The Fatal Pinch
paulgraham.com
paulgraham.com
I once saw one of my best friends fail his first startup. They had a kickass programming team, received investment and did a bunch of things wrong.
1) Spent the whole investment on Founders salaries. They had 4 tech programmers (top notch guys), and used the money to pay for their time whilst they were building the platform.
2) They had the wrong product market fit. They expected to sell their services to Universities for 50K. In my opinion, they should of targeted college students, and add a tutoring service and take a small commission.
3) They built a fully finished product. Their was no room to scale it or grow.
4) They expected that the product would just sell itself. We all know, that's not how it works in the real world.
5) They didn't do any market testing and validation = wrong product market fit.
The end result, they got an investment and spent it quickly, they didn't try to pivot, tried to get another investment and failed. The team broke up pretty quick, or as you referred to in your article, they got an unwelcoming 'pinch' on the backside.
I learnt a lot from seeing my friends fail, and their failure has helped me out a lot with my startups. When startups first get their investment, they should have a 1-2 year plan for that money (burn rate). Divide the investment by a specific time period and that's how you spend it.
Realistically, after you get through the TechCrunch 'trough of sorrow' as Andrew Chen puts it, you have to stay motivated and plan for the future. The future looks dim if your startup is heavily reliant on receiving additional investments to keep you alive.
More on the pinch, startups shouldn't be getting an investment to keep them going. They should have this already sorted out. A very wise person once told me, you should seek investments when you don't need them, as this means you have done your homework and can also find the best deals.
Great article, and I appreciate the awesome content.
Now they need to take the cash they saved and wisdom accumulated and bootstrap their next business up without any VC money.
One of the guys is a product manager at Google now, another moved back to his home town. Only one of them is still doing the startup thing.
They definitely got a lot of experience, this only counts if they learnt from their mistakes. Which, I really hope they did.
Nothing that you said suggests that there's something going on besides an honest rookie mistake. And if you are not willing to loose some dime because a rookie did something that in retrospective sounded stupid... well, it doesn't seem you will enjoy Venture Capitalism very much.
If and when these guys try to make a business model out of it, and there is a track of investor's money dilapidated in building technically sound products with zero market value... well, word can spread out pretty fast.
Interestingly enough, Joel Spolsky wrote about this danger in http://www.joelonsoftware.com/articles/VC.html , where he discusses the relationship between revenue, PR, fundraising, and code. Any of those can get wonky if one substantially outpaces the others.
I sell into the university system and I expect that each sale will take me at least 12 month to convert. The positive is that once you sell a university customer you rarely lose them.
That is also the reason why many colleges, or governments, end up with crapy overpriced software. You look at it and say "I can do 10x better and sell for 10x cheaper". The problem is you are not aware of the size of the iceberg lying under the water.
The big issue is, they didn't have anyone to do marketing for it or test the market to see whether it wants their service or not. They should of done a pilot system. Focused on one university in Beta mode, and then expanded. They were too fixed on selling it for 50K a piece.
>5) They didn't do any market testing and validation = wrong product market fit.
How does this happen? How do startups receive funding without doing some level of marketing testing and validation?
I ask because in Canada it seems extremely hard to get even angel funding (beyond family members) without demonstrable traction and growth. Is that not the case in the US?
Raising money is hard work, these guys got lucky in that respect. I think they made the absolute rookie mistake, afraid to talk to as they might 'steal' their idea. They thought it was a sure thing. Especially when they received the investment.
From what I know, a startup should look something like this. Build your MVP, get some traction, add on another feature, get more traction... A continually process of expanding your features and user base. Every time you add on features, you want to see growth.
The same goes for getting investment. Seed A, MVP with traction, add on a feature and go through Seed B stage etc etc. Adding on features to get more users which can lead to more investment. Investors want to see a plan for what a startup will do with that money.
Funny thing is that you got your first round of investment, before you even knew what you were building.
What?
What effect does this have on your criteria for investment? Or are you saying that raising less might in and of itself make the investment riskier by implying that they've under-estimated how much runway they might need?
I've often heard the advice that "it's not much harder to raise a million than it is to raise $250k, so you might as well raise a million" or some variation thereof. Is that true in your opinion?
Do you think the climate has changed since then to make it much harder?
An example would be that the founding team isn't skilled enough to get through the product market fit stage, so they hire in order to fill those gaps. Or maybe it's a chicken & egg problem, which often requires lots of time and luck to crack.
With the high salary requirements that engineers and designers have today, especially in Silicon Valley, this means burn-rates get very high very fast, even with only a few employees.
