Spending other people's money sounds like a great idea at first, but what exactly do you lose when you go down the funding road?

Show Notes

Taking outside money to start your business may seem like a good idea, but there are a ton of strings attached... You give up control. Cashing out becomes the #1 priority. It's addictive. It's usually a bad deal. Customers become less important than investors... You get the idea. Outside money should never be plan A.

Show Notes

What is Rework?

A podcast by 37signals about the better way to work and run your business. In Season 2, we're going through Rework (the book) chapter by chapter and talking with authors, Jason Fried and David Heinemeier Hansson, about what's changed in the world of business over the last eleven years since the book was published.

Shaun: [00:00:00] So how is everyone? David, you're sick. I have a cold. Jason's got a kid in the room. I think this might be a fantastic episode.

Jason: [00:00:09] Yeah, we all have germs. Perfect.

Shaun: [00:00:12] Perfect.

[00:00:12] Broken By Design by Clipart plays.

Shaun: [00:00:14] Welcome to Rework a podcast by Basecamp about the better way to work and run your business. I'm your host, Shaun Hildner. This week, we're talking about taking outside funding to start your business and why that option really should be your last resort, spending other people's money sounds great, right? Well, you're always going to be giving up something if you go down that road.

[00:00:34] So here to discuss all that and more are Basecamp's co founders and the authors of Rework. David Heinemeier Hansson, how are you today?

David: [00:00:40] I've been better, but all right.

Shaun: [00:00:44] We’ll power through. And Jason Fried, how are you?

Jason: [00:00:46] I've been worse. But all right.

Shaun: [00:00:50] Perfect. I'm glad this evens out. Well, this is going to be the first of what I assume is many episodes about taking outside money to start your business. And you lay out quite a few bullet points that we're going to go through one by one. But first, I kind of want to ask, what are the types of businesses that probably do require some sort of outside funding?

Jason: [00:01:10] Well ones that have, real capital expenses. If you're a restaurant, you need to buy a bunch of oven equipment and hardware, tables, chairs, that kind of thing. If you're a factory, you know, things like that. Retail stores, people who build hard goods, manufacturers, that sort of thing. Obviously, you need something upfront. And in some cases, it's quite a lot. In other cases, it’s not quite as much. But in the software business, you basically need a laptop, and an internet connection, essentially. And some server space and a few things. But those costs are so insignificant compared to a company that has to build things and has to buy machinery and that sort of thing.

[00:01:51] So definitely room, lots of room, obviously, for companies who need to take money up front and get loans and whatever. That's the norm for most businesses that have physical spaces and physical goods. But raising a bunch of money to be a software company just strikes me as an unusual first step.

David: [00:02:08] And I think we mainly wrote this essay to highlight our own example of building a software company in an environment where the majority of other high profile software companies took money as Plan A. That we're highlighting that for Basecamp, it was Plan Z as in, we never got that far.

[00:02:31] And that, here's an example of why that is. I think this connects to some of these other essays and some of these other thoughts we have on whether you're capable of building things by yourself, because that's obviously a key factor here. You can do things with a laptop and an internet connection if you know how to do stuff.

[00:02:50] If you just have an idea, and you have to hire a bunch of people to make that idea come true, then you do need a lot of money, either yours or someone else's. But the magic of software is that. First of all, if you know how to build it, it doesn't take that many people to get going. It doesn't take that many people to get big. This was after we wrote the book, but WhatsApp has always been one of those star examples. I would have said like a social network, that's something you perhaps need to raise a bunch of money for, because you don't know how to monetize it, whatever. WhatsApp builds a business that has what, a billion users by the time they sell to Facebook, off 50 people.

[00:03:33] And as my understanding was that they were even making pretty good money charging $1 a year for the service. So in software, it's just possible to get this scale with a small group of people who can build things by themselves, and therefore do not need to raise outside money.
Shaun: [00:03:51] I don't know if you have the answer to this. But I mean, it makes total sense that if you're building a factory, you would need to take some sort of investment. But how did this seep into the software industry?

Jason: [00:03:59] Well, I think a lot of it was due to business models, as David is sort of referring to. If you're trying to build a social network, you need mass scale, you need a lot of things. And it's hard to do that if you charge people money up front, because you're not going to get the scale that you want early. And it's not just social networks, of course, but that that is a good example, though, of, you got to have a big mass scale to get that to work.

