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Raising Money? Think Hard Before Your Business Takes The Plunge

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Raising venture financing has become commonplace among startups.  Tons of entrepreneurs takes this approach: create traction, raise money, step on the pedal to accelerate growth. But as we’ve seen in 37Signals’ bootstrapped community this isn’t the only way to build a business. Before devoting energy and resources into raising capital – and this is advice that I’ve heard from VCs themselves – make sure you’re raising money for the right reasons, don’t rule out bootstrapping as an option and understand the implications of the capital raise.

"Bootstrapping" refers to a business that is self sustaining and has not taken in an external investment. Bootstrapping doesn’t mean lack of revenue or profits -- in fact, it forces you to make hard decisions to keep expenses down. It helps you prioritize what is important and what is not.  Bootstrapping also acts as a strong filter for members of your team: they have devoted their time and energy knowing fully well the lack of any outside financial support which means they need to truly believe in the company's shared vision. Success stories are plentiful: a recent IPO candidate, Atlassian, bootstrapped for eight years before accepting venture funding. Lua spent two years doing contract work on the side building databases to keep the lights on before truly hitting the fundraising trail. Bootstrapping helps you earn your stripes.  So, why do entrepreneurs raise funds?

1. In certain opportunities, it takes money to make money

This is especially true in companies with higher CapEx: hardware technology; consumer services that require large investments to build a user base; and, in many cases, B2B services. One look at some of the largest technology IPOs in the last few years offers examples of companies that took a while to reach profitability: Facebook  and Twitter, which entered the public market with massive losses and more recently, Box which filed for an IPO while still unprofitable. Sometimes, it takes extremely large amounts of money to make money.

2. The founders do not have enough capital to realize their vision

Few of us have enough money in the bank to maintain a stable of employees, pay rent, and invest in the R&D to get a product into the marketplace. In these situations, a helping hand from investors is the only option to act upon your vision.

Raising backing might be the right path for your opportunity: it has certainly helped a long list of companies grow to become established players but understand what you’re signing up for before entering the game. Perhaps, a “lifestyle” business does fit better; otherwise, be prepared to give up equity, report to a board, and begin a “countdown".

 It’s All About Returns

Potential investors will be doing back-of-the-envelope math to gauge whether or not they believe your market is large enough to generate a 10x return on their investment. They will size your market, assume you reach 2-5% market penetration, and go from there. If that yield is not high enough, it will be tough to close no matter how good your idea might be. So, before you step into that pitch meeting, be sure your opportunity is large enough for investors.

 An opportunity that is too small to attract venture financing may not be a bad thing at all. You may have a great idea that solves a major pain point in a niche marketplace, which could become an excellent bootstrapped business. There are tons of great lifestyle businesses where founders generate enough revenue to maintain a comfortable lifestyle and remain in complete control but not enough returns to appeal to venture backers.

Answer to a Board

With financing, a likely term sheet requirement will be to create a board consisting of at least one member of your lead investor's firm. A board can provide good advice and alert you to potential landmines -- especially helpful to first-time founders. You should be prepared to defend big decisions. Funding naturally comes with strings attached, so the decision to raise funds is a statement that you are ready to be accountable to a board and sacrifice decision-making autonomy.

The “Countdown”

Once money is raised, a countdown begins as you spend more than you could previously afford – it’s a race to either profitability or enough success justifying the need to raise another round. The stakes might be high when you are bootstrapping, but once you raise money, hire a team, build out an office, and begin running a marketing campaign, you are now racing against time to prove that you are a real business. The pressure is on, and level-headedness is needed to ensure you do not dive headlong into rash decisions. Make sure you're ready for the mental battle before going down the venture route.