Bootstrap vs. Venture Capital Dilemma, 2x2 Matrix Decision & Time Machine Regrets - E409

Jeremy Au delved into startup founders’ decision to choose between bootstrapping and venture capital funding. He shared his dual experiences as both a founder (who had done both routes) and a venture capitalist (who had to judge startups). He reset the framing that bootstrapping has historically been the norm and the default financing pathway for startups even today, whereas VC funding has only 50 years of history and is aimed at high-growth potential businesses. He explained the VC fund model’s expectation of $1B returns within a decade creates both a judgment yardstick and pressure-cooker board pressure for businesses to rapidly scale, regardless of unit economics or profitability. He also touched on the dangers of mismanaging large capital inflows, where excessive funding can lead to inefficient spending which can hasten a company’s failure. He suggested using a 2x2 matrix to think through their company’s fit for VC funding.

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(01:31) Jeremy Au:

Hello! Today, I want to talk about a topic that many founders, including myself, have really had to struggle with, and it's a topic about bootstrapping versus venture capital. It's not an easy conversation because it's kind of theoretical. And of course, at a different level as well as why would you not want venture capital money?

But it seems like a no-brainer, right? If you want to achieve something, then more resources help you achieve it faster and give you a higher percentage odds of success. So from a logical perspective, sure, we see the news about venture capital-backed companies that fail or do stupid things with the money. And so as a result, you know, those companies end in failure. And so we kind of know that is happening out there, but if you ask me, "Hey, Jeremy, someone's offering you $1,000,000 today to get this product off the ground." "Hey, Jeremy, I'm going to offer you $10,000,000 to accelerate this further," then as you can imagine, you and I, and probably most people in the world will be like, "Yeah, why not?" Take it because time is money and let's be real. Let's just get started and have more money and it feels better and safer, and it's better to do it from that perspective.

I care about this topic because I've built one company that didn't have external capital and the other one that was VC-funded, and obviously there were different lessons I took away from both companies, and I've also been a VC and and I've had to make decisions about which companies deserve external capital versus which companies probably should bootstrap.

(02:54) Jeremy Au:

So, let's talk about it. When you bootstrap a company, it means that you're building a company with minimal or no external capital. Perhaps you have grants perhaps you can take on some debt, but the truth of the matter is that you're not really taking on venture capital. So, you know, if you think about it, 99% of all businesses in the past 1, 000 years was bootstrapped, by this definition. So I want to say is that bootstrap is actually the default state for most businesses to be built. A venture capital-backed business is not a norm, though many of us in the technology sector would look at it as a norm, but it's actually the opposite, the anti-gravity of how businesses are normally built.

Again, that different forms of financing, obviously there's customer capital, there's improving your working capital flows. There's also debt and eventually, it's convertible debt. And then eventually there's venture capital, but what we have to realize is that there is a spread of different ways to get financing into the company, an venture capital is an innovation that honestly has existed for 50 years. So, let's think through this together. If you're building a business, the default reality is that you should bootstrap it. Most businesses in the world are fundamental businesses. They are brick and mortar. They're building schools. They are distributing water. They are normal businesses. And so they are, by definition, a normal company that requires a normal set of capital.

(04:06) Jeremy Au:

What venture capital is looking to do is look for companies that can become a billion-dollar company within 10 years. Why? Venture capital funds are for high-risk, high-reward companies. The promise that venture capital funds are promising to limited partners or the funders that provide that capital is that they should be able to generate about 15% to 25%+ net IRR, or basically returns on capital on an annually compounded basis because they're investing in a portfolio of 20 high-risk, high-reward companies, out of which probably one or two of them will be able to achieve that billion-dollar valuation. The billion-dollar valuation is about a hundred million dollars of annual recurring revenue, times, on average, a public market valuation to revenue multiple of 10 times, which is normally characteristic of cloud economics.

Aha! So now you start to ask yourself, I want to build a company with a hundred million dollars of revenue, and I want to get a multiple of 10x. And then of course, if you start thinking backwards, it's also the opposite, right? Which is that if we have a time machine and we can tell that this business is best served by growing to a hundred million dollars of revenue across 20 years, across 30 years, then bootstrapping or some other form of private equity outcome is probably a better roadmap for their growth. If you're building a company in a geography or a sector that has a small market size, but you really care about that, then it's very difficult for you to achieve a hundred million dollars of revenue. So then you shouldn't take venture capital because you'll be a disappointment in the eyes of venture capital. Or perhaps you're building a company that's unlikely to achieve a 10x, cloud software as a service multiple. And so as a result, you are going to have to grow to $200 or $500 million of revenue to achieve that outcome. Then perhaps you're not a good fit for venture capital. And all of this has to be achieved within 10 years because the venture capital fund normally makes a promise, historically, that they're able to achieve this outcome within 10 years to the LPs. And if it takes 15 or 20 years for this billion-dollar outcome to be achieved, well, obviously as a founder, it's a success to you and the team and the executives and employees and the customers. Yet from a VC's perspective, it's bad. So from a founder's perspective, one of the realities of it is that the decision to make about whether you're bootstrapped or VC-backed is actually not in your hands. It is on the crowd wisdom slash citizen science of VCs out there to make that decision, whether you should be bootstrapped or whether you get the anointing and the infusion of a VC fund.