[00:04:21] But a lot of other companies that didn't need to do that followed in those footsteps, I think. People who are selling software as a service, with actual prices. Although, again, the business model was, give it away, let's land grab here. Let's get as many people as we can to use it and figure out how to make money later.

[00:04:37] And that works for some companies. But when that's the plan, like you obviously have bills to pay up front and you've got salaries and you've got rent or whatever you had, and so you've got to pay those bills and if you're waiting to make money in five years, you can't. You're not gonna be viable. So obviously, this is like stupid basic Economics 101, here I'm just reciting.

[00:04:57] So you need to pay the bills and to do that, you need to raise money to do that, because you're not raising money from your customers.

Shaun: [00:05:02] Right.

Jason: [00:05:02] So if you're not raising money from your customers by selling a product, you have to get that money from somewhere. And in the tech world scale and size and rapid growth was the thing, and still is the thing that people seem to be after. And you can't do that if you limit your growth and your scale up front by typically, you can’t do this, by putting an impediment up front to growth, which is charging money. So anyone who follows that path, needs something to pay. And that's where the thing came from.

[00:05:31] There's also, of course, there's an ego boost of having a gatekeeper let you through the gate and say here you could be a billionaire, too. So there's some of this thing going on, and IPOs, and acquisitions and scale and top line growth and all these things that are very appealing to the ego. So I think that's another big part of it as well.

David: [00:05:50] I think the magic here, to come back to, is software is truly unique in this regard of how large of a company you can bootstrap relatively quickly, by having a group of people who can do things on their own.

[00:06:07] Remember back to when we started Basecamp. It was Jason and I, and two other people. And that was enough for us to be able to build a software product that was appealing enough that people wanted to pay for it. And that's a way to get off the ground. There's a complete other version of Basecamp, where we did take money as Plan A, and tried to do the land grab and do all these other things up front. And odds would have been that we wouldn't have been here now. That 20 years later, the three of us wouldn't have sat here to have this chat.

Shaun: [00:06:42] It would have failed or sold.

David: [00:06:45] That's usually the outcome. Not always. There are of course the home runs that make it through all the way and then perhaps go IPO or something and where the people who started or are still involved. But for the vast majority of the people who go through that pipeline. For the vast majority, it doesn't work out. It's shut down. And then for the next slice of it, it's sold or put into something else. And I think that connects to some of these other threads we have in the book that when you take money, it sounds like the safe thing to do. Because hey, we just got a bunch of money, we must be better off now.

Shaun: [00:07:22] Sure.

David: [00:07:22] There's zeros in our bank account, and we can hire a bunch of people. That must be a safer place.

Shaun: [00:07:28] And it's not our money.

David: [00:07:28] Right. And it's not our money. But it's not a safer place, in many ways. It decreases the odds that this can succeed, because the kind of success you need to be able to satisfy that money is so much higher. And as we also talked about in this specific chapter, you get into some quite bad habits quite easily.

Shaun: [00:07:50] Yeah.

David: [00:07:50] Like, spending other people's money being a very addictive thing. And it doesn't have the normal constraints of, hey, we have to make more money than we spend because that's how we stay in business. No, I mean, in fact, once you take money, the whole purpose is to spend as much of it as possible as quickly as possible. No one is going to give you $50 million just so that you can go like actually, you know what, I just needed six.

Shaun: [00:08:15] Let's put the rest in the bank.

David: [00:08:15] Let's put the 44 in the bank earning what, zero and a half, or something. That's not the thing. The thing is when someone gives you $50 million in a Series B round or whatever, it’s like, hey, you got to spend that cash in 18 months, because we are on this train, and it's going in one direction only. Or we'd rather actually went off the rails and blew up.

Shaun: [00:08:38] Well, let's go through these the points one by one and lay out the problems with spending other people's money. To start with, giving up control of your company. When you take other people's money, you're giving something up, right?

Jason: [00:08:50] Well, what you're doing really is you're subscribing to someone else's timeline and schedule. And you're also subscribing to building a very specific kind of business. And I think this is, David is sort of getting at this, which is actually taking money reduces optionality, you jump in a specific lane. And that's the only lane you really have, which is, of course, this isn't entirely true. There are exceptions. But for the most part, you're, you're on the growth Lane, the rapid growth lane, you're going down a specific direction, you're on a timeline, which is like you know, five years or seven years or less. You're probably going towards a sale or an IPO or an acquisition or a merger or something like that. And you've got to grow, grow, grow, grow, grow.

