It was 1999, at the height of the boom, a few months before the bust of April 2000 so he can be forgiven. I stood before a crowd of entrepreneurs gathered at a hotel on Route 110 in Melville, on Long Island. They'd each paid $50 to come hear the collective wisdom of bankers, other entrepreneurs, lawyers, accountants, and venture capitalists. I was the keynote speaker and before me stood a twenty-something entrepreneur with that look in his eye.
The look said it all. He had the idea. He was going to solve the problem. He was going to be rich. All he needed was the capital to make his idea -- putting free postcards in the checkout aisles of supermarkets; postcards that were really ads -- graphically-enticing, hip images of Entenmanns's chocolate donuts and Tony the Tiger -- but nonetheless ads. He stood during the Q&A period and he told his story as a prelude to asking his question -- the question. I braced myself:
"So, even though I'm cash-flow positive, I can't even get a meeting with a VC. Why is that?"
I blew out the air from my lungs and surprised him with my response. "Why do you want to sell half of your profitable business?"
In 1999, though, I knew the answer to my question. After the huge run-up in the value public companies -- companies that had been backed by VCs -- entrepreneurs came to see venture funding as a requirement, the key to that elusive golden door behind which all happiness lay.
I went on. "Look'¦this is your first business, right?" I turned to the audience, most of whom were in their mid-forties and fifties, "How many of you have run businesses before?" A few hands shot up. I zeroed in one guy, your typical gray-haired exec. He told us his first business -- his current business -- was manufacturing specialty airplane engine parts. He'd launched the business in the late 1970s after he'd left Grumman. "And how did you raise the capital to get going?"
He smiled; he'd just finished paying off the second mortgage he'd taken out to get going, he said.
I looked at the parts manufacturer, pointed to my young questioner still standing in the dark room, and said, "And what would you have done if your business had low-initial capital requirements and was cash-flow positive from the get-go?"
He, and a bunch of his peers, burst out laughing. My young entrepreneur was still puzzled.
I tried to explain. "The best possible way to finance your business is from free cash flow. If you can meet your capital needs without selling equity or without taking on personal debt, do it. It's that simple." Moreover, I continued, if growth continued the way it had -- he'd done more than $3 million in revenue and $1 million in EBITDA in his first 18 months -- than he'd have a very valuable business; something he should want to own as much of as possible.
But, as I said, he should be forgiven. Given the amount of attention venture capital gets, it's easy to assume that selling equity is the only, if not the best, way to raise capital. But the truth is, even if you one day do need to sell equity, put off that moment as long as possible.
At the end of the talk, I grabbed my young friend and explained why I felt VCs weren't interested in his business (the idea is easily replicated; it's labor-intensive to refill racks in checkout aisles -- which is why the magazine-rack business is dominated by a few large players. It's not scaleable. Moreover, it's unlikely the business by itself could go public so the only exit strategy is a trade sale and, at that moment in time, VCs were interested in finding businesses the public would buy.). Naturally, he continued to pursue VC backing, without much luck.
When financing your business, look at all your options first; look to your savings, look at your personal expenses and see if there are ways you can do without. One VC I know used to ask prospective investees if they really felt they could afford to be an entrepreneur.
That's partly a purely financial question; can you really cut your expenses to the point that you could drastically reduce, or even forego altogether, your salary. If not, are you sure that running your own business is right for you?
Moreover, are there friends or family from whom you can borrow the initial capital to get your business launched? Often times, a wealthier parent, sibling, or relative is an ideal source of capital. But be warned: borrowing from friends and family carries a huge emotional risk. One woman I know has a challenging relationship with her now-retired father; much of her adult life has been defined by a quest to seek his approval. She recently took money from him as an investment (he bought stock in her new company; he didn't lend her money). If her business fails, she will have an even more challenged relationship with her father.
Only borrow money (or allow take an investment) from friends and family if you're absolutely certain they can afford to lose it all and that doing so will not jeopardize your relationships.
In the end, the best way to finance any business, and pay your bills, if - of course - out of cash flow. That is, make the business pay as it goes. Need to expand to take advantage of market conditions? Use your profits. If you don't have the profits, maybe you shouldn't be expanding.
Of course, that's a simplification. Many small business owners know that making a profit and receiving the cash that goes along with that profit are two different things. There are a number of ways to use your accounts receivables to smooth out the an unpredictable cash flow. Companies as diverse as American Express and UPS to your local bank all offer mechanisms that can help.
Only after you've explored all these options, should you consider venture capital. If you do, not only will you preserve more equity for yourself but you'll increase the likelihood of raising the money; after all, there's no company a VC likes to fund more than a company that doesn't need his money.