Should your startup take VC money?

Speaking with fellow investors, we often chat about whether we are always doing the right thing by investing in the businesses we do.  It’s not that we do or don’t believe in the specific business model, #revenue model, product or team, not in the least, it’s really more so about whether the founders truly understand the implications that come with taking pre-#seed money from investors; investors who are (more often than not) only in it to turn their money over ten fold.

MBAs generally think so

I was at Schulich business school this past week; as part of one of their organization’s (Social Impact Management Association – SIMA) social responsibility panel, and spoke with a few of these future business leaders about what it is like to take #funding versus trying to grow a profitable business right from the get go.  As would be expected from a business school, most of them were all very much for the #capital acquisition strategy and the rapid funding and ascent of a business.  They believe that there is very little time to make major wins in business and every advantage must be explored.

I am half on board with that.  There are times and reasons for taking money from funders such as angels or venture capitalists and there are definitely businesses that make much more sense and will definitely need the capital in order to foster any possible growth.

Guidance, mentorship, subject matter expertise

From my point of view, some of the real reasons to take money are for early guidance and support. #Venture capital investors are often subject matter experts who know where the industry is headed and what its consumers value. Further, because people like me and other VCs are very well connected, and especially in your industry, we are very apt to open doors, create dialogues, set up channel partnerships, and often are so in tune with the industry that we can pull some of the best talent that would fit you like a glove.

This all sounds wonderful, right?  It’s not all just about opening doors and getting you new talent, we as investors have some very high expectations of the type of growth required for these investments and we will often position ourselves on your board to make sure this happens. Let’s look at some of the reasons why you don’t want to take on #investment.

Why not to take seed (or often pre-seed) capital

Startups sometimes don’t understand how odd it is to qualify for a #VC. Only a very small percentage of companies are suitable. They need to match two main things: they need to have huge potential – say, to become a unicorn [a company worth over a billion dollars]. The second is they need to have the ambition to do that.

So from the above, there are plenty of reasons to take money.  The growth, the mentorship, the expertise, etc…  Here comes the scary part – most businesses really should not be taking money from VCs (maybe not even from angels) as they are immediately putting themselves against the wall if they take money too early.

Unnatural growth

Most entrepreneurs rely on investment (rather than #profit) as it promises rapid growth. This is problematic because most people underestimate how fast you need to grow to make this work (for investors).  Startups that are VC-backed need to grow at a rate of 15-20% per month in order to hit their targets and VCs will expect you to grow at this artificially high growth rate (which is probably not sustainable for your business). When you grow too quickly you do unnatural things to quintuple revenue year in and year out, and that’s not how 99.9 percent of businesses are built.

This usually reduces your chances (versus a bootstrapped business) as you end up with a less than 1% chance that you have the gargantuan outcome because VCs are going to expect that you return a certain amount before you exit (which is next to impossible for most businesses).

Most businesses start on the premise that they can grow as fast as venture would need them to scale the business however other than the rarest of cases, most are actually mom and pop companies.

Loss of control

By taking on VC funding, you will likely need to install one of the fund’s advisors to your board of directors, which means you now need to answer to a board every single time you want make a major strategic decision.

Wouldn’t you, as an entrepreneur, rather have total control/grow a profitable business and make all of the money? Would you rather have a chance to be rich, or would you rather be the king of your own castle?

If autonomy is important to you and you have your own growth goals, it is best to stay away from VC money.

Startup is going to be service-based

If your business is service-based, you’ll have no need for (and generally no luck) pitching to most investors. My friends have developed some wonderful and profitable businesses that rely on #technology-development skills. They knew these would never go public, and to this day, the acquisition offers they receive come from larger companies interested in their expertise or portfolio – not investors looking to make millions off their brand.

The VC model works best for product-based companies poised for parabolic growth. At least for a time, these companies scale production without adding infrastructure and personnel. Service-based businesses, on the other hand, must grow their employment roster at a rate similar to that they grow their customers at. Such circumstances make service-based companies poor candidates for VC funding.

 Venture capitalists may be the stars

I have often seen it that the venture capital firm is the real star and is profiled front and center on the #startup‘s homepage or key people. Have you ever seen a business that lists its bank (their financiers) on their homepage?  Or better yet, as a key member of the team? VCs get more attention than they should, given the vast majority of tech companies function without ever receiving VC investment.

VCs are behind the biggest names in tech: Uber, Facebook, Just Eat, Airbnb, Snapchat, and more recently in #Canada, Wealthsimple, Shopify and 500px, to name but a few. This perhaps helps to explain their allure, and they do have a significant impact on the economy. However the fact remains that most tech startups not only can’t but in fact should not go down the route of courting VCs for investment. At best it can be a distraction and a waste of time, and at worst it can be a huge, company-threatening mistake.

Immediately up for sale

Investors don’t give away money to be nice or to give someone “a chance”. They do it because they want ten times, or more, their investment back. Sometimes that means they will do everything in their power to make the companies they invest in look attractive for acquisition. Their primary concern is to make your product look shiny, functionality be damned. Obviously this isn’t the best thing for you, your employees, your brand, or your users. Yes, there are situations where a startup has no choice but to take investment, largely because they have a product with no revenue model.

