EQ Journal

By Bruce M Firestone, B Eng (Civil), M Eng-Sci, PhD

Abstract

In the five year period leading up to 2010, approximately 91.6% of all tech startups in the US were self-funded or bootstrapped, 8.1% were Angel-backed and just 0.3% were VC-funded. How to self-fund (self-capitalize or bootstrap) new tech enterprises is the subject of this paper.

Self-funding objectives are primarily fourfold—improve speed to market, retain a higher percentage of ownership of new enterprises in the hands of their founders, increase returns on equity and improve survivorship rates. Furthermore, self-capitalization results in more efficient use of a scarce resource—startup funding—crucial to national economic development.

Self-capitalization is a different form of financial capital. Unlike either debt or equity, self-capital is either ultra low cost or free (ignoring opportunity costs). Sources are many and varied. It is an underexploited form of capitalization. It is faster to raise than either equity or debt sourced from conventional sources such as Angels, VCs, commercial banks or Government programs.

Main sources of self-capitalization are trade credit (or supplier credit), deposits/retainers/advances/progress payments from customers or clients, rights fees from and/or investment by strategic investors/sponsors/partners, founder sweat equity, script, soft capital, home equity loans, micro capital loans, crowd funded capital sourced via sites like Kickstarter.com or Indiegogo.com, IP licensing, financial leasing, credit cards, receivable factoring, accretive buying, accretive selling, seller take back financing, trading and asset flipping, partner loans/contributions, consulting/moonlighting, competitions, barter, borrowing physical assets like office space/tools/furniture/personnel, co-branding and co-marketing. In addition to speeding up the go-to-market process, self-capitalization improves ROE, Return on Equity, as well as project IRR, Internal Rate of Return, causes the cash conversion cycle to become negative and allows entrepreneurs to control more of the equity of their own enterprises over a longer period.

Introduction

Texts on financing new ventures tend to focus either on micro-finance for tiny businesses mainly in Third World nations or VC-track enterprises. Leach and Melicher (Entrepreneurial Finance, J Chris Leach and Ronald W Melicher, South-Western College Publication, 2009) refer to early stage financing as ‘seed funding’ whose ‘primary source of funds at the development stage is the entrepreneur’s own assets.’

Schumpeter said in 1934, ‘Entrepreneurs are innovators who use a process of shattering the status quo of existing products and services, to set up new products, new services.’ Entrepreneurs are persons who efficiently use scarce resources, most of which are not their own, to disrupt the status quo. Hence, discussions of business valuation, first round financing, second round, mezzanine financing, bridge financing and IPO are almost wholly irrelevant to a vast majority of startups around the world today.

‘Empty pockets never held anyone back. Only empty heads and empty hearts can do that,’ Norman Vincent Peale.

The role of investment banking firms, venture law firms, commercial banks, public financial markets and securities firms is limited in the startup process. In Fool’s Gold, The Truth Behind Angel Investing in America (Oxford University Press, 2008), Scott Shane estimates that approximately 600 (pre-revenue) tech startups were funded in the US by VCs in 2004 while about 35.5% of all Angel-backed startups were pre-revenue. This works out to approximately 16,000 startups funded by Angels each year during this period (J Basil Peters, http://www.angelblog.net/Angels_Finance_27_Times_More_Start-ups_Than_VCs.html).

The US Census Bureau’s BDS data base suggests that an average of 198,000 tech startups (defined as those with 100 employees or less) were created per year in the five year period leading up to 2010 in the United States. Taken together, these figures imply that 91.6% of all startups during this time were self-funded or bootstrapped, 8.1% were Angel-backed and just 0.3% were VC-funded.

Self-Capitalization

If an entrepreneur is someone who efficiently use scarce resources, most of which are not their own, to disrupt the status quo, where does s/he get those resources from? Often they receive funding from future customers/clients and suppliers. Sources such as commercial banks and government support programs play a lesser role than they once did. Commercial banks in Canada and most of the world tend to lend money to people who already have significant collateral while governments may take too long to make decisions and provide support.

Supplier Credit

In 2009, trade credit (or supplier credit) surpassed bank lending as a source of finance for business in the US. TC amounted to $2.15 trillion that year versus $1.5 trillion in bank lending (which was down more than 6.5%, year over year) according to data from the US Federal Reserve.

