Bootstrap vs VC — The Ultimate Guide For Founders

Step by step guide for founders on that very crucial decision that we all have to make on quite early stage

My intention was to create “The Ultimate Guide” for founders on that very crucial decision that we all have to make on quite early stage — so whenever someone asks me whether he should take VC or bootstrap — I can just share that article with them, and then continue discussion from that point.

Disclaimer

First, let’s draft a little background of myself. Not to do some cheap self-promotion, but to make sure you understand my background and environment that obviously had a huge impact on my views.

I am founder of LiveKid.com — Vertical B2B SaaS company that creates management software for nurseries and preschools. We generate a low couple of million USD in revenue, growing 100% YoY, with around 70 people on board. So it’s asset light, not very capital intensive business. I’ve started that company when I was 19 years old, in one of the eastern Europe countries— Poland. We’ve managed to fully bootstrap to 1M USD in ARR, and then we raised our first investment round — 2.3 M USD (however, it was pretty unusual, because 40% of the round was actually secondaries)

I will do my best to be as objective as possible, but obviously, some of my conclusions could be less accurate for +40 years old ex-Google people living in Bay Area than for broke first-time-teenager-founder in Europe.

Now, let’s really dive into the topic.

Introduction

The single most important thing you need to understand in order to make a good decision, is to understand how Venture Capital fund works. Not what they do, but how their business really operates, what’s the business model and what are their KPIs. I think it’s crucial to understand that in order to avoid the worst possible scenario — raising VC money and having huge misalignment of interests later on.

There are a lot of early stage investment funds that are calling themselves “VC”, but in fact they are quire different animal. Funds that take 50% stakes on seed, invest on behalf of some government programs, funds that are parts of family offices, angels syndicates, or funds that invest in deal-by-deal formula. They are some form of growth investors (that might be worth considering!) but we will not cover them in that text.

We are talking about real, classic VC. Like those guys below.
Or anybody that aspire to be them.

Marc Andreessen, Bill Gurley, David Sacks

How VC works

Most of the VCs have 10 years investment horizon. It means they invest the entire fund over the first 5 years and then, they should liquidate all positions during the next 5 years. VC should aim to return at least ~3–4x cash on cash, so they achieve around 20–30% IRR (Best in class even more). Then all parties are happy. LPs get better returns than in real-estate/SP500, partners collect their 20% carry on the profit (or it’s part above hurdle rate), and they can raise another, usually bigger fund.

The size of the fund matters to them, because they have 2–2.5% annual “management fee”. It’s much harder to generate better returns (IRR)on bigger funds but… the bigger the fund, the bigger the annual management fee :) Sure, bigger fund usually means bigger team etc you know… “some people says” that those expenses are not growing linear to the size of the fund ;)There is funny/cynical video where Chamath Palihpatya talks about that. I highly recommend watching, both for intellectual and humour aspect.

What’s their strategy to achieve that 4x return?

As they typically invest very early, when there is high risk of failure, they are not trying to achieve that through making each company return 4x of capital. They are looking for just a few so-called “fund returners” so companies which valuation (on exit) allows VC to return the entire fund from their piece (preferably, even a few times). That’s why VC cares about the size of the market you operate in. Total Addressable Market needs to be big enough, to have at least a chance of building a “Fund Returner” type of a company.

To simplify:
5% chance of winning 10B USD market is better for VC, than 90% of chance of winning 100M USD market.

Here is how power law in VC looks like:

So you see. Only winners matters.

So now when we understand how VC works, we can jump into the topic of the headline dilemma, whether you should raise VC money, or try to bootstrap your business.

Let’s break it down to four major questions you should ask yourself.

1. Are you running a capital intensive business?

First, you need to understand what kind of company you are trying to build. There are business that don’t require huge initial investment to get your project off the ground, but there are also some ideas that requires huge R&D / CAPEX spent to even build prototype or Minimal Valuable Product.

If you are trying to build the next great TODO app or CRM software, you can validate your idea cheaply. It doesn’t mean you can easily build 1B USD CRM software company without external capital, but you can at least build initial product, get first customers and generate first revenue.

But let’s assume you want to build the next cloud provider (like Amazon Web Services), or you want to build a transportation marketplace like Uber. Both of those ideas will require much more capital to build any kind of proof of concept.

In the first case, you need to buy very specialized hardware and build complex software just to onboard your first client.

In the case of “Uber like” startup, on top of building great software, you need to solve the classic marketplace egg and chicken problem. So you need to quickly develop both demand and supply side to have liquidity in your platform. To make it even harder, your liquidity needs to be in “the real time” so passengers are not waiting more that’s 5min for a drive.

Sure, you can be street-smart and try to build local flywheel cheap etc– but in 90% of cases, building liquidity at scale — will require a lot of capital.

2. Are your interests aligned?

The second thing to understand is whether your interest as a founder is aligned with VC interests. It’s really import to ask yourself why you really want to build that company. Let’s be honest whether you want to get rich, build something big, become famous or change the world.
For some of those goals VC will be helpful, for others not.