[00:09:30] That's where you're going. So you might blow past the right size for your business. You might blow past the right size for you. You might blow past opportunities that you would love to take on but you can't because they're not big enough. So again, this does pan out. Someone can go, well, look at these companies and look at how this worked out. And it does work out. It obviously does. The odds are just very low, obviously. And the bigger problem to me is that you don't have other options. For example, in our case, we could decide to IPO if we wanted to. We could decide to sell the business if we wanted to. We could also decide to continue to keep the business running. We've been doing it for 22 years. We can keep doing it the way we've been doing it.

Shaun: [00:10:04] Right.

Jason: [00:10:05] We could spin something off and not have to answer to a board telling us you can't do that, or that's gonna reduce top line revenue overall. There's a million things we could do because we aren't beholden to someone else's money and someone else's expectations.

[00:10:19] As a business owner, I want optionality and want to be able to adapt, and to move if I have to, or whatever. Or take our own time. These are, I think, are really wonderful things to have. In my opinion, that's kind of the main reason why you want to go into business, is to have options of your own. Because really, if you start taking money, you're essentially working for someone else's expectations of your own business. And that's not, for me, particularly interesting. But of course, for others it is, but I think that's the big limiting factor here, is that you have to become a specific kind of company.

David: [00:10:51] And I think what's so insidious about the give up of control is not necessarily that the people who gave you the money are going to tell you certain specific things. Hey, you need to do this right now, otherwise, consequences. No, it's that you internalize the goal path here, the narrow lane that no, no, no, well, I guess we took this money, this is the path we have to go. And it ends up being this internal focus of control that's being imposed upon you that you have volunteered into or so it seems, even though you don't really agree.

[00:11:25] This sense of freedom that you give up this personal sense of freedom, not that other people are telling you what you need to do all the time, but that you feel obligated to put the company on a certain path. That's the part that really just gets me.

[00:11:40] I think there's so many things we've done in the history of Basecamp that don't make sense from this lane perspective that I look back on very fondly. Shots that we've taken, or things we've written. This entire book, in many ways, doesn't really make sense. I remember someone tweeting once that you can either be a successful business person, or you can write, as though those two things were in opposition, right? Like, there are no whatever billion dollar CEOs that also spent time writing books.

[00:12:12] I'm like, yeah, you're probably right, because they have internalized that that's not a thing I can do. Even if I have something to say, even if that's something I would want to do, because I have to be on this maniacal quest to maximize everything to the nth degree.

Shaun: [00:12:29] Right. The second point here is that cashing out becomes more important than actually building a quality business, right?

David: [00:12:35] I don't know if it's as true in the same way as it was, because I think some timelines have gotten longer for some companies that are raising money these days. But I think blowing it up as big as possible over building a quality business. Yeah, I think that is absolutely a contrast or a trade off where the choice once you've raised money is, you got to blow it up as big as it could be, whether that's good for the business, whether that's good for you. As Jason was saying, you can't choose to get off on a station before the end. Can't go like, oh, we're like a quarter of the way to our original goals and this is a great place to be let's just—

Shaun: [00:13:13] I’m good here.

David: [00:13:13] Let’s get off the train. Let's enjoy ourselves for several years, here. And what's interesting is how that relates to where we are now. In 2014, we chose to become Basecamp, as we call it, where we essentially stopped offering three of the products for sale, sort of. And that was one of those, let's just get off the train for a while. We chose to get off the train, we spent, what was that then, six years at that station, just having Basecamp as our prime focus. And then after six years, we were like, hey, do you know what, here's another train. Let's jump on that it says HEY on it. And then we could do that. And you can't really do these starts and stops and fits, as you see and as you would please. We need to be on the singular focus. There's not room or time for detours.

Shaun: [00:14:03] You mentioned earlier that taking money is addictive. Like that this idea that once you run out of that first level of funding, what do you have left? What do you do? You have to take more money, right?

David: [00:14:13] Exactly. Because the whole model is built in such a way that you're not supposed to be self sufficient until you get all the way to the end. In fact, if you start to develop self sufficiency, as in, become profitable, you're doing it wrong.