I remember five years ago in most cases you'd take a major salary cut (which was made up for in equity) when joining a startup as a first hire. You took a big risk to be employee number one or two. These days the landscape is so competitive you not only get equity, but a great salary as well.
I wonder if this has something to do with what you're hinting at?
I have never get investment (rarely in my country) but always thinking that I prefer a small push than a huge one.
The key is to stay very lean until you have definite product/market fit and can raise a huge growth round.
-David
I wonder this 500K benchmark is still something useful to investors in the valley. My guess would be that there end up being only a few YC companies each batch raising <500K and I doubt the amount raised ends up being a good predictor of success.
Meanwhile, entrepreneurs generally try to raise more too. Who doesn't want more cash if they can get it?
This is dangerous for those who don't understand these dynamics. The growth trajectory needs to align with the incoming cash. The second you raise a $3M seed round, you're on the roller coaster. You will need to show "hockey stick" growth in 12 months, and raise your A in 18. If not, you're dead.
0. I don't blame the VCs for doing this as they are doing what is best for them and their partners, but as a founder you should look very carefully at what is on offer and if what you are expected to do is viable.
1. Paul's point about the fatal pinch is correct, it is just that it is occurring much earlier (at the seed round) not 6 months from the money running out.
Depends how much control you have, and how resourceful you are in a pinch. If you can figure out how to stay alive until you see a different way to do things without raising more money, then you're not dead. They key is being able to bunker down without investors being able to pull the plug on you... $3m could buy a lot of bunkering time for a small team.
Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.
In a world with AWS and pay-as-you go services, it's more and more possible.
£19 19s 6d = £19.975
£20 0s 6d = £20.025Difficult to fathom why the fashion for these passed, because such systems provide so many advantages. A good example is the Spanish system of division into 34, which permits straightforward further division into not only 2 but also 17 pieces - a case very difficult to handle with the modern restrictive, awkward and inconvenient decimal systems.
negative net worth = brankrupt (misery)
It's worth noting that this is the antithesis of the stereotypical SV startup culture.
Infrstructure expenses are not what sinks most companies.
Similar to a previous comment by @LukeFitzpatrick, we built something for our alma mater that we thought we could sell to colleges for 50k/year. We got investment, we built it, we sold it to a few more schools but the software is not feature-packed and mature enough to attract sales fast enough. Higher ed also moves super slow even when you're doing well.
We're starting to see some traction with parties that want the software custom-tailored for their need (the consulting PG speaks of). But we're stuck in spot where we haven't gotten a check from any of these parties yet and are reluctant to pull the trigger and focus on only on the consultative sale.
The team, product roadmap, and marketing strategy is all geared towards higher ed. But it's clear now we can't become profitable in 6 months in that industry. How do we operationally perform the "pivot" into consulting? Do you agree it's time to do so?
p.s. I can email you if you don't want to share publicly
It's kinda shocking that PG omitted that part, because I've seen it happen several times.
(Read michealochurch's comment further down on this page, he pretty much nails it.)
[0] http://www.agence-nationale-recherche.fr/fileadmin/aap/2014/...
On one hand, you have your ideas, your product or whatever you're working on – which, by definition, isn't working all that great. On the other hand, you have a client (or more than one), who's willing to pay right now (usually you can negotiate something upfront) or at least just one invoice away. Plus you are able to charge a nice amount, certainly better than you'd make as an employee and better than going broke.
Somewhere down the line, you'll get more work. Maybe from the same client, maybe it's a referral. Do you turn them down now, that you've achieved the required runway? It's hard if you are a sole founder, it is much harder if you have more than one. Harder still if they are married, or with children or, god forbid, have a mortgage.
The consulting (there's no ish unless it is a somewhat minor customisation of an existing product or parts of it) path is a very slippery slope. It should not be taken unless the other option is death. And only after all founders are on the same page.
It's easier to set a goal when everyone is going broke, than when the money has started rolling in. There's nothing in the world that's more blinding than a bank deposit.
Except ask for their money back :)
If you think you can get away with running a sane growth company (100% Y/Y) and don't have to worry about the VCs asking for their money back, then the most rational thing to do is take the seed money and run the business as a "slow growth" business with an enormous runway. Unfortunately most VC's are aware of this and will not be too happy if you try :(
Thus they're not much of a stick. The only stick is the board voting to fire (or strongly encourage resignation of) the all or part of the founding management team, which if you're already on life support, can be a win/win: founders keep their shares, and someone potentially takes the company to profitability and exit. I can think of at least one major software IPO in the past 15 years where this made everyone (including the ousted founder) a lot of money.
