If You're Not Ready for Debt, Your're Not Ready for Equity

One of the challenges of raising capital is being in tune with both private and public market dynamics. If the public markets are frothy and money is easy, then private capital is probably cheap and equity is easily raised. If you've just had the worst recession since the Great Depression, then the climate is obviously different. Credit is tight, lending standards are onerous, and investors have the upper hand. For investors willing to shoulder risk, they require very favorable terms. Those who are more risk averse may only want to purchase notes and invest in debt that is secured. After all, they can earn strong rates of return and stay relatively liquid with security.

As I've mentioned in previous posts, you've got to give something to get something. If you sell equity in your company then you are essentially borrowing money and in return paying with equity in your company. If you sell debt in your company then you are essentially borrowing money and in return paying with interest.

Sometimes entrepreneurs are out of touch with markets and it shows. Other times they just don't realize that in order to raise capital you must demonstrate to an investor that you will do everything you can to ensure success and that investors receive a return.

Every entrepreneur I meet claims that he/she is 100% confident in the success of his company and that it will not fail. One easy way to determine whether an entrepreneur is committed to his enterprise is to offer debt that is personally secured by the entrepreneur. If you are so sure that this startup capital will generate returns, are you willing to secure it with personal assets?

The best answer you can receive from an entrepreneur is - "Yes. But I want you to know that I have already put all of my assets into the company and have nothing left." This is the entrepreneur that will do whatever it takes.

When the answer you receive is "No", then the obvious response is "How can you be so confident in your company and expect to return capital to investors if you are not willing to take a secured loan?"

Granted, this scenario is more appropriate for a cash-flowing startup that is looking for expansion capital than for an early stage venture. But the point is that debt is more expensive than equity - how bad do you want capital? Would you rather keep spinning your wheels with your current capital structure or pay for capital to accelerate the development of your business?

Comments

[Shankar]

Having been both an investor and entrepreneur, I agree with the key message of your post. People who want to do start-ups, but only with others' money, are not the right bets at all. People who have put in all they have and looking for additional support are usually good bets because you can be assured of their core motivation to succeed and salvage themselves.

[VentureDen]

Point well made,

I feel in most cases entrepreneurs seek funding too early and should get their startup as far as possible with what they have. I feel this also teaches them to be careful with how they spend and makes them more creative in marketing their company. These are improtant traits to learn early on.

[Chris Duesing]

I agree that until someone can find funding or revenue they will likely need to bootstrap, but your message is wildly irresponsible and potentially damaging to a would be entrepreneur. Much like parents who think their child is the smartest person ever born and deserves nothing but wild success, an entrepreneur is the worst judge of the merits of their own company. Their willingness to go in to bankruptcy for their endeavor is unlikely to be any indicator of success at all on which an investor should rely.

"The best answer you can receive from an entrepreneur is - 'Yes. But I want you to know that I have already put all of my assets into the company and have nothing left.' This is the entrepreneur that will do whatever it takes."

You are encouraging people who have an emotional, rather than rational, view of their company to sink their life savings and put their assets up as collateral.

How about this alternative: Entrepreneurs bootstrap their startup and have a reasonable timeframe in which to raise money or become profitable. If they don't reach this goal they give up, rather than doubling down and securing a loan with their house. It can be the VC's or the public's job to decide if the business is worth putting money in to.

[Aron Schoenfeld]

Couldn't agree more. I took out personal loans to fund my company and worked 9-5 to make sure I could pay the bills while I worked all night on my first startup. I then had the attitude that I could not let it fail. I have also seen others try and raise capital to protect their assets and play with other people's money. At least half of those people gave up when the going got tough. As I tell everyone, people are investing in you as much as the company. If you show that you are all in, they are more likely to go in with you.

[mba india]

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