Reasons Not To Raise Venture Capital

http://modelviewculture.com/pieces/five-reasons-not-to-raise-venture-capital

by aaronbrethorst • 12 years ago

327 85 12 years ago

andrewchoi7• 12 years ago

Just some examination of the math:

If the VC firm is taking 15% of your company for $15m, then you've got a valuation of $100m. As far as I know, the "We all know that nine out of ten startups fail" applies to all startups, not the ones that are being valued at $100m. Also, I think very few VCs are investing $15m into a company that they expect to have a 90% chance of failure. You're looking at more of a 3-5x on some of the deals to carry the consistent 1-2x that the rest of the portfolio is returning.

I don't disagree with a lot of the points in the article, but saying that a VC firm with a $150m fund is betting the farm on one $15m investment exiting at $3bn should raise some eyebrows.

pgeorgi• 12 years ago

So the numbers are simplified to make it easy to follow the general point. If they line up _that_ neatly, they usually are.

andrewchoi7• 12 years ago

What I'm saying is that there are very few VCs that are hoping for a 30x on one investment to make up for 9 failures. It's an order of magnitude difference, which I think is nontrivial.

If it was a general point, it would have been fine, but the difference between a $100m --> $300m company and a $100m --> $3000m company are huge.

phillmv2• 12 years ago

The way I interpreted it was more, failure in VC terms is "not blowing up".

That $15 mil investment might be acquihired, or continue to be unexcitingly profitable, or put up on the chopping block for its patent portfolio. They might not even lose money, but.

Also keep in mind that VC funds as an asset class are historically a bad investment: http://www.slate.com/blogs/moneybox/2012/05/07/most_venture_... http://avc.com/2013/02/venture-capital-returns/

It's not just that the VC expects the average startup to fail; it's also expected that the average VC fails - or at least underperforms the S&P500.

andrewchoi7• 12 years ago

I agree, especially in light of the preference structures that she mentions (and that I believe are industry-standard). But these arguments seem to lead to the conclusion that you shouldn't be an LP, not that you shouldn't take venture money. The only way that this becomes an issue is if the VC has enough of a stake to run their own decision making and executing process, and that (as I understand it) is the line between VC and PE.

scootklein2• 12 years ago

Just looking at YCs returns, the vast majority of the wealth appears to be concentrated into 3 of 600+ starts (Dropbox, AirBnB, and Stripe). Even a Heroku sale for 200M+ is a drop in the bucket compared to $10B private market valuation, say it out loud and it will sound weird. "Dropbox is worth 50 Herokus"

Betting the farm implies that they have no other options, which is not the case with VCs, and it's impossible to know which will be their "super unicorns" when they write the checks, so they write lots of checks.

There's not much reason to believe YC is unlike other angel groups, individuals, or VC firms, and their data should back up that the majority of their returns is 1 or 2 companies every so often with huge wins.

andrewchoi7• 12 years ago

The difference is that YC isn't investing $15m into companies, they're investing $20k. The corresponding valuations for the companies that they invest in is $1m on the high end (20k / 2%), not $100m. The risk profile for different check sizes is vastly different.

exelius6• 12 years ago

YC is seed stage; you expect a higher failure rate and higher returns from your successes.

Basically, you can break VC firms down into categories based on the size and timing of their investment. Typically you have the following:

* Seed / angel funds. <$1M investment, 90-99% failure rate (failure rate is higher the less you invest). Astronomical returns because they buy equity when it is at its cheapest; a "home run" here can net you several thousand times your initial investment. Your founders are often very raw and you have to work with them on basic business fundamentals.

* Series A funds. ~$1-3M investment, 70-90% failure rate (though this is dropping as more funds move from Series A to seed funding.) Probably the riskiest of the bunch since you're placing pretty big bets on a lot of companies; this is typically what people think of when they think "VC". Returns for a "home run" are 10-100x initial investment. Your founders think they know what they're doing but they don't; good VCs will help the founders through their network and by letting them make enough mistakes to learn from.

* Growth funds. $10-25M investment, 50% failure rate. These guys go after companies that have proven a market exists and there's an opportunity for huge growth if only they can scale. Still risky because scaling a business is hard. Returns for a "home run" are closer to 10x, but these guys can pull their funding if things are starting to circle the drain so a "failure" doesn't always mean a loss. Good founders here are starting to realize they are in way over their head and ask their VCs for help.