For startups, trade credit or supplier credit is a key source of funding. For tech startups, supplier inputs may include—software and hardware (both off the shelf and custom), consulting services, office space, fabricators, designers and developers (GUI, packaging, website, mobile app), product managers, HR, law firms (corporate/commercial and IP advisors) and accountants as well as IT and telecommunications infrastructure.

Some of these inputs may be contributed by suppliers on credit. Why would they do that?

• First of all, they do it because they trust the business they are providing credit to, to eventually pay them.
• Secondly, they want to expand the market and their market share—one of their key weapons for doing this is to provide credit to firms that buy from them.
• Thirdly, this tends to lock clients into their business ecosystem—once a client has been approved for trade credit, they tend to buy from the same source over and over again using their approved credit facility on a revolving basis. They also tend to be less price sensitive than retail buyers since they are using credit instead of their own cash and they often have the ability to pass on higher costs to their clients.
• Fourthly, once they establish good credit, they may apply for a higher credit limit to expand their business further.
• Fifthly, suppliers expect to be paid not by their clients but by their clients’ clients. So a supplier is actually funding (indirectly) credit worthiness of their client’s clients.
• Sixthly, suppliers want their clients to survive for a long period. They will often go out of their way to help out a loyal client who gets into financial difficulties by giving them improved terms for their financing, forgiving portions of their debt or trading debt for equity. Commercial banks may call their loans if they learn a new business is experiencing cashflow issues. Suppliers tend to remain supportive (to a point).

Customer Financing—Case Study

Tech companies can also source startup capital from their clients.

Game Tech, GT*, is an advergaming startup about five years old. They are a top notch Ontario-based advergaming firm. They have—i. significant growth in their order book, ii. a client list that includes Fortune 50 and Fortune 500 companies and iii. excellent technology and creative resources within their business ecosystem. With each new order, they need to build a bigger ‘pipeline’ to deliver their products—i.e., hire more highly paid tech developers on contract.

(* Company name and some of the data have been changed for this article.)

GT asks for and receives ten percent of order price upon execution of each new sales contract. They do not ask for nor receive any progress payments even when they hit important project milestones. They wait until their complex projects, many of which are multi-year, are completed plus 30 days to receive the balance of the order price.

As a result, they require substantial amounts of capital from their Bank to fund their growth. At one point, they exceed their approved $700,000 line of credit by $11,000 and, as a result, their Bank calls their loan. Within ten days, they will not be able to meet payroll.

However, in crisis, there is opportunity. Businesses experiencing financial difficulties can turn to four other sources for assistance—their Board, their shareholders, their suppliers and their clients. In GT’s case, their Board and shareholders are one and the same—they are all entrepreneurs with some personal resources but at this stage of their careers and development, they are fully committed. Consequently, GT is forced to adopt a different, bi-directional strategy—they ask their clients for advances on signed contracts and they change their business model.

Their clients (all but one of them) come to their assistance and save the firm. They do this because superb advergaming technology companies are difficult to replace especially mid-contract.

Next, GT changes their model which now calls for 1/3 deposit/retainer upfront with each new contract signed and then progress payments that always put the firm ahead in terms of their cashflow. Only 10% is due upon final delivery plus 30 days. Their Cash Conversion Cycle (CCC) changes from +274 days to -61 days and the firm goes on to open offices in New York, Toronto and LA. Total employment now exceeds 170.

CCC is an important tool for entrepreneurs to use—if it is 0 or negative, then entrepreneurs can grow their businesses without need of outside funding. Let’s examine GT’s current cashflow position using a simplified model.

Assume they do only one transaction in their financial year in the amount of $3,000,000, their cost of goods sold is $2,000,000, they pay 1/3 up front to their contract developers (i.e., $666,700) and they receive a deposit of 50% from their client or $1,500,000.

Their Cash Conversion Cycle is calculated as follows:

CCC = ART + INVT – APT,

Where:

ART is Accounts Receivable at Year End,
INVT is Inventory at Year End,
APT is Accounts Payable at Year End.

