Virtually every startup has to find funding somewhere. Although some founders take venture capital in exchange for equity, that’s not the only way to do it.
To learn more about the pros and cons of venture capital — and founders’ funding alternatives — I caught up with Mark McKee. Before being named president and COO of OnPay, a growing online payroll solution for small businesses, McKee worked as managing director of The Lenox Group, where he advised growing companies on how best to raise and structure capital.
Here’s his take:
Brad Anderson: As someone who’s worked in investment banking and been an early employee at a startup, do you think most founders understand their financing options? Why or why not?
Mark McKee: Most first-time founders I’ve met don’t, frankly. Serial entrepreneurs usually have a sense of the funding landscape, but new ones typically assume venture capital must be the right route.
In my mind, that’s for two reasons: The economy is good, so venture investors are flush with capital. That creates a market where equity funding is top of mind.
The other piece of the puzzle is that equity deals tend to get a lot of press coverage. That makes new founders think, “Oh, this must be the way to go.” Oftentimes, it is. But there are real trade-offs that many first-time founders aren’t aware of.
Anderson: So is venture capital the right approach for most startups? What are the pros and cons?
McKee: I think equity funding can be the right answer. Any type of funding can be an accelerant, but that doesn’t necessarily make the work of an entrepreneur any easier. The journey is hard, whether you take venture money or not.
With that said, there are some real advantages to it. VCs have been through it before. They can provide guidance, experience, and introductions that many new entrepreneurs struggle to get otherwise.
The trick is to make sure they’re aligned with your plan: How big do you want the company to become before you make your exit? How do you collectively plan to finance the business as it grows? Are they happy with the marketing and branding? Do they want you to expand to other markets and geographies?
That’s one of the real cons of venture capital. You typically have to give up control. When you give up some ownership to investors, you need to be ready to accept their input.
Do a gut check. Before taking any money, make sure your investors are smart people who can support the growth of the business. If you’re aligned on the front end, you drastically decrease the chances of conflict later.
Once you bring in equity, you need to be comfortable with that path. If you’re doing well, VCs will want to put more money into your company. If you’re doing really well, it becomes hard to take existing investors out at a reasonable valuation. But if you’re not doing well, of course, it becomes tough to bring other investors in.
Anderson: What if founders aren’t willing to accept those cons? What alternatives should they consider?
McKee: If you’ve grown your business to the point of positive cash flow, you should explore debt options. OnPay took private debt, but alternative lenders like Kabbage are great options as well. SBA loans are another low-interest route to consider.
If you do know a wealthy individual who would guarantee a loan for you in exchange for options in your business, go for it. That way, that person doesn’t have to outlay the actual cash. Your bank will be happy, too.
One area I think is often overlooked is grants and competitions. It’s non-dilutive capital you don’t have to pay back, plus it tends to create a great PR opportunity. You could try an online platform like Kickstarter, but you’re probably better off entering a venture competition.
Basically, a bunch of tech startups pitch or demonstrate their product to a committee. The winner usually gets somewhere between $10,000 and $100,000. It’s a supplemental source of funding — and winners often get the attention of local VCs.
Anderson: Can you describe how OnPay has viewed fundraising and how your path has worked for you?
McKee: We’re a payroll software company, but we spun out of a traditional payroll firm. That initial structure didn’t allow for us to bring in an equity growth investment. We bootstrapped the company, operating in a break-even cash flow environment.
That was tough, and we were eventually able to take on some debt. We reached out to high-net-worth individuals and small funds. We used those assets to growth further; now, we have equity investors and a bank loan.It wasn’t necessarily easy, but that path worked for us. Our approach is to be capital-efficient; we only take in what we need. We view ourselves as stewards of our investors’ money.
Anderson: What if OnPay hadn’t self-funded at the start? What can other entrepreneurs learn from OnPay’s approach?
McKee: If you can get equity funding early, do it. Had OnPay’s initial capital structure allowed for it, we would’ve done it. You need all the money you can get when you’re first exploring what an idea can be.
Be patient if venture investors aren’t biting. We couldn’t take equity money, so we found other ways to finance the business until we found product-market fit and started scaling. We took money from smart people with the experience to help us, and it actually put us in a much better place today.
Just as importantly, bet on yourself and your team. We’re proud of OnPay’s people because they allowed us to stretch. Before we raised equity, we knew we were asking a lot from our team. That was frustrating for us at times, but we pulled through.