Bootstrapping? Loans? M&A? VC? PE? - A Guide to Growing Your Business

This week I talked to a young agency owner who was trying to figure out where to take his business. In particular, he asked me if I thought raising venture capital money was a good idea.

"Let me ask you one question," I started. "Are you a service-enabled technology business or a technology-enabled service business?" He answered that he had built a few bits of internal tech but ultimately, he was a service business.

I then explained to him why he would never get VC funding: VCs want to invest in companies that have the potential to be worth one billion dollars in just a few years; service business, by nature of the fact that they are people-powered, can never scale at that rate.

This conversation made me realize that many business owners don't understand which growth options are available to their businesses, nor do they comprehend the different benefits and risks that come with each option. So I thought it would be valuable to provide an overview.

Bootstrapping

What is it? Bootstrapping means growing your business without taking any outside investment. So instead of paying yourself a fat salary, you take part of your profit and reinvest it in the growth of the business.

What Type of Business Qualifies? Any business that can quickly achieve profitability after launch. In other words, if you can set up shop in a coffee shop and get customers without having to first invest in a huge warehouse or expensive sales and marketing, you can bootstrap.

How Much Money Can I Get? As much as your business' ability to generate excess profit. Usually you need to pay yourself something to pay your home mortgage, but anything beyond that can be used to grow your company.

What are the Pros and Cons? The biggest advantage of bootstrapping is that you never owe anything to anyone, meaning that you control your destiny and you get 100% of the proceeds when you sell the business. The biggest disadvantage is that bootstrapping can be a very slow way to grow, as you are limited by the profit you can reinvest.

At 3Q Digital, we largely bootstrapped the company for the first seven years of the business (with the exception of a small AR loan, which I will explain next).

Debt Financing

What is it? Debt financing is taking out a loan, usually from a bank. Most banks will give you a line of credit based on your accounts receivable (AR) - your monthly revenue. So, if you've been averaging $300,000 of revenue monthly for the last six months, a bank might give you a loan of one or two times that monthly average. As your business grows larger and more predictable, banks may be willing to move beyond your AR and give you much larger loans. Debt financing usually does not get equity in your business, but it does need to be paid back, with interest.

What Type of Business Qualifies? Businesses with a track record of consistent and predictable profit. This generally means that debt financing is not an option when you launch your business.

How Much Money Can I Get? Debt financing amounts are usually correlated to the recent performance of your business.

What are the Pros and Cons? The advantage of debt financing is that you don't have to give out equity in your business, allowing you to scale faster and retain most of the upside. The disadvantage of debt financing is that you have to pay back the loan. And it is important to understand that most debt financing for small businesses are "recourse" loans, which often means that the lender can go after your personal assets if you default on the loan.

In 2018, when 3Q Digital bought itself back from our initial acquirer, we financed the repurchase with a loan from a local bank.

Mergers and Acquisitions (M&A)

What is it? M&A means joining forces with another company. In a merger, two companies come together largely as equals and neither company pays the other any money at the close of the transaction. In an acquisition, one company buys the other company, often giving the smaller company a mix of cash and equity at close.

What Type of Business Qualifies? Any two business can join forces. Typically, however, both businesses need to show a track record of success and a potential for future growth for a deal to happen.

How Much Money Can I Get? Companies are usually valued on a multiple of their last twelve months ("LTM" or "TTM") of business performance. In some industries, this is a multiple of profit and in others it is a multiple of revenue. The multiple range is very industry-specific. For example, technology businesses are often valued on a multiple of revenue but services businesses are usually valued on a multiple of profit (or to be more technical, EBITDA).

What are the Pros and Cons? A successful M&A transaction can create exponential growth. The combined companies may be able to win bigger clients, offer more services, and increase profit through internal efficiency (which, unfortunately, sometimes means laying off redundant staff). The downside of M&A is that it almost never works out the way the businesses imagined it would. There can be poor cultural fit between the two teams, the synergies anticipated might not happen, and the work required to bring the two companies together can cause the management team to be distracted from running the business.

In 2014, 3Q Digital acquired iSearchMedia as a way to offer new services and accelerate our growth. In 2015, we were acquired by Harte Hanks.

Venture Capital

What is it? Venture capital is an investment in your business in exchange for equity. There is no requirement to pay the venture capitalists interest on the investment, or even pay it back at all. Instead, the venture capitalist owns a portion of your business and when you sell, he or she gets some of the proceeds. So let's say that you get a one million dollar investment from a VC in exchange for 10% of your company's equity. If your company sells for one billion dollars, the VC gets $100 million - a 100X return on his or her money! If you go bankrupt, the VC gets, as they say in Yiddish "bupkis on toast."