We can determine Game Tech’s CCC thusly—

Accounts Receivable at Year End (AR) $1,500,000
Days Per Year 365.25 Days
AR x Days Per year $540,787,500 Dollar-Days/Annum
Annual Sales $3,000,000 Dollars/Annum
AR x Days Per year/Annual Sales 182.625 Days ART

Inventory at Year End (INV) $0
Days Per Year 365.25 Days
INV x Days Per Year $0.00 Dollar-Days/Annum
Cost of Goods Sold (COGS) $2,000,000 Dollars/Annum
INV x Days Per Year/Annual Sales 0 Days INVT

Accounts Payable at Year End (AP) $ 1,333,300
Days Per Year 365.25 Days
AP x Days Per year $480,700,000 Dollar-Days/Annum
Cost of Goods Sold (COGS) $2,000,000 Dollars/Annum
AP x Days Per year/Annual Sales 243.5 Days APT

CCC -60.875 Days

Notes: Payables Down 0.333333333 0.666667 In 30 days One Sales Transaction

Game Tech’s Cash Conversion Cycle is now a healthy -61 days which means that the faster GT grows, the more cash they have on hand.

This is a non-trivial advantage for them. If they had tried to continue to rely on their Bank to fund their AR and inventory then they are vulnerable to changes in Bank policy because of, say, appointment of a new Account Manager or an overall downturn in the economy. GT is relying instead on its customers and suppliers to provide them with financing, a more stable form of capitalization.

What if GT, instead of asking for half down from clients with each order, only receive payment when each order is delivered? What happens to their CCC? It becomes a significantly worse +122 days. So even though they are still only providing suppliers with 1/3 down, waiting this long to be paid by customers means that they will have to find outside financing for each new order they take.

Of course, if they don’t pay anything to suppliers until they get paid, their CCC will be exactly 0 which is an improvement on +122. However, clients are not then a source of capital for their growing firm. Small changes in company policies produce big changes in CCC.

One of the keys to self-capitalization is to reduce the need for startup capital in the first place. This can be done by looking for financing in the deal flow itself. If capital is available from clients and from suppliers, new enterprises should try to source as much as they can (within reason) from both. It is often low cost or no-cost capital.

Strategic Investors

One of the most overlooked sources of self-capitalization for new enterprises is the strategic investor. What is a strategic investor? Someone who has a strategic interest in your success.

How do you find them? Look through your value chain.

Why go to strategic partners? They will generally make investment decisions faster than Angels, VCs, banks or governments and they will have more capital and better connections throughout your industry than raising money from friends and family.

What will they ask for in return? Often much less than anyone else—perhaps they will be satisfied with, say, an exclusive period during which they can feature/market/use your products or services thereby keeping your products or services away from their competition and further differentiating themselves in the marketplace. The funding they provide may also come with fewer strings attached.

When Apple launches a new product like the iPhone, iPad or iPad mini, what is it worth to a third party app developer, say, to be included on their home screens? Organizations pay significant rights fees simply to be featured in product launches like these. What’s good for Apple is good for your next startup as well.

Equity Investors

Why do equity investors fund startups? It’s to improve their returns.

How do you convince anyone to invest in your startup without giving up too much equity? One thing entrepreneurs often underestimate is the value of their sweat equity. They focus all their time and brainpower on making a new enterprise successful. Investors are passive; alternative investments such as GICs provide minuscule returns—typically 1.7% p.a. or less. Entrepreneurs are expected to generate returns greatly in excess of this and, consequently, they have leverage which they can use to strengthen their negotiating position with either financial investors or silent partners.

Value can be attributed to sweat equity in a number of ways—it can be calculated as a product of number of hours worked times an hourly wage or the difference between the cost of starting a new enterprise and its fair market value. Entrepreneurs can use a financial model that provides an acceptable return to outside investors and assume that the balance of value created is (or should be) theirs.

An equity price is determined as most prices are—by what a willing, knowledgeable buyer and seller agree to in a marketplace where no undue pressure exists either to buy or to sell. The only rule that entrepreneurs need know in this regard is that there are no rules.

Raising Capital by ‘Issuing’ Script

There’s nothing new about raising money by issuing script. The Reynolds Brothers ran a sawmill (established in 1870 by Orson L Reynolds) in the Adirondacks. In addition to logging and operating a local mill, they also ran a company store and developed other sources of income including catering to boarders as well as selling merchandise to loggers in logging camps (Reynoldston, New York History of a Mill Town).

