Flexstrapping: The Flexible Financing Model
At the heart of building a company is funding ongoing operations. Typically, the founder has an idea, maybe even an operating company, but needs more capital to grow. To bring that idea to fruition, the founder can sell equity to venture capitalists; self-fund through reinvesting revenues (also known as bootstrapping); or borrow money from banks or other capital providers. Rather than committing to a single financing model, though, we at Hum Capital suggest you adopt a balanced approach using each option as it best fits the direction that you want or need to go. We call it “flexstrapping.”
In this article, we will talk about how to align your financing sources with your growth goals, the tradeoffs among them, and when each option might fit your objectives.
Let’s revisit those four major ways to finance a company in greater detail:
- Equity: Selling ownership shares in the company, usually to venture capitalists, who provide cash and guidance as the growing company grows and finally exits, via an IPO or acquisition.
- Bootstrapping: Reinvesting the company’s revenues to develop the business.
- Debt: Borrowing money in exchange for repayment on a set schedule plus interest.
- Flexstrapping: Mixing and matching the three alternatives above to minimize dilution and maximize growth.
Traditionally, equity financing, particularly from top-tier VC firms, has been viewed as the gold standard for financing a growing company. But experts estimate that barely 1% of new businesses in any given year receive VC financing of any sort, defaulting them into a different fundraising vehicle or stagnate growth. VC funding from a well-regarded firm provides validation, advice, access to a wide network of service providers, suppliers, customers, board members, and future employees, and capital that need not be directly repaid. Moreover, venture capitalists tend to be more patient and flexible than other types of capital. Venture capitalists won’t necessarily panic if your results fall short of expectations—in fact, they may put in more capital to help you over a roadblock. They’ll answer your phone calls and help solve your problems. Because venture capitalists become partners in the company, their interests are aligned with the founder’s—to a certain extent and for at least a period of time.
That “certain extent” is the tricky part of equity. While venture capitalists absolutely want your company to succeed, just as you do, their definition of success may differ from yours, because they’re investing other people’s money. As a result, they will keep a close eye on your performance with the lens of making sure they can give their Limited Partners (LPs) a healthy return on their investment. As one long-time top-tier venture capitalist commented, “If you don’t want a bunch of Type A over-achievers looking over your shoulder, don’t take venture capital.” Other caveats about venture capitalists are listed below:
- Venture capitalists ration their time. Venture capitalists know that about 35% of their companies will fail, 35% will return the initial investment, and 30% will deliver strong returns. Not every company is going to be a rocket-ship success. If your company isn’t succeeding, it may receive less attention than you might expect. For instance, a general partner may put an associate in the board seat if your company is not performing.
- Active investing may be uncomfortable for you. Many term sheets allow an investor various powers, including approval of the budget and management team. This may mean that your pet project gets cancelled. In fact, even your own position may be cancelled. You, the founder, may not be the best candidate for the CEO job, even if your company is doing well. You may be better suited to be the Chief Technology Officer, or, perhaps, the former CEO. The Mark Zuckerbergs who founded their company and still run it long after its IPO are rare; the skills required to found a company and get it to $5 million are rarely the same as those required to take it to $50 million.
- Your ownership will be diluted. Although you’ll own less of the company, the counterargument is that the company will be bigger—you’ll have a smaller piece of a larger pie. Be aware that you’ll need to hit the anticipated milestones to ensure that your next round’s valuation grows, allowing your remaining equity to increase in value. In addition, you may not have the option pool you’d like or the sense of ownership.
- Venture capitalists have a timeline. Because they’re investing on behalf of LPs, they need to get the money back by exiting the company, often by a certain date, to demonstrate their returns in order to raise a new fund. You may feel compelled to rush your company’s growth, expanding unprofitably or into risky ventures and selling more equity than you would have if you’d taken a more measured approach. Additionally, due to the constraints of VC fund lives, you (or your board) may sometimes feel pressured to sell your business or go public.
- Venture capitalists may not choose your company. They may say your addressable market is too small or your product too uncertain. Just because one firm opines against you doesn’t mean they’re right; a top-tier firm has an entire webpage devoted to the companies it passed on and regretted. “It’s not you; it’s me” can be absolutely true.
On the opposite end of the spectrum is bootstrapping, where you control your own destiny instead of answering to external capital, advice, connections, and a board. If less than 1% of startups raise venture capital, it’s pretty clear that a lot of companies are bootstrapped. A recent bootstrapped success story is MailChimp, the marketing platform that was acquired by Intuit for $12 billion after refusing venture funding since its 2001 launch.
Generally, companies that succeed at bootstrapping have a business model that brings in immediate cash. MailChimp’s subscription model allowed the company predictable revenues and its “freemium” approach hooked customers initially and escalated their value. Eschewing outside money means that you also eschew hypergrowth and stay focused on measured investments and strong business fundamentals.
The benefit of bootstrapping is total control of the company, its pace of growth, and its ethos. Ben & Jerry’s ice cream is known for its progressive politics and its annual “free cone day,” revenue-busters that would not have been encouraged by typical investors. With funding from a Vermont-only stock offering six years after its founding, the company grew from a single shop to an international operation using a franchise model. Even in its acquisition by Unilever in 2000, the founders insisted on an independent board of directors to “preserve and expand its social mission, brand integrity, and product quality.”
