So you’ve got a great idea to start a business? Maybe you’ve even written up your business plan, gotten feedback from qualified mentors, and tested your product or service in the field. You’re ready to become a genuine entrepreneur.
All you need now is money, right? A heft influx of cash from a venture capitalist will provide the fuel your small business needs to launch.
Actually, the idea that you need money to launch a business is mostly a myth. It’s a dangerous myth because it keeps smart people with innovative ideas from kicking off new businesses.
Have you seen the show Shark Tank on ABC? In this Emmy-winning production, budding entrepreneurs present what they hope are winning business concepts to the show’s panel of five “sharks in the tank,” all wildly successful business founders. The sharks have included luminaries such as billionaire Mark Cuban, fashion mogul Daymond John, and real estate tycoon Barbara Corcoran. These panelists poke holes in the ideas, business models, or products presented. To win on the show, you have to get a handshake deal from one or more of the panelists.
Shark Tank Makes Great TV, but It’s Not How Business Works.
Of the 40,000 companies that apply to be contestants on Shark Tank each year, only 158 actually get to pitch. Of those, about 88 make it on air. A handful of the 88 get a handshake. Out of that handful, 80% of the deals never actually happen post show. The entrepreneurs usually don’t want the money; they just wanted to hawk their product on a hit show for the publicity value. Basically, 40,000 companies apply to get funded by a shark, but none do.
This show makes great TV, but it’s not how business works. “Shark Tank gives you the impression that pitching your idea to investors and raising money are significant parts of being an entrepreneur,” Brian Hamilton wrote in INC. “The curricula at many of America’s premier business schools reinforce that–and it’s not true.” In fact, just five new companies out of every thousand get venture capital.
About 35%, however, launch with less than $5,000 behind them. Virgin, Dell, Microsoft, MailChimp, Shopify, WayFair, GoFundMe, and Qualtrics all got off the ground without any outside investment. If the founders of those companies can do it, you can, too.
Finding investors in the first year can be a waste of your time. In general, first-time business owners should be careful when considering a potential investment during their first year in business. Here’s why, what to avoid, and how to fund your business instead.
Investors Fund Growth. They Don’t Fund Ideas.
In year one, you have no proof your concept works. If you’ve field-tested your idea, you could have evidence that it might work given a perfect array of internal and external factors interacting exactly as you predicted they would. Most entrepreneurs don’t even have that, though. They just have an idea.
Now, that’s okay because a well-researched, rigorously planned idea is all you need to get started selling a product or service. But it’s not all an investor needs to sink money into a business.
Investors want to look at financial metrics with meaningful models of future returns. They want to see founders with just-right resumes. They demand proof of product market-fit. If you are in the first year of your business, you don’t have any of that. You have an idea. And ideas are not proprietary.
That means if your idea proves to be a good one, some other company will snatch it up and leave you with a product that’s overpriced, under marketed, or slightly out of sync with consumer demands.
Social Proof Is Important.
So the investor has to believe in the value of your idea plus your ability to execute that idea in the face of hostile market effects you haven’t considered yet. If you can’t quantitatively prove both your idea’s merit and your ability to manage the idea as a business, you’re not getting funded to try your idea. But once you’ve got that proof, you can get funded to grow your idea.
Chances are you won’t have much growth in the first year, but what you will have is mountains of data to collect. If you want to get external investment in your company, measure everything. Start now.
Don’t just keep track of revenue, know your company’s information inside and out. Track the number of new customers and second-time customers along with their ages and demographics. Learn your online-to-in-person ratio of sales leads. Assess customer engagement. Know your net promoter score. Be able to prove every number you record.
As Robbie Abed says in Fire Me I Beg You, “Social proof is critical to your career and business success.” Spend your first year in business collecting the data that proves your idea has legs and that you’ve built the team that can make it run. Then use that data to construct your case for investment. You’re much more likely to succeed with that approach than you are with little more than a business plan, no matter how well drafted it is.
Finding Investors During The First Year Can Mean Giving Up A lot.
Business ownership works much the same way as home ownership. With your mortgage, the amount of the house you’ve paid for is your equity. It’s the part when the agent hands you a nice fat check when you sell your home. You can also use home equity as collateral for a loan. The term equity refers to your ownership stake in the property. In business, that would be your stake in the company.
If you own the company outright, you hold 100% of the equity. When you get investors in your company, however, you sell each one of them a part of the equity. Then, you don’t own as much in your own company. It’s like sharing your home equity with the mortgage company. The bigger their share, the smaller your check come sales time.