When they needed to raise money, they issued script such as a $5 promissory note to pay their bills and to fund new ventures or additions to existing ones. The script says it is, ‘Due to the Bearer… In Trade At…’ What this means is that the bearer of the script cannot redeem it for cash, i.e., a sovereign banknote of the nation (the United States of America). The fact that it is redeemable only ‘In Trade’ is key.

Reynolds had a margin on each trade so a $5 note with a GPM (Gross Profit Margin of say 40%) only costs them $5/(1 + .4) or $3.57. It’s a good deal for Reynolds but is it a good deal for a supplier, equipment maker or labourer who accepts script instead of banknotes?

The answer is, it depends. If you can’t get any other work, $5 in credit at a Reynolds Company Store, $5 in cigarettes or candy from a Reynolds vendor (which could then be traded for other resources) or $5 in Reynolds products (milled lumber) might be better than watching your family starve circa 1876 even if you know that it’s only really worth $3.57.

Tech startups can learn from this. They can issue script to employees, contractors, suppliers and clients redeemable in the form of company products or services.

Accretive Buying

If you think that bootstrap capital is something only startups use, think again. Large firms including the Disney Company use Bootstrap Capital,

They did this when then CEO Mike Eisner acquired the Mighty Ducks of Anaheim expansion franchise from the National Hockey League in 1993/94. The franchise fee of $50 million was paid as follows—$25 million to the League and $25 million to the LA Kings (then owned by Bruce McNall). But the Kings were paid $5 million per year for five years, a form of Seller Take Back (STB) financing (or Vendor financing), a prime source of capital for startups.

In addition, Disney got a $20 million leasing inducement from Ogden Corp. (then owner of the Pond, now called the Honda Center where the Ducks play) to sign a longterm building lease. Next, Disney put in place a $30 million line of credit secured by their newest asset (i.e., the franchise itself). Hence, Disney acquired the team for a negative $20 million in cash.

This demonstrates that Bootstrap Capital is often ‘free’ capital. The $20 million dollar leasing inducement that Disney received from Ogden did not require any interest payments and, in fact, there were no principal repayments either. Vendor financing Disney got from the Kings was also, in effect, an interest-free loan for five years.

Free or ultra low cost capital can radically change your IRR (Internal Rate of Return) on a project and your ROE (Return on Equity) too. The two most important influencers on a project’s rate of return are—upfront costs and the passage of time. If you can reduce or even turn your upfront costs negative, impacts are substantial.

This can really help an intrapreneur inside an established organization stand out from her/his peers. Say you work at Cisco and you are an intrapreneur who knows how to use these types of self-funding techniques. Suppose you go to your supervisor and say, ‘I have a project that will take two years of R&D at a cost of $10 million but I have three launch clients each willing to pickup $2.5 million of that cost and take the first six months of production.’ It is likely that your idea will get an enthusiastic hearing. More enthusiastic than a colleague who has a competing project that takes the same amount of time to develop and costs as much to bring to market but they haven’t lined up any launch clients or received any hard commitments not only to buy the product once it’s ready for market but to contribute some (bootstrap and free) capital to help develop it as well.

Accretive Selling

Whatever you are selling, you will almost always sell more of it if you provide financing for your clients and customers. If you are selling $10 per month software seat licenses, you are probably going to sell more than if you sell one-time $1,000 software installs instead. Most tech entrepreneurs are familiar with those ‘Don’t-Pay-A-Cent-Events’ (OAC) that furniture and appliance stores promote but may not be aware that, before clients have even left the building, their sales contracts have. As a result, those retailers have more cash on hand after selling you a new home theater system than before because they sell these contracts to third party financiers for cash.

Tech firms can also turn each monthly service contract or seat license into cash if they pledge them in much the same way.

Alternatively, they can provide financing to clients who buy expensive installations—whether the contract price is $1,000 or $100,000, they can often find third party funders so that their clients pay a monthly fee instead of a one time upfront amount.

Crowd Funding

Bootstrapping is becoming more common for projects that are wholly original or appear to be. Craft businesses are being funded in increasing amounts on sites such as Kickstarter.com or Indiegogo.com. Without giving up any equity, entrepreneurs and artpreneurs acquire significant amounts of ‘free’ capital by pledging unusual experiences including first-in-line-to-buy, customized/personalized products or services, signed copies, dinner with the Founders, personal thank yous, lower prices for products, event tickets, special memberships, invitations to a house party, off-beat t-shirts and so forth.

