The startup dream goes something like this: A couple of entrepreneurs with a great idea hole up in a basement and hatch software and social networks that bloom into billion-dollar businesses.
The reality is much more complicated. Businesses don’t bloom into billion-dollar companies without a significant amount of capital. And raising money comes with a thorny question for startups: What might the venture have to sacrifice to obtain the funding to fuel growth?
Giving up equity too early in the life cycle of a company can be extremely expensive. But starving a company of funding out of a fear of giving away too much ownership can hamstring its potential.
Here are three things to understand before raising capital to fund business growth:
1. Equity is expensive.
If you have an early-stage startup with a promising future, giving over equity might end up being the most expensive way to raise capital.
While a venture capitalist or an angel investor might think that a 50 percent stake in your company is a fair exchange for an infusion of funding, you need to look beyond the current state of your business (a couple of coders working at a few computers). Calculate what this means if your company turns into the next Facebook, Salesforce or Instagram.
Instead of trading equity, consider using convertible debt, which delays a valuation of a company until the first institutional investor buys into the firm. At that point, the company will be more mature, which can lead to a more equitable valuation of the startup for founders.
Convertible debt can work well for both investors and entrepreneurs. For investors, it cuts the risk associated with a pure equity stake while maintaining the upside of an equity position. For entrepreneurs, it delays the valuation until the company has matured to a level that makes the assessment more than a guessing game.
Related: Raising Money Using Convertible Debt
2. Self-funding can limit growth.
Bootstrapping a company to its full potential is a lofty goal, but it's almost always unattainable. Businesses simply need capital to fund their growth. And most savvy business owners realize that without outside capital, they will never grow their company to its true potential.
If you're considering self-financing a company, think about the downsides before committing to this approach: Will it impede growth, restrict your market share or lead to a cash crunch?
Self-financed companies can find themselves in an unenviable position possible, running out of cash and desperate for financing. This can lead to a complete loss of leverage at the negotiating table with banks, venture capitalists or private equity groups.
“Entrepreneurs should always have a trusted advisor or CFO who can see ahead and make decisions proactively rather than reactively,” Dusty Wunderlich, CEO of my client Bristlecone Holdings, tells me.
“When entrepreneurs lose cash flow, they give up leverage and negotiating power and risk losing too much ownership in a desperate attempt to raise funding,” says Wunderlich, who is also a partner at private-equity group DCA Capital Partners.
Related: Self-Financing Your Startup
3. The burn rate matters.
A burn rate -- the rate at which a company spends its startup capital -- can vary wildly. Software companies can get off the ground and grow with a slim budget, but manufacturing companies and hardware makers consume enormous amounts of capital.
Bootstrapping a software startup is possible. But a manufacturing company will require significant financing or investor capital from the start.
Every business has different funding needs. But certain warning signs signal that a company is overleveraging or taking on too much debt.
“If you are taking on debt for operating expenses, you are probably not that healthy,” Wunderlich says. “Debt for assets, infrastructure or acquisitions is a more appropriate use of debt or leverage.”