The other important issue here is that many times, the money that a founder gets from an acquisition is the same (or less) that he or she would get from a sale. Anyone who’s studied up on the difference between how VCs and founders calculate valuation (or who’s familiar with the “option pool shuffle”) knows what I mean.

Distractions from core business

When entrepreneurs start out, they typically have an idea they passionately believe in. They’ve either seen a problem that they believe that have a solution for or they have a new and potentially disruptive idea. At first glance, looking for investment seems like the easiest way to give wings to an idea. You have money to pay your bills (which is so nice) but the problem is that once you are beholden to investors, you’re subject to their whims. You’re no longer building what’s in your head. If you’re bootstrapped, you can follow your idea and build it in isolation.

Further, pursuing VC money takes a huge amount of time and can be a fatal distraction for startups that are already pressed for time and resources. Make some good strong friends in the investment space and get their feedback about how ready you are, what it will take and if it’s even worth your time before you put a ton of time into getting your pitch materials ready.

The worst thing you can do is go out on a dog and pony show while your startup really needs all hands on deck to power through a set of releases that would have taken you over the top.  I have seen founders leave their posts for months at a time chasing the next cheque only to come back to home base to realize that it’s now time to shut down the business (sprint or weeks away from having realized a big sale or some amazing feature that they could have actually sold to their current clients).

Dull your drive

Once you accept investment capital, you will start to worry about things that are not related to your product or idea. Suddenly you’re focused on setting up your office space, buying furniture and organizing catered lunches, attending board meetings and taking investor calls. It’s a distraction that often squishes the hacker mentality. Suddenly you have to behave like a grown-up, you can’t move as quickly and you start to worry about things that aren’t your products. If you have investment, you’re not going to run your business the way you would if every dime was coming from your own pocket. If you’re bootstrapped, you’re more focused on what matters: your product. From experience I know that you can turn out a really successful product that was built in cheap basement space, using old doors and sawhorses as desks.

Diluting your own value

There are a lot of downsides to raising investment capital. At the top of the list is dilution. The sooner you sell equity, the more it will cost you in the long run through the loss of dilution and leverage. Don’t just think about how current terms would affect your equity position; calculate how much you will get diluted in future rounds. If your company performs well, dilution will be offset by your valuation increase. But to protect yourself, you always want to try to negotiate your best dilution terms. If raising VC funds is the best option for you at this time, focus on milestone raises — raising only as much as you need to get to the next milestone. Doing this will at least prevent unnecessary dilution and allow you to get the highest possible value for each round.

Being disciplined

Taking VC money can be a great way to kick your company into the next gear, but it’s also a dangerous road. Bootstrapping forces you to ruthlessly prioritize your spending and cut away unnecessary expenses, but having a pool of venture money forces you to have much more personal discipline when it comes to spending money.

Having invested in several startups, I have seen my share of founders who got a big fat cheque and decided they no longer needed to be frugal any longer; buying up all new equipment, new office furniture, flying business class, etc…  Being bootstrapped means you will intimately care about the money you are spending rather than just having a sense of entitlement and looking for the next big payday.

An injection of cash from a VC makes accountability more difficult. Money in the bank changes how you measure the bottom line. It makes net income (or, more likely at a startup, net loss) a less meaningful number. When companies have money, they spend it. That’s not always a good thing. Some startups are meant to grow at a more gradual pace. The mixed blessing of funding is scaling quickly, but this also means you may run out of money faster. By definition, you’re growing at an unsustainable rate. The decision-making and cultural impact of cash infusion has positive and negative consequences. Startups don’t always have their eyes open to the impact of funding.

Liquidation preference

One of the scariest terms in a VC term sheet can be the liquidation preference. In Brad Feld’s words, this “determines how the pie is shared on a liquidity event.” If the company has an exit, often the VC makes out with a much bigger share because of how this term is drafted, especially if multiple rounds of financing are raised. Oftentimes, to get a 10x return, the company will have to raise more than a round of financing to hit big enough targets to create a meaningful exit for the VC. Make sure to pay close attention to how this is crafted in your term sheet.

Conclusion

The best way to build a business, at least most businesses, is to slowly creep your way to profitability, using the revenue you make from the sale of your early product(s) (or services) to grow.  One of the biggest problems entrepreneurs have these days is that they have all read stories of WhatsApp, Instagram, Uber, etc… and expect that they will have the same luck to be at the exact right place at the right time, with the perfect idea and execution thereof.

You can build anything for a few thousand dollars, and I have dozens of examples of companies who, with a just that amount, have started income-generating products in a few months (often selling off of mockups). The argument that you need an investment to start is moot. Once you actually start your company, you should generally be trying to hit the following numbers:

• Monthly churn below 5 percent (ideally less than 2 percent),
• 10 to 20 percent month-over-month growth, and money revenue
• proven advertising funnels that get your invested dollars back in less than 12 months.

Once you hit those numbers, go to investors — or just wait, and they’ll probably come to you.