It seems only a matter of time before crowd funding merges with/begins to compete with the equity finance industry but only after regulatory hurdles make this legal. Crowd funding sites are only permitted to operate on a reward or donation basis but President Obama’s JOBS Act of April 2012 may make it possible to trade equity for investment on these sites (Inside The JOBS Act: Equity Crowdfunding, Forbes, June 2012) after the SEC provides a set of rules for this expected to occur sometime in 2013.

The Last Word

We keep adding to our list of sources of Bootstrap Capital. We hope that it will continue to be helpful to entrepreneurs (and intrapreneurs) as they build new services, products and enterprises of all types. Self capitalization techniques are useful not only to for-profits businesses but also non-profits, charities and NGOs. No list can be complete and ours certainly is not. To view the entire list of self capitalization techniques, please visit, http://www.eqjournal.org/?p=1171. Here are some of the primary sources of bootstrap capital for tech startups—

1. Soft capital—money from family and friends
2. Home equity loans—ultra low cost debt secured by the value of your primary residence
3. Future customers—acquiring cash from launch clients in advance, securing deposits/retainers/progress payments from customers earlier in the deal flow
4. Future suppliers—getting credit from trade contractors, paying later in the deal flow
5. Strategic partners—organizations providing various forms of support (cash, credit, office space, tools, personnel) because they stand to benefit from your offering
6. Micro capital lending—programs that quickly provide small amounts of capital with few strings
7. Government support programs—such as the SBL (Small Business Loan) program in Canada that only requires founders to personally guarantee a small percentage of the loan or SR&ED Tax Credits and NRC-IRAP grants
8. Rights fees—upfront payments to be included in a product launch
9. Product placement—fees paid to be featured in a product launch
10. Licensing fees—royalty payments on patents and other IP
11. Consulting services—moonlighting to support a startup
12. Partners—providing cash and valuable skills
13. Investors—seeking higher returns
14. Financial leasing—pledging fixed assets
15. Factoring—trading receivables for cash
16. ESOPs—Employee Stock Ownership Plans
17. Advertising—securing sponsors who want to be associated with your new product or service
18. Trading—buying low and selling high/asset flipping
19. Credit cards—multiple providers
20. Accretive buying—having more cash on hand after buying a company than before
21. Accretive selling—providing customers with 3rd party financing
22. Script—coupons redeemable in trade by suppliers, customers, employees
23. Crowd funding—non monetary compensation for supporters who supply cash
24. Seller Take Back financing—low cost financing provided by Vendors
25. Sweat equity—supplied by founders.

Conclusion

Financings have been done for a long time using two basic types of capital—equity and debt. However, if we ask the question, ‘What is cheaper—debt or equity?’ with a follow up question, ‘What is cheaper than debt and equity?’ we may conclude that self capital is a new form of funding. Debt is usually cheaper than equity and bootstrap capital is usually cheaper than both because, essentially, it’s free.

Supplier credit is often extended to startups without cost (that is, without interest or other fees usually associated with financings) because, if the startup is successful, a supplier has helped to create a new client for itself, often a very loyal new client.

Clients can also be induced to extend credit to a new enterprise (in the form of deposits/retainers/progress payments) without cost because, again, if the startup is successful, the client has helped to create a new supplier for itself, often a very loyal new supplier.

Self-capitalization methods are tremendously varied. It subsumes sweat equity which is, of course, a form of human capital—capital contributed by startup founders in the form of free or low cost labour.

Financial capital can be broken down in business models and plans into three categories—debt, equity and self capital. Other forms of capital include social capital, intellectual capital, cultural capital and environmental capital, all of which are beyond the scope of this article.

The Internal Rate of Return on a project as a whole is made up of a type of weighted average of the returns on equity, debt and self capital. If the cost of bootstrap capital is small or zero (ignoring opportunity costs), it improves overall returns on equity which explains why many entrepreneurs see IRRs on their own investments much higher than passive investors. It also explains why issuing equity to employees, partners or other stakeholders as a form of payment can be expensive. If a new enterprise is successful, this is likely the most expensive way to source funding. Entrepreneurs must exercise caution in this area if they are to retain longterm control over their new enterprises—additional debt or bootstrap capital is an antidote to losing control to partners, employees, VCs or Angels with one proviso—the enterprise must be successful.