If they are rare in agreements then more founders should "pivot" to a lifestyle business after raising a whole lot of cash. With a couple of million dollars in the bank you can certainly build a very nice low risk business that will provide a great income :)
So, perhaps not exactly "rare", but uncommon. And rarely used, even if included. Back in 2008ish when I was more into fundraising, I didn't see them.
Ultimately many of the good VCs would rather not "keep control" of founders. They'd rather just pass on the investments that look like they will become a big drain on VC partner time & attention in the future. A startup where there's a big power struggle over company directions and the board has to kick out the founders is far worse than not making the investment in the first place: it consumes a scarce resource (partner bandwidth) that could be much better spent searching for new opportunities. Much better to seek out founders where your goals are aligned to begin with and then trust them.
The difference in your experience and parasubvert's could be explained if the VCs you dealt with believed that your startup has a trajectory that would make it likely that it would become a lifestyle business, contrary to their interests. Then they'd want a way to claw back their capital if it looked like they would never see an exit.
My experience is from sometime ago (long before YC). Interestingly my business did pivot to being a lifestyle businesss, not out of choice, but because I could not get VC funding. My only regret is that it took my customers longer to learn about our products than they would have if I had not had to bootstrap.
So if someone starts a company that is in this category, is it just dead in the water if the founders aren't already rich/connected?
It's smart, because the discount for the follow-on was pre-negotiated, so investors get perhaps a more favorable discount if the company is a run-away success, and the entrepreneurs were able to buy peace of mind, and could count on the money regardless of macro-economic forces.
So my guess is that these founders were either already successful previously, were well connected or had already bootstrapped quite a bit of the technology that would underlie the product (ie patents, team, etc...). Any or all of that the case?
They did their research and validated the market by finding prospective customers before raising. Which is a good model to remove risk from any venture – especially one that would take many years to build.
Just out of curiosity why not just raise 2MM+? What value is there in this to the investor unless they have the ability to back out of the prenogociated follow-on? It seems like an expensive way to get no peace of mind?
Just from practice, you'll never see this from normal (professional or practiced) startup investors. Nor will you see its identical twin, the required second tranche.
Absent other advantages, you will need to get to product-market fit pretty quickly if you want to survive.
Isn't that the point of those companies though, that you aren't seeing traction for a while? It could be that PG is making the distinction implicitly between revenue/profit and traction.
So for example twitter, FB etc... were not profitable or getting revenue well after they had already amassed millions of users. If that is the case, then we aren't learning anything new and it doesn't help people who are trying to make new, hard, breakthrough technologies.
As in, the more traction you show, the harder it becomes to continue that traction, or alternatively, more traction is now expected of you. Combine this with the increasing complexity of a growing machine.
Maybe PG's analogy is that at first it starts off a pinch, but grows to be a very large guillotine until you finally can outrun it.
Is this really true? I'm very sceptical.
Does anyone have any evidence to back this up?
It may also be based on the premise that if you're doing consultingish work, you're probably not doing it for one of the top tech companies, but more likely for a smaller company that doesn't have dedicated developers.
From prior experience working at a consulting startup, this tended to be the case more often than not. Obviously, YMMV.
This also assumes your customers are the kind that pay for custom code and have coders, which obviously only applies to a subset of startups.
For instance, if you have a clever solution to sales funnel optimization, chances are that even your savviest software customers aren't in a good position to deploy strong engineers on that problem; they're too busy making the things your customer wants to sell.
This is true of a lot of business functions: marketing, sales, recruiting, integration testing, devops, project management, bug tracking, log management, reporting, email. Basically take every product anyone ever sold successfully to tech companies and there's a list of things tech companies aren't good at effectively deploying in-house talent on.
For example, have you ever seen someone statically allocate a million element array to hold ~1-2000 6-digit numbers? Did I mention the program had significant memory usage problems? Then again, after looking at that particular mass of 30-year-old goto-loving, copypasta C, maybe I should have been grateful they never once used malloc.
Plus, a lot of custom work in software is not sophisticated. Customer mainly have basic needs (from the POV of software development) but many of them, in disorder.
Working for them, is more about have patience ("pls move this 1cm to the left, not right, can you also do X?, no we decide after all don't do that" etc) than the kind of "raw skills" of a uber-developer.
There are good programmers in the enterprise (meaning, say, investment banks or large corporations or governments) but they generally fall, ambition-wise, into one of three categories:
(1) those who want to become managers or software architects (or, in finance, quants and traders) and will define and oversee work but delegate the dirty bits. This would be fixable (they could oversee a team of mediocrities, who'd be grateful just to be employed) but they generally don't have the patience for that.
