Venture capital can look dramatic. Bubbles, crashes, giant IPOs, 7-billion dollar acquisitions, lecherous investors, and out-there founders with millions of devoted followers make starting a business seem like Die Walküre. This has lead to a strange amnesia about how most startup business strategy actually works: selling a product to customers for a profit. This antiquated notion even has its own fancy new term, “fundraising from customers.” Contrary to how it sounds, this does not refer to customers investing in the company. Rather, it’s encouragement for entrepreneurs to consider selling their product to customers over selling part of their company to an investor.
In the U.S., roughly 43% of public companies founded between 1979 and 2013 have been backed by venture capital firms (GSB). But the majority of companies do not go public, and raising venture capital does not guarantee a company’s success. Venture capital is also not the only form of financing for an early-stage company. There are several other sources of capital for startups, including revenue, debt, and revenue-based loans. In addition, a hybrid of VC funding, debt, and revenue is possible and likely.
Consider the highly competitive direct-to-consumer mattress market, which is largely dominated by startup Casper, founded in 2014. (Casper co-founder Neil Parikh made an angel investment in Holloway.) Casper’s dominance is due in no small part to the fact that they spend $80M annually in advertising, having barrelled their way into the market with over $200M in venture funding. Contrast their rapid rise with Tuft & Needle, a startup that bootstrapped in 2012 with a $500K loan, became profitable in 2017 on $170M in revenue, and merged with mattress brand leader Serta in a deal rumored to have a value north of $400M (re/code). At the far end lie the earliest entrants to the mattress milieu, Saatva and Amerisleep, both of which bootstrapped their new businesses in 2010, pouring the profits back into the companies and growing slowly (Fast Company). Up until recently, neither had taken any form of external funding (Saatva reportedly just took an undisclosed investment from private equity firm TZP Group).
In order to determine whether venture capital is the right fit for your company, in this chapter we’ll discuss the meaning of “venture scale,” where VCs’ motivations and incentives may differ from a founder’s, what VC’s expect from their investments, and a few other important things founders should consider before they begin financing. We’ll also lay out the basics of alternatives like bootstrapping and crowdfunding, and share a bit about what some are saying is a trend away from venture capital.
“That’s just how I am built. I’d rather go slower and have more equity than gamble with someone else’s money.” —Ron Rudzin, CEO of Saatva
Because of the way VC firms and VC financing are structured, venture capitalists have to be motivated by the prospect of huge returns on investments that will make them and their investors rich. The fact that VCs need to return large sums of capital to their investors creates some incentives that may not align with an entrepreneur’s goals. In order to meet their investors’ expectations, venture capitalists seek to invest in companies they believe can be the biggest, most successful companies in their market.
There are firms out there who are happy with smaller returns and smaller exits, and investors who work closely with founders to make sure no decisions are made that they are not comfortable with. (You’ll learn how to research and discover firms aligned with your interests in Creating a Target List of Investors.)
But the VC business model is predicated on growth—there are countless stories out there of companies who were pushed by their investors to move too fast to becoming a $1B+ outlier. What’s the downside of that? Capturing enormous market share is not in the best interest of many kinds of companies, particularly startups motivated by impact in communities and smaller sectors; moving too quickly to grow may result in a company that lacks real understanding of its customers’ needs, and thus lacks staying power; businesses with sky-high valuations have sometimes not reached profitability, making the future of those companies post-IPO uncertain. There are a few things to consider that will help you decide if this is the right route for funding your new business.
From an entrepreneur’s perspective, there are two main considerations when thinking about whether venture capital is the right form of fundraising for their business: money and time. Venture capital can be a good option if your company needs a lot of money up front before it can bring in revenue—that is, if it’s “capital intensive”—and if the company needs to grow rapidly in order to beat other companies to market.
Capital intensive businesses often involve a j-curve where the business needs to invest a lot of money in research and development before it can turn a profit. Today, biotechnology companies are still highly capital intensive, as the period needed for experimentation and clinical trials—all before any revenue—can be years or decades. Software companies, on the other hand, generally require less capital than they used to—today they can turn to cloud-based providers like Amazon Web Services and Google Cloud Platform instead of spending millions on their own servers.
