Commentary 02: Do Not Take Money From Strangers
We often encounter resistance to this adage...
We often encounter resistance to this adage. The common argument is, how can anyone start or expand a business without taking money from strangers? Throughout my 40-year career, I have dealt with this process many times—raising capital for startups, obtaining financing for business turnarounds, negotiating credit lines, financing plant and equipment, debtor-in-possession financing, bridge loans, IPOs, and more—all of which contradicts this saying. So, why do I offer it?
THE AMERICAN DREAM
75% of small businesses fail within 15 years.1 Less than 1% ever secure venture capital, and of those who get venture capital, 75% fail to exit successfully.2 82% of small businesses fail because they're unable to attract outside investors or secure financing.3 This raises the question, why would you design a business model that requires outside capital to launch or operate? Private equity and banks are the common sources for companies looking to launch or finance their operations. However, both of these options are risky when you consider the impact they can have on your operations.
For some entrepreneurs, the American dream is to create a business plan, secure venture funding, and exit via an IPO or acquisition while making millions. Star-struck entrepreneurs dream of private jets, luxurious boardrooms, million-dollar mansions, etc. The harsh reality, though, as indicated by the above statistics, is that the likelihood of getting funded and successfully exiting is minuscule. The unfortunate side-effect of this dream is that millions of entrepreneurs have gone up in flames running their businesses to attract investors rather than attracting paying customers.
SOURCES OF FUNDING
There are primarily two sources of capital for a small business, equity and debt. Equity can come from private equity funds that invest other people's money or individual investors, sometimes called angel investors, who invest their own capital. Equity investment is the avenue for most start-ups that need outside capital to launch. While the chances of most entrepreneurs getting funded by a traditional VC are almost non-existent, equity capital from friends, family, and acquaintances is not uncommon.
Banks are a potential source of funding, but they do not typically provide capital to start-ups. They usually lend to well-established businesses with a strong track record and enough assets to secure the loan. A 2024 study found that 59% of small businesses did not have a strong enough financial position to qualify for traditional bank financing.4 While it is possible to obtain funding from predatory lenders, it is not advisable to do so unless it is absolutely necessary. Interestingly, the default rate of traditional bank loans is less than 3%, indicating the high standards that need to be met in order to secure funding.5
BANKERS AND INVESTORS ARE NOT YOUR FRIENDS
When you first enter into a deal, investors and lenders are on your side. However, their attitude will change if your deal runs into trouble (which it likely will). When dealing with a venture capitalist, private investor, or lender, you must sign a document including negative covenants.6 These covenants specify what will happen if certain conditions are not met. They are designed to protect the interests of the party providing the capital, which is certainly reasonable.
Many first-time entrepreneurs tend to put themselves in a subservient position to the investor or lender. They often feel grateful, if not desperate, for the capital and view the investor as a savior or "angel.” This mindset doesn't allow for robust negotiations, and as a result, many entrepreneurs end up with deals that put them at a significant disadvantage. At this stage, with the promise of plenty of cash on hand, most entrepreneurs commit to overly optimistic projections, ultimately leading to future problems due to the covenants.
The issue is that these covenants are primarily based on a forecast that requires the entrepreneur to predict the future in a chaotic and uncertain environment. If you fail to comply with these covenants, the lender can raise your interest rate, limit your access to credit lines, or even call their loans. Investors can take more equity, be granted more seats on the board, require approval on financial decisions, or even replace the founder. Ultimately, whoever is providing your capital will be in control of your enterprise, with their only interest being to recoup their money at their expected rate of return.
SHOULD YOU TAKE MONEY FROM FRIENDS AND RELATIVES?
It is often said that you should never mix family and business. If we advise you not to accept money from strangers, should you accept financial help from friends and family? The simple answer is yes. When you set clear expectations, friends and family can offer more flexibility, understanding, and support compared to external investors or lenders. It's important to avoid relatives or friends who are only looking to profit from your business or are risking too much on your venture. When appropriately structured, funds from friends and family can serve as a great source of startup capital and short-term financing.
In this vein, crowdfunding is an evolving form of financing available to entrepreneurs.7 Crowdfunding was established so that customers, potential customers, admirers, friends, etc., can become equity investors without traditional methods' rigorous demands and standards. The primary difference between crowdfunding and traditional equity investment is the lack of control crowdfunded investors have over the enterprise. There are no covenants, operating restrictions, board seats, or other methods of controlling the business.