Shaun: [00:14:28] Right.

David: [00:14:28] I mean, literally, by the book, you're doing it wrong. You’re not spending aggressively enough. Why are you trying to make a profit? You should just spend three times on top of that and then grow even faster. Which of course is such a useful pattern because you can argue that in sort of, hey, this is just good. We're just trying to maximize the opportunity. But you can also argue it in a way that this ensures that you will be dependent on the people who provide you the money and the next people provide you the next money until you get all the way to the end which is an IPO or something else. Once you build up a burn rate where, hey, we hired 150 people, 200 people, and we're losing $100 million a year, whatever. Yeah, you don't really have a lot of choices, right? You can't really just say like, oh, actually, I want to get off at this station. No, no, no.

Shaun: [00:15:17] Yeah, yeah.

Jason: [00:15:18] And then for the entrepreneur, I think this is a matter of what are you going to get good at. So we get good at the things we practice and the things we do repeatedly, essentially. I mean, of course, you can do them poorly, or well, but the more you do something, the more experience you have with it. And so if you raise a bunch of money, what you get really good at is spending money.

Shaun: [00:15:36] Or raising money.

Jason: [00:15:36] Yeah, raising and or spending, or both, versus making it. And at some point, you've got to know how to how to make money if you want to stay in business. And the problem is, is that if you haven't built up the muscles for that, they've atrophied or they don't exist, you've just gotten really good at spending. And so then when, one day, if you can't raise more money or something changes in your business, and you don't have a business model, that that's going to generate enough revenue to support what you have. You've built up this enormous latticework that's very hard to support. When you don't have a big amount of money funneling into your account from an outside source, all of a sudden, keeping that going, without knowing how to do it, without having any experience having to do it is incredibly difficult. And then it's just stress from all the way down. Enormous stress and enormous pressure. And you're being forced to do something now that you've never done before, and you don't know how to do well. And that's just a really scary place to be. And it puts you at, I think, significant risk.

[00:16:31] Because if you get good at making money, you can always spend money, too. You can, you get both.

Shaun: [00:16:37] Right.

Jason: [00:16:37] But if you don't have the get good at making side, you're gonna be in trouble at some point.

Shaun: [00:16:44] Kind of piggybacking on this idea of newer entrepreneurs, one of the problems that you lay out about spending other people's money is that when you're first starting out, you don't have any leverage. Can you talk a little about the pitfalls for brand new business owners?

David: [00:16:56] I think the problem there is, are you selling an idea or are you selling something real?

Shaun: [00:17:01] Right.

David: [00:17:01] When you’re selling an idea, the price of that idea is obviously going to be far less than the price of a proof. This is a hypothesis here. There are many hypotheses of all sorts. And we have to discount them heavily because most hypotheses do not pan out. Once you have proof, hey, this actually works. People are interested in buying the product that we built, we have something tangible, and that's of course, worth far more, at least in some sense.

[00:17:30] I will say that is also one of the things that perhaps has changed a bit, at least as into right this moment. 2021, November 30th, because it could very well change next month.

Shaun: [00:17:42] When this episode comes out?

David: [00:17:44] Right. Which is the sense that money right now is incredibly cheap, and there's so much of it, and it doesn't know where to go. So it’s slushing around in a way where the deals, or the bidding of hypotheses is quite healthy. There's a lot of people who are able actually to raise a staggering amount of money off the back of a hypothesis, because of these factors as they are right now. Should they change shortly, should interest rates go up, should all sorts of things change in that environment. All of a sudden, things shut off.

[00:18:17] That's the other thing I think, that's so interesting with the history of Basecamp, when we started building Basecamp, that was 2003. It was still in the hangover of the dot-com bust.

[00:18:29] When you can build something on your own and don't need other people's money, you don't have to wait until the quote unquote “good” times. In fact, there's so many businesses that have gone on to be great successes that were started in recessions, or downturns. And I think there's something healthy about that, that when you start in this non-frothy environment, as Jason says, you learn how to be scrappy in a way that is helpful even once you don't need that anymore. It enables you to run a much tighter ship, and that ship has more options when the weather turns.

Shaun: [00:19:02] Now let's talk a little bit about customers. We're a customer focused company.

