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« Learning by analogy | Main | Breakthroughs and drips »

Debt, equity and a third thing that might work better

If your business needs money, it seems as though you have two choices:

  • Get a loan from a bank
  • Raise equity from an investor, giving up part of your company in exchange

Banks are everywhere, so the idea that they can loan us money seems obvious. And venture capitalists and the companies they fund are in the news all the time... and making a billion dollars sounds like fun.

Here's the thing: for most businesses, most of the time, neither is a realistic option.

Banks aren't in the business of taking risk. Which means that they make boring loans to boring companies for boring purposes. They do everything they can to be riskless. Which means you need to guarantee the loan with your house or with assets worth far more than the loan. Which means that a good idea is not a sufficiently good reason for a loan.

And equity? Well there are two problems. The first is that the number of investments that professional VCs can make is microscopically small compared to the number of businesses that want them. A bigger reason is that if there's no obvious and reliable exit strategy (like going public or selling to a huge public company) then there's no rational reason for someone to make an equity loan. The entire upside comes when you sell, and if you can't easily sell (which is most businesses--they're even harder to sell at a profit than a used car) then there's no VC investment to be had.

But that doesn't mean you're stuck. I'd like you to consider the idea of selling part of your income.

It works like this: you have an idea, a fledgling business or a new market to enter. You find an amateur investor (a wealthy dentist, a retired executive) and raise the money to bring it to market. And in return? The investor gets $xx for every unit you sell. From the first one until forever.

No fancy bookkeeping, no board meetings, no worrying about the accounting. Instead, you pay a royalty on income. The rest is up to you.

Of course, this is exactly how the math of book publishing works. The publisher puts up money and keeps 80 or 90 percent of the income. You get the rest.

It could even run on a sliding scale, with early royalties to the investor being lower, or with a buyout once a certain amount was earned back... If you needed $5,000 for some tooling, perhaps you could offer an investor $100 for every unit you sell until you've paid her $10,000, then $40 a unit forever after that. (typos fixed, sorry).

Need to raise money for a restaurant? It's hard for an investor to figure out how to win by owning equity (because it's so easy for the owner of the restaurant to manipulate profit). But if the investor gets 4% of every check paid, that's money back starting on the first day.

Investors are as irrational as the rest of us. They buy a story and expectation about risk. They buy the excitement of upside. They buy an opportunity to turn one thing into another. Banks want a boring story. Other investors might like this alternative story quite a bit.

My general bias for entrepreneurs starting out is to bootstrap their business, because raising money is so hard and so distracting. But if you've set out to do something that needs cash you can't raise any other way, this is worth exploring. Tell a story to an investor that wants to hear it, and create a cash-flow scenario that makes the investment worth it for both of you.

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