* Pre-IPO funds. $25M+ investment, very low failure rate. Returns are relatively low but also much safer: investors here are basically funding you pending an inevitable IPO. This is basically your traditional private equity firms at this point. Founders here need guidance on how to take their company public (legal, cultural, etc.) -- hence why PE guys who are often ex-investment bankers play in this space.

exelius6• 12 years ago

Partially true; practically not.

Most VC funds do have exit dates and specific life spans (typically 7-10 years). The way it was explained to me that if you have 10 companies in your portfolio, by year 7 you will have:

* 3 total busts. Out of business; zero return on investment.

* 4 "walking dead". Still in business, but just barely breaking even. Might as well be zero return because these investments are not liquid (who wants to buy a 7-year-old risky business with no profit?) Anymore these end up as acqui-hires with the VC getting pennies on the dollar.

* 2 minor successes. Good, profitable companies that will probably never produce a hockey-stick graph. 2x-3x return.

* 1 home run. If you're lucky. 10x return (though usually closer to 5x).

Her example was bad, but it was just an example. VC is a tough industry to actually make any money in. VCs don't pressure founders to do things because they are greedy, it's because they're scared of losing their shirts.

wpietri3• 12 years ago

Some actual numbers from Fred Wilson are here: http://www.usv.com/posts/why-early-stage-venture-investments...

He makes the interesting point that 2/3rds of his successful investments made major changes along the way.

eloisant• 12 years ago

Maybe the numbers could have been better chosen, but the message is correct: when you raise money, you're raising the bar for what will be called success.

This is especially important now that infrastructure is close to free, it's easier now to bootstrap your company or even start it as a week-end hobby. That wasn't true in the 90s or early 2000s when you had to buy costly servers and hosting just to get started.

So it is very important to know what your goal is. You want to get a slight chance to be the next Google or Facebook? You'd better raise money. You want to build a sustainable company for you and a small number of employees? Maybe raising is not the best thing to do.

mandlar• 12 years ago

Mirror: http://webcache.googleusercontent.com/search?q=cache:http://...

bishnu• 12 years ago

I found the comments about the derision of lifestyle businesses interesting, particularly in light of some of the consternation around the Tarsnap price cut [0]:

[0] https://news.ycombinator.com/item?id=7523953

danielweber2• 12 years ago

There's a world of difference between, at one end, taking VC that puts you on a rocket ride of "get rich or die"; or, at the other end, not taking any money at all so that you cannot hire even 1 engineer to help you making the essential backup service into something that's one bus away from losing all my data.

ChuckMcM• 12 years ago

You just need this sentence:

"VCs aren’t unintelligent. Nor are VCs evil (not all of them anyway). They’re not even necessarily misaligned with you. What they are doing is optimizing for a very specific outcome. Share that alignment, or don’t take their money."

If you understand what the VC wants and you want that too, then you are aligned. If you don't then you are making a mistake.

crusso• 12 years ago

Good advice that most founders who are offered $$$$$$ will ignore without the barest of a thought.

jfoster4• 12 years ago

That almost gets you there, but founders who misunderstand what VCs want will still take the investment. That sounds like a nitpick, except that, in my experience, lots of entrepreneurs misunderstand what VCs want, thinking that 7 - 8 digit exits are what VCs aim for.

blinduck• 12 years ago

I'm very curious. What is it you believe VCs aim for?

tlogan• 12 years ago

But there is one important reason why to get VC money: if you have business model working, VC money will help you (or it is necessary) to hire more people and generate more revenue.

Now, of course VCs want great returns but they are also ok with ok returns.

autarch• 12 years ago

But did you see the bit about preferred investment shares? An "ok" return may be ok for the VC, but it could leave the founders and options-holding employees with very little (or nothing).

Contrast this to a bootstrapped company. In that case, an "ok" return can be pretty good. If you're bootstrapped and you own 40% of the company, a $5 million sale is pretty great.

chiph• 12 years ago

Investors sometimes say mean things about these “lifestyle businesses” but you don’t have to care what investors think.

There's nothing wrong with a lifestyle business, as long as it's run like a business. There can be decent exits (purchases by competitors, private equity, etc). But the employees seldom see a big payoff. In return, you usually get a pretty comfortable work experience.

watwut• 12 years ago

Employees seldom see a big payoff. Period.

Startups trade salary and benefits now for maybe huge payoff later. The maybe in previous sentence is important, most startups fail.