David: [00:19:06] No. I'm just gonna, for the sake of argument, which is what I love to do, I'm going to say no. Because it connects to the topic we were talking about a couple of episodes ago, about the mission statement, right? Are you customer focused?

Shaun: [00:19:20] Ah, right. Sure. Sorry. You know what, I take it back. You're right.

David: [00:19:24] Which I think is it is important to say, though, because, of course customers are part of the focus. But I don't want to fall into the trap, the trite trap of like, well, customers are above all else. Because no, they're not. In some regards, right? They're really high up on the totem pole. And for us, they're much higher up than investors, which is the thing we call out in this—

Shaun: [00:19:45] Yes, that's the point I’m trying to get at.

David: [00:19:46] But they're not above all else, right? Like if Jason or I, and the rest of the people work at Basecamp really hated what we did because we had some awful customers and that was what we had to deal with all the time. You’re like that's not a business I would want to run.

Shaun: [00:20:00] Sure.

David: [00:20:00] But to this point, putting customers above investors in terms of what's good for them, I think is incredibly healthy in the regard of figuring out where you’re doing and where are your ethical lines.

Shaun: [00:20:13] But when your investors are giving you more money than your customers ever will where your allegiances?

David: [00:20:17] Yes, exactly. And what's so insidious about that is that even when it works all the way to the end, that you turn out to be one of these few businesses that make it all the way to the end, you're still getting paid by investors. There are so many companies in this genre of tech, that end up being a quote unquote, “huge success,” who make it all the way to the end, who never got paid by the customers. Who always got paid, like the people who started it, and the people invested in it the first, second and third time, they all got paid by later sets of investors.

Shaun: [00:20:47] Right.

David: [00:20:47] Not because the business itself was doing it or the customers of the business, were doing it.

Shaun: [00:20:54] The final point here is that it's distracting. And I think we pretty much covered that, that your focus becomes so much more on raising more money and spending that money that you're actually not building a business at all. You don't have time for that.

Jason: [00:21:08] Yeah, I mean, this is, of course, all anecdotal, because we didn't raise money. But I do know, I talk to lots of entrepreneurs who just constantly worrying about fundraising. Especially early on when they should be focused on the product.

Shaun: [00:21:20] Yeah.

Jason: [00:21:20] And how they market their product, how they talk about their product. They're focused on fundraising. And fundraising is draining because it's a legal process. It's a legal process. It's a financial process. There's a lot of due diligence, there's a lot of questions, there's a lot of paperwork, there's a lot of that stuff. And when you know the other person on the other side can end you by not giving you what you want, like, you're fully focused on that process.

Shaun: [00:21:42] Right.

Jason: [00:21:42] And it's draining.

Shaun: [00:21:42] Yeah.

Jason: [00:21:46] And you're pitching and you're doing trips and talks and a roadshow kind of thing. And meanwhile, you're probably just getting started in your business, and you don't really have any time really to waste on that stuff. You've got to get in and make the product great, and hire the right people and build that stuff.

[00:22:04] So of course, again, people break through this, there are businesses that do wonderfully well this way. But I think if you were to bring 100 people in a room who've gone through this process, they would all say it's extremely draining. And many of them would say it wasn't worth it.

Shaun: [00:22:16] Yeah.

Jason: [00:22:16] So ultimately, the odds aren't great there.

Shaun: [00:22:20] Yeah. All right, one final question, and sort of the elephant in the room. How is this different than what you took from Jeff Bezos? And a really quick brief, for some, maybe some new listeners about what that deal was?

Jason: [00:22:33] So Jeff, bought a small piece of the business in 2006. Yeah, he bought some shares from David and I, so he didn't really put money, there was actually no money that went into the business itself. This was taking some risk off the table. So David, and I put a little bit of money in the bank to make sure like, hey, if this all falls apart, at least we didn't lose everything. Because we didn't know. We were like two years in on this Basecamp thing. Who knew?

[00:22:57] So first of all, no money went into the business, okay. Second thing is, this was a deal based on essentially no control. So we didn't start a board. Jeff's a minority shareholder, he really has absolutely no say or sway over the business. He didn't want it. We didn't want him to have it. It was a good situation there. There was no timeline, like, well, I need to get my money out in five years or seven years, or we need to go IPO and whatever. All of those things that are typically built into these kinds of deals were not built into this deal, because that was not the kind of deal that we were signing with Jeff. It was a risk mitigation deal. It was a little bit of money off the table for the founders of the business early on, and essentially no control.

