Over the past couple of years, I have commented extensively about the challenges startups must overcome to be successful.
Recently, I wrote about how new federally funded accelerators and incubators are graduating large cohorts of well-trained entrepreneurs who are facing the question: “Now what?”
Successful startups need great ideas, smart people, money and a little luck. Entrepreneurs have control over their ideas and the people they hire, but money and luck are a different story. And since we can’t do anything about luck, let’s focus on the other key, but often uncontrollable, factor in their success or failure: money.
Startups have a couple of choices when it comes to funding – they can finance themselves or find someone else to do it. Most tech companies need to secure at least some outside capital to survive the critical early startup stage.
The question is whether to turn to friends, family and angels for funding or look for venture capital.
The biggest difference between self-financed companies or those with limited investor support – known as “bootstrapped” startups – and well-funded companies that are backed by early-stage venture capital investors is how fast they can grow.
VC-backed startups are generally able to expand their teams more quickly than companies that are bootstrapped. While access to venture capital does not guarantee long-term success, it does increase a company’s ability to scale quickly and take advantage of market opportunities. On the other hand, bootstrapped companies tend to struggle to expand their workforces and therefore often require more time to achieve key milestones.
A typical bootstrapped company relies on its founders to work for little or no pay while employing teams that are paid below-market rates, adding staff only when absolutely necessary. That way, the company can stretch out its working capital until it is either investment-ready or cash flow positive. In addition, bootstrapped companies often require government programs to provide them with grants and credits to support their development activities.
Early-stage VC-backed startups are few and far between, mainly because they face a classic catch-22 scenario: they need great talent to get financing, but they need financing to attract top talent. That, combined with the fact that Canada has very few early-stage venture capital companies and the definition of “early-stage” is getting later all the time, means the probability of a young startup securing venture financing is low.
As a result, most of Canada’s successful tech companies rely on a combination of bootstrapping and venture capital, using their own funds or money borrowed from founders’ friends and family to support their initial product development, then turning to venture capital when they are prepared to grow.
Cognos is one of the best examples of a local company that used this strategy. The software maker, which was eventually acquired by IBM, started off as a consulting firm called Quasar that used its own revenue to build its initial PowerHouse product. When it made the switch from a consulting company to a product company in the mid-1980s, it sought external financing to fuel its growth and evolve into the successful firm that became known as Cognos.
Klipfolio is a more recent example. The software firm began life as Serence in 2001, bootstrapping itself with help from its founders’ friends and family to build and mature its product through a high level of customized services. By 2008, the company had a strong user base to finance the product and changed its name to Klipfolio. Since then, it has used two venture capital rounds to fund its growth and success.
Fluidware, an Ottawa software company that was acquired in 2014 by California-based SurveyMonkey, is another great example of a firm that bootstrapped its way to major growth. The company had two original founders: a highly experienced technology executive, Eli Fathi, and a talented developer, Aydin Mirzaee, who was a recent university graduate with a unique idea for a product.
As Fluidware grew over the next six years, it reached sales of more than $5 million per year and built a team of more than 75 people. Its founders prided themselves on the fact that the company was self-financed, with few outside investors other than friends and family. They worked 15 hours a day, six or seven days a week, to manage and grow the business. When the company was sold, the founders and original investors received a great return on their investment.
Fluidware’s story demonstrates how an experienced serial entrepreneur such as Mr. Fathi can self-finance a company and act in many executive capacities at the same time. Many serial entrepreneurs start a company, build it through sweat and perseverance, sell when it needs a new partner to grow, then repeat the process with their next company.
In contrast, success stories among startups that turned to venture capital very early in their development are few and far between, which is why we see very few companies following this path. Founding entrepreneurs know the challenges they face, and VCs know these firms’ probability of success is low. With the large number of startups competing for VC cash and the high level of due diligence required, hitting it big is a long shot.
During the 2000s, Ottawa had dozens of venture-backed startup failures, including Ceyba, Liquid Computing, Meriton and Zynastra. These companies had almost unlimited capital, but in the game of “go big or go home,” most of them ended up going home.
The next generation of entrepreneurs and investors learned from those mistakes. Startup growth is now better managed and “moon shots” are discouraged.
Experienced founders know that getting a VC investment is both a benefit and a challenge. Many founders lose control of their companies once a VC invests. They also know they will lose at least 25 per cent of their ownership stake at each financing round. Entrepreneurs tend to want to delay the need for venture capital until they have some success and can better manage the terms of an external financing.
The bottom line is any startup with the potential to scale to a large company – what I define as having annual sales of $1 billion or more – will need to find cash somewhere. However, there is currently not enough funding available in Canada to support the number of startups that are being created and supported through accelerator and incubator programs.
Young companies need more access to capital in their early stages, as well as better tax incentives for early investors, more access to debt and more early-stage investment funds that will be supported and not crushed by later-stage investors.
I have invested personally in seven startups over the past 15 years. One sold for a small gain, one broke even, two sold at a loss, another pair went bankrupt and one went public at below my initial investment. As an angel investor, my ownership was crushed when the startups secured VC financing and any hope of recovering my investment was lost.
The lesson is clear: fledgling firms need a strong plan to support their initial investors and protect them against catastrophic dilution from follow-on financing. Many startups end up selling to a larger firm rather than securing VC financing, since being acquired is often the best financial solution for the founders and the initial investors.
Startup entrepreneurs typically look at bootstrapping as the brief stage before they try to secure venture capital financing. Yet a look at Ottawa’s successful tech companies shows that bootstrapping and angel funding has been essential to their early-stage development and initial product or service launches.
There is no clear-cut answer for what type of financing is best for a startup.
Founders know that a well-financed startup can scale quickly. But bootstrapped companies tend to grow more slowly and are prone to stagnate when they run short of capital.
However, founders and initial investors of bootstrapped companies also have more control over their own destiny as they experiment and refine their business models. Most of Ottawa’s successful tech companies have focused on achieving some growth and cash flow before turning to venture capital.
After all, it is always better to ask for money when you don’t need it.
Jeffrey Dale is the president of Snowy Cloud and the former president of the Ottawa Centre for Research and Innovation.