Startup Financing - Bootstrapping vs. Venture Capital

Photo by Markus Winkler / Unsplash

Founding a company is not easy and often expensive. You don't only need to cover the living expenses of your team but also everything you need to build and promote your product or services. But where to get the money for that?

And there is another thing: The more innovative your company and business model is, the riskier it is. 90% of startups fail. No bank would give you a loan because for them the investment is too risky.

But there are still options left: In the startup world you often hear the terms Venture Capital and Bootstrapping. What is this and what should you choose. That's what we are going to discuss here.

Bootstrapping

Bootstrapping refers to a procedure in which a team tries to survive and build their product without external money (e.g. from investors) and slowly lead the startup to profitability. The founders try to avoid expenses as much as possible, to hire as few people as possible and to do product development and marketing in a cost-effective way. Often, founders start out by working other jobs on the side to pay their rent before they can afford to pay themselves from sales of their own startup. Many startups go this route, even though it often seems like every startup gets an investment from business angels or investment firms.

Venture Capital

One of the best-known ways for startups to grow their business is through venture capital from investors.
But why would they give the money if they know that 90% of all startups fail?
What is exciting for investors are the 10% that do not fail. Startups that are designed to raise money from venture capitalists are designed for large growth. If a startup that is designed for growth like the well known internet startups Facebook, Airbnb or Slack, they are worth billions after around 10 years of building and growing. Investors that bought shares of these startups along they way when their valuation was only a tiny fraction of this final value, they made a pretty good deal.

As an extreme example, take Facebook: Peter Thiel was the first investor in Facebook, buying 10.2% of Facebook's shares for $500,000 (so company valuation at the time was $4.9 million). At the time of Facebook's IPO in 2012, the company value was $100 billion. Peter Thiel's 10.2% stake in the company was therefore worth over $10 billion at that time.

Of course, this is an extreme example that happens very rarely, but it shows what investors are speculating on. If 9 out of 10 of their investments fail, then the 10th must yield such a large profit that it makes up for the failed investments.

It's also important to know that venture capitalists invest directly into the company und their success; meaning there is no private liability for the founders.

You can also distinguish between two types of venture capitalists: Business Angels and VC firms. Venture capitalists who come in at the early stages of a startup are often called business angels. They are usually wealthy individuals with strong ties to the startup scene (e.g., founders who sold their startup for a profit). Business angels often support the startups beyond providing the money with advice and helpful contacts. The first investments of business angels in Germany are around €50,000 - €200,000.

At a later stage where startups need more capital, the money doesn't come from individuals but from investment firms that manage bigger funds and try to make good returns for the institutions and family funds that provided that money.

The goal of the startup from the investor's point of view is an "exit". This can be a sale of the startup to a larger company (e.g. the sale of Instagram to Facebook) or an IPO, where investors have the opportunity to be paid for their investment.

Bootstrapping vs. Venture Capital

Both options have their pros and cons.

First there are situations where you don't have both options. Bootstrapping is great when you slowly build a software-as-service product or app that you can build and scale very cost-efficient, but if you want to build a startup where the development of the product is very capital-intensive, like for example the super-sonic-airplane startup Boom, bootstrapping isn't an option.

And if the app you want to build doesn't have the potential to become a billion dollar company (or you just doesn't want it to be what's totally ok), it will be difficult to attract venture capitalists.

But if you have both options, in general, venture capital offers many opportunities for young startups to quickly follow their vision, fully concentrate on their startup and develop and launch an internationally scalable product. The downside, of course, is that large shares of the company are given to individuals and institutions whose pure interest is to grow the investment.

The best way in my eyes is if you keep an eye on profitability from day 1, think about how you can grow your business and see how external investment can accelerate that journey. If you don't depend on getting the next investment for your startup it is also a good negotiating position for your talks with investors. And if they see that you are on your way building a big company and you don't necessarily need the money; they will provide you with money for terms you can't refuse.

Matthias Nannt

Matthias Nannt