Venture

Venture capital is a hell of a drug

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Eric Paley

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Eric Paley is a managing partner at Founder Collective.

More posts from Eric Paley

There has been a lot of money sloshing around the startup world for the past few years. Cheap and accessible capital has advantages: More founders get the opportunity to pursue big dreams and previously “unfundable companies” not only raise huge amounts of money, but some ultimately achieve unicorn status.

Discussions about the downside of this trend are usually related to systemic risks, like the perpetual bubble talk, but few are discussing the problem as it relates to founders — more capital equals more risk. But who is bearing this risk, and what really is the downside? Sure, capital providers are taking this risk — but they aren’t the only ones.

Venture capital increases risk for founders

On a short-term basis, raising VC reduces a founder’s personal risk by allowing the team to draw a salary. Founders don’t need to put development costs on a credit card or face short-term economic hardship. But while counter-intuitive, raising venture capital makes your startup riskier in two key ways.

You limit your exits 

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 startup 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.

I regularly see 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 startup. Billions of dollars have been outright wasted by founders selling future value that didn’t materialize, while surrendering present value that could have been navigated to great success. My advice: Don’t give up your present for a future you haven’t validated.

You 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. 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.

Every dollar you spend is a dollar of dilution. One rough rule of thumb is that startups should be able to triple their post-money valuation in two years. If you can’t figure out how to get 3X leverage on every dollar you spend, you’re better off not spending the dollars — or raising them in the first place.

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 — you 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 startup 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 behavior 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 your business fails, which probability says it most likely will, that VC has 29 more shots on goal. You destroyed your single startup, 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.

This is just fine for a subset of founders. It’s great that Ferraris exist, but it doesn’t make sense for the average person to mortgage their home and their future to buy one when a Toyota Prius can fetch groceries just fine.

Exit value is a vanity metric

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

For example, the Huffington Post was reportedly acquired for $314 million, and Arianna Huffington made about $18 million. Michael Arrington sold TechCrunch to the same buyer for $30 million and reportedly kept $24 million. To a VC, TechCrunch’s sale would have been a “loss,” and many VCs would have pushed Michael not to sell. Yet Arrington was more successful, financially, than Huffington.

Practice efficient entrepreneurship

One argument I’ve heard from many VCs is that a founder won’t build a billion-dollar startup unless they go all-in from the start. This is nonsense — to become a billion-dollar business, a founder first needs to build a $10 million business. Founders shouldn’t jump to the end game before they’re ready. You focus on the first step and still become a huge player in the end.

This is empirically true — just look at Wayfair, Braintree, Shutterstock, SurveyMonkey, Plenty of Fish, Shopify, Lynda, GitHub, Atlassian, MailChimp, Epic, Campaign Monitor, Minecraft, LootCrate, Unity, CarGurus and SimpliSafe to name just a few. None of these startups embraced the “billions or bust” mentality at the start, though many are worth billions now. Most took very little venture capital until after they proved out product/market fit and knew how they could use the money to accelerate growth. Some didn’t take any capital at all.

All were hyper-efficient in the way they used capital from Day One. Several have gone public, a few have been acquired for billion-dollar sums. I don’t fetishize bootstrapping, but there is a lot to learn by studying how these founders built huge businesses with efficient use of capital.

Smart people, dumb money 

I was very happy to build and sell a startup for nearly $100 million, and while I would have liked to build a billion-dollar business, too many founders treat the probability of either outcome as close to equal. Earning billion-dollar exits is startup nirvana, for sure. But selling for $500 million is a home run, $100 million exits are amazing and $50 million exits can change the lives of families for generations. Even a “humble” million-dollar exit can make a huge difference in a founder’s life.

The point is, don’t be so quick to irrationally trade all of those options! Only trade these options when you’ve proven enough to have confidence that the future value of your company will be much higher. Capital has no insights. Don’t trade a solid business for a lottery ticket.

Irrationally raising money to scale something that doesn’t work does not result in building a big business. Founders should focus on smart growth and use VC to support that — instead of treating it like a steroid. Make efficient entrepreneurship your mantra. By all means, dream big — I’m not arguing that founders build small companies, solving small problems. If you have a legitimate need for capital, by all means raise it. But on the flip side, don’t sell your chance for success by giving up optionality and prematurely scaling burn rate in the name of fundraising glory.

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.

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