Many in venture capital preach the gospel of raising equity, saying that a small piece of a large pie is better than a large piece of a small pie. This is often self-serving. Although sometimes raising equity makes sense, entrepreneurs are too often on the side of parting ways with equity too easily, so that isn't the best advice.
That being said, raising capital is an unavoidable reality for many startups. Having been in the business of providing capital to small and emerging businesses for the better part of a decade, and also having had to make these decisions in my own ventures, I'd like to share a few basic "rules of thumb" on whether you should raise equity.
Here are two simple rules to follow:
Give away equity as a last resort
Raising equity capital should always be avoided if possible. It goes without saying that entrepreneurship is risky. It takes a lot of guts, stress, patience and incredible amounts of hard work to succeed in what you're trying to do. Throughout all this, your business will truly become your baby.
In the early stages, your baby is still an infant, undeveloped, unstable and certainly not generating any meaningful earnings or cash flow. Nobody is going to ascribe much value to your baby. To bring in a tiny bit of investment, you'll have to sell a very significant chunk of your thing.
The alternative to this is debt. If you can simply pay a fee to rent capital rather than selling a significant piece of your business, this is in many ways preferable. First, try to get terms from your suppliers, and see if you can get them to agree to wait on payment, or negotiate a payment plan so that you pay them as you make sales.
Next, can some of your equipment be leased or rented? Do you have any private investors, friends or family members that might lend money to your new venture? The friendlier the debt the better. If you'll see a fairly immediate return on the investments you're making in your business, as you will with some types of equipment, then this is a great option.
If you've maxed out what you can comfortably borrow but still need more capital, or you can't borrow because it'll take a long time before your business starts generating positive cash flow to service debt, then alas, we have reached the point where equity must be considered.
Give away as little as possible
There's two ways that things play out. Either things go to plan and you succeed, or they don't go as planned. If they don't, which is likely, then it's best to fail and pivot quickly without burning too much capital. For this reason, minimize the amount of capital required for startup. If you get carried away with spending before the first real market test of your product, you might not get another chance to try again.
If you succeed and you've raised equity, you're going to wish you hadn't sold that significant chunk of your business back when you couldn't justify a high value for it. It's rather foolish to part ways with significant ownership in your baby to inject a rather small amount of money during the early days.
Ideally, raise the least equity you need to hit your next milestone, and then raise more only once that milestones' been hit, since the valuation you'll be able to get will grow with each milestone. Part of raising less is also needing less. Be prudent and thrifty, budget very carefully and watch out for spending money on "nice-to-haves" as opposed to what your business really needs at its current stage.
Startups often experience "spending creep" after raising equity because it can create a feeling you can always just go back to the well for more if you need it. So they lose discipline. It can start to feel like any investment that might help the business grow is probably worth doing. Soon you might be tempted to shell out for a salary for a new big-time executive or a fancy new software system, which can suck up significant cash.
The perception of the endless well is far from the truth. If you don't hit your next milestone before needing more equity, the next equity raise will be extremely tough. It's also easy to forget that times change. Capital markets are a volatile beast, and investors and terms that were once available can evaporate overnight.
When you do raise equity, find investors who can actually help you in ways other than writing a cheque. "Smart money" with experience can give you operational and strategic advice, and perhaps make critical introductions that can take your business to the next level.
It's best to work hard, be frugal, avoid raising equity, and use debt when feasible. With a bit of luck, your baby will become a valuable cash flow-generating machine, and you'll own most of it.
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