Do You Really Even Need VC?

Posted on Jul 22, 2009 | 27 comments


apollo_11_launchI 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.

Video on the topic if you want to watch is below (or click this link), otherwise the text following it covers what I talk about in the video:

For most tech entrepreneurs my advice is:

1. Raise a very small round of capital – usually from angels or 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.

bonds 7353. 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.

  • Brendan Biryla

    Steps 1-5 sound perfect… Where do I sign?

    Question Mark, I was reading Peter Lee’s blog and he wrote about the recent trend of larger funds having to come in on the seed rounds. What’s your take on this and does this impact step 3 at all? (http://seeingeyetoeye.wordpress.com/2009/05/22/read-an-interesting-article-in-businessw/

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  • marksuster

    If you can raise money from a seed fund that has a history of supporting CEO’s through small capital raises and small exits then they can replace the seed funder. I do not believe that this is FRC’s model nor Baroda’s – but they are both much closer than the firms that want to invest $8 million in your firm. The facts always remain – angel funders would be happy with a 2-3x whereas most VCs have a higher exit goal. The flip side – most angels are individuals so they may feel more pain if your company isn’t performing and MAY want to therefore interfere since the investment may impact them personally. So a small seed fund can be just the right balance.

  • http://www.s3edge.com Anush

    Mark, thanks for the concise, simple and yet powerful post; made for great reading and helped solidify the path we are on currently.

    Cheers

    /a

    http://rtvs.wordpress.com

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  • http://nubli.com Kumar Saurabh

    What an awesome post! As a first time enterpreneur, i had managed to come to a very similar conclusion in my head, but its very reassuring to hear from someone experienced with such clarity…

  • http://www.echosign.com Jason M. Lemkin

    Great piece. I learned this lesson firsthand in my last company. We sold the company and the investors earned 375% in 14 months — and not a single one showed up to the closing dinner.

  • http://www.cleencell.com Nima Shar

    Another great post, along with the previous Angel post. As an entrepreneur, VC is attractive because you are dealing with professional investors that bring know-how and contacts to the table. The 3 Fs are usually missing this and make ridiculous offers like $100k for 40% (which makes the company unattractive to VCs down the line), and few contacts that can really help your business (and sometimes they slow you down).

    The rocket feul analogy is the best. It seems 2 good questions to ask are: Can your company use rocket feul? And, can you as a CEO go along for the ride at rocket speed?

  • marksuster

    Wow, that’s pathetic. Funnily enough when I sold my second company there was no “signing party” on behalf of the company that bought us. People wanted to hurry out of the lawyers offices to get home. I’ve always been big for marking occasions. I wonder if that’s not an individual thing rather than a VC thing.

  • marksuster

    Nima, I agree with your comments about the 3 F’s. But they can be very useful in getting you from start to completing V1 of a product and getting initial customers. That can allow you to get to the seed stage or VC stage. So it is necessary for some entrepreneurs depending on their personal financial circumstances. Thanks for the input.

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  • http://www.growvc.com valto

    Would like to add one question here: Are you sure that you dont need to make any drastic change of direction?

    With rocket fuel you are sure to go fast to set direction, better make sure it’s the right one.

  • http://www.growvc.com valto

    Great post Mark. We are working to simplify and make the steps 1-5 more effective and easier to manage for everyone involved. Also including international opportunities along the way.

    Just few days back I wrote this post about the steps / process that we are focusing on with our service:
    http://www.growvc.com/blog/2009/07/the-process-from-idea-to-competitive-startup/

    Question to mark? Why are 6a & 6b in this order? If those would be in other way around I could have added from 1-6a

    Those that want to move beyond to VC we want them to be educated for what to expect, so this post hit’s that point well.

  • http://twitter.com/JerLevine Jeremy Levine

    Mark, thanks for the post. These are the exact issues I am currently considering and it was very helpful to read your advice. I have a question though: So I know that I have a huge idea that definitely fits in with the last part of your post, but I also know I can work to prove it slowly in the next year with much less. So, I am debating if I want to try to raise a large sum early on (at presumably worse terms) and push towards the end vision or raise as little as possible to get to a real proof point where I can then raise the necessary amount at much better terms. Any advice or opinions?

  • marksuster

    6a, 6b is only the order that my brain was working when I wrote the post. Not meant to be specific.