But that isn’t to say software companies can’t be capital intensive. In some cases, companies need to lure particularly specialized, and therefore expensive, employees. Self-driving car startups, for example, need to hire PhDs and also need to purchase expensive hardware before they can even begin much experimentation at all. In other cases, a team is close to finding a solution for a market, but they need time to iterate, test, and repeat a cycle of exploration before finding something that works. If your company faces any of these challenges, you may want to explore raising venture capital to finance your company.
Companies often raise venture capital to finance growth once a company has found a business model that works. The idea being that, once you’ve figured out how to sell a product successfully and repeatedly, you may want to go hire a larger team to improve and sell your product to the market before someone else beats you to the punch.
controversy Taking institutional investment like venture capital almost guarantees that you will be pushed to grow as fast as possible, and you may not agree with the strategy or tactics suggested. Here are a few examples of challenges related to growth in VC-backed companies:
In 2014, investors in HR startup Zenefits called then-CEO Parker Conrad’s $10M revenue goal “bush league.” Subsequently, the company went on to face multiple scandals that ultimately resulted in Conrad’s departure.
In 2016, e-commerce startup Nasty Gal filed for bankruptcy after bringing in nearly $100M in revenue at its peak. Much of Nasty Gal’s growth resulted from spending on advertising, which ended up being unsustainable.
This push for rapid growth can have other negative consequences, especially when the ethos is applied to industries like biotechnology. Theranos is a particularly good example of Silicon Valley’s “hypergrowth” mantra turning into an absolute disaster.
The goals of founders and their investors don’t always align. VCs aspire to return 3X their fund for their LPs, but what founders want is less straightforward, and can change over time. When these goals get out of line—and they do—things can get ugly fast. Investors can remove founders, block the sale of the company, or hold the threat of these things over founders heads in order to strong arm the founders into certain decisions.
How does this happen? Despite many founders belief that the best defense to VC control is maintaining more than 50% ownership in their company, VCs can control a company via two other powerful mechanisms: privileges granted to preferred stockholders in protective provisions agreed to in the investment term sheet, and seats on the company’s board.
That total control of a company comes from maintaining ownership of more than 50% of your company is a pervasive myth that is dangerous for founders, and it comes from a fundamental misunderstanding of how voting rights work for stockholders in companies who grant preferred stock to investors.
Somehow, somewhere, people got the idea that founders and investors all got the same kind of stock. After all, why would there be different kinds of stock, and what would that even mean? Ownership is ownership, right? Wrong.
Investors get preferred stock and founders almost always hold common stock. During an investment negotiation, investors frequently negotiate special privileges for preferred stockholders called protective provisions (we have an entire section on this in Terms and Term Sheets), which require a majority of the preferred stockholders to vote on certain decisions that could impact the value of their shares.
danger After a company has granted protective provisions to preferred stockholders, investors with even 1% of a company’s overall stock could block a decision to sell the company for a profit to another company because they want the founders to work for a few more years on the company so they can sell it for a larger return. And this happens.
Delaware corporate law (which covers the majority of startups established as C Corporations) states that C corporations have to be supervised by a board of directors. When a company incorporates, the board is usually made up only of one, some, or all of its founders. Under Delaware corporate law, boards have the authority to control the day-to-day matters in a company. You should always defer to your legal counsel when determining what decisions need a board vote, but in our section on protective provisions we cover the decisions that almost always require a board vote.
It’s rare for an investor to negotiate a board seat at the seed stage unless they’re writing a large check ($750K+). Boards of directors usually meet quarterly for meetings as long as three hours; they’re a big commitment and investors usually don’t want to sit on too many boards. But at some point beyond the seed stage, you will have to give up board seats to investors, and that means you’ll need the support of any investors with a board seat when making major decisions.
Between protective provisions granted to preferred stockholders and board seats, every entrepreneur needs to know what they’re giving up in a deal with investors. Some investors, like Mark Suster, are transparent about how they think about working with entrepreneurs when incentives change. Going into a working relationship with an investor with your eyes open about the risks is certainly preferable to putting years of your life into a business only to be surprised by your investors decision to block an acquisition or replace you as CEO.