Internet tools are abundant and many are available for free or practically no cost. These let you bootstrap a website, online store, blog, social media presence, do basic accounting, make and receive payments, process credit cards, backup your data, share data and transfer data for no money or very little money. It is much easier to start a business in the 21st Century than at any other time in recorded history.

Bibliography

Accounts Receivable Factoring Guide, Curt Matsen, CPA, 2012.
Entrepreneurial Finance, J. Chris Leach, Ronald W. Melicher, South-Western College Pub, 2011.
Entrepreneurial Finance: A Casebook, Paul A. Gompers, William Sahlman, John Wiley & Sons, 2010.
Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur, Edition 2, Steven Rogers, Roza Makonnen, McGraw-Hill Companies, 2009.
Equity Valuation for Analysts and Investors, James Kelleher, McGraw-Hill, 2010.
How to Get the Financing For Your New Small Business: Innovative Solutions From the Experts Who Do It Every Day, Sharon Fullen, Atlantic Publishing Group Inc, 2006.
Optimizing Company Cash: A Guide for Financial Professionals, Michele Allman-Ward, American Institute of Certified Public Accounting,2007.
Strategic Trade Credit, Salima Yassia Paul, 2010.
The Kickstarter Handbook: Real-Life Success Stories of Artists, Inventors, and Entrepreneurs, Don Steinberg, Quirk Books, Original edition, 2012.
The Lean Startup: How Today’s Entrepreneurs Use Continuous Innovation to Create Radically Successful Businesses, Eric Ries, Crown Business, 2011.

Author Biography

Bruce M Firestone, B Eng (Civil), M Eng-Sci, PhD

Bruce M Firestone is best known as a professor, entrepreneur and founder of NHL hockey team, the Ottawa Senators and their home Scotiabank Place as well as Author of Quantum Entity Trilogy, Entrepreneurs Handbook II and Urban Nirvana (2014/15).

Firestone is Executive Director of Exploriem.org, a Canadian registered Not-For-Profit corporation focused on educating and mentoring entrepreneurs, intrapreneurs and artpreneurs in Canada and around the world. He is also coaching, mentoring and teaching via Learn By Doing School, an organization dedicated to providing student entrepreneurs with access to research, education and a network of high achievers not available elsewhere.

Firestone has launched or helped launch more than 172 startups in fields including tech, real estate, design, art and services. He advises clients on business modeling, self-financing, smart marketing, social media, differentiated value, strategic selling and business development, market channel development, harnessing the Internet, urban design, real estate development, design economics, product management, sponsorship and development economics as well as issues related to entrepreneurial organizations including not-for-profits and charities.

In May of 2006, Dr Firestone joined the University of Ottawa’s Telfer School of Management at as its first Entrepreneur-in-Residence. He has previously taught or studied at McGill University (Bachelor of Civil Engineering), Laval University, Harvard University, University of Western Ontario, University of New South Wales (Master of Engineering-Science, Traffic and Transportation), Australian National University (PhD in Urban Economics) and Carleton University. Firestone is now Entrepreneurship Ambassador for the Telfer School.

Dr Firestone has been an operations research engineer, real estate developer, hockey executive, professor of architecture, engineering, business and entrepreneurship, real estate broker (with Century 21 Explorer Realty Inc), writer, researcher, columnist and novelist. He is a peerless husband and father of five great kids and one fine grandson.
You can follow him on Twitter @ProfBruce and @Quantum_Entity and read his blogs at www.eqjournal.org and www.dramatispersonae.org. You can find his works at www.brucemfirestone.com and www.learnbydoing.ca. You can engage with him on Facebook via http://www.facebook.com/QuantumEntityTrilogy and http://www.facebook.com/Exploriem as well as via LinkedIn at http://www.linkedin.com/in/profbruce. His real estate interests are at www.OttawaRealEstateNews.com and www.thelandstore.org. YouTube channels include http://www.youtube.com/user/ProfBruce and http://www.youtube.com/user/quantumentitytrilogy. You can also send the first four chapters of Quantum Entity Trilogy to your friends for free from: http://www.exploriem.org/quantum-entity-subscribe/

His current motto is, ‘Making Each Day Count‘.