Borrowing From Parents To Start A Business Beats Giving Up Equity

Something a friend of mine, an MBA-holding executive in Silicon Valley, once said made me stop and think.

“Taking investment is the worst-case scenario.”

There’s a related saying too: “An IPO is what you do when you have no other way left to raise money.”

Both are full of implications about fundraising in a startup.

In any business, the important thing is controlling the balance between risk and reward.

Money itself has no color. It has no wings, and it isn’t strong or weak. A dollar is a dollar no matter where it came from. So the choice of fundraising method is a huge opportunity to minimize risk while keeping reward intact.

I’m not a corporate finance expert, so I’ll limit myself to a few points that are easy to understand at a basic level. If you’re interested, consult a specialist for concrete advice.

A company can’t operate without capital. Broadly speaking, there are two ways to obtain it: “borrow it” or “exchange it for something.”

For example, even if you put your own money in during the early stage of founding a company, treating it as a loan from an officer counts as “borrowing” (even if it’s the founder’s own money). If instead you put it into capital stock and hold 100% of the shares, that means you “exchanged it for equity.”

You can also make money by generating revenue. If that comes from selling some kind of asset or providing a service, that too is ultimately an exchange.

In the borrowing case, what matters is things like interest rates and repayment terms. The lower the interest rate, and the longer the grace period or repayment period, the better controlled the risk is.

In the exchange case, the important question is “what was exchanged, and for how much.” This gets a bit more complicated.

To take an extreme example, if you received some amount of consideration in exchange for something you didn’t need at all, the risk was essentially zero. But if you gave up something that would become enormously valuable in the future for a pittance, that’s a case where risk and reward were out of balance.

If what was exchanged here was a product or service, that thing was made in the first place to be exchanged for money, so as long as the business model wasn’t designed poorly, risk and reward should be considered under control. The real issue is equity funding.

People joke that “taking investment is like getting married, except you can’t easily get divorced.”

There are many risks to giving away equity, but the biggest one, needless to say, is “where control of the company resides.” The lower the current management’s ownership stake falls, the more their influence risks being diminished. In the worst case, there’s a takeover from outside.

Some executives barely care about their ownership percentage. It’s not unusual for a founder to be below 10% at the time of an IPO, but a founder who gets close to that level while still private is undoubtedly someone with real nerve.

There’s also the problem that with each round of equity investment, the valuation rises, and if it rises too much, the next round becomes harder to raise. Investors putting in a large amount of money naturally want a commensurate stake, but once the valuation rises, getting that stake requires an enormous investment. When that amount becomes something nobody can pay, an IPO becomes the last resort — that’s the idea behind the opening quote.

Taking a company public and scattering shares across the market is, in a sense, like entering into a terrifying number of simultaneous marriages. From the company’s perspective, it doesn’t even know who these partners are, or what they’ll do. And it can’t refuse them.

Given that taking investment carries risk to a greater or lesser degree, it’s natural to wonder, based on the balance discussed above, how “borrowing” stacks up.

Many companies run on borrowed money.

Investment, in particular, comes from people who care about capital gains, so they expect exponential growth from the company. But the world doesn’t have that many businesses that good.

My friend Y, an executive, runs a music school and related services. Since it’s an equipment-based business, borrowing is the basic mode of fundraising.

He often consults me saying “I want to do equity funding,” and I advise him that if he can borrow, he should just do that. His response is always something like “Well, I know that, but still…”

Depending on how you look at it, running on debt gets you evaluated externally as “ordinary growth,” while taking investment gets you evaluated as “dramatic growth.” Any executive probably feels some longing for the latter.

A really skilled CFO balances borrowing and investment. This is quite a skill, and not something I can easily explain.

The annoying thing about borrowing is that, of course, it’s still money you have to pay back.

Debt comes with a repayment period, and contractually, paying it off within that period is absolute. But in reality, refinancing before the repayment period ends is common.

For a bank, what matters is building a track record of lending and receiving repayment, and that connects to a behavioral principle: lend more to stable borrowers. In other words, if a company has kept up stable repayments, and it happens to be short on repayment funds right now, the bank will extend additional financing — in fact, it will have the current debt paid off in full and enter into a new loan agreement.

The longer and more stable a relationship with a bank continues, the more a company can fall under the illusion that it will go on forever. But in reality, the world is full of cases where additional financing gets cut off, repayment is demanded, and the company goes bankrupt.

Everyone knows this, so they always approach borrowing with some wariness.

Generally, companies try to reduce risk by borrowing from as many different banks as possible, while banks try to lock in a main bank relationship and consolidate debt as much as possible — a tug-of-war that plays out everywhere.

A syndicated loan can fairly be called one of the schemes driven by the latter, bank-led approach.

At this point, you should have a reasonable understanding of the pros and cons of each side.

Given all that, what is the strongest fundraising method? It’s still “borrowing from your parents.”

First, you don’t give up any equity. There’s nothing to exchange.

It is a loan, but if treated as a personal gift, it can even be folded into capital (effectively, pay-it-back-when-you-can financing).

No collateral, low interest (in some cases no interest), and repayment terms that are extremely flexible.

There’s hardly any other funding method with such favorable conditions all in one package.

Of course, this isn’t relevant to a phase like “raised $X million in a Series A.” This is about the few hundred thousand to a few million yen needed to build a super-early prototype.

If you’re working and have reasonable savings, just use those. But if you’re a student about to hand over excessive equity in exchange for $10,000 or $20,000 from an investor, stop doing something that foolish immediately, buy some good sake, go back to your parents’ house, and talk to them.

As an executive, I believe you always need to pour your heart and soul into controlling risk and reward.

Presenting to your parents, bowing your head, enduring plenty of complaints and scolding, and negotiating and negotiating until you somehow work something out — that, to me, seems like a far more genuine act of “pouring your heart and soul into it” than people give it credit for.

The content of this post is an excerpt (original text) from the following book. If you’re interested, please pick up a copy.

The Shape of a Happy IoT Startup

The Shape of a Happy IoT Startup

Originally published in Japanese at https://clazytech.com/2022/08/1069/. Translated with LLM assistance and reviewed before publication.