Of course, bootstrapping comes with its challenges as well:
- By definition, you can only grow as fast as your cash lets you (or by dipping into your personal savings). If your competitor has outside funding for paid acquisition campaigns (Super Bowl ads, anyone?) or expensive but rapid feature development, you must either rely on your product strength to attract customers or be convinced that the market is large enough for two players. Similarly, your ability to invest in risky development efforts is constrained, as you don’t have free cash to allocate to research and development.
- Working capital can become a struggle if you’re depending on the business to generate all the cash for growth. You must therefore be conscientious in managing cash flow and evaluate potential investment opportunities carefully. Because you probably have not started your business to be its accountant, be sure to hire a good controller or CFO early.
- Attracting and retaining top talent can be difficult. Venture funding supplies an implicit “seal of approval” as well as recruiting help, often on a national scale. But using online recruiting efforts and your own network can suffice, as long as you don’t compromise on the search for top-tier talent. Retaining that talent can also be challenging if you’re unwilling to share equity, as many startups reward their employees with stock options, in part to convince them to take lower salaries. So think through your compensation structure carefully to ensure you can provide a competitive and balanced package. (By bootstrapping you technically have more of the equity pie to share with employees, so you can gain an advantage in talent attraction if you’re willing to part with it.)
- Your board of directors is limited to you. Compared to a venture-backed competitor, you may struggle to attract customers or make mistakes that an experienced board could help you avoid. While you can find advisors that don’t hold board seats, their alignment may be more tenuous if they don’t have an ownership position.
Taking on Debt
We’ve talked a lot about debt in earlier posts, so we’ll just do a quick overview. With debt, you can either borrow against money you’re owed, using products like receivables financing or factoring, or against your company’s prospects, through lines of credit, senior debt, or venture debt, which can extend the proceeds of an equity sale. (There are a wide variety of options for debt financing in the market today. To get a sense of some of your options, check out this overview of common debt vehicles.) You get to keep all your ownership, while still leveraging your company’s cash to expand your growth beyond what your revenues will support. Debt is helpful in bridging revenue shortfalls and funding discrete expansion efforts. It’s important to understand, though, that lenders are not investors.
Any amount of debt also comes with drawbacks:
- You are on the hook for paying the principal plus interest. Regardless of your company’s performance, there is nothing you can do to get out of debt, short of defaulting. Lenders will try to help you especially if you give them ample notice, but fundamentally the buck stops with you.
- Covenants will limit your flexibility. Because lenders want early warning of any problems, the debt will often come with covenants, or financial ratios and metrics, that serve as “early warning systems.” These may be the amount of cash you have on hand or in the bank to service the debt. Breaching covenants triggers any number of penalties, including a fee, an increase in your interest rate or collateral, or, at worst, termination of the lending agreement.
- Having debt on your balance sheet will constrain your strategic options. Taking on debt, especially with prepayment penalties, means you have to focus on repaying the loan. You may therefore invest in activities with more certain returns, rather than riskier alternatives that could ultimately have a higher return, but generate less near-term cash. Long-term debt obligations will limit your strategic optionality.
- Lenders are not investors. They need to get their money back and will act more quickly than equity owners to shut down the business if they fear they won’t be repaid.
With flexstrapping, you take the best of these worlds and use them to grow your company into the organization you envision. Once you’ve bootstrapped your company to sustainability, you may want to grow faster than your revenues will allow. At that point, you can choose between taking on debt and selling equity, making this decision with a keen sensitivity to the tradeoffs involved and ensuring that every dollar you take into your business is spent on areas that justify its cost. In other words, you:
- Use debt to pay for profitable, de-risked activities that exceed your cash flows, such as customer acquisition, where per-customer revenues exceed your costs, or inventory to fill order backlogs. Most of expense management platform Jeeves’ recent $131M round led by Andreesen Horowitz was raised as “non-dilutive rocket fuel” to support growth and expansion.
- Use equity to pay for uncertain, risky activities exceeding your cash flows, such as product line extensions or new product development. We could cite examples here, but you can likely think of plenty from your own news feed.
- Grow at a speed that makes sense to you given the competitive landscape in which you operate and your vision for the company. Take for example Lusha, founded in 2016 and entirely bootstrapped until 2021, when it raised $245M to compete with its acquisition-loving competitor Zoominfo.
Many companies, like ZipRecruiter, have grown through a combination of debt, bootstrapping, and equity. Founded in 2010, ZipRecruiter developed an AI algorithm for more accurate job seeker/opportunity matches. ZipRecruiter was bootstrapped until 2014, when it raised $63 million from three VC firms. In 2017, it obtained debt from Silicon Valley Bank, and then sold additional equity in 2018. The company went public (NYSE:ZIP) in May 2021.
According to Silicon Valley Bank, 63% of venture-backed companies that went public in the first half of 2021 had also used venture debt. The principal benefit of this strategy is that it allows you to minimize dilution while also bringing in equity to finance risky investments. You can avoid selling equity until you have reached an important milestone, ensuring that the new round occurs at an attractive valuation for existing investors, which include you and your option-holding employees.
It all Depends on What You’re Trying to do
Think through how you want your company to grow. If you’re going to be sending stuff into space, you’ll probably need external capital. If you can self-fund your growth, you may be able to bootstrap and keep all the ownership for yourself. More likely, you’ll use a combination of these methods. Many entrepreneurs don’t have the time or domain expertise to work through the details of a flexstrapping approach. Typically, this role has been played by investment banks, which assumes your business has reached a certain (large!) size. If you’re not there yet, contact us at Hum to see how we can help you find the right flexstrapping approach to keep your business—and your dreams—humming.