That's what happens for most startups. If you look at Southeast Asia, the number of pre-seed companies versus the number of seed companies that are out there, then there is a death rate of over 90%. In effect, the market has told the founder that they are better off bootstrapping rather than be funded by VC. For the 90% that are rejected by VCs as a result or unable to raise further capital at some stage, especially at early stages, what they are effectively told is they have a signal, which is that they can't raise venture capital, but then they should go on to either bootstrap or close on a company. And the awkward reality is that most founders will close on a company because they want to tackle a larger idea and they want to tackle the idea in a way that's venture-backable.So let's think about this as a 2x2 chart.

The X-axis is whether you're able to achieve venture capital funding on the right-hand side. And on the left-hand side, the wisdom of the crowd or the foolishness of the crowd is that they're not able to provide you that venture capital funding. The other axis that's really important is whether you should have raised venture capital. Whether in fact it is a billion-dollar outcome within 10 years, and the south of the axis of the Y-axis is that in a time machine, the outcome that you're able to drive out is maybe a hundred million dollars or $10 million valuation. The sweet spot of course, on the top right of the quadrant is that the company you've built is one of the finite good ideas that's out there and you are one of the finite teams that can execute and have the hustle and drive to exploit it and make it happen. And so you are able to make it happen. You just needed a capital to make it happen. And you also found the right VC that's able to support you and make it a no-brainer expansion path. And so that is honestly the dream scenario for most successes that we see in the media today. So we look at Airbnb, we look at Tesla, we look at SpaceX, we're looking at transformational companies that can achieve a billion-dollar valuation, and they're able to raise venture capital

(08:07) Jeremy Au:

On the bottom left of the quadrant, as you can imagine, that companies that never receive venture capital. And also the truth of the matter is that the idea was broken at some level or finite. In other words, for example, would be if you want to be a ghostwriter for a book, if you want to write books, what would giving you 10 million, a hundred million dollars to our front? It's not a scalable business. It's not something that's going to generate super normal profit. So yeah, you can get, receive an advance on a book, you know, half a million, a million, a bestseller guy, $10 million on the next book, but the truth of the matter is that, you're not going to create a billion-dollar valuation on a systematic, structural, non-individual basis. And truth is the market has known that, and the market does not give that. So it's very easy to be thoughtful about how you spend money when people are not going to give you that venture capital money.

The other quadrant is what most founders are thinking themselves, which is that you're building a company that's one of the finite good ideas out there that can become a billion-dollar company and is only a method of exploration and testing. And you think it's like 50%, 60%, 70% chance that's going to happen, but you don't receive funding, or it's not easy to receive VC funding. So this is a very interesting part because the truth is we don't know, we don't have a time machine to figure out whether you're right or whether you're wrong, whether the VC is right or whether the VC is wrong. What I'm saying is that most founders in this point of the quadrant are basically saying themselves that they want to push on really hard, that they want to learn how to fundraise and they want to learn the tactics of fundraising so that they're able to achieve that.

And there's a totally understandable framework to approach it, because if you don't receive capital to launch a product, that you never know, to some extent. Of course, from a VC perspective is, is there a way for you to have found out whether this idea is a good idea or not way earlier in advance without needing my money? Because if you find out that it's not a good idea and you're using my money, then you're going to lose my money. So the top left quadrants and the bottom right quadrants are a little bit fuzzy. It's a little bit of a scrutinous cat. It's hard to tell because, you know, what do we need to do differently? It's understandable because at an early stage, you need to achieve product-market fit.

