Financing a Startup Company Series: Bootstrapping
This post begins our Financing a Startup Series, and focuses on “bootstrapping.”
What is bootstrapping? Bootstrapping refers to the practice of growing a company with money provided by founders and revenues generated by the company.
What type of companies are suitable for bootstrapping? There are generally two types of companies that can bootstrap: (1) a company with a serial entrepreneur as the founder who has money from a prior exit; and (2) early stage companies that do not need large influxes of capital to grow. Bootstrapping allows founders the time and flexibility to operate without the demands of outside investors. If the business outgrows the founders ability to fund its growth and development, other sources of capital will become necessary.
What are the advantages of bootstrapping? Bootstrapping is cheap. Because only founders are investing in the company, founders equity and control over the company is not diluted. The founders are truly their own bosses: they retain control over the decisions to operate and grow the company, and can keep the profits for themselves.
What are the costs and disadvantages of bootstrapping? Because bootstrapping does not bring experienced investors into the business, the main downside is that companies might be able to grow faster if they had more capital and know how. Founders can try to bring non-investing advisors into a company to get access to experience and business leads. However, the greater hurdle can be the lack of capital; if the company doesn’t generate the capital it needs to develop products and grow it can run into trouble quickly.
Another potential pitfall arises with determining just how much equity to issue to founders for their investment, especially when one founder is contributing more money than others. When founders contribute unequal amounts of cash, or take unequal amounts of equity for the same amount of cash contributed, adverse tax consequences can result. Taxable income under 83(a) is calculated as the fair market value of the equity received, minus the amount of cash contributed. If one founder is contributing a disproportionate about of cash, their contribution may set the fair market value, which could cause the lesser contributing founder(s) to recognize a large amount of income upon which they would be taxed. The fix is to have each founder buy their stock for the same price per share, and then have the large contributors use a promissory note to get the rest of the cash that they are providing into the company.
Never “Commingle” Funds. One point that holds true for any company, no matter how it is financed is that company funds and personal funds should never be commingled. Comingling funds defeats one of the major reasons to incorporate, or setup an LLC: the limitation of personal liability for corporate debts. Using company funds for personal expenses, or personal money for company expenses, can lead to personal liability for corporate debts. Use a separate bank account for the company and keep accurate books and records of all income and expenditures. When founders provide money to the company, the company should document the transaction as a capital contribution or issue a promissory note to the founder.
Depending on the specific facts of each company’s foundation, myriad other issues can arise when issuing equity to founders. A great resource for learning more is Wilson Sonsini partner Yokum Taku’s “Startup Company Lawyer” blog. Consulting with an attorney who works with startups is very important at this stage of company formation. They should be able to quickly, and fairly cheaply, get your company setup without creating adverse tax consequences, and ensuring all of the founders are on the same page.