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CHAPTER 1
SETTING THE STAGE
"I never failed once. It just happened to be a 2,000-step process."
— Thomas Edison
Since you turned the page from the introduction, I am assuming that you have either decided to raise outside funding for your venture or you first want to learn more about the whole process so that you can make that determination. But since I don't know your current starting point, let's just start at the beginning.
BOOTSTRAPPING
With as little as it costs to get a software startup off the ground these days, many entrepreneurs start off as bootstrappers rather than fundraisers. Bootstrapping is when your company supports itself on existing or personally available resources rather than external sources of capital. Many startup ventures are initially bootstrapped until a sufficient business plan is developed and some minimal level of validation exists in order to attract investors. There's nothing wrong with bootstrapping, but staying in that mode for too long can carry some consequences that you should understand if you're just getting started and later plan to raise money from investors.
There are many different methods of bootstrapping. For example, living off your savings account so you can work full-time on your startup venture is bootstrapping. Borrowing against your 401(k) retirement account to pay your bills while working full-time on your startup venture will cause you to incur debt and might not be recommended by your financial advisor, but it is bootstrapping. Working on your startup venture during nights and weekends while funding it with income from a day job is bootstrapping. Selling your car, leasing out your garage apartment, and auctioning off your valuable comic book collection to pay for your business expenses is bootstrapping. Secretly selling your spouse's car and auctioning off his sentimental family heirloom paintings might cause a divorce, but if you use the proceeds to fund your venture, it is bootstrapping. Convincing others to work on your venture for no cash compensation while combining with any of the previous options is badass ninja bootstrapping.
What about investing your own capital to fund the engineering work to build a prototype of the product? That's not bootstrapping; it's self-funding.
What about friends and family funding? Borrowing money from Aunt Sally and Uncle Fred or convincing some sorority sisters to make a small investment to help you out is not bootstrapping. Instead, it's an external investment just like borrowing money from a bank or convincing an investor to write a check. I mention this because I often hear entrepreneurs brag about bootstrapping all the way to their product launch, only to later discover prior investments from friends and family. I tip my hat to their accomplishment and then inform them about my definition of bootstrapping. OK, you get the idea. It's less important to have an official definition than it is to evaluate and understand the commonalities among the various methods and approaches to bootstrapping. We often refer to bootstrapped ventures and bootstrap-minded founders as scrappy. There are definitely benefits of being scrappy in the early days while you're still trying to figure things out. But there are downsides that need to be understood as well, especially if the bootstrapping continues for a long period of time.
BENEFITS OF BOOTSTRAPPING
Many of the successful entrepreneurs that I respect the most are consummate and repeat bootstrappers. In fact, they take great pride in letting you know they're bootstrappers. If you look, you'll find them in your own community.
Before we talk about how long to bootstrap, let's review some of the biggest benefits of bootstrapping. Some of you will be able to skip the bootstrap phase altogether for one reason or another, and that's great. But you'll miss out on at least some of the benefits.
Bootstrapping forces founders to find and attract other team members that have genuine passion for the problem being solved versus those looking for a paycheck. It causes hyper-focus on making rapid and sufficient progress to either be able to get funded or start bringing in revenue from product sales. It forces a detailed understanding of exactly where every dollar is being spent and its specific value to the mission.
Bootstrapping fosters maximum creativity, flexibility, and instincts for survival. It avoids investors telling you what to do, giving you a hard time about the decisions you're making, or asking for a bunch of updates. Future investor prospects will be impressed by your passion and personal commitment to the venture as evidenced by your bootstrapping phase.
It is also true that a phase of bootstrapping comes with no dilution. In other words, you and your co-founders get to divvy up 100% of the equity. But there's a reason that I mention the dilution benefit last. Please don't extend your bootstrap phase as long as possible just to avoid dilution. If your business venture is best developed and grown by taking on some investment, you will be happier and richer in the long run if you do so. One of my favorite sayings is "Optimize for growth, not dilution." You would much rather have a single-digit equity stake in a venture that eventually exits via acquisition or IPO at a valuation of $1 billion than having double-digit equity in a venture that crashes and burns or exits for $2 million, $10 million, or even $50 million.
