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Why Small Business Loans Can Be Better Than Raising Venture Capital

Why Small Business Loans Can Be Better Than Raising Venture Capital

Many small business owners might be looking for the next level of growth for their company – but what is the right way to finance that growth? Venture capital gets a lot of headlines in the business media, but it’s not always a good idea for business owners to raise capital by selling equity in their company. There are also some pitfalls and risks of raising too much capital too quickly. Depending on your business and your growth objectives, it might be better to aim for manageable sustainable growth with debt (small business loans) instead of equity financing. If you want to hold on to 100 percent of the ownership of your company, small business loans can help you get off the ground.

We talked with Matt Turner, management consultant with Boston Turner Group, about the possible drawbacks of venture capital and why debt can be a better way to finance your business’ growth.

Diluting the Value of Your Business Ownership

One of the risks of raising venture capital is dilution of the founders’ ownership stake of the business. “If you are running a profitable business and have grown successfully through organic means, then maybe you shouldn’t raise money right now,” Matt says. “Many venture capitalists would love to be a part of that kind of business, but that kind of business is also one in which you want to maximize your ownership. If you can see the path to growth and profitability, then don’t fall for the trap of raising money just because you can.”

Raising Capital Can Breed Complacency

This may sound counterintuitive, but sometimes raising too much capital can be the first step to even worse problems. “You take a company that is profitable and growing, sure they’ve struggled to get to where they are, but those struggles taught them how to be operationally excellent and focused on their customers with laser precision,” Matt says. “Now they’re rich in cash and they get a little bit sloppy because they can. In that case, you took a great company, diluted the ownership and endangered its scalability and sustainability.”

Ask Yourself: What Kind of Company are You Running?

Matt says that it’s worth asking the question, “when is the right time to seek VC money?” Venture capital is typically focused on high-risk capital seeking a very high rate of return by scaling a company as fast as possible and exerting the VC investors’ influence in any way possible to protect their investment. “So the business owner needs to ask themselves, do you have the type of company or idea that has a short window so that you need to quickly get market share? In my opinion, that is mostly true only for three types of companies. First, some companies require a large upfront investment in research and development. If you are building a new type of machine, electronic device, biotechnology, etc., you’re not going to bootstrap your way to market. Second, if you have a big idea and you need to become the 900-pound gorilla in a hot market before a competitor becomes entrenched. Internet retail is an example. Although Tony Hsieh has famously commented that he took too much VC money in the beginning, one could argue that Zappos needed to gain market share quickly to guarantee its long-term success. Third, if your strategy is based on mergers and acquisitions, you need access to large amounts of capital to pull off the business model.”

But if your company is not one of those three types of companies, try not to take the venture capital money. “The cost is just too high,” Matt says. “The average initial VC investment is going to require at least 40 percent of your equity, but it can be much larger depending on a number of valuation factors such as your current growth rates, strength of the management team, available sources of funding and more. If you’re growing at 25 percent, which is pretty good already, it would take you three years of growth just to get back to your original level of equity value. Will the VC money allow you to double your growth rate in a sustainable way? That’s what it takes to make it worthwhile, which is why I think it’s only needed in cases of large development costs, acquisitions, etc., because you’re investing in growth you couldn’t access organically.”

Assess Your Timing and Consider Your True Needs

When deciding whether to take VC money or take out small business loans, the first consideration above all is timing and need. “I’m a fan of having the company founders stay away from selling too much equity in the beginning stages of their company,” Matt says. “First, your valuation is going to be the lowest possible at that stage in your life cycle because you haven’t proven your products and markets yet. Second, early stage companies have an ability to grow very quickly on a percentage basis, which quickly reduces the value of the money to the founders. When you have only a few hundred thousand dollars of sales for your beta product, a couple million in VC money sounds really good. Then all of a sudden, your product takes off and when you’re doing a couple million in sales you might have some regrets that you didn’t prove the concept on your own. Of course there are exceptions where you need a large influx of cash to buy market share or get a complex product developed. Unfortunately, that kind of company needs to keep getting new capital to keep growing and many entrepreneurs find they are diluted even further as they keep needing more investment to reach their goals. It’s not uncommon to see founders diluted down to 10 percent ownership of the company.”

So when is it definitely the wrong time to take VC money?

“If you are really early stage and don’t need the funds for large R&D, then you don’t have enough to justify a decent valuation,” Turner says. “If you’re small, then you already have a decent chance at organic growth, so I think you should try alternative sources of financing to get profitable. Alternative sources of financing – other than VC funding – are also highly valuable if you’re concerned about maintaining control of your company and managing the overall vision for where the company is headed, because you will give those things up with VC money.”

The Advantages of Debt Financing

Debt financing is very powerful in a number of ways, especially if you have a dependable business and growth. You know you can pay off the debt through current revenues and growth without giving up equity and control. “There’s really not much you can’t do with debt financing that you could do with VC money unless you need large scale capital that you couldn’t pay for through cash flows,” says Matt.

It’s also important for small business owners to evaluate their big-picture goals for why they’re running their business and what they ultimately want out of life. Although fast growing, VC-backed companies make headlines, many entrepreneurs have other goals than just large market share. “You might have lifestyle goals. Driving up your exit value might be more important to you than short-term profits,” Matt says. “You might want to invest in property as part of your business to increase your wealth. Maybe you want to build a healthy and sustainable family business that you can pass down. Maybe you’re in a business that has great cash flows but no real exit value, so you want to grow those flows but cannot offer a liquidity event for a VC.”

Ultimately, raising VC money can be a blessing or a curse, depending on what you really want out of your business. Debt financing might offer you more control while still enabling you to reach your business growth goals. “I think a downside to VC money is that it creates an unearned sense of success,” Matt says. “First you become focused on things that are not core to your original idea – hiring, bigger office space, larger marketing budgets. Second, that puts pressure on you to keep growing and performing. Third, you may not be ready for that kind of scale but you’re burning through higher amounts of cash. Maybe the demand for your product isn’t there yet and the market will take longer to get educated.”

Even if you decide that VC funding is not the right route for your business growth, there’s nothing wrong with that. With the rise of platform lenders and other sources of small business financing, there are more options than ever before to help small business owners achieve their growth goals – while maintaining their vision for what they want their companies to become.

What do you think about the ideas in this article? Would you ever want to seek VC funding to help your business grow faster, or is it not worth giving up a large share of your company equity? Leave a comment and let us know!

 

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Kabbage Team

The Kabbage Team is here to not only fund the small business loans you need, but to help you grow your business through free marketing tips, webinars, tools and more. Is there something you'd like us to cover or want to get your small business featured on our blog? Send us a note at content@kabbage.com.

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