Raising venture capital is a means, not an end. If you’re an entrepreneur, your goal is at least to build a successful business. Economic value, as measured by valuation or price per share, is not the only way to measure a business’s success. Before building a pitch deck and pitching investors, think on and discuss with your team what success means to you. Does success mean fame, fortune, and everything that goes with it? Whether or not you decide to take on venture funding, you and your team or co-founder can get aligned on your goals by considering the following:
Impact: Many founders are motivated by a yearning to work in service of something larger than themselves. Founders who want to change the world still have to ask themselves, “But, will it scale?”
Lifestyle: The average time from founding to IPO is eleven years, and there is a pervasive culture of workaholism among startups that is reinforced by investors. Many founders self-impose a 60+ hour work week. There is a widely held belief among investors, however unfounded or unproven by data, that long hours signal commitment.
Money: Entrepreneurship is hardly the best way to get rich. Given that most companies don’t succeed, think twice about starting a company before you quit your day job. That said, it’s okay to think about the numbers you’re comfortable with for now, and the numbers you want to get to. Would you be happy with a steady salary of $75,000 a year? $1M after an exit? $100M?
Control: Many entrepreneurs start companies out of a desire for independence. But don’t forget: raising venture capital means selling a part of your company. Often, that means other people now have a say in how you go about doing things. “Being your own boss,” doesn’t really fly when you’ve committed to do your best to return your investors money plus a healthy return. Raising money from venture capitalists can mean giving up control of your company. Raising a priced round usually means agreeing to protective provisions for preferred stockholders or giving up a board seat, which in turn lead to investors gaining the ability to legally block certain activities (selling your company, raising more capital, and more).
Ownership: Many venture capital firms seek to own 5–20% of your company. In most cases, a company will raise several rounds of financing, which will further dilute the founders’ ownership. It is not uncommon for a company to raise large sums of money and sell. Because of liquidation preference, the founders might not make much at all, if anything, in that event.
Optionality: Investor money comes with expectations. Optionality, or having the option to sell your company but not the obligation, means having control over your company’s fate. If you’re not sure whether you might want to sell your company in a few years, taking venture capital may not be a good idea. Given VCs’ incentives, modest positive outcomes (1–2X returns on the amount of capital raised) are not “venture scale,” and hence not interesting to most venture investors. In many cases they may be able to block a sale of the business that would be very lucrative to founders but doesn’t generate the outlier returns they seek.
Definition Venture scale is a colloquialism broadly used to refer to companies that can multiply the value of their investors’ ownership by a factor of 5 to 10 over a period of about 5 to 10 years.
A company can be considered venture scale if venture capitalists believe the company is capable of at least the following:
Dominating a large market: Venture capital firms only invest in companies that are developing products to solve problems in big markets. Even if you’re building a business in a $10B market, you have to believe you can capture 10% of that market in order to have a business that is compelling to venture capitalists. One counterpoint is that smaller markets can be strategic to take as a go-to-market tactic, with smaller markets acting as bowling pins.
High margins: Venture capital firms want to invest in businesses with high margins—that is, companies that spend a small fraction of the sale price of a product on creating and selling it. For example, a company that spends $0.94 to make and sell a product that costs $1.49 to buy would have a 37% profit margin. While high margins may be less common in hardware or biotech companies (they have to spend more money to create their products) and therefore less of a consideration, high margins mean companies are more profitable. More profitable companies have more money to reinvest in building new products, which can then go on to make the company more valuable. Because of this more profitable companies can exit for higher multiples. Higher multiples mean better returns for VCs. What’s a high margin vs. a low margin? Investors don’t necessarily agree, but anything under 50% can be considered low and anything over 50% can be considered high.
Growth and speed: High compound annual growth rate (CAGR), which translates to achieving these high market caps and margins within 5–10 years.
This is an excerpt from the Guide to Raising Venture Capital, which was released Summer of 2019.