Some business are build to stay there, grow and earn enough for founders to make them upper middle class/rich for the rest of their lives. It is different then Facebook like success, but most would count that as successful too.

danieltillett9• 12 years ago

I have often thought that it would make sense for employees of different companies to pool any equity. You already take on enough risk being employed by a startup business without adding on your equity risk too.

exelius6• 12 years ago

I feel it's a good lesson that people new to the industry often learn. And working for a startup is a lot of fun; you get to wear a lot of hats and a 23 year old software developer gets way more responsibility at a startup than they would working at Microsoft or Google.

If you're fresh out of college, what do you have to lose? You either get underpaid for a few years and learn some valuable lessons (one of which being equity in a startup has a value close to zero) or you get lucky and can retire before you're 30.

rhizome2• 12 years ago

Employees seldom see a big payoff. Period.

You know what I've never heard of being tried? Creating a private business with big enough margins so that the office manager is paid $200K.

at-fates-hands• 12 years ago

>>> Employees seldom see a big payoff. Period.

Great point.

The best example of this is when RIM was sued by Minformation. After several offers by RIM to settle for around 60-70 million, one of the RIM attorneys said, "I have no idea why they won't accept our offer. You could give every employee of the company $5 million with what we're offering."

When they finally won (and then lost) that $147 million dollar settlement, how much you think the employees saw of it??

georgemcbay• 12 years ago

"Employees seldom see a big payoff. Period."

Yeah this is an obvious but oft-overlooked fact. As a VC you can manage the high rate of failure of startups by investing in many of them simultaneously.. that's what the whole model is based on.

As an employee, not so much, you're probably doing 2 fulltime jobs worth of work for one single company very likely to fail.

This is why working for shitty pay in return for non-founder equity is a very -EV financial move (I'll allow that maybe it makes sense for some people as a learning experience or whatever). And this is without even getting into the fact that your company could have a very successful exit and your equity could still evaporate due to dilution or outright clawback of options (ala Zynga's pre-IPO moves), or any number of dick moves from the founders/investors.

jroseattle• 12 years ago

"Employees seldom see a big payoff. Period."

I believe this, coupled with demand, is what is driving the cost of engineer salaries in the market today. Equity allocations mean almost nothing to candidates -- as they should.

That doesn't mean you get a pass on offering equity; you just have to match it with a market salary.

danieltillett9• 12 years ago

There is the issue of control. Not having external investors means you can do what you want with the business. The value of this freedom is worth a lot to the business owner.

foxylad• 12 years ago

This is the big reason for me. I've built my business on my values, and it is incredibly satisfying to see it succeed against competitors with different values.

inthewoods2• 12 years ago

Another problem with raising money: if you raise early, you probably don't yet know if you have a VC-appropriate business or a lifestyle business. If you turn out to have a lifestyle business and you've raised VC, it is amazingly depressing - as in, "I'd love this business if I owned all of it and I'd be happy with a small exit".

throwaway212• 12 years ago

I don't know much about VC, but these sorts of claims are always surprising to me. Is it really moonshots or bust when you raise a VC round?

Even with a 2x liquidity preference, don't you just need to double the invested amount in order to have personally broken even on the VC deal?

Say you have a $10M business (pre-money), and you raise $5m at a 2x liquidity preference, giving up 50% of the company in the process. That would leave you with a $15M post-money valuation. So long as you can use that $5M to turn you from a $15M business into a $20M business, didn't you just break even on the deal?

I'm know it's not an outcome that the VC is looking for, but it would seem to be a fine outcome from the founder's perspective.

danieltillett9• 12 years ago

The most interesting section of this article is the very appropriately named section "venture math is a harsh mistress". Out of the 1000 companies 188 were acquired, 28 went bust big time, 8 went public, leaving 80% unaccounted for. What are all these companies doing?

newaccountfool• 12 years ago

In my opinion its a no brainer to accept the money, some group is giving you $$$ for you to do what you want to do, and if you fail ther's no real downfall, you just go back to doing what you did before.

onezerozeroone• 12 years ago

Until you get into the board meeting and realize you don't get to just do whatever you want to do while telling everyone what is best. If you go cowboy, you better make sure it 100% pays off, otherwise your time to failure is going to be quite short. At best you don't get more funding, at worst you get yourself blacklisted.

danielweber2• 12 years ago

Worst outcome: just slogging along, not good enough to exit but not bad enough to kill so people can get on with their lives.

nmjohn• 12 years ago

That's not all bad though, assuming you are successful enough to be pulling in an equivalent salary to what you could make elsewhere.

danieltillett9• 12 years ago

Yes for normal companies this is fine, but for VC companies? How long do VCs let companies slog along before the pull the pin? It would seem not that often.

j45• 12 years ago

I heard an interesting explanation a while back ago about not seeking venture capital, and instead seeking an investor.

