This post explores meaning of financial capital for bootstrappers. It addresses the real costs of market exploration and product validation and verification.
A Practical Introduction to Financial Capital for Bootstrappers
“Everybody needs money. That’s why they call it money.”
David Mamet in “Heist” (voiced by Danny DeVito playing bad guy Mickey Bergman)
Mamet’s dialog underlines a fundamental truth: people understand the value of money. We know that sound financial capital opens a lot of doors and provides entrepreneurs with access to vital resources. We know it’s essential to make money. And there are countless sources and self-help books focused on funding and raising money to produce a venture-backed startup.
This post is not one of them.
What is Financial Capital
In case you’re unfamiliar with what the term encompasses, below are some examples of the financial capital your startup most likely owns:
- Bank accounts
- Equipment and tools
- Real property (i.e. office building, automobiles, furniture)
- Inventory and physical work in progress
- Accounts Receivable–including recurring revenue obligations
Startup capital is also referred to as “seed money.” Here are some typical sources:
- consulting / freelancing / day job
- VC funded
I work primarily with entrepreneurs in the exploration phase of their venture. And they typically fall within two categories: the employees who are thinking more and more about pursuing this other idea, and the unemployed who suddenly find themselves with a lot of time to pursue something new. Both types know that a startup needs initial funding, whether for office space, permits, licenses, inventory, product development, manufacturing, marketing, or any other expense.
The goal of this post is to address where novice entrepreneurs have trouble and provide guidance on calculating the real costs of testing their service or product, curbing their personal consumption, and letting go of arbitrary self-imposed constraints.
Bootstrappers Manage the Work-Work Balance
Instead of focusing solely on raising money, I want to address financial capital from the bootstrapper’s perspective. Your primary challenge is to stretch existing funds and reduce expenses in intelligent ways while maintaining a healthy work-work balance. The work-work balance is the need to earn money while you are engaged in getting your startup off the ground. Often you have to freelance or stay at your day job much longer than you would like to fund your market exploration, customer discovery, and early sales efforts. There’s a temptation to quit everything in pursuit of your visionary idea.
It’s like being an aspiring actor. Pretend I have this dream of starring in a lead role for a big Hollywood production. Casting calls, auditions, and acting courses all help me reach that goal but require money and time. And I have rent and other necessary expenses I need to pay monthly. So while I am reaching out to agents, I am also waiting tables part-time to earn a living. If I focus on my dream completely, I can’t afford my apartment and food. If I focus on my part-time menial day job completely, I’m missing critical auditions and will never make my dream a reality.
Unfortunately, even if you managed to conjure the perfect solution (which alas is more unlikely than either of us would like), that idea may not turn a profit for at least six months to a year, and sometimes longer. This is especially the case if you measure profit not as covering the additional expenses that the startup is incurring but as replacing your current salary (or at least funding a minimal lifestyle while you focus primarily on your startup). Consequently, entrepreneurs work in positions that may be completely unrelated or only tangentially related to their startup, while simultaneously working to progress their startup.
The challenge is to balance your survival job with your startup and pursue both. The first step is to calculate your minimum day-to-day personal expenses, then add the funds needed to explore and test your idea. You can do this exploration and testing with help from cofounders, but it’s unlikely you will be able to secure investment until you have an idea that both requires and merits investment. Even if your plan is to seek funding eventually, you will need to manage the work-work balance until you have proof of viability. It’s better to seek funding in the form of revenue from customers. Revenue does not dilute your ownership and provides proof that customers are willing to pay for your product.
Calculate Your Living Expenses
Whether you are working part-time or full-time, or you are interviewing for work, you need to figure out your living expenses. Make a list of what you need to support your life (e.g., rent, utilities, groceries, clothing, transportation, entertainment) and then what you will need for that to be sustainable for at least 1-2 years. This is not planning for a camping trip; this is preparing for a move to the wilderness. Using one to two-year time frames force you to consider what will be involved in living more simply long enough to make sure that your idea is viable.
Successful teams often have to explore several ideas before they find a winner, and even then, it can take a while for it to start generating revenue, much less profit. Set a time limit to explore an idea, anticipating that you may need to examine several ideas before you find a winner. If you don’t get interest after 20-30 real conversations, it’s time to move on. The advantage of making this runway calculation is that it forces you to set some limits. This is especially true if some of your expenses are subsidized by a significant other, understanding spouse, or supportive relative. You need to structure your exploration as a sequence of experiments that may or may not work and be willing to abandon an idea based on what you learned. If you are getting support from others, you need to treat them as board members and report results–successes and failures–as you go. Don’t exhaust their patience.