What I'm trying to say here is that at the top left of the quadrant, where the outcome is a billion-dollar company but you're not receiving venture capital funding now, then the key challenge for you is to learn how to become a better fundraiser. And all costs, the best VCs that are out there who are being incentivized to chase you will eventually try to figure this out. You know, they don't really get paid for finding the no-brainers. The ones that everybody else agrees would be a billion-dollar company because there's a lot of confirmation bias, but also it's highly competitive. The VC industry, at the individual level, the individual funds and individual partners incentivize a hunt for you, right? That this is one of the finite good ideas in the top left quadrant, but then you are being undervalued by the VC market. You're not finding it easy to achieve VC funding. And so this is why you have specialist VCs, right? VCs that are focusing on deep tech or robotics or logistics or some sort of special insight because they believe that they're able to correctly price and therefore correctly fund an underpriced company like yourself. That's hard to find. And the net effect of all these individual partners competing with each other on this dimension is that they're able to find the companies, on average, should and could be funded and given those experimental dollars to figure out and de-risk it to see whether it's a $10 million company, a hundred million dollar company, or a billion-dollar company.

The interesting part, of course, is the bottom right of the quadrant, wherein a time machine that we have, honestly, the company should not raise venture capital is not going to achieve a billion-dollar outcome within 10 years. So for the bottom right of the quadrant is a quadrant as most interesting, which is that if we had a time machine, we will find that the objective value in all of the multiverse is that this company is going to achieve a 10 or a hundred million dollar valuation maximum, or that is a billion-dollar outcome but it's going to take 20, or 30 or 40 years to build. And so, as a result, venture capital is not necessarily the best asset or the best funding mechanism to fund it.

Obviously, we don't need a time machine. If we knew nothing, we didn't do anything. We didn't do any first-order logic principles of thinking that obviously a time machine is the best way to achieve it. But of course, you know, most of us can think through this idea maze. And so we can chain multiple ideas. So we can see and say, "Hey, we're building a writing business," "We're selling sweets by the road in a stall," like this is not necessarily a VC type of business. Or I'm not passionate about this idea at all. So I want to do this on the side as a hobby. These are all different mechanisms of logic paths that make it clear that this is not going to be something that's going to be a large outcome. So I think being honest with ourselves about the first order logic is super important in order to realize whether we can achieve that large valuation. Now this is an awkward dynamic because a lot of us are basically in a situation where, Hey, we understand this. We don't know if this is going to be large or not. Maybe it's not, but maybe it's better to take venture capital first.

(12:32) Jeremy Au:

So the truth is we kind of don't know at this point of time, maybe with that time machine, you know, somewhere 50-50, right? We know that we have a 50% chance and it's a reasonable way of looking at it. And maybe the multiverse time machine shows that it's a 50 percent chance of achieving that billion-dollar company within 10 years. So, what I mean about that as a result is that I think it's quite reasonable to start out with venture capital because venture capital, at some level, is risk capital. It's meant for you to experiment and find out whether this makes sense or not. What I'm trying to say here, though, of course, is that you want to raise the right amount. And that's an awkward conversation to have because if you raise too much money, then VC money makes you dumb. We've seen that in the news. I've seen it in my own eyes.

And the truth is, when you're given too much money, then basically you want to accelerate, which is fair, but then you become sloppy because it's human psychology that when you receive a lot of money, you spend it. We can see this for lotteries where lottery winners often spend this very unproductively and they end up in a situation where it's better off than where they were in the first place, but it's not uncommon for them to have, you know, really squandered a large chunk of it. And I think that's what happens for a lot of management teams. And what I'm trying to say here is that it's not because the management teams are dumb or sloppy or lazy, but also because the VC bots are also egging them on because they rather have a 50% higher chance of you becoming a billion-dollar company and also take on the other half of the 50% chance that you go to zero. So they want to push you to the high-risk high reward. Whereas for you, if you are being smart, you're being creative with the funds that you have, and you figure out a way to squeeze out efficiency, then obviously the growth may not be as high, and you may not be able to achieve that billion dollar outcome within 10 years as much, but then you're able to reduce the floor risk of the company.

As a result, a lot of founders feel like they're being allotted of cash to accelerate towards a giant brick wall, which is that either they go and burst through the brick wall or they get killed by the brick wall. And that's what we see for a lot of startups. And I think that's something that we should be reflective of is that if we don't think this company is going to become a billion-dollar company within 10 years, then perhaps VC money or a limited amount of VC money is a better approach. And it's really important for founders to always be thoughtful about the efficiency of the company because the more efficient they are, the more likely they are to survive either VC outcome or a bootstrap outcome.

(14:34) Jeremy Au:

So what does that mean? Technically, the big thing I will recognize for you is always be thinking about your burn multiple. The burn multiple is really about the amount of fee cash flow over your net new ARR. In other words, it looks at the productivity of the company and whether you're generating new revenue that's recurring and dividing that by the amount of cash that your company is spitting out. We'll provide links to the burn multiple because we think that it's a helpful metric for you to always be thinking about because it gives you a very strong insight about your fundamental efficiency and creativity of the business.

On that note, we'll chat more about this in the future.