In a 2018 interview with Recode, Moiz Ali, founder of deodorant start-up Native, described how out-of-place he felt at Silicon Valley parties. Entrepreneurs, he said, would talk about how many people they had employed and how quickly they were adding staff. Ali’s small company consisted of just him.
“In Silicon Valley, it’s often embarrassing when you haven’t raised money,” he told the magazine.
Ali was eventually able to scrape together $550,000 from a small group of investors, enough for him to employ a team that never numbered more than ten. But the amount wasn’t enough for him to follow the model generally used by Silicon Valley start-ups. That model requires companies to raise seed funds to build their product and test the market. Once they’ve confirmed that they’ve created something that people want to buy, they raise more money to buy the rest of the market. They scale rapidly, using funds supplied by venture capitalists to subsidize sales and swap profits now for market domination in the future.
While traditional companies grow, slowly adding employees at a rate that matches their new customers, start-ups scale. They add staff, splurge on marketing, and spend to buy rivals in a bid to increase revenues faster than the rise in marginal costs. They pay to hook customers who they hope will remain long after the subsidies have ended.
It’s a model that’s been followed by companies that are now as large and established as Microsoft and Google. Uber is valued at more than $87 billion despite losing more than a billion dollars in the third quarter of 2020. The company might be big and has now been in business for more than ten years, but it’s still not profitable and still dependent on VC money to keep scaling.
For most Silicon Valley entrepreneurs, that model remains the ideal. The founders might shrink their ownership share when they take VC funds but they’ll assume that 30 percent of a billion-dollar business is better than 100 percent of a million-dollar business.
But what if you don’t want—or can’t find—venture capital funds? Is it possible to scale without creating a pitchdeck and presenting to a room full of skeptical fund managers?
Why You Don’t Want to Pitch
Because so many of the world’s best known tech firms have grown using the power of venture capital funds, the temptation to fire up Powerpoint and start designing slides is clear. But there are also good reasons not to bother.
First, the chances of success are very low. According to Fundera, a financial advice company, just 0.05 percent of start-ups receive venture capital funding—and of those only 1 percent grow into a billion-dollar business. For most entrepreneurs, knocking on the door of a venture capital firm will be thankless and unrewarding.
And if they do succeed, they’ll lose flexibility and reduce the speed of their decision-making.
That’s important because a start-up has to be nimble. The goal of a start-up is to discover whether a product idea can become a product, and whether that product can find a market. It’s less a business than a vehicle in search of a business model. Sometimes, the original idea doesn’t work but in the development process, the company discovers a better idea, and pivots. Odeo started as a podcasting company that found it could land a bigger audience as a micro-blogging platform. It became Twitter.
Investors who sit on the board of a start-up that has promised to create one kind of business might hesitate before allowing their funds to be used to create a different type of product. Those pivots are easier and quicker to make when the company’s founders are also its sole owners.
Founders who don’t turn to venture capitalists also get to retain a larger share of the company. Thirty percent of a billion-dollar company might be worth more than 100 percent of a million-dollar company, but 90 percent of a billion dollar company is better than both.
And the traditional venture capital model can also reduce the chances of a start-up’s long-term success, encouraging it to scale before it’s entirely worked out its business model. WeWork raised almost $13 billion over its funding rounds, increasing its valuation even as its losses grew. As investors continued to throw money at it, the company was able to ignore the fact that its workspace rental income couldn’t cover the cost of its real estate. It was also able to ignore founder and CEO Adam Neumann’s self-dealing.
If WeWork had had less money to scale, the company and its early investors might have been able to spot the problems earlier and build a company that actually worked.
So as well as the benefits of rapid scaling that VC funds can bring, there are also disadvantages. The challenge for a start-up that wants to avoid the drawbacks of taking venture capital funds is to find a way to scale quickly without that money. It’s not easy but there are a number of ways to do it.
Bootstrap Your Way to a Billion-Dollar Business
One option is to bootstrap, which is how most businesses start. Fundera notes that 77 percent of small businesses begin by using their founders’ personal savings.
While that might work for small businesses that expect to stay small—such as a mom-and-pop store or a wedding photography business—it’s less common for technology start-ups where the potential is so much bigger. An SaaS company can serve an endless number of customers around the world so not spending large amounts of funds to reach them as quickly as possible can feel like a wasted opportunity. It can also give better funded rivals a chance to take and hold that market first.
