Venture Capital is Not For Everyone

Venture capital

Venture Capital Mindset by Dilbert

We are often approached by founders who believe that venture capital is a necessity to guarantee their company’s success. The VC community, to its credit, has done an excellent job of extolling the virtues of and benefits of this source of financing and one might think that the only way to build a successful tech company and exit at a great number is by tapping into venture capital. In fact, while a successful exit by a VC-backed company results in plenty of press, an equally successful exit by a bootstrapped company more often than not goes unnoticed. 

Venture capital plays a very important role in the capital markets and financing high potential growth companies but importantly, it is ONLY appropriate for certain types of companies and those that have phenomenal growth opportunities…a fact that many founders do not understand.  Matching the appropriate type of capital to the company’s opportunity is key and in light of this need to match, we thought that the following article would provide founders with food for thought.  

Eric Paley from Founder Collective wrote an interesting article detailing his thoughts on the negative aspects of rushing into a decision to bring on venture capital investment. Venture Capital is a hell of a drug strikes us as a very balanced view particularly when one considers that many founders do not understand the economics that drives VC investment decisions.  

As you read through the article put some thought into how Paley’s insights might have changed the outcome for Toronto-based Flashstock Technology.  Flashstock, founded December 2013, raised a total of $3.1 million in three rounds: $800,000 in January 2014 from a boutique New York-based VC and $2.3 million from two angels in rounds of $800,000 (June 2015) and $1.5 million (October 2006).  On June 28th, the company announced that it had been acquired by Shutterstock Inc. (NYSE: SSTK) for US$50 million

 The three main observations from Paley’s article are:

Venture capital increases risk for founders
Exit value is a vanity metric
Capital has no insights. Don’t trade a solid business for a lottery ticket

A more detailed summary and direct quotation from Paley’s excellent article follows.

Venture capital increases risk for founders in two ways:

It limits a founders exit

VC cash comes at the cost of reduced exit flexibility and the burden of an increased burn rate. Viewed probabilistically, the most likely positive exit for a start-up is an acquisition for less than $50 million. This outcome has little benefit to VCs, and they will happily trade it for an improbable shot at a higher outcome.

Entrepreneurs agonize over a percent of dilution while ignoring the fact that they are surrendering their most likely exit options for a low-probability shot at building a superstar start-up.

Founders often use the capital infusion to increase burn to dangerous levels 

Beyond signing away exit options, new venture capital typically is raised to fund higher burn rates. That increased burn rate is a great investment when it is being used to fuel a model that is working. Paley observes that more often, the increased burn is used to search for a model that works, and the company quickly learns that capital has no insights; it’s just money. Then the company cannot sustain the burn, the CEO decides to cut the burn way too late and cannot manufacture enough VC enthusiasm to keep the dream alive.

Paley puts forth his view that one rough rule of thumb is that start-ups should be able to triple their post-money valuation in two years. If founders can’t figure out how to get 3X leverage on every dollar they spend, then they are better off not spending the dollars — or raising them in the first place.

According to Paley, “founders need to think of venture capital as a power tool — a fairly dangerous one — but instead often mistake it for some magical, infinitely renewable resource. In the right hands, power tools can solve some real problems. Used incorrectly, they can chop off your hands”.

VCs need billion-dollar exits, founders don’t

Billion-dollar exits are brilliant, but they shouldn’t be how founders calibrate success. The mania for billion-dollar valuations is the result of the business model of the venture capital market — not some legitimate definition of start-up success.

Here’s a very rough illustration of billion-dollar VC fund logic:

VC raises a billion-dollar fund, needs to triple the fund to be successful
VC makes ~30 major investments
VC breaks even on 10, loses money on 10, needs remaining 10 to be worth an average of ~$300 million in proceeds to their fund

VC can only expect to own 20-30 percent of any given company (often less); anything less than $1 billion exit of your business isn’t a success in this model

This is why there is so much focus on billion-dollar exits. Not because this outcome is high frequency, but because a few massive funds need it to be so. Let’s not just point fingers at the billion-dollar funds. Similar VC math causes irrational trade-offs for founders whether their investors have billion-dollar funds or quarter-billion-dollar funds.

As a general rule of thumb, assume that your exit needs to be approximately the size of the VC fund to “matter” in its returns. Of course, this is the tail wagging the dog, as the capital gatherers are encouraging irrational behaviors of founders with a sales pitch of “go big or go home.” No one says the truth, which is “go big or ruin your life.”

When the founder’s business fails, which probability says it most likely will, that VC has 29 more shots on goal. You destroyed your single start-up, not to mention the wasted sacrifice over years of your life. In most VC deals, the investor is taking much less risk than the founder.

Exit value is a vanity metric

If one of a founder’s goal is making money, focusing on the exit price is a bad idea. It’s quite possible to sell a start-up for a billion dollars and make less than someone who sells theirs for $100 million.

Venture capital isn’t the right choice for most businesses, but when used well, it can be very powerful. Unfortunately, many VC-backed founders are using it incorrectly.

Eric Paley, Managing Partner, Founder Collective 

Posted in: Q1 Blog

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