Calculate Your Exploration Budget
Once you have a relatively stable income that pays for your personal life, consider how much it will cost to explore your idea. There may be a range of approaches you can use to evaluate a product idea. I like to sort them by the combination of how quickly you can get a useful answer and how much risk or uncertainty does your research or experimentation remove from your potential business. Include not only the money you will need, but also intellectual capital (expertise you can leverage or may need to develop), social capital (trusted connections who can advise and open doors), and time. This exploration needs to be done on your own time using your own materials, so plan to schedule conversations before and after work and during your lunch break.
If I wanted to test my new software idea, for example, I would keep the user interface very simple. I would postpone writing 90% of the error checking in order to get a testable model out quicker. Once I was confident there was strong interest and a willingness to pay, I would update the software and complete other tasks I deferred. You want to utilize funds, connections, and expertise to address feasibility and customer demand, not to start on a whole product before you know people are willing to pay. Distinguish between your idea exploration budget and your full product completion budget.
The goal here is not to budget for a completed product, but to budget for a demo or example that verifies you are working on an important problem for a customer–meaning one they are willing to spend money on–and communicates your solution and its benefits clearly. This could be in the form of a scale model, a wireframe, a success story, or even a piece of paper. Go ugly early, and focus on understanding the problem.
The main question to focus on: what is the bare minimum I need to deliver my service to a customer and start receiving feedback? The combination of your living expenses and your exploration budget defines the financial capital that entrepreneurs who are bootstrapping need. This does not have to be a lump sum. If you have a job or a freelance gig, then you can pay as you go as long as your outgo does not exceed your income.
An Example From Genentech’s Founding
Here is an example recounted from “Something Ventured” about the founding of Genentech: Tom Perkins is the Perkins in Kleiner-Perkins and Herb Boyer is one of the founders.
- Tom Perkins: They wanted to raise $3M build a factory and hire the people see if would work. But underlying it all was the tremendous risk factor of “would it be possible?” It was pure research. Everybody knows that venture capital should never openly fund pure research. My idea in everything has been to address the risk up front and to get rid of the risk as fast as you possibly can.
- Herb Boyer: Bob and I were very naive about how we were going to do it.
- Tom Perkins: We changed the business plan. I persuaded them to do it a different way, to subcontract the experiment to two different institutions.
- Narrator: By subcontracting, Tom Perkins eliminated the need to buy equipment, build a lab and hire staff. The estimated $3M startup costs were reduced to $250,000. Kleiner Perkins put up the money and Genentech was in business.
Rather than spend time and money on a maybe, Genentech leased a lab for a year to figure out if their idea was technically feasible and then set about producing it the right way. They were targeting an established market–insulin for diabetics. They did not need to assess customer demand. In reality, your exploration needs to cover feasibility, desirability, and profitability as well.
Investors are not art patrons: they are not interested in something beautiful. They want you to create a business that will repay their investment. As a entrepreneur, you need to adopt this same mindset since you are making an investment in yourself. You want to make sure that investment will be repaid. Just like an investor, you need to determine how the results of your efforts are going to connect to revenue and profit. The three key goals of the exploration phase are to make sure you can create something:
- that works (feasible)
- that people want (desirable) and will pay for
- at a profit (viable business)
In general, you need two different budgets for your idea. The first covers exploration efforts that discover if your idea is feasible and desirable, constantly testing your value proposition. The second is tapped if your idea is viable and covers building a profitable business.
Consider Service First
One approach that works well for entrepreneurs is service-first. Instead of first building up your technology–software or hardware–to where it’s safe and effective for customers to use, sell the results as a service. When service-first is possible it has many advantages:
- It’s much easier to configure and adjust a service on the fly, adding manual process steps to aspects not covered by your existing solution (hardware or software).
- It forces you to focus on the outcome and determine if it’s something that the customer wants and is willing to pay for.
- Because the customer is paying for the outcome, service-first forces you to treat your time as a cost, not valuable or billable in and of itself.
If you find an early adopter who wants the results your technology can deliver, it’s much more likely they are willing to pay for some results provided as a service than to wait for you to finish the product. This allows you to ask for the order immediately and shortens time to money. To be able to quote a price and offer to get started is far more compelling than responding to strong interest with, “I’ll have to get back to you. I’m just doing research right now.”
Service-first also makes it easier to explore pricing. Each offer is configured and somewhat unique. In the exploration phase when you are also trying to assess desirability, price low enough to be credible (given the application area, for example no one wants to buy a car for $10) but not so high that it would turn anyone off. If people are not willing to pay even a low price then you have a problem. Free is not a price.