On the positive side, sharing equity means sharing the startup costs on the front end. By giving up a little equity, you buy yourself some peace of mind. That could be a good bargain, but be sure the mental real estate you’re buying isn’t overpriced. After all, every time you relinquish another part of your stake in your company, you are probably selling off a small piece of the reason you became an entrepreneur in the first place — independence.
You might not work for a boss any longer, but if you sell equity in your business, you will work for a group of investors who have far more riding on your success than the middle manager you answered to at some corporation did.
Be Careful Giving Up Equity Right Off The Bat.
Not only does selling equity reduce your independence, but it also limits your future options and your authority as a leader. By holding on to your corporate equity, you can maintain control of key decisions, focus on growth over revenue, and develop the team you want instead of the team your investors believe will succeed. You also keep open the option to build a board of advisors instead of investors. You can pay people for their expertise and opinions without giving them a share of the company.
Most importantly, as your company grows, so does the value of your equity. To use the home ownership example, a house that was worth $150,000 can increase to $200,000 in just a few months if the area around it develops properly. In the same way, a successful business‘ equity can grow in perceived value over time without you having to invest a dime.
Hence, you can sell your equity in the first year — when your company is worth very little — or you can sell it later when your company could be worth much, much more. A 15% stake in a company bringing in $50,000 won’t net you much. But a 15% stake in a company hauling in $5 million and projected to double in five years? That could be worth a lot!
Equity is precious. It gives you freedom and increases in value with time and hard work. If you decide to sell your equity early, make sure you drive a hard bargain for it.
The Money Probably Won’t Help Much.
Like children, entrepreneurial enterprises grow in predictable stages of development. First, there’s the launch stage when sales are often slow, startup costs can be high, cash flow dips, profit lags behind sales, and entrepreneurs have nervous breakdowns. Like a parent with a new baby, you’ll spend a lot of time pumping resources into one end of your company and cleaning up a mess at the other end at this stage.
During the first year you are still finding product- and- market fit. Likely, you’re not scaling your sales and marketing at this stage. Money will rarely speed up the process of getting to initial traction, and this stage is a grind no matter how many dollars you have in the bank.
The good news is that, like parenting, entrepreneurship gets easier for a while. The second stage is called the growth stage. Here, investors may start to notice what you’re doing. Sales growth accelerates rapidly. You break even. You start to make a profit. There’s cash in the register at the end of the day and you can take it home. Life is sweet.
As Your Business Mature’s..There is More To Consider.
But then come your business’ teenage years. Raw sales numbers keep going up, but the rate slows down. You have to hire more employees, and often these people are less vested in the company than the original team was. Competitors move in. Profits decline. Basically, your company locks itself in the bathroom and shouts from behind the door that you don’t understand it. Entrepreneurs wonder what happened and if all their sacrifice and hard work were worth it.
Hold on because maturity is coming. At this stage, sales ramp up. Profit margins get thinner, but cash flow increases. Capital expenses also increase. Product volume goes up. The once-weak startup is now a major player in the market. This is a great time to get investors.
Your company is now valuable, so anyone who wants in will need to pay you a premium for their piece of your equity. Plus, with that new money, you can start to do research and development on fresh products and thus extend the life cycle of the business.
A Good-fit Venture and Sweat Equity Go Hand & Hand.
If you absolutely need investors to get your product or service through the initial 12-24 months, it might not be the right venture for YOU. A tiny fraction of small businesses get venture capital — about 0.05%. More get small business loans. Most bootstrap their way to the top.
Why do entrepreneurs choose to go without external funding? In some cases, it’s because they can’t get funded. In others, they choose not to. Bootstrapping your business gives you creative control, lets you keep the money you earn, and allows you to reinvest the profits.
If you do choose to pursue outside funding, which definitely offers its own set of benefits, you should probably wait until the second year or even later to seek investors. At that point, you’ll have proof of concept, evidence that you can bring that concept to market, and data showing that the market for the product actually exists. Your equity will sell for more, and you’ll have formed a lot of your corporate culture and fundamental team members in the first year before a board saps some of your authority.
People think you need money to make money, but you don’t. “A startup,” says serial entrepreneur Penelope Trunk, “is the perfect convergence of a brilliant idea and a founder just crazy enough to stick with it through anything.”
Do you have a brilliant idea? Are you crazy enough to stick with it? Then you’ve got all it takes to launch your company. Investors need not apply.
Check out all of the articles in the ‘How to Survive the First Year of Your Business’ series:
- Why You Shouldn’t Quit Your Job When Starting a Business
- Don’t Have a Partner? You May Want to Hire a Co-Founder
- You Probably Won’t Make a Profit Your First Year and That’s Ok
- Why You Need to Hire Your First Employee as Soon as Possible
- Finding Investors in the First Year Can Be a Waste of Time
- Building a Business Is a 7-10 Year Journey