Bootstrapping vs. equity financing

Small businesses need money to grow. Consider bootstrapping or equity financing to get your business the cash it needs.

What is bootstrapping?

Quite simply, bootstrapping means being frugal and creative when it comes to business finances. Bootstrapping usually starts with seed money you provide from your own savings. Outside investors are not used.

Once the business runs, you start to earn money from sales, which you pump back into the business. Bootstrapping is about minimalism and doing as much as you can yourself. Lots of bootstrappers start without employees, wearing all hats in the company.

Pros and cons of bootstrapping

This method has benefits and drawbacks, of course. According to Edgar Radjabli, managing partner of Loan Doctor, "The main benefit of bootstrapping is that the founders keep more equity and control of the business."

A downside is that you may be tight on cash and resources.

Danielle Roberts started insurance agency Boomer Benefits with her brother and relied mainly on sweat equity to get it going. The choice to bootstrap meant they had to downsize their lives and pour their profits into the agency.

Matthew Ross, co-owner of mattress review site My Slumber Yard, started with a small amount of seed funding from family and friends but bootstrapped the rest. "A business that is bootstrapped generally doesn't have the resources to launch big marketing campaigns or to hire additional salespeople," he says, and that means slower growth.

How to bootstrap

Bootstrapping requires you to think creatively to get the cash and resources you need to launch your business. Consider the following techniques.

• Bare-bones operations. Instead of renting an office, run your business out of your home, and hire employees who can work remotely. Shared office space is another option.
• Direct shipping. Some distributors or suppliers will direct ship your product to your customers. Jeff Neal owns The Critter Farm, which sells crickets and other insects as reptile feed. Neal's suppliers drop ship the insects, so he doesn't have to use capital to maintain inventory or build his own grow facility. However, he says, "The downside is that the margins aren't as large compared to having our own grow facility."
• Trade credit. You may be able to negotiate purchasing supplies on credit, allowing you to get the supplies you need to make sales. "Trade credit is good for short-term cash needs," Brian Cairns, CEO of ProStrategix Consulting, notes. Roberts is in the Medicare insurance industry, where some carriers allow a nine-to 12-month commission advance instead of monthly commissions. "We used this early on to stay ahead in the cash flow," she says.
• Factoring. Another way to access cash is to sell your receivables to a finance company. They pay you a percentage of your receivables' value as you bill, and they collect the payments. This gets you cash faster, but you lose a chunk of it for the privilege. "Factoring makes sense if you have a long billing cycle," Cairns says.
• Loans. Although bootstrapping does not involve equity financing, it frequently involves loans. Home-equity loans are a common method. "If you're just starting a company, personal loans might be your best bet since your options are quite limited," Ross says. "You might be able to go the SBA route, but typically those are harder to qualify for." The advantage of a personal loan, he notes, is the flexibility. "You can generally use personal-loan money as you please."

What is equity financing?

Equity financing raises capital by selling ownership shares. Cairns notes that you will need to show a value for your business to access equity financing or show widely acceptable comps—companies in that sector that have been successfully sold.

Ross explains that equity financing doesn't have to mean involving strangers. "A lot of times friends or wealthy relatives will give you a loan or invest in the business for a small piece of equity," he says. "These types of arrangements are often preferable since there are fewer headaches, paperwork, and personal risk."

Pros and cons of equity financing

Equity financing has the benefit of funding your business upfront. "An equity investment gives the business more resources to grow," Ross says. "The company can hire more employees, launch marketing campaigns, launch new products, invest in infrastructure, increase manufacturing capacity, etc. Businesses may also benefit from the knowledge and expertise that the new investors provide."

The major drawback of equity financing is that you are no longer the sole owner of your business. Calloway Cook, president of Illuminate Labs, says: "I decided to take equity financing to reduce personal financial risk. The benefit of removing all personal financial liability from launching a business outweighed the drawbacks of giving away a percentage of ownership and waiting months for all the legal documents to be completed and the investment money to clear."

"Carefully consider your investors and their respective personalities," Cook cautions. "If these are people who are going to hound you and add stress to your workdays, it may not be worth it. I would recommend getting investment from people you know personally if you have the network to do so, as you can judge their character better than an investor you just met."

Although Neal has bootstrapped much of his business, he did take equity financing from a former employer. Once was enough for him, though. "Our ownership has been diluted, and we now have an investor who we are legally obligated to work for, in his best interest," he explains. "And sometimes trying to secure profits for an investor is counter-intuitive to trying to grow and gain market share."

Making the choice

It's important to consider which method works best for your business. "If your growth expectations are modest, needs are short-term, etc., the non-equity methods are preferable," Cairns says.

Radjabli has both bootstrapped and equity-financed different companies. "Bootstrapping is usually best when the addressable market is small or niche, such that there is a limitation on how large the valuation of the company can grow," he says.

"Once you've exhausted the bootstrapping and have a clear plan that needs funding, that's when you should pursue equity financing," Neal says.

Bootstrapping and equity financing are both paths to business success. Choosing the one you are most comfortable with allows you to grow your business with confidence.