By structuring your initial offering as a service, you can quickly make offers and get feedback on what people want and are willing to pay for. You avoid the lag of adding new functionality to meet a revised specification. And you avoid the costs of making the product safe and effective in customers’ hands. Since you or a team member will be operating it, you can tolerate some failures and “sharp edges” that would otherwise kill a prospect’s desire to use the product.
Be Smart and Frugal, Not Short-Sighted and Cheap
Throughout this exploration phase, in conjunction with assessing costs, you should also be looking for a core team, assembling what you know, and understanding why similar ventures have failed. After your exploration phase, once you are sure that your idea is feasible and desirable, you need to create a business that can scale. You can cut corners and curb costs where you can, in order to iterate rapidly, but eventually, you will need to spend money. The challenge is knowing where a low-cost approach is acceptable and where it will make you appear cheap, short-sighted, and untrustworthy.
Simulation models of various sorts can help you save prototyping expenses when done correctly. Ray Kroc recounts the following example of simulating an imaginary business in his book Grinding it Out.
“An equally unusual thing happened in 1953 when the McDonalds were designing their “golden arches” building. They wanted to lay it out in the most efficient way possible, placing windows and equipment so that each crew member’s job could be done with a minimum number of steps. Mac and Dick had a tennis court behind their house, and they got Art Bender and a couple of other operations people up there to draw out the whole floor plan with chalk, actual size, like a giant hopscotch. It must have looked funny as hell–these grown men pacing about and going through the motions of preparing hamburgers, french fries, and milkshakes. Anyhow, they got it all drawn, just so, and the architect was to come up the next day and copy the layout to scale for his plans.”
Ray Kroc in Grinding it Out
Be smart about testing products and services, avoid engaging in a false economy, and spend money on what works. To a certain extent, there are equipment and facilities to borrow, favors to call in, and domain expertise to leverage to cut initial costs. But if you try to do everything for ‘free,’ things will fall apart. You will end up owing too many people too many favors, exhausting whatever reservoir of goodwill you started with.
Commit to Creating Value, Not to a Particular Idea
The two biggest mistakes I see entrepreneurs make:
- They don’t budget enough time and money for market exploration and customer validation.
- They don’t let go of a product idea that’s not compelling for customers–this requires a focus and a queue of candidate product ideas.
The challenge to drafting your exploration budget is that it’s not clear how long it will take. It’s more than likely it will take more time than you would like and will require you to evaluate and tinker with several ideas before you find one that’s compelling. This additional time also equates to more money. Successful individuals and teams take the following steps to ensure their exploration phase doesn’t lead to complete frustration or bankruptcy:
- They keep their day jobs but set time aside every week for exploration. In effect, they treat part of their salary as an investment in their next venture.
- They adjust their lifestyles to allow them to live on a lower spending rate, maybe enlisting the support of their spouse or significant other and keeping them informed of progress and setbacks.
- They make a list of good ideas in one to three focus areas where they have experience and demonstrated expertise. And they avoid fixating on any one idea simply because it’s the only one they have.
It’s very likely that you will need to explore multiple business ideas, some of which are mutations of your original idea. The business concept that succeeds can be remarkably different from what you started with. You will need to be ruthless with your preconceptions and personal attachment to a product idea when you are testing value propositions during the exploration phase. It’s better to let go of several mediocre product concepts that did not not inspire customer enthusiasm, (much less a willingness to pay), than to spend an order of magnitude more on an implementation that is proven to be not compelling.
Getting real feedback on a product can be extremely challenging. You have to like a product idea to invest effort in it, but you cannot assume that prospects will feel the same way. Commit the time to explore its potential in an objective fashion, and be ready to drop, or at least to tinker with, a product idea that does not generate customer attention and interest. It’s not uncommon that a lack of interest has nothing to do with the solution you are proposing, you may not be addressing a need that a customer considers to be a critical business issue.
The best indicator that prospects care about your solution is not an enthusiastic endorsement but constructive criticism. These can either be suggestions for how to improve your offer or request for help on a related problem they consider to be more important. Make real offers to determine if customers will pay for your product. If they tell you how excited they are but don’t open their wallets you have a problem. If they counter with some key improvements that need to be made before they can use the product, pay close attention. When a client tells me they need to find “smarter prospects,” that’s a clear sign they aren’t listening objectively. If 30 people were unconvinced that your product could help them, the issue is not with the 30 people. There’s a problem with your pitch or with your solution’s viability.
