At some stage to help fund growth, a business needs to decide whether or not to seek external financial support. Support may come in the form of additional equity investment, debt finance from a lender, or alternatively the business may decide to rely on bootstrap finance methods to fund its development.
The main problem with bootstrap finance is that the business tends to grow more slowly as it can only grow at the speed at which the available finance allows it to. So for example, bootstrap finance methods would not be suitable for a business which needs to grab market share and grow rapidly, or for a capital intensive business which requires large upfront investment.
The main advantage of bootstrap finance is that the entrepreneur founders retain ownership and control of the business free from the requirements of outside investors, and do not have to spend time seeking investment.
Some startup businesses use bootstrap finance out of necessity in that they either do not have access to external finance or operate in a low return business environment which is not attractive to outside investors. Others bootstrap finance out of choice in order to retain as much of the ownership of the business as possible in order to maximize their personal wealth and return.
Bootstrap Finance Method Example
The best way to see the effect of using bootstrap finance on the owners personal return is to look at a simplified example of using the three alternative methods of finance.
Suppose a startup entrepreneur is looking to create personal wealth of 1,100,000 from their business. The owner decides the business needs to grow and is seeking additional finance of 261,000.
Equity finance requires the startup founder to sell a percentage of the business to an outside investor in return for the cash funding.
Suppose in this example the entrepreneur is prepared to sell 45% of the business in return for the required funding of 261,000. This dilution would leave the startup entrepreneur with the remaining 55% of the business.
When they started the business the entrepreneur’s personal financial goal was to create wealth of 1,100,000. Since they now only own 55% of the equity, they must grow the business to a size sufficient to make their share worth 1,100,000.
The size of the business needed is calculated as follows.
% of Ownership retained = 55% Financial goal = 1,100,000 Value of business needed = 1,100,000 / 55% Value of business needed = 2,000,000
As a result of selling 45% of the business in return for cash of 261,000, the entrepreneur must now use the cash to grow the business to be worth at least 2,000,000 in order that their 55% share is sufficient to achieve their financial goal of 1,100,000.
Suppose now that the entrepreneur decides instead of equity to raise the required funding using debt finance.
Debt finance does not require the entrepreneur to give up any equity in the business, but the business must pay interest on the debt and it must repay the amount borrowed at the end of the term.
Assume for simplicity that the principal amount of 261,000 borrowed is settled when the business is sold.
Again, the entrepreneur has a personal financial goal of generating wealth of 1,100,000 from the business. This wealth however is after repaying the debt finance of 261,000 and so the business must be valued at a higher amount calculated as follows.
% of Ownership = 100% Financial goal = 1,100,000 Debt finance = 261,000 Value of business needed = Financial goal + Debt finance Value of business needed = 1,100,000 + 261,000 Value of business needed = 1,361,000
As a result of borrowing 261,000, the entrepreneur must now use the cash to grow the business to be worth at least 1,361,000 in order to achieve their financial goal of 1,100,000.
Finally, if the entrepreneur decides not to raise external finance and chooses to using bootstrap finance, the lack of additional funding will mean the business will probably grow more slowly. However, in this case, the entrepreneur has not had to give away any of the equity in the business and retains 100% ownership, and the business does not have any debt finance to repay.
Under these conditions the entire worth of the business belongs to the entrepreneur, and therefore to achieve their financial goal of 1,100,000, they only need to grow the business to a value of 1,100,000.
To highlight the differences between the three methods of financing the business, the table below sets out a summary of the results.
All amounts are shown in ‘000.
|Debt to repay||261|
Although this is a simplified example, it demonstrates the effect of choosing the bootstrap finance method.
If the entrepreneur chooses to expand the business by raising external finance then they have to be prepared to grow the business to a value which will compensate for either the reduced equity percentage they own or the requirement to repay the debt finance. In the above example the value of the business needed to be 2,000,000 in the case of equity funding, and 1,361,000 in the case of debt funding.
By choosing to bootstrap finance, due to the lack of cash to fund expansion, the business will not grow as large or as rapidly as it might have done with the injection of funds. However, to achieve their personal financial goal, in this example, the bootstrapping entrepreneur only needs to grow the business to a value of 1,100,000.