Reasons Not To Raise Venture Capital
modelviewculture.com
modelviewculture.com
"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.
I'm not a VC, but if $5MM (7-digits) is raised and the exit is only $20MM (8-digits), that's an okay return, but it's probably not what the people who put money in were hoping for. 4x seems good until you consider the tremendous risk the investors exposed themselves to.
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.
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.
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.
I have a very limited understanding, but the impression I got is that VCs typically have short maturity dates and thus are riskier in nature, whereas PE funds typically have the luxury of biding their time. How this is structured, or why exactly is beyond my ken.
So upside being, VCs are incentivized to encourage larger risk taking than what would be otherwise optimal from the perspective of a bootstrapped founder.
The bootstrapped founder, on the other hand, doesn't necessarily need to exit the investment in those 8-10 (or shorter) years. There are, of course, serial entrepreneurs for whom that is their goal, and for them (as the article points out) their incentives are aligned. For "lifestyle company" founders (not meant to be disparaging), an exit may not be necessary at all. The key differences are time horizon and exit.
The most typical arrangement is 20% after 1x in LP distributions, with some variation in what are called hurdle rates (that is, different percent carried interest at different multiples or IRRs).
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.
Consider a "soft landing" (VC gets their money back), vs complete death (VC gets no money back). When put alongside a $3B acquisition they're both completely irrelevant, even if on paper the 1x money back is not considered a "failure".
Check size doesn't appear to matter, the data for YC and for VC that I've seen suggests a similar power-law-ish distribution of returns.
I would say that the risk profile is not irrelevant: if you're betting that 1/10 of your investments are returning your fund, then just one miss is the difference between a good year and "I don't have a VC firm anymore". Compare that to betting that half of your investments are returning your fund: one miss is the difference between a good year and an "ehh" year.[0]
That's true; when you compare both of them to a 30x, the difference between a 1x and 0x is small. But what I'm saying is that at a $15m investment, very few VCs expect to see a 30x, and when you compare it vs. a 3x or a 5x acquisition, the difference between no money back and your 1x liquidation pref paying out is much larger, proportionally.
The same power law may apply, but you see more of the tails in when you have a much larger sample size. If there were just as many $15m investments happening as $20k investments, you'd see the same result, but there aren't.
Off-topic: are you the same Scott Klein I talked to over the summer re: statuspage.io?
[0] Of course, that glosses over different probabilities of success and failure, but what I'm trying to say is that VCs are risk averse.
To add to this, the top 10 VC firms make up around 85% of all of the returns of VC firms combined, and the top 15 VC firms make up around 95%. (don't quote me on those specific numbers, but I believe they are roughly accurate based on a report from a16z).
Long story short - very very few VC funds see worthwhile returns. The one's that do are absolutely killing it.
It can't be based on pure charity because that's not a sustainable model, so there's got to be an equity component. But I suspect YC barely breaks even.
Regardless, the way VC measures returns is typically at between 70% and 100% of the life of the fund. If after 7 years, you're getting 1x your money back, that's a pretty big loss considering you could have just put it in an S&P index fund and earned ~7%. Even a 2x return after 10 years isn't that great; you're looking at an equivalent annual interest rate of ~7%. Things don't even get interesting till you start talking 5x or more (~17%). The time component of the equation is very important; the only reason people invest in VC is because it has the potential to provide greater returns than other asset classes if you're patient enough to wait 10 years for the payoff.
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.
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.
He makes the interesting point that 2/3rds of his successful investments made major changes along the way.
His numbers are in a different context; but I get his point. Venture investing is a portfolio business; you fully expect a high failure rate.
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.
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.
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.
Now multiply this across dozens of companies. Plus, most startups give options, not equity unless you are a very early employee.
More seriously there is a number of ways of doing this. I would imagine the simplest would be to create a trust and have everyone give their equity and options to the trust.
The bigger issue is how to ensure that people don't game the system. The assets being put into the pool need to be accurately valued so people don't put in what they know are worthless assets. Of course there is there is the reverse situation where those already in the pool undervalue new assets.
Most of the effort of this idea needs to go into setting up the rules so that everyone does the right things and everyones interests are aligned. While I think this might be hard, I don't see anything that can't be solved by some smart people.
Don't get me wrong, it seems like an interesting idea. I would love to have some way for my un-diversified work portfolio to get diversified. But short of creating a sweat equity only market/exchange I don't really know how you'd do it.
Even that has problems because people could fake a startup well enough to gain access to the returns creating a free-rider problem. It's probably easier to cook up a bunch of buzz and interest over an orchestrated 3 month campaign (esp. with a Kickstarter) than to actually do a startup. And since you're faking it you can promise the world and raise huge money from unsuspecting dupes with no intention of (much less a plausible method for) making good on your promises.
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.
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.
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??
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.
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.
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.
My understanding is that even if you take less, so that investors don't have outright controll, VCs will have incentive and substantial power to push small wins toward becoming either big wins or big failures. And they begin that push early, so that it's easy for VC-funded startups to end up in a grow-or-die situation, even if they theoretically might have taken a different path.
Note that there's some selection bias involved. If a VC thinks that the business is only going to be a $20m business, they won't invest. They also won't invest if the founders seem like the kind of people who will stop early. They're in the business of finding 10:1 odds on 100:1 money.
As an aside, it's a little dangerous to do valuation math like that. The valuations at A-round levels are highly speculative. If you take your $10m company and add $5m in cash, in theory it's a $15m company. But it's mainly fantasy. It's very different than a $15m operating business whose valuation is based on revenues and profits.
Your numbers are a bit off compared with what I'm thinking as well - "say you have a $10m business" - that misses the point - he starts the business and there is little to no revenue. He raises a bunch of money but doesn't know if he can create a business that can get bought for $20m. He takes the money and then discovers he has a nice $2m business - but he can't scale it anymore. Because he doesn't have a great growth plan, no one is buying him out for 10x revenue. Thus he's a bit stuck.
The worst part about it - if the company exits at a low value, it's likely to be classed as a 'failure' - even if it is profitable and has happy customers.
It's impossible to know in advance which companies will only scale to a certain size - hence the problem.
I guess the solution is to only take on money when you can show that you have a scalable business that just needs more investment to fly higher.
The Limited Partners could force the dissolution of the fund after ten years--the remaining assets, including any private company stock, would be distributed to the LPs--but they generally don't want to deal with direct ownership of the equity of a company going sideways. VCs are usually better at finding creative ways to sell their piece of a business for some small amount of money, so they would rather the VC take the responsibility for it.
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".
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.
Now, of course VCs want great returns but they are also ok with ok returns.
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.
Kind of like how you get married to the right person if you just keep being yourself.
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.
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.
We put the blame on funders for accepting, but maybe offering is to be considered as well.
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)