The Hierarchy of Capital

Best Sources of Capital to Grow a Business

Only a tiny percentage of companies raise venture capital or should. Because it is one of the most exciting categories it gets more attention than other approaches. For most small businesses, other forms of capital make more sense.

I give this advice to entrepreneurs often:

Think of capital to grow your business as a hierarchy, starting with the cheapest to the most expensive.

The first source of capital to grow a business is money from your customers. Nobody will ever care about a product more than a customer or potential customer. Are you selling power bars? Make a few dozen and find some people to buy them. After that, find a few hundred, then a few thousand. Are you selling complicated technology that takes millions to build, like an electric car? If customers want it badly enough and the solution is good enough, perhaps a few will pay advances or put down deposits. Kickstarter and similar services have made this sort of capital easier to raise than ever. For more mature companies there are ways to get capital up front for purchase orders and receivables.

Second, consider government. There are often many sources of capital or loan guarantees to help small business. The Small Business Administration is a potential resource. For technology companies doing deep technology, government agencies like NSF, DARPA, NIST, DOD, and government labs are often great ways to prove out a basic technology. Yes, it can take a long time to get through the process, but it is a really cheap source of capital.

Third, think about debt. Obviously an early stage company will not get a loan from a traditional bank without a personal guarantee from the entrepreneur. I do NOT advise entrepeneurs to go into personal debt to start companies. While debt can be really hard to secure, think about customers, suppliers, and others who have a stake in your success. They might be willing to take the risk when traditional sources would never do it.

Finally, consider venture capital if, and only if, you have a company that meets all these criteria:

  • Addressing a big problem that translates to a large market opportunity (at least a billion dollars a year in revenue within 10-20 years)
  • Has the opportunity to build a strong differentiation from competitors immediately
  • The differentiation can grow over time, creating barriers to entry
  • You and your co-founders are willing to accept dilution and are willing to give up some control of your company. Also, you need to be prepared to potentially give up full control over decisions like sale of the company, future money raising, and who is the CEO.

This is the sort of company that can make money for venture investors. We are looking for a future when the company is growing rapidly (revenue growth of 50-300% a year) and has large margins (more than 30%, ideally more than 50%). And future investors or acquirers of the company expect that growth to continue.

If, instead, you forsee a company with very predictable profits and steady but slower growth, there are other sources of non-venture equity that might be better. These are the conditions that companies like restaurants and commercial real estate experience. They have different funding structures and different types of investors.

Each of these steps can build credibility for the next. A company that has already sold some product at a profit, has a loan from a supplier or customer, and has won a competitive government grant or contract is way more attractive than a raw startup of some people and an idea. This is especially important for ideas that are either the bleeding edge or categories that might be out of favor. Why? Because all those points are validation that you are solving something important.

If you are having trouble raising venture capital, try re-thinking how you could raise from a category higher in the hierarchy. That might all you need. Or it might set you up for venture capital in the future.