Does every startup need VC capital?

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Virtually every startup I mentor at MIT seems to believe that they need to raise outside capital immediately. While there are few notable exceptions, it seems like the entrepreneurial culture puts a premium on raising venture capital – it’s sort of the startup seal of approval. But Peter Strack argues against the tide in his Forbes article Why You Shouldn’t Always Raise Money For A New Business. Here are his arguments annotated by my comments:

You Can Keep 100% Of Your Company

As a notable VC once reminded me, “They only make 100% of the company, so act accordingly.” But there’s a more important factor than how much equity you have upon a liquidity event, that factor is control. Once you take a VC investment you will be giving up a board seat to that investor. Since first rounds are often syndicated, there may be two or more VCs looking for board seats as well. Generally you can get two insiders on your Board, the founder and another member of senior management, to balance the two VCs, but you aren’t going to have the freedom and independence you had as a new founder. Keep in mind that you may be working with these investors for years, so make sure the individual partner and their fund are going to contribute more than money – contacts, advice, feedback, and support when times are tough.

Bigger Is Not Necessarily Better

While tech startups often need engineers to build their product and these engineers typically will want a salary, which can increase the pressure on the founder to raise money. But keep in mind Mr. Strack’s admonition: Premature scaling can cause technology startups to fail. And 46% of professional, scientific and technical services companies close within the first five years.

You Learn So Much From Doing It Yourself

I consider learning to be job one for any founder. No matter what your academic credentials, not matter what hot startups you’ve worked at, being the CEO of a startup is very hard. The longer you can stay in control and learn the ins and outs of running your company the more you will learn, and the more valuable the company will be. Of course, there is a point of diminishing returns where you will need to bring on partners and staff but premature hiring is almost as dangerous as premature scaling, actually it’s a subset of that problem.

So what does Mr. Strack advise in lieu of taking on investor capital?

• Hustle – hard work is just the ante. To create value in your enterprise you need to be productive. That means being absolutely ruthless on how you spend your time, your most valuable asset as a founder. Focus on productivity not activity.

• Be smart with the funds you have – I was taught by the VCs to stretch the dollar. For example, rather than hiring full time staff who require not only salaries, but benefits and stock options as well, use consultants and contractors to work on a project basis.

And let me add one other point: look for leverage. As Archimedes said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” Examples of leverage include hiring interns instead of consultants and contractors, finding a law firm that will defer your fees until your first round of investment, and sub-letting office space from another tech company that may have a surplus and be willing to offer you a cut rate.

There is nothing wrong with raising capital, but be strategic about it. The best time to raise capital is when you don’t need it. Believe me, investors can smell desperation a mile away and they will take advantage of it. And keep in mind it can take six months or more between starting to raise capital and the check clearing the bank. So start understanding the VC climate in your region. Get to know some VCs informally. But just because you are studying something doesn’t mean you are committed to it. The Boy Scouts’ motto applies to raising capital: Be prepared.

Incomplete article on why Massachusetts can’t birth tech IPOs

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Scott Kirsner of The Boston Globe has a business section front page article entitled Where are all the Massachusetts tech IPOs, sub-titled When it comes to going public, the sector remains in the long shadow of California. 

This is scarcely news to anyone who has been or is in the entrepreneurial economy in Massachusetts. Silicon Valley has lead Massachusetts in every dimension of tech startups since the downfall of the Route 128 computer companies like DEC, Prime, Wang, Data General, and Apollo.  I assume what prompted Scott to write the article is the current flock of IPOs and soon-to-be-IPOs from Silicon Valley, including Uber, Lyft, Zoom, Pinterest, and Slack.

Unfortunately the article, while accurate, is incomplete. It principally blames founders for several sins:

  • Thinking too small – building million dollar companies that get acquired versus billion dollar companies that go public
  • Inadequate PR – not creating the kind of buzz that attracts big investors and star employees
  • Poor culture of mentorship – “We have a poor culture of mentorship relative to the Valley and now New York,” says Michael Greeley, an investor at Flare Capital Partners in Boston.