Entrepreneurs need to strike a balance: they cannot become too attached to any one idea, but they need to spend enough time to explore and refine the idea to avoid giving up too soon. Startups move through three stages. At first, a startup incurs incremental costs for exploration, outreach, and product development. These are typically funded from your salary/freelancing or savings. During this stage, you’re spending roughly one quarter of your time and are still very much dependent on a full-time day job. Next you discover a niche market that wants to pay and your startup can cover business and living expenses (for some level of lifestyle). You can think about shifting to a freelance job or even embedding your work as a service in your startup. When a startup is cash flow positive and able to pay enough to match your old salary, perhaps adjusted for old aggravations avoided, you can leave your old job and focus full-time on your startup.
Focus on, and budget for, exploration and validation of an idea rather than the particular idea itself.
Funding Has Many Faces
My goal in this post was not to list all of the ways you can raise money, but to provide an alternative perspective on financial capital. Gathering funds is secondary to testing your idea. In fact, having proof of the viability of your idea will make it easier to raise funds later.
There are a number of ways you can seek investment: “friends and family,” crowdfunding, loans, and venture capital are the most common. The most overlooked method is to keep your current job and forgo consumption.
This requires buy in and support from your spouse or significant other–and acts as a filter on finding one if you are currently unattached. It’s definitely a complicated conversation, but you may be pleasantly surprised: most entrepreneurs are not very good at hiding their entrepreneurial ambitions. To forgo consumption means that you’re giving up on that summer trip to Yellowstone, or you’re eating out less often, or sacrificing other activities you both enjoy. Any accessing of savings should likewise be a mutual decision.
Keeping your current job means that you stop complaining about it. It means that you view it as an interim annoyance but you don’t take any actions that would lead to your termination. You can frame your job as temporary in your mind to help manage it’s aggravations and annoyances, but you cannot act as a short timer. It means giving up on career aspirations at your current firm but still meeting the performance requirements. If keeping your current job is simply intolerable then find a new one you can tolerate to provide funding for market exploration and product development
Funding could also come in the form of intellectual property or information. Sometimes you approach a customer or prospect and they say they’re unwilling to pay for that product or service yet. But they are willing to give you data and further access to their problem. If you have not clearly demonstrated you understand their problem and solve it to their satisfaction it’s worth engaging on an “access to real data” basis to refine your understanding of customer needs. If you feel you have demonstrated a useful solution you should seek specific feedback on where they believe your offer falls short.
It’s much harder to sell a well-subsidized bad idea than a poorly funded good idea because you are tempted to persevere with the former when you should make adjustments in your approach.
While funding and raising money for your startup is important, it is not a primary concern (at least not initially). The first priorities of a entrepreneur are figuring out what the real problem is, what the real need is, and then making offers. You need proof of value in results achieved by customers.
Money can help speed up connections and access to resources, but spending money without the understanding to back it up is wasteful and could hinder development. If you don’t listen to your prospects with an open mind, if you fail to calculate the real costs of exploring your idea, or if you fail to devote the necessary amount of time towards building your social capital and intellectual know-how, then the amount of financial capital at your disposal is superfluous.
Key points to remember about initial funding for your startup:
- Make sure your spouse or significant other is supportive of starting something.
- Keep your day job, or find one you can work until you have an idea that is viable.
- Adjust your lifestyle to allow you to live on a lower spending rate.
- Save your money.
- Only leave your day job (or stop freelancing) when people are willing to pay for your product.
We Can Help
It’s essential to understand all three types of business assets you will need to succeed. Call us for an office hours session to help you evaluate current and potential business assets and map out your path from today through break even to scaling.
Related Blog Posts
- Five Serious Financial Mistakes Bootstrappers Can Avoid
- Q: Should I Tap My 401K To Bootstrap?
- Three Points about Seeking Investment
- Investment Presentation Formats
- Michael Ellsberg: Four Reasons Why Passive Income Is a Destructive Fantasy
- 8 Tips for Evaluating Funding Alternatives
- Bootstrapper Breakfast Blog: Holly Devito: 7 Basic Financial Controls Bootstrappers Should Have In Place
- Bootstrapper Breakfast Blog: Bootstrappers Benefit From a Simple Financial Model
Working Capital Series
- A Primer on Business Assets for High Technology Startups
- A Practical Introduction to Financial Capital for Bootstrappers
- Basics of Intellectual Property for Bootstrappers
- A Practical Introduction to Intellectual Capital For Bootstrappers
- A Practical Introduction to Social Capital for Bootstrappers
- Building, Borrowing, and Keeping Trust
- Taking Stock of Your Business Assets
- How to Leverage Current Business Assets For Growth
- A Holistic Approach to Launching a Bootstrapped Startup
Image Credit: (c) RedLineVector Licensed from RFID Image ID: 45484985
1 thought on “A Practical Introduction to Financial Capital for Bootstrappers”
Pingback: Bob Biglin’s Review of Working Capital: It Takes More Than Money -