As I mentioned in my June 2006 column, an entrepreneur has three basic approaches to meeting capital needs:

  • Attempt to self-fund: use your own funds or acquire the needed resources on your own by selling assets, accumulating funds from the business' profits (if any) and/or accumulating funds from your other sources of income;
  • Use conventional "Other People's Money" (OPM): Debt or equity financing; or
  • Use "Other People's Resources" (OPR).

There are advantages and disadvantages to each approach. Depending upon the circumstances, some forms of OPM or OPR may be easier to obtain or less costly than others. In other words, the entrepreneur must make strategic choices with respect to whether or not to seek OPM or OPR, and if OPM or OPR are sought, which category of OPM or OPR to seek, how much to seek, and when to seek it.

Self-funding vs. OPM

If you have a choice between self-funding and using OPM, which should you choose? The answer depends upon the circumstances. For example, you may not be able to self-fund, or OPM may not be available to you on reasonable terms.

One of the primary benefits of using OPM is that it can open the door to opportunities. It permits you to start up or expand a business in ways that would otherwise be beyond your resources. It also can help you move quickly to take advantage of windows of opportunity -- it lets you play in the game. If your resources are not sufficient to let you take advantage of an opportunity, the "choice" between self-funding and using OPM is made for you.

On the other hand, the conventional forms of OPM may not be available to you at a reasonable price. For example, you might not qualify for a loan at a reasonable interest rate, and equity investors, if available, might insist on too large a percentage of ownership for their contribution. Realistically, in those situations, your choices are to self-fund to the extent that you are able, delay until you become more credible, and/or use OPR.

But what if you are able to self-fund if you are so inclined, and also have the classical forms of OPM available to you?

As mentioned in the earlier column, self-funding has certain advantages. There is a cost associated with the use of OPM (e.g., interest payments or sharing ownership or control of your company). By self-funding, you avoid that cost, as well as various potential securities law considerations that can arise from seeking conventional OPM.

However, even if self-funding is a viable alternative, there are reasons why you may still want to use OPM:

Share the risk: The potential funding commitments may exceed your risk-tolerance. Even though you may be able to self-fund the venture, you may not want to risk the entire amount. Using OPM spreads the risk.

Leveraging your funds to pursue other opportunities: The primary cost of self-funding is opportunity cost. There may be other things that you want to do with your money, other opportunities that you want to pursue.

Appreciated valuation: The valuation placed on a business by a potential equity investor is occasionally so favorable, so much in excess of expectations, that using OPM is exceedingly attractive. This sort of thing can happen when the potential investor has a better appreciation of the potential scope of the enterprise than the founders, e.g., the founders think strictly in terms of sales to the military, while the investor recognizes major commercial applications for a product. (Of course, when a valuation is greatly in excess of expectations you should make sure that the potential investor understood all the facts, in making the valuation. The last thing that you need is an investor that comes to think that he or she was misled.)

Other contributions by the co-venturer: An investor may bring more to the table than just hard cash. The mere participation of some investors may give the venture credibility, and an active investor may bring the venture needed expertise.

In a typical case, a cost-benefit analysis of using OPM is in order. Is the post-OPM value of your ownership interest greater than the value of your pre-OPM ownership interest? (Of course, a small percentage of a large number can be much greater than a large percentage of a small number). If so, is it sufficiently greater to compensate for any non-monetary aspects of the price of the OPM?

In any event, even though you may be able to self-fund the venture, depending upon your risk-tolerance and your attractiveness to investors, you may want to minimize your cash investment and leverage your resources to the fullest extent possible.

Published on: Aug 1, 2006