PRACTICAL ADVICE
What options does an entrepreneur have if they are unable or don't want to secure funding from VCs or banks?
Start-up entrepreneurs. If you're eager to start a business, consider looking for self-funding business models that don't rely on outside capital for growth. Bootstrapping is an American tradition, and many successful Fortune 500 companies attribute their success to this self-sufficient approach. However, if your goal is to create the next Uber in 5 years, entering this arena with a clear vision and realistic expectations about the challenges you may face is important.
Small business entrepreneurs. If you've started a business that requires debt to grow or operate and have modest growth expectations, you should consider deleveraging your balance sheet. If your business is making a profit, set aside a portion of your operating income to pay down your debt faster. You can also consider looking for other sources of capital within the company, such as surplus equipment that can be sold or slow-moving inventory that you can sell off. Use the proceeds from these sales to repay your lender. The goal is to decrease your debt to a level that you can comfortably repay without affecting your company's operations. Once you've reduced your debt, focus on finding opportunities for organic growth to expand your business without relying on external capital."
Growth entrepreneurs. If you have a small business and want to grow, it's best to do it conservatively. I have been involved in several expansions in the past, and I know they can be quite risky for a small business. Most expansions happen through acquisition, franchising, or introducing new products or entering new markets, all of which can disrupt the ongoing operations of a small business. The best way to grow is organically, starting with your existing customer base. Focus on increasing your sales to them and then explore new ways to serve them profitably. Only after you have maximized opportunities with your current customer base and product/service offering should you consider launching new products/services or entering new markets.
IN SUMMARY
If possible, avoid taking money from strangers. Stay away from investors and lenders. Bootstrap, deleverage and pursue organic growth. If you have no choice or decide to pursue traditional lenders or investors, consider making Ephesians 6:10-18 your daily devotional.
10 Finally, be strong in the Lord and in his mighty power. 11 Put on the full armor of God, so that you can take your stand against the devil’s schemes. 12 For our struggle is not against flesh and blood, but against the rulers, against the authorities, against the powers of this dark world and against the spiritual forces of evil in the heavenly realms. 13 Therefore put on the full armor of God, so that when the day of evil comes, you may be able to stand your ground, and after you have done everything, to stand. 14 Stand firm then, with the belt of truth buckled around your waist, with the breastplate of righteousness in place, 15 and with your feet fitted with the readiness that comes from the gospel of peace. 16 In addition to all this, take up the shield of faith, with which you can extinguish all the flaming arrows of the evil one. 17 Take the helmet of salvation and the sword of the Spirit, which is the word of God.8
Deane, M. T. (2024, June 1). Top 6 reasons new businesses fail. Investopedia. https://www.investopedia.com/financial-edge/1010/top-6-reasons-new-businesses-fail.aspx#:~:text=According%20to%20the%20U.S.%20Bureau,to%2015%20years%20or%20more
Jarchow, W. (2024, June 10). The venture capital success rate for startups. Non-Dilutive Capital for SaaS Companies | River Saas Capital. https://www.riversaascapital.com/blog/the-venture-capital-success-rate-for-startups/
Heaslip, E. (2023, December 20). 3 Reasons Small businesses fail (How to Avoid them). CO- by US Chamber of Commerce. https://www.uschamber.com/co/start/strategy/why-small-businesses-fail#:~:text=According%20to%20SCORE%2C%2082%25%20of,being%20spent%20at%20your%20business.
Treece, K. (2024, April 18). Small Business Loan Statistics and Trends 2024. Forbes Advisor. https://www.forbes.com/advisor/business-loans/small-business-loan-statistics/
PayNet Risk Insight Suite | Loan Performance. (n.d.). https://sbinsights.paynetonline.com/loan-performance/#:~:text=The%20Equifax%20Small%20Business%20Default%20Index%20(SBDFI)%20is%202.35%25.
Peterdy, K. (2024, July 11). Loan Covenant. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/commercial-lending/loan-covenant/
Smith, T. (2024, May 30). Crowdfunding: what it is, how it works, and popular websites. Investopedia. https://www.investopedia.com/terms/c/crowdfunding.asp
Staff, Y. (n.d.). Ephesians 6:10-20. YouVersion | the Bible App | Bible.com. https://www.bible.com/bible/111/EPH.6.10-20.NIV