11/18/2011 04:28 pm ET Updated Jan 18, 2012

Why You Should Forget About Venture Capital

There, I said it -- and it must sound so out of vogue, since financial magazines are full of articles about M.B.A. students competing for big investments from venture capitalists. After all, who wouldn't take a check for $5 or $10 million to fund a start-up?

Well, I hate to be the one to tell you that there is no Santa Claus: VC money comes with a price, and because of that, it's not all it's cracked up to be. First, it is extremely hard to get, so chances are you will spend a fortune in time and end up with nothing. Your time could have been spent elsewhere, like fine-tuning and selling your products or services, and landing smaller investments.

If you are one of the few who do land big VC money, it will cost you a big slice of your equity ownership (so that if you are successful and eventually sell out, your payday will be watered down). Unless you're the next Steve Jobs, you won't have much of a product or position from which to negotiate when the VC of your destiny cracks open their checkbook. You're at their mercy, and it would be naïve to expect they will show any.

Then there's the matter of a board of directors. The VC's will demand places on your board, and maybe even control of it. You know what this means --your board of directors could throw you out of your job any time they want, and you could end up owning a declining percentage of your business with someone less qualified than you running it.

But enough gloomy talk. Let's say you have an exceptional product and land VC money. If all goes well, you and the VC's will ride off happily into the sunset, with your net worth exploding month after month. Maybe you're the next Google, Netflix or Amazon. If you believe this is possible, then...go for it. Just keep in mind that 95% of business start-ups fail within the first 10 years.

Now let's consider all the M.B.A. programs' entrepreneurial classes and the focus they put on sharp business plans and the holy grail of landing VC money. Nearly every school does this, so if it's popular, it must be right -- right? This is where herd mentality is inevitably wrong. The focus is on getting VC money, not on whether or not the product or service will sell and support a growing business. That, not VC money, is what will make you a success in the long run.

For these reasons, VC money is not all it's cracked up to be. Unless things go exactly to plan, you're quite likely to lose control of your business. So here's what I suggest as an alternative: Turn the tables on the situation by focusing on a seemingly unexciting commodity product or service niche that will attract little competition and provide steady cash-flow. Why is this smart? Because once you have cash flow you can service bank or private debt. And once you can service debt, you can retain controlling interest in your company.

It's a clean and simple solution that I describe in Chapter 10 of my book, Chicken Lips, Wheeler-Dealer, and the Beady-Eyed M.B.A.: An Entrepreneur's Wild Adventures on the New Silk Road.

Let's take some examples. Mary and John are bright software engineers from one of the top technology schools in California. For their doctoral research they developed a new generation software product to more simply facilitate low-cost telephone communication via the Internet, but need $500,000 to develop it through phase one. They think it will be a big hit. They spend months writing a complex business plan and hire consultants to link them up with potential VC's. Both of their parents are academics.

Beth and Bob have liberal arts degrees from a small regional college, some M.B.A. night coursework from a community college, and want to start a 100% organic grocery store to provide cancer-free diet to the Twin Cities area. They have noticed from their own shopping that the leading "whole foods" retailer in the nation actually sells a very low percentage of truly organic, cancer-preventative produce, and is just using presentation and décor to increase profit margins on normal, pesticide-laden produce. Sensing a niche, they want to start small, limit their risks, and see where the business takes them. Beth has an uncle in the grocery business who has helped them shape their thinking, and Bob's father is in the real estate business. They have leased a 5,000-square-foot vacant grocery in a neighborhood shopping mall at a very low price and are excited to get started. Regional organic growers can deliver to them six months of the year, minimizing transportation costs. Beth's uncle has introduced them to his banker.

Fast forward seven years. Mary and John developed their product for three years, while keeping their day jobs, investing all their savings and borrowed money from their parents. A few angel investors pitched in, but no VC's were interested. "It's a crowded space," was a familiar remark as VC's turned them down. In year four the product was abandoned when the founders ran out of patience, money and hope, and were mired in $250,000 of debt.

Bob and Beth had a product the public needed and wanted, and structured the lease on their building to match their hoped-for growth. Since the space had been empty for three years, the landlord was willing to scale payments from very modest in month one to fair market price in month 48, thus giving Beth and Bob time to financially grow into it. They eventually hired a veteran buyer and staff accountant to track best-selling merchandise, and expanded month after month. Four evenings a week they have nutritional health speakers and noted fresh-produce culinary experts on site, at no cost to the store. They have $350,000 of long-term debt, and are easily making monthly payments, as well as paying themselves modest, but livable salaries--which they project will grow comfortably. The Twin Cities weekly paper has them at the top of their "best of" annual lists. Bob and Beth have done it the classic way: start small at ground zero and understand what makes the business tick.

Bob and Beth had a less flashy product line, but it was a product that could immediately pay its way. It was also a product line you can build a fortune around, step by step. It's similar to many of Warren Buffet's business investments: strong niche, repeat business, steady profits and sales. That is, it's a compounding machine, spewing out sales and profits day after day to a clientele that inevitably will want more and more.

The moral of the story is this: Whenever possible, use bank debt, not venture capital, to build your business and maintain at least 51% control of its ownership. You'll be happier and work better. And you won't have the drag of partners second-guessing and contesting your decisions. No one knows your business as well as you do, so keep it in your hands, where it can best be nourished and grown.

The tough love of this theorem is that using debt financing forces you to focus on your business sooner; to find an in-demand, cash-producing product or service from which you can build a successful company, support your family, and build a respectable fortune.

Just think: If some VC had cut you a check for $5 million back in year one, you might still be flying blind, with no idea of how your business should function. Better to start in your basement or garage, sweat all the details from day one with a skinny checkbook, and know exactly how your product or service should be marketed and maintained.

Never forget that VC's have one goal: cashing out. They don't really care about you or your business. Few have experience actually starting and building a business from scratch. Though they're probably smart, this won't keep them from making inappropriate, often just plain stupid, decisions that can hurt your company and you. Your company is just a tool for them to try to leverage, whereas for you, it's your baby, the engine to support your family and future.

So hang on to it and nurture it day by day until it's time to sell. Once you find the right local banker, he or she will stick with you every step of the way.

Frank Farwell is the author of Chicken Lips, Wheeler-Dealer, and the Beady-Eyed M.B.A.: An Entrepreneur's Wild Ride on the New Silk Road, available at