Does every startup need VC capital?

money

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.

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.

 

 

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.

Revenue share – an alternative path to financing a startup

Human hand reaching for money

TechCrunch interviewed more than 200 investors and asset managers to gauge their interest in various new ways to fund early stage companies. Their finding? That 63.1 percent were will to explore revenue-based financing.

The concept of revenue-based financing has been around for a long time. It’s relatively straight forward. An investor funds a company and is later repaid by a percentage of the revenue of the company. However, to make this work the company needs to have a predictable cash flow, such as subscription-based businesses. And the company needs to have high margins, so that it can continue to operate whilst paying out a significant share of its revenue to its investor. Imagine you want to buy a bread and breakfast but lack the down payment. You get a loan from the bank for the down payment, based on the revenue that the B & B generates. Assuming that the B & B has a history of a good cash flow business, meaning it has a high occupancy rate and generates enough cash to both pay off its bank loan, cover its operating expenses and generate some profit for its owners this type of deal makes sense for the bank (the investor) and the B & B purchaser (the entrepreneur).

An increasing number of venture funds are now deploying revenue share tools. Novel GP has a $12 million fund that makes revenue  share in SaaS-based companies, which almost always charge their customers on a subscription basis. Indie.vc recently raised their second $30 million fund that invests through a “profit-sharing” structure by which the fund receives disbursements based on net revenue or net income, depending on which is greater. Candide Group, Adobe Capital and the TechCrunch affiliated fund VilCap are additional examples.

However, there are a number of issues with revenue share financing, for both the investor and the founder. For the investor, the author’s calculation on a hypothetical revenue share investment in 30 companies on average it would take about 4.4 years to realize a 3X return on the initial investment amount of $20k, to $100k. But how many startups can get off the ground on that amount? That’s about what the average founder can raise from friends and family on a convertible note.

Not only does the recurrent obligation to pay the investor shrink the pool of capital available to reinvest to grow the business, other investors who aren’t familiar with the model may be scared away, as were several investors interviewed by author Allie Burns.

And even if you add up all the capital under management of all the revenue share venture firms, I doubt it even comes close to approaching the average size fund of a single traditional equity VC fund. So it seems like founders would be going after a small amount of capital from a very small number of investors.

… based on the experience of VilCap Investments and other practitioners like Candide Group, we’ve found that revenue-share financing is generally only appropriate up to a certain size of investment, generally between $50,000 and $500,000, depending on the expected return multiple and timeline, and the company’s annual growth rate and traction at time of investment.

So while it’s encouraging to see alternative forms of investment available to founders, in reality it’s only a very small number who will be a good fit for this model. My advice would be it would probably be a better return on time invested to study crowd funding, especially since the SEC’s changes to rules governing investors have changed recently. No longer must an investor have a net worth exclusive of primary residence of $1 million dollars or more or an annual income greater than $250,000 to qualify as an accredited investor. Check out the Regulation Crowdfunding page of the SEC’s web site. And while you are at it you might want to review the Exempt Offerings page, which explains the exemptions from registration that are most frequently asked about.

Under the old regulations the SEC forced any company with 500 investors or more to go public, which basically shut down crowdfunding. Now that is no longer true, and unlike revenue share, crowd-funding is a new flavor of equity financing, something all investors understand.

Things you should know about VCs

vcThere are lots of myths out there about VCs, about how they will take over your company and replace you as CEO or that getting a VC investment paves the way on your path to riches. But Jason Lemkin of SaaStr, the world’s largest community of SaaS executives, founders, and entrepreneurs, has an excellent article on some facts you should know about VCs – forget about those myths!

  1. Entrepreneurs tend to think about VC firms, but in reality VC firms don’t do investments, individual partners at VC firms are the ones making the investments. Just like medical device makers don’t sell to hospitals, they sell to the individual financial decision makers in departments in hospitals that need those devices. And the hard truth is that partners at VC firms do very few investments per year, typical just one or two. So as a collective firm they may do a significant number but the individual partner who’s a potential fit for your firm only one or two. So you need to have a really compelling fit for that VC and you better know from your research which partner in the firm might invest in your firm. That knowledge should be based on their track record, blog posts, social media presence, and G2 you can gather from their portfolio companies.
  2. As the Bob Dylan song goes, “Everybody gotta serve somebody” and in the VCs case it is their limited partners, those pension funds, college endowments, and wealthy individuals who invest in venture capital as part of their diversified investment portfolio. So check out the limited partners, for example, when we were talking to Greylock about funding Course Technology it turned out they had six or seven limited parters which were college and university endowments – so they were excited to invest in our educational software and publishing company.
  3. Partners are diversified, you aren’t. Unless you are Elon Musk or Jack Dorsey, chances are very high that the only company you are fully invested in is your own. Not so for partners in VC firms. In essence they are portfolio managers; your firm is just one amongst several in their portfolio. So they will tell you that their interests are fully aligned with your’s but in fact they are not. Resources – money, connections, and their attention – will go to only those firms in the portfolio that they perceive as the winners.
  4. VCs don’t just make money on exits, they make money on management fees. And to make a lot of money on management fees – typically 2% of funds invested per year – they need to raise multiple funds. And they raise those funds by getting step ups on the valuations of the companies in their portfolios. Yes these are paper gains but they can show their LPs strong IRR on their current investments. So VCs always have one eye on the next fund and how they will raise it.
  5. Small VCs Align With You, But Lowball You.  Big VCs Don’t Align As Well, But Can Pay More. Big VCs can write big checks and they also can hold funds in reserve, so they can participate in multiple rounds without getting diluted. But small funds will probably have to syndicate their rounds – share the investment and any returns – with other firms. Big VCs can write very big checks, but then they need to have a big return to impact the fund. And partners can only serve effectively on just so many boards – typically no more than seven to nine – so if you only need a small amount of funding they can’t afford the opportunity cost of taking the time and attention to invest in you, let alone serving on your Board.

Entrepreneurs have learned about product/market fit, but investor/venture fit is equally important. The amount you need to raise, the market you are targeting, how you play with the partner’s portfolio, and your need to raise multiple rounds to get to breakeven are all factors you need to take into account before you even start contacting VCs. As Sun TZu wrote in his work The Art of War, “Every battle is won before it’s ever fought.”