(2) those who want to do highly-theoretical R&D work that doesn't necessarily solve any immediate problems of the business.
(3) those who have a specialty (say, deep neural networks) and want to be in the umbrella of a large organization that can protect it. Pull them out of their specialties and they'll try to leave.
In other words, these supposedly stodgy non-technology companies do, contrary to stereotype, have good programmers (I've worked in a few) but the ones who are at all decent have career strategies that they expect to be able to implement in their full-time work. They won't work on "just anything" and if you stick them with the random muck that comes from the line of business or zealous "product people", they'll either leave or slack in order to learn new skills on the clock, and the project will be done poorly or even abandoned mid-flight.
The appeal of the $3000-per-day consultant is that he'll work on what he's told to do and he doesn't expect you to consider his career needs. He's not going to do a shitty job and leave after 6 months because the people allocating the work don't care about his career; that's what the money (4-6x typical salary) is for. He gets his education and career advancement on his own time and dime (but earns a premium to account for his unpaid work). And while he might not be a great (2.0+) programmer, he's better than anyone in-house who could actually be assigned a bad project without political friction or high departure risk.
The average Bay Area startup programmer, like the average software consultant, isn't great; but he's far better than the corporate serfs who get sloshed around on the worst projects. He might be 1.4-1.5; so Goldman's R&D engineers and it top quant-coders will be better, but he's a relative colossus compared to the in-house peons (0.7-1.2) in back-office IT who'd get assigned to grody projects based on internal processes.
(Of course, not all the work that consultants do is undesirable. You also have the specialists and those with elite levels of skill. My point is that a "mercenary" consultant will power through the ugly projects for the pot of gold, whereas in-house people expect investment in their careers.)
In other words: yes, Goldman can hire great people. But if you want to hire someone great to do a project where 99% of the work is mediocre (and the 1% is extremely careful and requires an expert) you want the $3000/day consultant because Goldman can't get anyone good who's in-house (and not getting a consulting salary) to do the work. One might ask: why don't they pay an internal person $3000 per day, as they would a consultant? The answer is that it'd have him out-earning his boss and they'd often end up promoting someone not on traditional definitions of readiness (increasing scope, leadership) but because he took on an icky project.
The last sentence is a very important point in enterprise IT shops: Lack of self-confidence in line managers is a big disincentive to hiring smarter developers. They worry that the smart developer (who often shows up with a bit of an attitude) will overshadow the manager and our point out their weaknesses.
lol...well you just described my last contract.
And, while I do buy that all three of these developer archetypes exist in the real world, I do not buy that they are the reason that companies don't deploy talent aggressively to upgrade "support services". Rather, companies make straightforward buy-vs-build decisions based on whether projects are part of the focus of the business or not.
It does. That's not the sole reason why consultants make more, but that's a factor.
If you're a full-time employee, you expect your health insurance, HR, work supplies, 401k, office space, finding of work, and your career growth and promotion planning to be taken care of, and you're likely to leave if you're not getting it. If you're a consultant, you're taking on those responsibilities for yourself. That's a big part of why you charge a higher hourly rate. It's to include buying your own health insurance and having to manage your own career with no expectation that the people giving you work give a damn about your vector.
That's not to say that typical middle managers or companies actually care about the careers of most people under them, but they at least pretend to, and some actually do. It's part of the social contract that exists for an employee and not for a consultant. Of course, after being an employee for a while and seeing that part of the social contract ignored, many people decide that the job is too important not to do themselves and start managing their own careers... and some become consultants.
A well managed internal team could do the work at 1/3rd the cost but the work is rarely a core part of the business and no executive wants to deal with the internal headaches and risk associated with the work when it won't get them anywhere politically.
The "contracting" world is much more like what michaelochurch described. And to be fair there are a large number of individual contractors working at large firms for great daily rates (think $1000/day on the lower end) for which what he is saying is true.
http://michaelochurch.wordpress.com/2012/01/26/the-trajector...
I've never seen it used by anyone other than him either.
This is more up to date than nostrademons's link:http://michaelochurch.wordpress.com/2013/04/22/gervais-macle...
Also, from Quora: http://www.quora.com/What-do-the-top-1-of-software-engineers...
(4) Good but insecure (at least in a financial dimension) who seek the safety and anonymity of large corps and
(5) Favor 9-5, low stress, and a steady paycheck
Contrary to what is often said about middle management being hell on earth, it's not worse (on average) than being on a team, just different. You don't have to be unambitious to want a job where you primarily evaluate others' work instead of doing the work.