Investors are more committed and interested (by the explainer) to the entrepreneur instead of looking for deal flow and exits above all else (which I guess most VCs are more interested in)

mindcrime• 12 years ago

The other issue that didn't come out here, is that venture funds are time limited by definition. So it's not just that the VC fund wants their portfolio company to have a big exit, but they want them to have a big exit in a specific timeframe.

This is one thing I like about bootstrapping... the timeframe goals are down to a combination of what me and my co-founders want, influenced by competitive issues. But, as it stands, our burn rate is low enough that our "runway" is, essentially, infinite. Except that's not completely true since we don't live in a static ecosystem. Other companies are out there advancing tech and making moves of their own.

But still, I generally like not being bound to a VC and having to deal with the whole misalignment of objectives issues. We may still raise VC money at some point, but it'll be if/when conditions clearly mandate it - it's not something we'd do "just because that's what startups do".

Gustomaximus• 12 years ago

I've seen this time issue with a couple of companies. There hits a point when the VC wants to exit so they start pushing to shut down areas of a business that have future potential to maximise the expense/revenue/profit ratios within their short planned exit window.

redguava• 12 years ago

An article on reasons to raise venture capital would be more appropriate. The default should be bootstrapping.

wpietri3• 12 years ago

Oh, the article's definitely appropriate, because right now there are a lot of people for whom raising money is basically the point.

I mentor sometimes at startup events, and there's a big difference between the people there to build a business and the people who have been freebasing startup propaganda. I never thought I'd be nostalgic for the post-bubble period when startups were unfashionable.

EGreg• 12 years ago

It's interesting how things work out. Since we didn't have the connections at first, we wound up getting our company to the point where we don't NEED venture capital to get to where we want to go. We can get there organically. If we take VC, it will be for a land grab and massive acceleration. So in some ways, things work out just the way they should if you don't go out of your way to chase people.

Kind of like how you get married to the right person if you just keep being yourself.

cjf4• 12 years ago

It baffles me that more startups don't have this approach. If you're going to take VC, you'd damn well be targeted and have a specific idea of how your going to use it to grow your business.

mccloy• 12 years ago

"2. Raising venture capital doesn’t make you a good person." Is there anyone out there trying to raise money because they think it'll make them a good person?

velik_m• 12 years ago

I think that would be probably better put as "Not raising venture capital doesn't make you a bad person", but that doesn't sound quite as good.

Im_Talking• 12 years ago

... because equity is gold.

graycat• 12 years ago

The main problem with the OP is that it was looking at broad averages while necessarily venture capital and ambitious start ups need to be quite exceptional. The broad averages say next to nothing about the exceptional cases. In particular, the probability of being exceptional is just irrelevant. Instead, what is just crucial is the conditional probability of being exceptional given the details of the specific project. So, it's just crucial to consider the details of a particular project.

A sad part about venture capital is that it is looking for exceptional projects, necessarily ones that will in effect push forward the boundary of computing in our civilization, and doing so with in nearly all cases very poor qualifications in doing or evaluating such projects.

And venture capital has another problem: Too few projects on the other side of the table have much potential of such pushing the boundary.

For all concerned, only a tiny fraction of the venture general partners have any hope at all of evaluating projects that push the boundary.

We should be making much faster progress.

bsaul• 12 years ago

Wonder if any VC would refuse to invest money in a very promising startup after realizing the funders are not "aligned" with the VC goals ( providing the money would give a certain amount of control of course ).

We put the blame on funders for accepting, but maybe offering is to be considered as well.

pushkargaikwad2• 12 years ago

This is what I have learnt from my experience and what I have seen in Indian startup ecosystem

1. VC making money, Company making money and Founders making money are three different things. Don't get confused between them. Most often, the founder get the leftover, with big exit, it can be huge amount but not for everyone.

2. VCs are there to make money. That's it. That is there ONLY goal. Anyone VC firm who is saying that they are behind entrepreneurs, they are NOT. They are only after money and the entrepreneur is between them and money. So if your goal is same as their's, start chasing money.

3. You will lose your freedom for ever once you raise VC money and along with it, your choices.

Reasons Not To Raise Venture Capital

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