Fundraising

Why Your Startup Should Consider Alternatives to VC Funding

Share this article!
TwitterLinkedInFacebookPocketBufferEmail

A lot of companies get VC funding without truly considering their other options. Founders need to consider the tradeoffs they’re making — before defaulting to “venture”.

I just left my first startup, Moz, after 17 years of building it. That’s pretty much my whole adult life. Many entrepreneurs think that they can take a stab at this every two or three years, which is certainly true in some cases. But it’s also true that you can find yourself having a life that’s basically consumed by this one experience.

Before I started Moz, I wish someone had explained to me the mathematics and the statistics of how venture capital backed companies survive, how the outcome works, and the ways your options are limited by accepting investor money.

I’ve come to the conclusion there aren’t a lot of tortoises beating hares in the venture capital world, but there can be. That’s something that I never understood until it was too late.

The venture model is misrepresented

The numbers don’t lie, but the stats still aren’t stressed enough. A few big ones:

Every entrepreneur who raises venture capital thinks they’re the exception, not the rule. They go, “Yeah, I’m going to be that 1 in 10.” Of course, investors encourage that. They say “yeah, you are, buddy, come with us! We got you! We’ll get you there.”

It makes sense for a venture capitalist to focus on the low-probability, high-reward outcomes. They know statistically that most of you will fail and it will not be a good experience for you, but they’re very comfortable with that. Because it’s not their life. They all take August and December off every year, and they make a bunch of money on the carry. This is not to malign them — it’s their model, which they are often quite open about.

But it’s really different when you are the risk taker versus the person going out and finding a few hundred risk takers. You are one of 200 to 500 founders in your investor’s portfolio, and they certainly want you to be focused on the light at the end of the tunnel.

VC backing makes a startup grossly inefficient

Even founders who’ve been very successful would tell you a similar story: an infusion of capital came in, it was a lot more than they even really needed at the time, and they felt pressure to spend it quickly.

Don’t get me wrong – it’s smart in many ways. You want to raise more than you think you’re going to need – especially if the cost of capital is low, which it is right now, because there’s not a lot of other opportunities for good returns in markets.

The only problem? When you put that capital to use quickly, you generally are both inefficient and often have poor return on that investment. As a result, burn rate goes way up but doesn’t close the gap with profitable earnings. And thus, in order to survive, you either need to raise a lot more money or you need to cut your team and your projects significantly.

Oftentimes when you start pouring money into a channel, even if it’s been successful in the past, you eventually reach a point of diminishing returns. When you’re in a growth-at-all-costs mindset, you feel pressure to dump more money into the same channels that have worked up to that point.

These concepts are not very well understood by both founders and investors. But certainly as a result, you get a bunch of companies that run out of money and need to raise more capital. In my opinion, it kills a lot of companies that could have stayed smaller to have a shot at slowly growing into bigger, successful companies in the long term. But they’re killed because they can’t survive that process.

VC funding isn’t necessary, contrary to popular belief

Many companies in the past 100 years have executed on tremendously exciting ideas that didn’t require venture capital. In addition to that, many companies  have raised venture capital and been extraordinarily successful without using the VC money that they took.

But this reality runs counter to the Silicon Valley narrative that you have to raise money if you want to be a successful tech company.

One of the most famous examples was eBay, who never used the venture rounds that they raised. They just grew and were so successful that the money sat in the bank. Google was a similar story, where they didn’t need all the cash they raised.

There are a very small, limited number of companies for whom that model works well and makes sense. For these companies, it’s a reasonable bet for VCs to make. But I think for every one where that’s a good move, there’s probably 50 or 100 where that’s a big mistake.

Instead, a better alternative is to find slow, long-term profitable channels of investment, and only putting capital towards them once you’ve proved out that ROI. And even once you prove ROI, be cautious about growing due to the diminishing returns discussed above.

Profitable companies are built to last

When you have that focus on pure growth rate as the True North, you ignore efficiencies that could get you greater profit. You ignore efficiencies that could make you a better, healthier company, able to withstand downturns in the market, changes in demand, shifts in the model, or competition.

In the high-growth model where you build a sales and marketing machine that demands an incredibly high amount of outside capital to get going, you essentially place a very pure bet on exactly what you are doing or moving toward in this one particular direction. And that’s a dangerous thing.

You’re putting all your eggs in that particular basket, and as a result, you’re going to have to face the consequences of any failure to hit those numbers. Things like significant layoffs and cost cutting measures that can be very stifling: challenging for teams, emotional for people, and very harmful to company reputations. When you have a focus on profit, you build companies that are structured to last for a long time.

The myth persists because VC-backed startups are glorified

Despite the data about venture-backed performance and many examples of successful companies that went another route, why do so many founders feel compelled to become venture funded? I think the answer is quite simple: the culture of glorifying VC-backed startups.

It’s as simple as that. The press, media, the startup world, investors, entrepreneurs, employees, friends and family members — everyone in this ecosystem incorrectly glorifies the process of raising money.

Just think of how many congratulations happen when you launch a successful product that serves a nice audience, that makes your company profitable — returning millions of dollars to you and your employees for years to come. No one applauds that, No one writes about it. No one tweets about it. No one gives a shit about it, very frankly.