[00:23:41] And because we're an LLC, Jeff gets distributions every year when we're profitable. We've been profitable every year the business has existed. So Jeff's taking money off the table, also, while still retaining ownership. So it’s a really good, fundamentally good, almost like an annuity style investment. I mean, who knew that would be the case. But it's just a very different thing than Jeff needing to have a big huge exit in order to make this worthwhile, so that the incentives are aligned quite a bit differently than a traditional venture sort of deal.

David: [00:24:11] Yeah, literally, if you walk through the points that we give here. You give up control. No, we gave up no control. Cashing out becomes more important to building a quality business. Absolutely not. There has been no cashing out. Jeff bought the minority stakes from Jason and I, what was that, 15 years ago. Spending other people's money is addictive. We never spent any of the money that Jeff paid on the business. We always funded the business off the revenues. It was usually a bad deal. No, it was a pretty decent deal. In fact, the deal was so decent for us that I remember Jeff's advisors at the time thought he was kind of bonkers putting money into it. And that was of course the reason it worked. Because this didn't have the terms of a VC investment deal.

Shaun: [00:24:59] Right.

David: [00:24:59] Because any sane investor, who's purely just looking to get the maximum return, would have asked for all the things that people who make these kinds of investments ask for. And Jeff just didn't do that. Because for him, it was hobby.

Shaun: [00:25:15] Right.

David: [00:25:15] It was fun, like, hey, I get to be involved with some businesses, I get to see some things. We would chat with him over the years. I think that was what he got out of it more than whatever contributions he's getting out of our LLC distributions. And it didn't move the customers down the totem pole. Right? He didn't supplant anything like, oh, wow, now we got to make sure that Jeff is happy. No, in fact, that relationship was so simple that the business mechanics of it were such that we'd send his team an email, once a year. It'd be like two paragraphs, hey, things are good. Here's how much money we made this year. Cool. Talk to next year. Which, I mean, to some extent, there was more interaction in the beginning, and we leaned more on him and had more chats with that. But just in terms of kind of the control and all these pitfalls, all the reasons we would want money as Plan Z. They were just they were not there.

[00:26:13] And what's interesting is that that deal at the time was truly unique. But now there is some interest in that concept. And I've seen a handful of other companies trying to replicate the idea, basically, of buying in on a Jeff style purchase scheme. Hey, you buy a small part of the business. You don't get control. You don't get any of the VC stuff. And you just get to take some dividends off these businesses if they make money.

Shaun: [00:26:40] Yep.

David: [00:26:40] And I always thought like, yeah, clearly, in Jeff's case, this worked out exceptionally well. We paid him back like five times over and he still owns the stake, and he still makes money off the stake that he has, right?

Shaun: [00:26:51] Right.

David: [00:26:52] This was a good financial deal for Jeff. There’s got to be a model here. And now after all these years, there's finally people trying to see if there is a model that can make sense on a slightly broader scale than this was just this one off weird investment that Jeff made this one time in 2006.

Shaun: [00:27:08] Well, fantastic. I think that's a great place to stop. I know you guys have to get out of here pretty soon.

[00:27:12] Next week, we're going to be talking about how little you need to actually start a business. So thank you for joining me, Jason Fried.

Jason: [00:27:21] Thanks, Shaun.

Shaun: [00:27:22] And thank you, David Heinemeier Hansson.

David: [00:27:24] All right, thanks, man.

Shaun: [00:27:26] We'll see you next week.

Jason: [00:27:27] Adios. Bye.

David: [00:27:27] Later.

[00:27:27] Broken By Design by Clipart plays.
Shaun: [00:27:34] Rework is a production of Basecamp. Our theme music is by Clipart. We're on the web where you can find show notes and transcripts for this and every episode of Rework. We're also on Twitter at @reworkpodcast.

[00:27:47] If you're following along with the book, next week, we'll be discussing the chapter “You need less than you think.” If you liked the show, I'd really appreciate it if you would leave a review on Apple Podcasts. And if you have any comments or questions for Jason for David, leave us a voicemail at 708-628-7850. Or better yet, record a voice memo on your phone and email it to