What Type of Business Qualifies? VCs, as noted, want to invest in companies that can scale quickly. Generally, this means technology companies, like SaaS software, cloud storage, or consumer technology. That said, there have been plenty of VC investments in direct to consumer (DTC) product businesses (Casper, Dollar Shave Club), content sites (Buzzfeed, The Bleacher Report, MasterClass) and other tech-enabled businesses.

How Much Money Can I Get? Some VCs make small investments in very early-stage startups or pre-launch startups. These "seed" or "professional angel" investments usually start around $500K. At the other end of the spectrum, "late stage" VCs might invest billions in a business that is already on a clear path to an IPO.

What are the Pros and Cons? The biggest advantages of VC investment are, firstly, that you have no obligation to pay back the investment, and secondly, that a good VC will provide your business with strategic guidance and a network of potential partner businesses. The disadvantages of VC are, firstly, if you have a massive increase in valuation, you end up giving up an equally massive percentage of your business to the VC, and secondly, VCs can sometimes put pressure on you to optimize for the short-term, which may be counter to the way you want to run the business.

3Q Digital never raised VC funding. As noted, a service business like an agency is not the target of venture investors.

Private Equity

What is it? Private equity (PE) is an investment from a private investment firm. In many cases, the private equity company acquires the majority of the company's equity. The PE firm will then go to a lender and take out debt financing to fuel growth.

What Type of Business Qualifies? As with VC, PE comes in many sizes and flavors. There are PE firms that will buy companies with a couple of million dollars of annual profit, and there are others that only look to invest in companies that already have hundreds of millions of dollars of EBITDA. Generally speaking, a PE firm wants to invest in a business that has a solid foundation of growth, which means years of profit, an experienced and committed executive team, a defensible position in their industry, and a product/service strategy that will grow market share in the future. I often describe this to business owners by asking: "If you got hit by a bus tomorrow, what would happen to your business?" If the business would fall apart without the founder, it is probably not something a PE firm would consider investing in.

One important difference between PE and VC is that PE firms do not shy away from non-technical business. The VC model assumes that one in ten investments will drive a 100X return and the others will muddle along or outright fail. The PE model assumes that the majority of their investments will have a successful return, but the return will likely be in the 3-10X range. As such, a service business like an agency or a restaurant chain can be very attractive to PE.

How Much Money Can I Get? Like M&A, the value a PE firm will place on your business is a combination of your historical business performance and the typical multiples in your industry. One other important point about PE: most PE deals involve a "rollover" investment by the founding team. For example, if a PE firm values your business at $10 million, they may offer you $6 million in cash and then require that you keep $4 million of equity in the business. This is intended to incentivize the management team to continue growing the company after the deal is completed.

What are the Pros and Cons? As with VC investment, PE funding is not a loan, so you don't have to pay it back, and it gets you access to the PE firm's expertise and network. Unlike VCs, PEs use debt financing to enable growth. This can be an advantage when things go right (the company grows faster and you don't have to give out as much equity to outside investors), or a disadvantage if the company doesn't grow as anticipated and the amount of cash required to "service the debt" overwhelms the company (see ToyRUs).

In 2019, 3Q Digital took private equity investment from Erie Street Capital and PSP Capital.

No Perfect Answer

Whatever path you decide to go down, there will be tradeoffs. Bootstrapping is a great way to preserve control of your business and maximize your personal upside when you sell, but it is often a slow path that might result in missed growth opportunities. Debt financing can turbocharge your growth but could also bankrupt you if you can't pay back the loan. M&A can create a "peanut butter meets chocolate" moment of exponential scale, but it rarely works out perfectly. And VC and PE investment can turn your company into a unicorn, but it can come with pressure to optimize for short-term returns.

For 3Q, the right answer was different at different points in the trajectory of the business. Bootstrapping made sense initially until M&A offered us a path to faster growth. Debt financing then helped us buy back the company, with private equity investment shortly thereafter to help us with operational efficiency and scale.

Regardless of your industry or your business size, there are dozens of business owners who have been in the same situation as you. With that in mind, the best advice I can provide is this: don't reinvent the wheel! Ask for help - I've generally found that most people are willing to share their learnings, even if competitive industries.