But he manages to mainly give a pass to both investors and the Commonwealth of Massachusetts. Having been in the “innovation economy” for 39 years, I can tell you there is a very strong investor culture here that is in one word conservative.  The first generation of VCs came out of companies that were consistently profitable. In fact, back in the day of DEC and Data General, the rule was you could not go public until you had four consecutive quarters of profitability. Tell that to the investors in Uber, Lyft et al! These VCs also hated consumer plays. They told me there was no way they could perform their due diligence on B2C companies. With enterprise companies they could call all their CIO friends in large companies and get a reading on the viability of new products from these potential customers. They had no idea who to call to get a reading on a consumer startup like Uber. So they passed. I can’t count the number of times I was told by founders from California that the startups I couldn’t get funded here in Boston would easily have raised capital in Silicon Valley.

And Scott leaves out one of the major governmental problems with the startup economy in Massachusetts: non-compete agreements. In California non-competes are illegal. Period. You can leave your company on a Friday and form a startup on a Monday to compete with your former employer. And many entrepreneurial-minded employees do just that. It’s a fact of life in the Valley. But it’s more than that. The constant spawning of new companies creates the winners that go public and in turn spawn more startups. Not here. The large legacy companies and their lobbyists have kept the legislature from ending indentured servitude in the tech sector. Until the legislature wakes up and does away with non-competes, Massachusetts is doomed to fall further and further behind the Valley.

But founders also share part of the blame that isn’t mentioned in the Globe article. The best and brightest leave Boston for Silicon Valley. The canonical example being Mark Zuckerberg, who founded Facebook in his dorm room at Harvard, but as soon as he got traction he headed for the Valley. Perhaps far more importantly, but lesser known, is that Paul Graham, the founder of Y-Combinator, perhaps the most important early stage investor of the past ten years if judged by the sheer number of investments it has made, started Y-Combinator in Boston. For a while he maintained both an East Coast and West Coast presence, before shutting down his office here and putting all his focus on Silicon Valley.

The tech sector in Massachusetts has been second fiddle to Silicon Valley since startups moved from 128 into Cambridge and Boston. But it has fallen farther and farther behind to the point that Massachusetts is no longer even number two, it’s behind New York, and if we aren’t careful, we will fall behind Texas next.

And there is plenty of blame to go around: entrepreneurs, investors, state government all play a part in squandering the tremendous entrepreneurial engines of MIT and Harvard. Until the culture changes amongst all three groups my advice to the founders I mentor is, sadly, “Go west, young man.”

 

How to raise your first round of capital

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If you are looking for great information about startups in an easily digested format, e.g. slides, I highly recommend Slideshare.net.

One major change in VCs in the past decade or so, which I believe was spearheaded by Brad Feld of The Foundry Group and Fred Wilson of Union Square Ventures, has been a sincere attempt to educate entrepreneurs. While I’ve known both of them I never asked them about their motivation, but I can take a good guess. Top flight VC firms see literally hundreds of pitches a year, year in, year out. Yet a partner like Brad or Fred may make only one or two investments per year. So it is in their interest to teach entrepreneurs not only how what VCs want to see in a pitch, but how to conduct themselves in a VC meeting, as it is much more efficient to deal with educated founders rather than having to teach everyone, one at a time.

I’ve already written about and recommended Brad’s book, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. Now I’m going to recommend a great slide presentation by Jeff Bussgang of Flybridge Ventures entitled Mastering the VC Game: How to Raise Your First Round of Capital. It’s a 19 slide primer that takes the founder from first pitch to due diligence. While its six years old I don’t think anything has really changed in the VC game regarding how to raise your first round of capital. Of course Jeff being a VC he doesn’t spend any time educating founders about the alternatives to VC funding, such as corporate VC, angel groups, angels, super angels or grants like SBIR. After you’ve gone through Jeff’s presentation check out my blog post VC funding and its alternatives to help decide what type of investor is the best fit for your venture.

I have to admit I have not yet read Jeff’s book, Mastering the VC Game, but based on his blue chip reputation and the quality of his slide presentations (you can search SlideShare for others), I’d venture to say it’s well worth reading.

If you still have questions and the time to search for answers there are a number of posts on this blog that fill in the many gaps in knowledge of raising capital that I’ve seen from mentoring dozens of founders in the past decade.

