Do You Really Even Need VC?

I recently spoke on a panel in Santa Monica organized by my friend Jason Nazar, CEO of DocStoc, titled Startups Uncensored, Pitching Venture Capitalists.  There were about 200 people in the audience.

Jason started by asking the audience how many of them were start-ups – 90% of the hands went up.  He then asked for a show of hands of people who had already raised a round of Venture Capital – no hands.  I guess you’re thinking, “duh, that’s why they came to the panel discussion.” ;-)

He next asked me specifically how many of these companies were likely to get VC funding (thanks, Jason) and I responded, “less than 5%,” to which I heard a big gasp.  I responded that I thought this was a good thing – not something nasty.  I contend that the vast majority of companies should never raise venture capital.

Raising venture capital is like adding rocket fuel to your business and for most businesses this a) isn’t warranted b) creates the wrong incentives and c) even if it is successful means that the founders don’t make enough personal money when the ultimate business is sold.

I repeat this advice on a very frequent basis to most entrepreneurs I meet and I find it usually surprises people.  “You’re a VC – aren’t you supposed to want to give us money?”  No.  I want you to create a successful company that will be fulfilling to you and your employees and will make life better, faster and easier for your customers.

I also want you to make a great deal of money when you sell the company one day (or pay yourself great annual dividends to be paid out at a lower tax rate than you pay for your salary).  A banker once told me that he was surprised how many $50+ million exits where the founders made very little money.

For most tech entrepreneurs my advice is:

1. Raise a very small round of capital – usually from the three F’s (friends, family & fools): $100-200k

2. Use this to get a product built, sign up pilot customers and get your initial team in place

3. Raise a round of angel money / seed capital: $250k-$750k.

4. Keep your burn rate REALLY low for the first year.  Your goal if to prove to your investors and to yourself whether you have a scalable business here

5. Assess the situation in 1 year. For many businesses you will find that within 15 months into your operations you will know whether you can carve out a meaningful position in the market to build a small company.  I see so many companies that get to $1-2 million run rate and are break-even somewhere within their first three years.  This is fine.  It creates options for you.

6a. VC Route – If you arrive at this point and you believe this can be a really big business ($50-100+ million in sales) then it’s time to start thinking seriously about VC.  Awesome.  I know that some people know from day 1 that they’re building businesses that will require VC – they have a huge idea and want to “go for it.”  I accept that this is sometimes the case.  But it is rare.

6b. Angel Route – If you’re in the more likely situation that you can see how to get your business from $1 million this year to $3 million within 3 years and maybe $8 million within 5 years then VC may not be for you.  VC’s aren’t looking for companies that are doing $15 million in sales in 8 years from their investment.  In this scenario I advocate a combination of bank debt, venture debt, small equity raise ($1-2 million) from high net-worth individuals.  These people would be thrilled with a company that could potentially double or triple their money.  VC’s would not be happy with this outcome.

Shouldn’t most businesses at least TRY to go out and raise VC if they could?  No.

1. Adding VC is like adding rocket fuel to your company.  VC’s want to get your business into orbit (e.g. to scale) quickly and reach huge levels of revenue.  At times this may be at odds with your economic interests (and/or not within your capabilities).  If you try to go t0o quickly and don’t gain quick adoption you’re left with either an un-financeable company that could go bankrupt or be sold in a firesale or more likely the VC puts in a bridge loan to “rescue” you.  If you’re fortunate enough to eventually raise another round you may find out that you own a much smaller percentage of the company that you had initially wanted.

2. VCs want big outcomes.  When you raise money from a VC they will demand a veto right over the sale of the company.  You might be very happy selling your business for $9 million and owning 50% of the company.  Your VC is not necessarily going to be happy getting $3 million for his 33% stake for which he invested $1 million.

Wait, but isn’t that a 3x return?  Yes, but in aggregate it’s still just $3 million and if the VC has a $300 million it is just 1% of the money that he needs to get to reach his “hurdle rate” of when he’s entitled to earn carry (e.g. big bucks).  It’s just too much time to spend with a company for such a small total return.  Many VC’s would still let you sell the business at this price if you really wanted to.  They would likely think either that it’s senseless to go on with a company where the CEO is set on selling or maybe on the basis that you’d be interested in raising money from this VC for your next company and really make that company a home run for all involved.  Be aware that some VC’s have been known to actually block sales.

3. Preserve your options.  My final advice that I give to entrepreneurs is, “if you ARE going to raise VC, raise a small amount initially.  If you raise $2 million from a VC and along the way you get the feeling that this is going to be an interesting company but maybe the market won’t be as big as you expected or suddenly Google decided to compete so it may be harder to become the 800 pound gorilla then it iwill be easier to have a medium outcome while still retaining value for yourself.  Maybe you can run it for 3-4 years and find a way for Microsoft to buy it for $12 million to compete with Google.  If you raised $5 million it is unlikely that the VCs would settle for this outcome and would likely rather push you for a much bigger outcome.

So why not preserve your options.  If the business is really “taking off” and you see the white space in front of you to become a huge company then you can always raise a larger round to accelerate.  Think about Ning or Meebo.  Once they each raised their huge rounds at large valuations … could they really ever try to do anything but going into outer space?

One last comment on the subject of optionality.  There are certain mega funds that are institutions in Silicon Valley that maybe of backed Google or Facebook and have regularly churned out multi-billion companies over the past 20-30 years.  While it might be nice to be an investor in one of these funds you also need to be aware that some (not all) of them are much less interested in the “double” and at least one firm is known for either stopping to attend board meetings of companies that won’t be rockets or even worse blowing out the CEO’s who can’t get into outer space and finding ones they think can.  I’m not saying that I blame them – they obviously have a success formula.  But if you want to preserve your options for a double make sure that you don’t raise money from the Barry Bonds of VC … who only swings for the fences.  Obviously talking to other entrepreneurs will help you determine how your potential VC might act in this situation.

So why on Earth do you work in VC if you feel this way?

I said that most businesses shouldn’t raise VC.  But there are still many businesses that are capable of becoming very large ($50-100+ million revenue) businesses.  These businesses need cash to grow.  When a business has this kind of high potential I always counsel in the same way, “if you really believe that this is going to be a big market and you can be a market share leader then I guarantee there are 3 Phd’s in San Jose who think the same thing.  They’ll have access to venture capital and will be filing patents to kick your ass.”

“If this market is big then by the time you start announcing your first customer wins it will perk up the ears of a third-time, serial entrepreneur who sold his last business for $80 million.  He is going to sniff out the opportunity and put money and energy behind grabbing this market.  So if you’re not prepared to grab the market opportunity while it’s here somebody else will.”

In the right circumstances and in the right amounts … VC’s is the best way to scale mega businesses.  And it is those businesses that I’m looking to fund.