Let’s take a look at an example of building next great CRM Software.

There is a very high chance, that you will achieve low single digit millions in revenue over next 3–5 years, so there could be 10–25M USD exit on the end. There is obviously demand for that product, proven business model and lots of potential strategic buyers. If you are a broke guy and want to build your first fortune, then that might be life-changing event in your life and great output in general. On the personal level, it might not be worth for you to risk not taking those 10M USD and trying to fight for 100M USD (with risk of getting nothing)

The situation is very different when you have your financial backup (you sold your previous company, or you are lucky and have a rich family).
Then, you might don’t give a shit about those 10M USD, and you actually want to “GO BIG OR GO HOME”. In your case, very nice home :D

If your goal is build huge business, have an impact on world at scale or become famous/well-known person — there is a higher chance that you will achieve that with VC rather than bootrsapping. Then VC is a right tool to help you achieve your goals.

Apart from your personal motivation, alignment can come from the type of the business you want to build. Let’s take a look at capital-intensive business we talked about earlier.

There isn’t anything like “three million revenue” Cloud vendor. To provide modern scalable cloud hosting, with great SLAs, top-class security etc — you need to invest a lot of capital, so before even thinking about exit — you need a loooooot of revenue. So you don’t have a clear, <relatively> low risk way to “small” exit .

You need to build a big company to make it work.
So your personal interests and your VCs interests are aligned.

Okay, but how this affects your business?

You might think “I can say to VC that I am shooting for the moon, but I can have hidden agenda, or change my mind on the way, right?“

Well, I would not recommend that.

During your startup journey you will come into decisions whether to attack certain market, pivot into different business model etc. VC will typically advise/push you to do bold bets that can make your company huge (even with a risk of going bankrupt) rather than playing reasonable safe to grow at less impressive rate, but without risk of going off the rails.

They can afford that risk, because they don’t do risk management on a single company level, they do it on the portfolio level.

Simplified portfolio math is: 9/10 bets will not work, but this 1/10 should win so big, that it will return the entire fund few times.

Ok, but you can always disagree with your VCs and do what you want, right? Or you can make a decision that “ok, it’s enough for me, time to sell!”

So you can raise 5M USD seed, then 10M USD Series A and then try to build a very big company. But if you fail (but not die while trying), you can always stop and sell it for those ~10M USD right?

Well… no, you can’t.

There are some paragraphs in your investment agreement that will make sure it won’t happen. Or at least, it won’t happen with a good output for you.

VC try to mitigate “early exit” risk by having something called “liquidation preference”. Standard, most “friendly” liquidation preference means that if you raised 15M in funding, you will not see a penny if your sale price is below those 15M USD. (note: It most of the cases it totally makes sense by the way, I am not arguing about that)

Why it matters so much?

Because you raise on very, very paper valuation. Your seed/Series A round valuation formula is like:

a * 100 / b = valuation of your startup

a = how much money I need at this stage
b = how much equity VC can get (typicall 10–25%),
so there will be more room for next rounds

But when your growth rate flattens, typical buyer will have different method for valuation. They will multiply your ARR (or most likely EBIDTA) by some number. In many cases, single digit number.

So while you were raising your 15M USD Series A, on 1m USD ARR, you technically raised liquidation preference to 15M USD level. Let’s assume you only managed to get to 3M USD ARR and then your growth flatten (or you changed your mind about trying to push beyond). Then most of the buyers will not offer you much more that 3–6 times your ARR, so 15M USD for entire business.

It means you get nothing, or almost nothing, because most of the exit price comes back to VC via liquidation preference.

3. Do you have scalable acquisition channels?

So let’s say your interests are aligned, and you decided to go VC way

It means you will raise round after round. 5M USD, 10M USD, 50M USD etc. You will have access to insane amount of capital to make sure you grow at least 2–3x a year for some time.

You and your co-founder while deploying raised money :)

But can you really spend all of that money in the more less efficient way?
Are your acquisition channels deep enough, you can really convert all of those millions into paying customers?

Can you spend 10x more money next year on sales/marketing and get at least 5x more results?

There are products, and markets, that doesn’t work like this.
Nine women will not make a baby within 1 month.

I would recommend to check if it’s not the case of your product, your market or your GTM strategy.

4. What are the alternative costs?

Maybe you operate on “winner takes it all” market, or there is very competitive environment with risk of getting disrupted/killed by those cash-loaded competitors.

You need to do your own SWOT analysis and think of what can happen if you don’t raise money.

Still not sure what’s right for you?

Luckily, there are many more options on the market than classic VC or hardcore bootstrap. There are a lot of investors that are something in between. That was the right choice for me, and maybe that’s a right choice for you. There is no good or bad answer to the question headline question “VC vs Bootstrap”.

It all depends on you and your business. If someone is religiously advising that you should go one path or another — don’t listen to that person.

Please feel free to disagree in the comments (or my twitter), so this guide could be as truthful and useful as possible. I will try to keep this post up to date, according to my best knowledge. You can change my mind in the comments! :)

Happy raising (or not!),
JP