Lessons learned by a successful serial entrepreneur

investors

I’m going to excise the important lessons learned from the Forbes article 300 Investor Rejections And 1 Failed Startup Led This Entrepreneur To Build A $1 Billion Business by 

Here are his lessons learned along the way, which I heartedly endorse, both from my own personal experience as well as experience mentoring dozens of founders:

Three Essential to-do’s

  1. Surrounding himself with good product engineers
  2. Really getting a handle on product market fit
  3. Learning how to talk to investors

If he was to ever start again:

… he would spend a lot more time thinking about and vetting an idea before jumping into it. Spend a lot of time talking to customers or potential customers, and also talking to investors, and really starting to define and refine the business model, the customer acquisition strategy, the business model, the defensibility, the network effect.

Raising capital

  • He had to go from fundraising in California to New York where investors got it
  • He learned the secret isn’t convincing investors, it is finding the investors that love the idea
  • Learn to leverage a lead investor who will syndicate the deal to others
  • Learning some sales skills

Ward had about 300 turndowns from investors for his two startups! But his second point is perhaps the most important lesson learned about raising capital: it’s all about investor-venture fit. Founders tend to think that by getting more meetings, sending more emails, making more phone calls – whatever, more is better – they can convince an investor to fund them. No! If you don’t get resonance from the first two meetings move on! Take that energy and your precious time and dig for a well elsewhere, digging deeper and deeper won’t strike oil! Of course, this assumes you have heeded Ward’s start again tip to talk with investors before you jump into a venture. You have studied their portfolio and talked to some founders they have invested in – performed your due diligence on prospective investors.

 

 

VCs need to hit grand slams, not just home runs!

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The best single line I’ve heard about how venture capital works is from investor Marc Andreesen: “returns are a power-law distribution” with the majority of returns concentrated in a small percentage of companies. That’s true now more than ever, and one of the great promises of the venture capital industry that motivates and drives investors.

It’s vitally important that founders seeking investment understand the venture capital industry, what motivates VCs and how they make investment decisions. The article on Medium by Eric Feng A stats-based look behind the venture capital curtain is de riguer reading for founders planning to raise capital from VCs.  Eric Feng is now at Kleiner Perkins. Previously CTO of Flipboard, Founder of Erly, Founding CTO of Hulu, and Microsoft Research alum.

Mr. Feng’s article focus on how the VC industry has changed in the last fifteen years – which is substantially – more money, more investors, more deals, bigger exits!

In the past 15 years, the amount of money invested by US-based VC firms into startups grew more than 4x to almost $85 billion dollars last year. Before 2011, an average of $28 billion was deployed each year but in the past 7 years, that number has jumped to $62 billion invested annually. Not surprisingly the number of deals has seen a corresponding sharp increase. From 2003 to 2010, the industry averaged almost 3,800 investment deals per year. But since 2011, the average number of deals per year has shot up to more than 8,700.

What is the effect of many more funds deploying more capital into more companies? The industry is making over 5,000 more investments each year compared to 15 years ago (with most of those being seed investments). One would think that it must true that any given startup thus has a better chance of raising capital than 15 years ago. However, there’s an unintended consequence of the changes: On average, there are more than 7x the number of billion dollar exits now than a decade ago. 15 years ago venture capital was considered a hits business where the hit had to be a home run to make up for all the strikeouts in an investors portfolio. But now?

“Venture capital is not even a home-run business. It’s a grand-slam business.” Bill Gurley, Benchmark

As a result there is even more pressure on an investor from their fellow partners, their peers and their limited partners to swing for the fences. Now the rule of thumb is that you need to build a company with a minimum of $100 million in yearly revenues, so it would be valued at 10X sales, or a billion dollars, commonly called a unicorn. If you can’t meet this yard stick don’t waste your time chasing VC dollars or pivot to a multi-billion dollar market where you have a markedly better chance to qualify for the grand slam derby.

exits

If you search Eric Feng’s article for the term “profit” you will get zero hits! That’s right in an article about venture capital the word “profit” doesn’t appear even once. If you need more proof that profitability is not a key success factor for startups just look at all the companies now going public or that have gone public recently. They are all losing money with the exception of Zoom! Uber and Lyft are losing billions of dollars.