And yet, that slower scaling is exactly what some companies have done. Mailchimp started as a side project at a Web design business called Rocket Science Group. It remained a side hustle for six years until the founders, Ben Chestnut and Dan Karzius, decided that they’d had enough of designing websites. But they still didn’t seek investor funding, preferring to grow the business with their revenue. That made their competition from other email services providers such as ConstantContact much sharper.
But by working closely with their customers and growing at a pace that matched their capacity, MailChimp has been able to scale into a business that expected to produce $700 million of revenue in 2019. Slack had made $133 million the previous quarter and was operating at a loss. That VC-backed company recently sold to Salesforce for almost $28 billion.
It’s possible that had Mailchimp accepted VC funds at the beginning, the company wouldn’t have taken eighteen years to reach that $700 million of revenue. They might have reached that target much faster, and like Slack, sold for several billion dollars to a bigger company. It’s also possible though that had they accepted those funds, Chestnut and Karzius would have focused on spending it and reaching new markets instead of on solving their customers’ problems and improving their product. They might also have paid less attention to their outgoings, and wasted some of that money in the same way that Adam Neumann blew Softbank’s funds on private flights and selling his own We trademark.
But the rise of Mailchimp does show that it is possible to start with a side hustle, scale it slowly, and reach critical mass without handing over any of the business to venture capital investors.
Borrow Like a Boss
The venture capital equivalent for most businesses is a loan. Venture capitalists, which usually provide larger amounts of funds, throw in consultancy advice, and take higher risks than banks, expect more from their money than a small interest rate. They usually demand equity.
An alternative, though, is revenue-based financing which bridges the gap between equity shares and interest rates. Instead of giving investors a share of the company and a seat on the board, revenue-based financing demands a share of the company’s revenue up to a set level. A typical cost is between 1.2x and 1.8x payable over twelve to 36 months.
Unlike interest payments, the amount that the start-up pays each month can vary. If the start-up does well, it will find itself paying more to its investor; in bad months, its payments fall, ensuring that its debts aren’t responsible for wiping out the business. The application process can be fast, so there’s no waiting months for an appointment with a VC, then weeks more to receive the rejection. Some lenders can supply an answer in minutes.
David Teten, CEO of Versatile Venture Capital, a seed-stage venture capital firm, has listed some of the most important revenue-based financing venture capital firms. Bigfoot Capital, for example, reviews about 20 companies every month and accepts about a quarter of them, a rate much higher than the success rate of traditional venture capital.
But while the price of accepting revenue-based finance is much lower than the equity cost of traditional VC funds, the benefits are smaller too. The amount of capital lent tends to be less than a traditional VC investment. Corl, for example, only provides up to a million dollars in return for between 2 and 10 percent of monthly revenue although it is willing to continue lending to companies with which it has established a history. The criteria are tighter too. Corl demands that companies have at least $10,000 in monthly revenue, gross margins of 30 percent, and post-revenue for six months. In practice, says Tenet, Corl tends to lend to companies with annual revenues of $1,226,589 and annual profits of $237,479. The companies use the money largely for sales, marketing, and market expansion, followed by product development and recruitment.
The relatively small amounts make revenue-based financing a weak option for rapid scaling. A million dollars can help to fund a marketing campaign but it won’t allow a company to compete for a market against a rival powered with hundreds of millions of dollars of VC funds. It can be a useful way to begin scaling though, without giving up equity.
Ride a Client
An alternative option is to use those funds not to win lots of customers but to land one big one, then use that client to reach others. Partoo, for example, helps companies to manage their customer relationships and drive people to points of sale. According to Thibault Renouf, the company’s co-CEO, the company used three tools to scale without using VC funds.
First, it bootstrapped and kept a close watch on expenses. One of the company’s rules is to get win clients before hiring new employees. Second, Partoo also asks customers to make all their payments in advance. “This can be easily justified since our ‘suppliers’ bill us annually and since our onboarding process remain time consuming,” says Renouf.
But what really drove the growth of Partoo was landing a big client that gave the company a high profile. Partoo’s first customer was the French supermarket chain Carrefour, which they landed through a reseller. The company’s partnership with Carrefour gave Partoo credibility, making it easier to sign other companies. Within three years, Partoo was working with more than 100 enterprises in France and Europe, and had opened offices in two additional countries.
It’s possible that venture capital funds would have enabled Partoo to expand and scale faster but it’s spread quickly enough, and in a way that allows its founders to retain ownership. As for Moiz Ali’s Native deodorant firm, that was bought by Proctor and Gamble in 2017, two-and-a-half years after launch. The multinational paid $100 million. Ali, who had scaled the business without using VC funds, still owned 90 percent of the company.
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