When I founded my first software company in 1989 raising money wasn’t nearly as glamorous as it is today. There were no accelerators, no pitch competitions, no billionaire entrepreneurs-turned-celebrity investors who hosted reality shows in which startup teams competed, Hunger Games-style, to see who would win a round of seed funding. Too many entrepreneurs today assume that they have to raise money to build a great company and give little or no thought to what that money will cost them — which is a good way to get burned.
So if you’re thinking about raising capital for your startup, you should know what that money will cost you before you pass your hat around. Knowing the true cost of equity capital might make you think twice about raising it — or, at the very least, motivate you to consider alternatives.
The Monetary Cost of Equity Capital
The most obvious cost is financial. Let’s say you need $500K to launch your startup, and to raise it you have to sell 20% of your company. Let’s also say that in five years your company is worth $100M (congrats!) and that you didn’t need to raise any more money. Do you remember that server you bought for $3,000 after your financing closed, the one you gave away two years later when it became obsolete? It actually cost you $120,000. That shabby office space you leased for $10,000 before you began generating revenue? It really cost you $400,000. Every dollar you spent from that investment actually cost you $40.
Yes, this is an overly simplistic way of looking at the cost of equity capital — you have to think about what you can gain from it, too — but it illustrates my point. Equity capital is expensive. And that’s true even when things work out.
Don’t get me started on what could happen if you raise a “down round” later, or want to accept an offer to sell for too small an amount. I’ll write more about these complexities in future posts, but it’s important to understand that if you sell equity, you’re placing a bet that is more likely to work out in ways other than your dream scenario.
The Time Cost of Equity Capital
On top of reducing the value of your ownership stake, raising capital will cost you time. Every day you spend raising money is a day you won’t spend talking to your customers. Managing your team. Developing business opportunities. Improving your product or service. Growing your business. Making money.
After all the pitch practice, deck re-writes, and investor pitch events, when an investor does say yes, the money rarely comes quickly. There are term sheets to negotiate and due diligence to complete. And once you do finally have the money in hand, you’ll spend time managing your new investors. Writing reports. Preparing board packages. Justifying your decisions. Explaining missed sales targets. Following up on opportunities your investor thinks you should follow up on, even if you don’t. You get the picture.
The Control Cost of Equity Capital
As you’re starting to see, whenever you raise capital you lose control. That loss of control comes with having to share decision making with people whose goals are not entirely aligned with yours. Your investors want to make the highest possible return in the shortest possible time, while you, presumably, want to build a world-class company.
At times those goals will come into conflict. The more money you raise, the less influence you’ll have on the outcome of those conflicts, until one day you may find that you have no influence at all. Do I smell burning hair?
Consider the Alternatives
So before you raise that seed round, consider the alternatives. Can you get lease financing to pay for the equipment you need? Can you and your team work out of your garage for another six months? Can you get by a little longer without a salary? Can you obtain a grant or a loan? A line of credit? Can you get a customer to finance your product development in exchange for a future discount? (Don’t scoff: I raised $250,000 that way, without giving up a single share of stock). If you think it’s just not possible to build a high-growth company without venture capital, then you’re not familiar with the story of Mailchimp, the email marketing company. Founded in 2001 by Ben Chestnut, Mailchimp grew its annual revenues to $400 million without ever taking a dime from outside investors.
For many startups raising capital is the smart thing to do. The right amount of capital, from the right investors, if strategically deployed, can launch a startup into high growth mode. But before you start working on that pitch deck you should explore every available alternative and consider every possible way to build your business without outside money. Because if Ben Chestnut can do it, so can you.