And what's fantastic about funded startups from the perspective of a software muggle is that not only might they have a product already in existence that you can check out and find reviews from other customers but they've also been given the stamp of approval by investors, investors who are likely far more knowledgeable than the average software consultancy customer. Just look at the Obamacare website debacle as a case in point of how incredibly difficult it is to a: find a quality development shop who can actually deliver what you want, and b: do so within reasonable budget and time constraints. And the difference between finding a good development shop and a poor one isn't merely a better quality product, it's a factor of maybe 2x or more in development time (which is, of course, tremendously valuable) and a factor of 10-100x in cost.
So, millions of sole proprietors do that.
So, maybe it's not too much to ask of venture funded entrepreneurs to do similar 'budgeting'.
Still, it can be easy for such entrepreneurs to be fooled by venture firm Web sites that emphasize that they have been in the shoes of entrepreneurs and know what they are going through, are committed to their entrepreneurs, through good times and bad, through thick and thin, etc.
Still, the the importance of planning is old: In early aviation too many smoking holes taught the possibilities of head winds, bad weather, and mechanical problems and, thus, the importance of flight planning reserve fuel, alternate destinations, at least two of radios, each of the fire wall instruments, etc.
Is this because you feel it's pretentious to do so?
I feel like having a concise name for a concept is one of the most important steps to broad understanding of it and always try to come up with good names for concepts that I want to be able to talk to people about. You might be doing us a bit of a disservice by resisting this.
They were getting paid, right? I'm not losing time I work at a company that will eventually fail.
Investment is very important, though, for various big-growth reasons, but mostly to extend reach beyond what the business-as-organism is capable of attaining independently. Better to grow strong by remembering who really pays the bills: true customers.
Too many startups conflate investor/customer in strange ways before they realize there is actually a relevance to how much of the company is your company.
So if you can convince your entire team to eat ramen for an indefinite period of time between your first raise, and your second raise, you would have "solved" this problem for some definition of solved.
Money is used to purchase acceleration. It's not totally crazy, although it implies very different trade offs as compared to running one's own business without investors.
You may be able to revert to ramen profitability again, but it will be painful (cut your burn rate).
Ask somebody in the Valley who sees more of them, but N months after a Series A, I'd expect to see at least 8 people on the team and probably closer to 20. That implies a salary bill in the, hmm, $100k to $200k range. Every two weeks, due like clockwork. Obviously, if you've already hit ~$500k a month in revenue, you're golden (as long as you freeze hiring), but most similarly situated companies haven't hit that yet.
If you're already at $500k MRR, you're in Series B territory.
If you have a good enough product to hold its own, shouldn't you be capable of getting at least a decent ROI on ads? If you can't do that, why try to grow? Spend the money on improving your product and branding instead.
(My take on this is very secondhand, unless you count experience from 1999.)
Edit. Changed how to who :)
Investors are looking for a particular curve. The slow burn, 7-figure exit that founders want is almost useless to VCs. The model requires that the winners pay for the losers. The VC has a finite number of at-bats every year, and each one needs to potentially be an out-of-the-park home run. A company that deliberately bunts is costing the VC an opportunity to recoup their losses on failures, which is the majority of their portfolio.
Founders like to kid themselves about this, but if they raise from a big institutional VC and plan on sitting on the money or executing on a "safe" 1.5-2x model, they're the ones being deceptive.
Safe, conservative plans are awesome. That's why companies should bootstrap.
There's a difference though between swinging for the fences and throwing money away.
This is the problem isn't it. Investors are basically saying unless you can hit 30% month on month growth then we aren't interested in you, but if you do what is required to hit this target then we won't give you the funding to do this with a reasonable runway.
>Safe, conservative plans are awesome. That's why companies should bootstrap.
I agree 100%. Almost all founders should avoid taking VC money and just bootstrap. This of course is not the sort of meme that is popular with VCs.
It is debatable if VC model couldn't be made to work better, but if this is how they are going to play the game then you are better off not playing and get on with bootstrapping.
But for founders who are attacking markets with those characteristics - the existence of VC is a huge boon that can accelerate what would normally be a lifetime process (eg. Walmart, Microsoft) into a decade or less (Google, Facebook).
One of the fundamental aspects of the web is that presentation is done by the client, not the publisher. Please let me reflow the text as I see fit.
After opening the article, copy & paste the following line into the URL field:
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Make sure your browser doesn't strip the "javascript:" at the beginning automatically, there's a good chance that it might; in that case, you'll have to type that in yourself.
tl;dr :: tl;drs suck