Shoehorning startups into the VC model

http://cdixon.org/2012/07/19/shoehorning-startups-into-the-vc-model/

by darrelsumi • 14 years ago

82 13 14 years ago

mvzink• 14 years ago

If there is one thing I wish I saw more of on HN, it's posts about funding and business outside of the VC model. I feel the thoughts expressed in this post are on the rise.

acgourley• 14 years ago

I'd like to see analysis that suggested if traditional VCs have it right or not. Yes, yes, startup returns follow a power law distribution, I agree. That doesn't necessarily mean that it's optimal to chase the potential top companies!

aaronblohowiak2• 14 years ago

"Shotgun" angels take a different strategy..

Edit: also, if you think about the YC acceptance rate vs the VC acceptance rate in terms of attempts to money, then it is interesting that VCs consider YC a filter. IIRC, YC has a higher acceptance rate than most top-tier VCs. Note that i probably don't remember correctly ;)

jjacobson• 14 years ago

Agreed. It's fascinating and confusing to learn about the difference between VC's and Angels, especially when you have VC's acting like Angels and making smaller, seed round investments these days.

aaronblohowiak2• 14 years ago

VCs make more money because they have more money under management, but angel investments are so much cheaper because of lower due diligence...

VCs may also be making angel investments not so much for the equity but in order to have a shoe in the door in order to have a "right of first refusal" (implied/socially) in later financing rounds.

Unfortunately (as some are learning) this can also mean you make some less-desirable angel investments that would create a portfolio conflict with a desire to do a later round with a competitor in the space... this is why some VCs might have an "angel arm" or similar "separate" structure so they get the best of both worlds...

adventureful• 14 years ago

His billion dollar marker is drastically high. He has been living in dotcom fantasy land for far too long.

There's no reason you can't raise $250k for 25% from an angel investor, to build a $10 or $20 million business. That's a helluva result to put it mildly. You know, building an actual business that produces actual profits, not vaporware built-to-flip companies that produce nothing and only exist in a tiny corner of the economy.

The stock market hasn't moved in real terms in 13 years or so. Interest rates are on the floor. Any investor outside the big VC game would kill for a 10 or 20 fold return over 10 or 20 years. There's a beautiful thing called dividends, which a successful business can pay to its owners. Dixon doesn't seem to know anything about that however, as his assumed scenarios require the big exit and ignore any other possibilities.

If you take $250k, and you build a $10 or $20 million valuation business, it's not difficult to kick off a very nice dividend to the investor that provides a stellar return on their capital. AND if you ever choose to sell, said investor also gets their big exit as well. You can also buy their stock back at the higher valuation and they get their exit that way. These types of results are common in the real economy, but not so common in the fantasy dotcom economy.

il2• 14 years ago

I doubt a business going from 0 to $20M in <5 years while paying out millions in dividends along the way is common anywhere. You have to remember that for investors it's all about IRR. That kind of IRR on the 1 out of 10 investments that gets to that level isn't interesting to any real investor. Your focus on profit and dividends is misguided. Taking money out of a company in its early stages is a suboptimal strategy for value creation.

I rewrote my comment several times to make it less rude, but your advice is completely wrong and I hope nobody seeking investment follows it.

rdl• 14 years ago

Is IRR really the thing VCs are trying to optimize? Since they're once and done with the money, and have limited bandwidth (board seat capacity), I think total returns are their goal -- they'd rather have their $500mm fund make $2b investing 100% vs. have their $500mm fund invest only $250mm total in its lifetime and make $1.5b.

geoffschmidt2• 14 years ago

Chris is not talking about this. He's talking about venture capital, where (1) you typically need to raise at least $2M (otherwise the firm can't justify the board seat), (2) the money for the investment came from a venture fund that was raised from limited partners, and the fund's lifecycle is structured such that the investments need to see liquidity within 5-10 years.

As for angel investors, the angel deals you hear about on HN and TechCrunch work differently from what you're talking about. They don't buy common stock and they wouldn't receive dividends even if you paid them. Instead the angels receive a debt instrument that turns into series A preferred stock once you raise venture capital. If you fail to raise venture capital, the angel writes off the investment as bad debt and walks away. Historically these deals wouldn't even fix a value on the company, though the conversion caps that are now in vogue are effectively valuations.

One reason it's done this way is that just the legal fees for issuing series A preferred stock easily run to $50-75k. That money is spent drafting the protective provisions that make the stock "series A preferred" rather than "common". Another is that, historically, angels have found that the big wins are so big that they make the rest of the portfolio irrelevant.

So sure, if you can find an angel that will buy $250k of common stock in a tech company that has no chance of a big upside, go for it, but I think you're going to be looking for a long time. Of course you're right that many businesses are financed through small common stock deals, but these are more often small businesses like your local restaurant or auto mechanic, where the business model is well understood but there is no chance for this 10x return on capital you mentioned, and the money usually comes from friends and family, not from professional investors.

geoffschmidt2• 14 years ago

More succinctly, if you're able to build a $20M business on a $250k investment, the money to build the business came from your customers -- you've used customer financing, which Chris described in his blog post as the most desirable form of financing.

gruseom• 14 years ago

This comment is an exemplar of how not to behave on HN.

It is as insulting ("dotcom fantasy land"? "Dixon doesn't seem to know anything"?) as it is wrong: Chris's post is explicitly about "the VC model" as opposed to "investors who are less aggressive about returns". Since he's recommending that fewer startups pursue that model, you could hardly have missed his point more completely.

But it's the tone that is inappropriate, that sharp-elbowed nastiness that strives to pack something mean in every phrase. I know it feels good to write this way; I've done my share. But it really is like peeing in the swimming pool, and not underwater either.

brudgers• 14 years ago

"There are lots of tech companies that are very successful but don’t fit the VC model. If they don’t raise VC, the founders can make money, create jobs, and work on something they love."

e.g. Microsoft

Shoehorning startups into the VC model

Related Stories