s 100 different baskets in which to place your eggs. For the VC model to make sense, these companies must get “stupid big.”
“They don’t just need to succeed; they need to blow everyone else out of the water,” Slayback said. “Eighty percent will fail or not return much money at all.”
So how big is stupid big? Slayback says you’ll want your valuation to be in the neighborhood of at least $500 million by your seventh year. In Pittsburgh, only a few companies can boast this level. The most prominent examples are Argo AI, which has seen $2 billion in investment from Volkswagen and Ford over the last two years, and East Liberty-based language learning company Duolingo, which hit a valuation of $1.5 billion in early December after a new funding round, making it Pittsburgh’s first unicorn.
But most companies in Pittsburgh don’t meet these requirements—not even close.
“I’m confident that in the next decade or so we can get companies that big … but if you’re a founder, more often than not, we’re not sure if it’s venture-scalable,” Slayback said.
“This does not mean that you shouldn’t build the company,” he’s careful to note.
A company tends to raise at a higher price if it’s getting investors from New York or San Francisco, making it all that much harder for companies in the Midwest. “That is starting to change, thankfully,” said Slayback.
When is it time to raise private equity instead of venture capital?
Categorically, there are certain types of companies that could benefit from raising venture capital funding because it doesn’t always make sense—and it’s not always possible—to raise private equity funding if your company is in a speculative market.
For example, lidar companies will have a hard time getting a convertible note from a bank or a loan from an individual, Slayback said, so it’s a good idea to try out venture capital for a change.
Whether to raise VC or PE is a difficult question, but WeWork is a great example. If you view WeWork as a typical real estate company, you’ll find it makes sense to raise private equity. However, founder Adam Neumann tried to propagate the idea of WeWork as a software company, which is usually more in the domain of venture capital. That’s because software companies tend to have annual returns of at least 5-6X, and they’re able to scale significantly while using very little raw material, except for development at the beginning. That vision, as we now know, tanked when WeWork went to the public market, which saw it as a real estate company.
So ask yourself: What kind of company am I trying to build? The market will shake out the fibbers, so be honest with yourself.
What are some questions that I should ask myself before raising venture capital?
Slayback said there are a few key things you need to think long and hard about before you decide to take on the time-consuming and ego-shattering business of putting yourself on the line before venture capitalists. Ask yourself:
-Why are you building this company? Are you building it for a lifestyle you want to have, or are you planning to run it for a few years then sell? If you go the private equity route, you can cash out and someone else will run the business. But if you can see yourself making a career from your startup, it may make sense to go the venture capital route.
-Are you building a scalable product or a service?
-Would you rather own 50 percent of $50 million or 10 percent of $500 million? Think about it: if you go for VC, “You’re going to have bosses that are more than just your customers—you’ll have a board,” Slayback said.
What are the drawbacks of raising venture capital?
Watson, who bootstrapped, said that he has two good friends who recently built and sold software companies. Neither of them has to work for the next two years thanks to that cash, yet neither wants to go the venture capital route again. And it had pretty much nothing to do with money: It’s because there was a lack of control, loads of outside pressure, misaligned incentives, and a tight timeline to adhere to because investors expect a return.
“It’s like, ‘Man, I want to go in this direction, but my investors say no,’” Watson said. That back-against-the-wall feeling really irks some entrepreneurs. If that’s you, say no to VC fundraising, because you’ll be practically doing one of those painful squats from gym class that burns the hell out of your thighs until you satisfy your investors.
That’s when bootstrapping might be a good idea.
“There’s something to the psychological framework where I know it was my skin in the game, my chips in the game, and I know I’m the reason I succeeded or failed,” Watson said. “It’s drawn a lot out of me, but I’m a better organizer.”
When should I go to angel investors?
For Lauwers, it comes down to competition.
“For one to go to angel investors, it’s when you need to make a line grab, when you really need to spend a lot of money because the idea is so compelling and you need to get ahead of the competition,” he said.
In 2004, it was smart for Facebook to take on venture capital, lest another company take its spot as the social media behemoth of the 21st century. Facebook would have taken a lot more time to scale—and may never have—without VC funding.
What makes a company a good fit for bootstrapping?
Lauwers said that if there is something pretty niche about the area your company is working in, it makes sense to bootstrap. Also, if you’re in education, like BirdBrain Technologies, or another slowly growing sector, it makes sense to bootstrap. What’s the rush, after all?
If your company is product-based, bootstrapping also makes sense. Service-based companies are going to want to scan over their options and perhaps will land on venture capital as the best option.