DEFINITION: DILUTION
Dilution is the result of an activity that causes a shareholder's equity to be reduced (diluted). Since equity is calculated by dividing a shareholder's quantity of shares by the total shares held by the company, the most common causes of dilution involve issuing additional shares of stock into the company. This could happen as a result of raising an equity round of funding or needing to create a new stock option pool with available shares of stock. In both cases, the number of issued shares increases, and this causes each of the previous shareholders' equity positions to be diluted.
HOW LONG SHOULD YOU BOOTSTRAP?
To answer this question, I need to set aside ventures that are planned to organically become profitable and sustainable on their own. Instead, I want to describe the more traditional tech startup scenario of pursuing multiple rounds of funding over time to grow aggressively and eventually reach a big exit.
I usually recommend bootstrapping at least long enough to gain sufficient evidence that your solution is desirable, which means your target customer wants it bad enough that they're willing to pay for it. It's also beneficial if you're able to prove that the solution idea is feasible, which means it can be built to deliver the intended benefit. That doesn't necessarily mean you will end up with a v1.0 product ready to launch after the bootstrapping phase, but rather that you should have enough proof that there's minimal technical risk.
With both desirability and feasibility validated (or mostly validated), you still have a long way to go before you've grown a great company that's both scalable and sustainable, as you can see from figure 1.1, but you are considerably less risky than before desirability and feasibility were validated. And that means you could be ready to pursue a round of funding. There are dozens of reasons why you still might not be successful getting funded, but that's a topic for a future chapter.
Most startups that follow this approach will raise their first round of funding to launch the product and seek hints or proof of viability. Viability means the customer acquisition model yields a customer lifetime value (LTV) that is greater than the customer acquisition cost (CAC). Not just a little greater, but sufficiently greater to cover the costs of the other functions that aren't related to customer acquisition, as well as various other operational overhead.
THE DANGERS OF BOOTSTRAPPING TOO LONG
From time to time I come across startups that have been in bootstrap mode for a seemingly long time. You might be thinking that with all of the bootstrapping benefits I listed earlier, why not stay in this mode as long as possible? There are a few reasons to consider if you plan to raise funding from investors.
SLOW PROGRESS FOR TOO LONG
While in bootstrap mode, your financial resources are limited enough that your progress is also limited. If that goes on too long, investors might ask, "How is it that you've been working on this for almost two and a half years and only have ___ customers and ___ revenue?" Investors like to connect many dots, but when they connect yours over a long period of time, the slope of the curve isn't very interesting.
MINDSET
The processes, culture, and general mindset of bootstrappers is fairly different from those that are funded and dialing in a big outcome. Staying in the bootstrap mode too long can cause that mindset to sink in to the point that investors are forced to wonder if you'll be able to shift multiple gears directly into a big-outcome mentality after getting funded.
ASSUMPTIONS
Investors can easily assume your business venture went through a significant pivot, multiple pivots, a co-founder breakup, unsuccessful prior fundraising attempts, and so on. It's even possible that some of those things are exactly true and caused the bootstrap phase to last longer than intended. But investors will often pile on additional negative or skeptical assumptions — overshadowing whatever you choose to reveal. They might assume the market is too small or doesn't sufficiently suffer from the stated problem. Or they might even assume you're not the right team to grow a successful company.
As I hope you've concluded, bootstrapping during the early days, until you've mostly demonstrated desirability and feasibility for your business venture, can be a great thing. But too much of a great thing can turn into a bad thing.
Compare notes with your co-founders and trusted advisors so you have a general strategy and plan for your bootstrap phase. Once you're ready to take on your first round of investment, prepare for a change in mentality. You will have obligations and accountability to outsiders — namely your investors.
WHAT'S IN A NAME, ANYWAY?
The name of a round of funding is often used to describe the evolutionary phase of a startup. If I told you about a startup and described them as pre-seed versus Series A funded, you probably form a mental image about the company along multiple dimensions. What's interesting is how different people can have fairly different mental images for the same funding phase. That's because there are wide variations in the uses of these descriptors, and they also change over time. Around the turn of the recent century, a Series A was raised well before a product was launched. Back then, the concept of a pre-seed funding round didn't even exist. Since I use these descriptors throughout the book, I need to provide my own parameters so that you know where I'm coming from. Just realize you will hear about and read different interpretations, which is only natural for the dynamic world of startups.
