There is a time and place for capital injection for startups making no revenue with zero equity. Most entrepreneurs believe that if they concentrate on building and perfecting their products and/or services, large sums of money will automatically start trickling in. Although some start-ups may get capital injection from investors at the seed stage, it is not typical. Most start-ups need to make money from day one and may never see external financing other than the line of credit from their bank. Others may not even have such luxury and may need to resort to bootstrapping and maximizing all of their personal credit cards. There are basically two types of start-ups of which deserve different treatment in its early stages.
The first types of start-ups are e-commerce, brick & mortar retail stores, and consulting/professional services, practically majority of the business in existence. These types of start-ups need to have positive free cash flows from operations in order to fund the continuing operations of the business. Holy grails of these businesses are ones that have either negative or zero cash flows from financing. That is, the business can survive without having external financiers.
The next type of start-ups are those that are launching innovative products and/or services. Think newly formed drug companies with a patent on a drug or a software companies with an innovative product that will soon launch to market. A negative cash flow from operations for these types of business is acceptable. That is, they may fund the operation from financing activities. The only main criterion is that the internal rates of return have to be positive. If the internal rates of return from R&D expenses are deemed to be positive, then it will only make sense for the business to seek external financing for their business. However, the question than becomes, which products or services are considered to have positive internal rates of return and what type of business are considered innovative products and/or services?
To answer the first question, the product or service has to be innovative enough to withstand on its own and generate astronomical rates of return by capturing a large percentage of the market. For example, if the product is a prescription drug that can potentially cure terminal cancer, the demand for such product is definitely there. It may just need to complete the clinical trial phase and gain FDA approval before it can come to market. This would mean the business would not generate any revenue until the clinical trial phase ends and the drug gets approval from the FDA. Until that happens, the start-up will need some sort of capital injection in order to bring to market. The capital injection at this point needs to be large enough to create a buzz in the market. That is, when people refer to a drug that cures cancer, they will think of that particular drug. The reason for this is simple. If the drug gains popularity but fails to capture a large market presence, there will be copycat firms coming out with similar products and they may corner the market instead.
To answer which start-ups are considered innovative think of Picasso, Da Vinci, and Polack. They were considered the greatest artists of their time because they brought to the art world a new medium, becoming the pioneers of their styles. Others have followed suit, but when one thinks of cubism, they quickly point to Picasso. In essence, for a start-up to be truly innovative, the product or services has to be something that the markets wants but hasn’t realized yet. In the course of a day, I come across several start-ups telling me why they are different. In reality, however, they are the same service or product that is already in the marketplace but with a little twist to it. For example, almost every other start-up that I come across is some sort of social media that does not make any revenue. The first question that I ask is how they will generate revenue and the typical answer that I get back is nothing more than having a glorified website that may or may not attract traffic. If that is the case, their business is more like the first type of start-up and needs to make money from day one in order to survive.