The art of the bootstrap

[Editor’s note: With the economic downturn drying up venture capital in Silicon Valley and elsewhere, more early-stage companies will be forced to bootstrap their way to profitability. But what does that actually mean for the companies who go this route? Javier Rojas, managing director of equity capital firm Kennet Partners, offers his insights.]

Times being what they are, it’s encouraging to know that some of the world’s leading public companies got to where they are without taking any early venture capital funding. That’s right, Microsoft, Dell, Cisco, Oracle, eBay — they all “bootstrapped” it.

Others, like Siebel Systems, Checkpoint Software, Broadcom and dozens of others, have followed their examples to success. The early years may have been challenging for the new execs forced to turn down paychecks. But they kept the faith that focusing more on customers and real revenues than market sizing and early valuations would someday pay off.

There are many compelling reasons for young companies seeking venture capital to turn to bootstrapping, even when they have other options. Not only might it be a safer way to go today, but it’s also a smart way to build a business.

How it works

When you decide to bootstrap, you commit to fund primary development and growth through internal cash flow from real-life customers. You — the founder — and a limited number of early employees may forgo paychecks for quite some time to make this work. But to keep that strategy to a minimum, it’s common for bootstrapping companies to turn to consulting engagements, non-recurring engineering contracts, value-added reseller agreements and projected supplier contracts. In short, “moonlighting.” These funds go toward initial growth and expansion until the company can stand on its own two feet.

A solid foundation

Opting to be self-sufficient (either voluntarily or not) and rely on real revenue means one thing: The customer is suddenly king. This focus becomes baked into the company’s DNA. Its very survival depends on developing products that its target market actually wants and likes. Customers are often involved in beta testing and are encouraged to become involved in the process. And early on is the time when you want to solidify a customer base for future sustainability.

Bootstrapping companies can also be more rational and less speculative with their allocation of resources. Because they can’t afford to throw money at problems, they have real incentive to solve potentially destabilizing conflicts and errors before they become systemic.

How much bootstrapping is enough?

Raising the right money at the right time can make or break a company’s growth, so it’s important to know when your company has outgrown its boots. Here are some indicators:

– Market growth rate is accelerating: If the market is growing faster than your internal funding, you risk losing market share (and equity) by not catching up.

– Customers are buying products and sales are predictable: You can scale your sales team, and more effectively channel the VC money you raise. As a rule of thumb, you should feel confident that you can predictably bring in at least $2 in gross profit for every $1 you spend on sales and marketing. I recommend a $3 to $1 ration as an even safer barometer.

– Complementary products or businesses have become available: It may be time to expand your offerings through an acquisition. Can you economically acquire new customers through a merger? If you are considering M & A activity and need help financing your growth, it’s time to raise capital.

– The current economic cycle favors growth: This isn’t what we’re experiencing now, of course, but hopefully it won’t be too far off. If the market seems to favor technology investment, or you see new growth areas on the horizon, it could be wise to switch.

– Your balance sheets are weak, or you want to diversify risk: Co-mingled balance sheets can be a major challenge for bootstrapping businesses. A prudent decision for a company may be imprudent for its founder (scaling sales at the expense of cash-flow, for example). As a consolation, selling off some shares can let founders offload some risk as well.

Where do you go from here?

If you’ve bootstrapped long enough to face these issues, you’ve probably done a pretty good job establishing growth and maintaining an equitable personal stake. Now the question becomes, “What do I look for in an investor?”

My advice: Don’t just look for the money — look for a partner with vested equity interest to help you expand. After this point, many parts of your business and how you manage them will need to change. Your investment partner should offer substantial contributions in this direction, not just capital.

A disclaimer: Bootstrapping is not for everyone

Some startups don’t even have the luxury of bootstrapping. Their markets might require immediate action, and they don’t have three to four years to foster growth. Their concepts may be capital intensive, requiring funding from the beginning. And in some cases, founders simply can’t invest “sweat equity” in their businesses by waiving months of pay. Bootstrapping is only for the entrepreneur who has the time and wherewithal to heed all of these factors. But for those who do pursue it, it can lead to a great company and even greater financial rewards.

Javier Rojas is managing director of Silicon Valley-based Kennet Partners, which provides growth equity capital to bootstrapped companies in the U.S. and Europe. Kennet targets capital-efficient businesses with annual revenues of $5 million to $50 million.