The best way to visualize a hypothetical startup's evolution is to start with the most pristine — but least likely — path from the idea phase through Series A funding. As you can see in figure 1.2, I'm using the metaphor of shifting gears through the evolutionary phases. The idea phase starts before raising money, while the next three phases each commence with a fundraising activity. The new funds provide the needed fuel (time and resources) to accomplish whatever will be needed to reach the sweet spot for the next round of funding. With each such boost of new fuel, the startup is able to shift a gear to move faster and do more things concurrently.
You'll notice that the shown sequence of funding stages ends with a Series A funding. Successful startups that want or need continued growth capital will later raise a Series B, Series C, and beyond, unless or until they no longer need external capital to fuel their growth or become sustainable.
IDEA
The idea stage doesn't usually start with, or require, external funding. Instead, it is the phase when your original idea gets formulated into an initial business plan and also when co-founders are sometimes recruited to the venture. It involves lots of customer discovery interviews and personal soul-searching to determine if the venture is worth pursuing in the first place. Bootstrapping is the most common method of funding this phase, and tons of startups never successfully exit this phase.
PRE-SEED
In the still-early days as you approach pre-seed funding, you have a developing idea but probably not even a working prototype. You need funding to build the prototype or a clunky, buggy, ugly, but minimally functional, minimum viable product (MVP) so that you can prove feasibility (can it be built?) and possibly start to get a sense for desirability (does anyone want it bad enough to pay for it?). During the idea phase, you should have completed enough customer discovery to refine the problem statement and to derive a huge list of assumptions as the starting business plan.
The pre-seed funding stage probably involves some planned continuation of bootstrapping (to reduce the amount of external funding needed) and the first outside funding, from friends and family and maybe some angel investors. You will be raising money mostly based on hope, vision, promise, and potential (let's call those HVPP for short). Investors will also highly evaluate you and your other team members' skills, experience, drive, and passion.
DEFINITION: ANGEL INVESTOR
Angel investors (often called simply angels) are high-net-worth individuals who allocate a portion of their personal net worth to investments in early-stage company ventures, such as startups. Many angels earn the moniker by also serving as an advisor to the startups they invest in.
Startups entering this phase don't have much in the way of operational maturity or method to their madness. It's possible they have an initial product development methodology and other very basic business processes, but since there isn't really any business yet, excessive processes and procedures just seem like unnecessary overhead.
Pre-seed funding rounds don't usually raise enough money to pay more than the smallest of salaries, which means most or all of the team members will still be working part-time on the venture. Some pre-seed investors might require that at least one team member convert to full-time after the funding so as to demonstrate a real commitment.
A pre-seed funded startup spends most of its time getting the product into a form that's ready to launch but probably only has some basic form of product development methodology. Lining up the first beta customers is a key focus, and there should be time spent defining the initial strategy for acquiring customers and pricing the product.
SEED
To move from pre-seed to seed funding, you should have at least a working prototype product — your MVP. While working on your MVP, your product development methodology should have matured to the point of having a rhythm to your various product iterations. It is possible that you stretched your pre-seed stage long enough to actually get a v1 product launched into the market and with some first paying customers. If not, that will be a key theme for your seed round.
Seed investors will expect to see a fairly developed business plan and will closely evaluate the attributes of your team. The business plan should have matured to include important insights from your customer discovery, market size research, plans for customer acquisition, and one to two years' worth of financial projections. But you still have a lot of theories and assumptions that need to be validated. The investors can at least touch and feel your product and get a sense for how smart and driven your team is, but there is still some HVPP being evaluated.
A seed-funded startup usually has founders working full-time, but at way less than market-rate salaries, as well as some number of part-time employees and advisors that are equally passionate about the mission. New members get recruited to the team in order to fill various gaps and to allow the founders to each focus their energy on a smaller subset of the business. Everyone still wears multiple hats — just fewer of them. This slightly expanded team focuses a lot of attention on further proving desirability and starting to test for viability (is there a customer acquisition model that is sufficiently efficient and effective?).
(Continues…)
Excerpted from "Startup Success"
by .
Copyright © 2019 Gordon Daugherty.
Excerpted by permission of River Grove Books.
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