Of course, you do, because you’ve just been hugely more successful than 99% of venture backed investments. But go out and raise a seed round of $1.2 million and the congratulations will be nonstop! It will be like a train running through town shouting your name. Everybody onboard just cheering for you, and that includes mainstream media, blogs, social media, all your friends, and everyone else in the startup world.

You suddenly become exciting and an interesting company, and now you’re worthy of praise. The million dollars in profit you made last year? Who cares! The $1.1 million you raised in venture funding — amazing! That is the culture I’m talking about, and I think that’s exactly why we have the bias that we have.

Decide what you want before becoming venture-backed

My biggest issue with companies going the venture route is that they don’t know what they’re signing up for. Here are three points I’d urge founders to consider before taking VC money.

1. Accept the risk

The first thing I would urge you to do is determine that that is what you want. Look at the risk profiles, look at the stats for survivability of, for example, a consulting business versus a new product business, versus a venture backed product business. And you will see that the day you raise venture is the day that your likelihood of lasting for five years drops from about 50% to under 10%.

You have to be comfortable with that, and be willing to say, “I am okay with the fact that I just went from a good chance of this company lasting for five years or more, to a very low chance.”

2. Accept the strings

I think the second thing that you should ask is, are you comfortable with the strings that are attached to that funding? Meaning that this company could be extraordinarily successful, and in half or more of the scenarios, your personal financial benefit will be very low or none. There’s a strong likelihood that you will be pushed out of the startup, or you’ll be a shareholder but your shares won’t be worth anything in an eventual sale. You will likely be asked to take an under market salary because of the potential of your stock and stock options.

You need to accept those strings and know that you are entering that risk scenario.

3. Accept the limited number of exit options

When you run a venture-backed company, your exit opportunities go from nearly unlimited — you can do anything you want with the company, it’s your company! — to three.

There’s dozens, if not hundreds of different ways that you could choose to run an exit from a business, but when you accept VC money, you only get three ways: You go public, you sell, or you die. If you’re willing to take all those other options off the table and you’re comfortable with the odds, then I think it makes sense to incorporate venture into your business.

Unfortunately, people often start in the reverse manner: Could we think of a way to apply millions of dollars to solve this problem? Most of us can think of a way that millions of dollars can be put to use in order to grow a company with brute-force. Whether that’s right or not is tough to say, but I worry when that choice becomes the default.

We need more middleground (which I’m exploring at Sparktoro)

Entrepreneurship comes in all different shades and styles, but right now we have models for only the two extreme ends. One is you’re going to be a moonshot or die, and so you should raise venture. And the other is 100% bootstrapped.

At my new company, Sparktoro, we wanted the advantage of raising capital without the disadvantage of limiting our options for growth and exits. The model we landed on preserves optionality on both counts.

Our structure allows investors to benefit as the company grows and to be rewarded for the slower, more profitable growth model of the company.

If we choose to aim for that rocket ship growth — tens or hundreds of millions in revenue —  our investors will benefit just as much, if not more, than they would from a traditional angel-style venture deal. But SparkToro could also be a $3 to $5 million a year business, and our investors would still see a significantly better return than if they put their money into a traditional convertible note.

Our model would not work if you have LPs that need to allocate a billion dollars. But for a lot of companies and for a lot of types of investors, I think there should be more flexibility in the field and I think there’s a lot more ways to make money than people are currently taking advantage of.

We open-sourced our funding documents, including the term sheet, investor prospectus, LLC agreement, and Class A Unit Purchase Agreement. You can find them here, and read my post on the SparkToro blog about our funding round. Our investor, Chris Savage, founder of Wistia, wrote eloquently about why early-stage investors should also bias to this model.

Conclusion

I know I sound like I’m so negative on venture. I’m not. A lot of venture capitalists make these same points – publicly on stages, and when they meet founders. It’s just a lot of us don’t internalize it. The culture of glorification, which many venture capitalists do participate in, also plays a problematic role.

But I think if you are okay with all these things, it is wonderful that venture exists. It’s a great asset class for people who embrace high risk, are comfortable with the fact that you can be forced out, and accept the relatively low odds.

In that case, venture’s a wonderful thing. But the problem is, I don’t think that that calculus is done well enough most of the time.

If common wisdom and the general populace says one thing, you should absolutely question that prevailing wisdom. There’s no harm, and there’s almost always great benefit, in asking why. “Why does the model always work this way? Why can’t there be anything else? Why isn’t there anything else?”

Generally speaking, you’ll see returns on those questions.

Image Source

Share this article!
TwitterLinkedInFacebookPocketBufferEmail
mm

Rand Fishkin is the founder of SparkToro and was previously cofounder of Moz and Inbound.org. He’s dedicated his professional life to helping people do better marketing through the Whiteboard Friday video series, his blog, and his book, Lost and Founder: A Painfully Honest Field Guide to the Startup World. When Rand’s not working, he’s most likely to be in the company of his partner in marriage and (mostly petty) crime, author Geraldine DeRuiter.

Published In

Fundraising

Everything you need to know about early stage fundraising from our unique perspective helping our clients close deals everyday.

Browse all 13 Articles

Up Next