So founders, pay attention to what VCs pay attention to: top line revenue, revenue growth, growth of your customer base, and stickiness of your customers. You can start worrying about making money after your IPO, what you need to worry about now is growth and the ability to scale.

Questions to help you become investor ready

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I’m a strong proponent of the Socratic method and as such I’m always on the lookout for good questions to ask, especially for the founders I mentor. The Forbes article 15 Key Questions Venture Capitalists Will Ask Before Investing In Your Startup by

I’m going to simply refer you to that article along with a couple of posts of mine. If you can successfully run the gauntlet of all these questions you’ll be ready to sit down with an investor, with confidence!

Here’s another set of questions, Investors questions to address and the post Are you investor ready?

But rather than simply view answering these questions as a one-time exercise I recommend you convert them into a to do list, as it will be highly unusual for a zero-stage founder to have good answers for every question. For example, if you haven’t launched your product you should make sure to arrange for customer testimonials and if you haven’t built a set of KPIs (Key Performance Indicators) there’s a major milestone for your venture. For that one I’ll refer you to my post 12 KPIs you must know before pitching your startup.

 

 

How things look from the investor’s side of the table

power law

Eric Feng, now a VC at Kleiner Perkins, but previously a CTO of Flipboard, founder of Erley and founding CTO of Hulu knows what venture capital looks like from both the founder’s and investor’s sides of the table.

His article A stats-based look behind the venture capital curtain on Medium has an analysis of trends in VC funds in the US over the past 15 years that is highly recommended reading for any founder seeking capital.

From 2003 to 2011, an average of 157 new funds were raised each year. But from 2012 onward, that average rose to 223, or an impressive 42% increase. More funds equals more active investors working at those funds.’

Another insight from Mr. Feng is that all the recent growth in the number of funds raised has been from seed funds, not venture or growth funds.

There has been an even bigger increase in the number of seed investors active in this country because of the disproportionate growth in the number of seed funds raised each year. So if it feels like there are thousands of new investors in the industry, particularly seed investors, that’s because there are.

“A lot of capital does disrupt venture capital, which is the problem we’ve had as an industry.”

— Sarah Tavel, Benchmark

Founders heed well: So even with the sharp influx of seed funds, the vast majority of the dollars are still invested by traditional venture and growth funds. Since 2011 the average number of seed deals per years (4,300) is not about equal to then number of non seed deals *(4,500).

But as veteran VC Bill Gurley says: “Venture capital is not even a home-run business. It’s a grand-slam business.” Virtually every founder I have met with over the past couple of years just assumes they will raise venture capital. However,

As investor Marc Andreessen has said, “returns are a power-law distribution” with the majority of returns concentrated in a small percentage of companies. That’s true now more than ever, and one of the great promises of the venture capital industry that motivates and drives investors.

So while this article is written from the viewpoint of a venture capitalist, it is well worth studying for founders in search of capital. Basically if you can’t show a VC that you have the potential not to just hit a home run, which was good enough the previous decade, now you have to show that you have the potential to hit a grand slam. Otherwise you are unlikely to even get a meeting with a VC, let alone an investment. Yet at the same time there are significantly more investors today than 15 years ago. The size, growth rate, and dynamics of your target market are the gatekeeper metrics for a venture capitalist today. In other words, disrupting a very large market is table stakes. If you are going after anything smaller you need to either bootstrap (be self-funded) or find an angel that falls in love with your startup,

Getting a VC investment has now become much like getting an acceptance to an elite college or university. The strategy is the same, send out a lot of applications and pull every string you can find in your web of contacts to get warm introductions. The only exception to this rule is Demo Day, where you get to present to a mass of investors, alongside your fellow founders. Demo Days are highly efficient for both founders and investors as both sides can cut through the introductory dance to get directly to a presentation or demo of the venture’s product. In higher education the table is tilted in favorite of athletes and legacies – children of alumni. How does a founder tilt the table in the VC game? By being a serial founder! It’s a chicken and egg problem, if you can’t raise money because you never have raised money what can you do? For one thing, find a partner who is a serial entrepreneur. Beyond that close advisors, like your former professors, with deep startup experience can help you distinguish your startup from all the competition.  But keep in mind where you truly need to distinguish yourself is in the minds of customers. If you can do that the money may well beat a path to your door.