  • David Semeria

    Hi Mark,

    Most VCs require customer validation before considering an investment. This makes sense for consumer-facing websites because frequently it’s a bit of a mystery why one product gains traction whilst another doesn’t.

    But what if the product development phase itself requires significant (further) funding? Catch-22: we’ll fund if we see customers, but there won’t be any customers without funding.

    Any thoughts?

  • Rajat Suri

    Mark, had another idea for a post…many CEOs on a certain website seem to complain a lot that certain VCs use information from pitches/DD to fund competitive companies, or even found their own.

    Is this common?

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  • http://www.visiontree.com Adam

    Great notes Mark, I don’t think many people consider these items when considering VC rounds.

    I have passed this on to our CEO and will be using your notes in our meetings.

    One question, what if you are looking for $1-3mill; that seems like too high for Angel and too low for rocket fuel. Thanks!

  • marksuster

    $1m you can get done with angels, $3m is more VC. So answer depends on which end of the spectrum you’re looking for. Good luck.

  • DJHunt

    Mark, I just ran across this article and think it's great. Founder need to understand what VCs are looking for and know that VC funding's not the “usual” path for startups, despite what they think. One little nitpick: in 6B you state that angels would be happy with a 3x return. While there may be plenty of high net worth individuals who would be happy with 3x, my experience says that most “professional” angels are looking for returns more along the lines of VCs. The Kaufmann Foundation suggests that angels have 10 companies in their portfolio each with the possibility of 10-30x returns, because only 1 of those companies will likely have that kind of exit. Of the rest, 4 will fail and 5 will have negative or modest returns.

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  • DJHunt

    Mark, I just ran across this article and think it's great. Founder need to understand what VCs are looking for and know that VC funding's not the “usual” path for startups, despite what they think. One little nitpick: in 6B you state that angels would be happy with a 3x return. While there may be plenty of high net worth individuals who would be happy with 3x, my experience says that most “professional” angels are looking for returns more along the lines of VCs. The Kaufmann Foundation suggests that angels have 10 companies in their portfolio each with the possibility of 10-30x returns, because only 1 of those companies will likely have that kind of exit. Of the rest, 4 will fail and 5 will have negative or modest returns.

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  • http://cromotion.net BerislavLopac

    I've ran into problems with your very first item on the list. You say “Raise a very small round of capital – usually from the three F’s (friends, family & fools): $100-200k” — but where I live (Croatia) this is the point where most startups fail. First of all, $100k is anything but “very small”; a startup can live on this money for a couple years with no revenue at all. But more importantly, FFF's with money are practically nonexistant here: although about 80% of population owns a house or an apartment, the cash available for investment is in very short supply. When we add a general lack of knowledge and distrust of entrepreneurs, we can simply forget about any seed stage funding whatsoever, and the only startups with any hope are those which can build a product on sweat equity only.

  • http://berislavlopac.tumblr.com BerislavLopac

    I've ran into problems with your very first item on the list. You say “Raise a very small round of capital – usually from the three F’s (friends, family & fools): $100-200k” — but where I live (Croatia) this is the point where most startups fail. First of all, $100k is anything but “very small”; a startup can live on this money for a couple years with no revenue at all. But more importantly, FFF's with money are practically nonexistant here: although about 80% of population owns a house or an apartment, the cash available for investment is in very short supply. When we add a general lack of knowledge and distrust of entrepreneurs, we can simply forget about any seed stage funding whatsoever, and the only startups with any hope are those which can build a product on sweat equity only.

  • http://bothsidesofthetable.com msuster

    Sorry to hear that. Are there no VCs or seed investors in Croatia or the surrounding areas? Might need to look to Germany, France or the UK which have more developed VC markets. Or Switzerland. Good luck!

  • http://bothsidesofthetable.com msuster

    Well … here's my experience. An angel may want 10x but if presented with an opportunity to get a 3x in 6 months they'd take it. Many VCs would not want this result and you might find some that encourage you not to sell. That's what I see as the main difference. But you're right that most angels expect a higher return. Thanks for your comments.

  • http://bothsidesofthetable.com msuster

    Sorry to hear that. Are there no VCs or seed investors in Croatia or the surrounding areas? Might need to look to Germany, France or the UK which have more developed VC markets. Or Switzerland. Good luck!

  • http://bothsidesofthetable.com msuster

    Well … here's my experience. An angel may want 10x but if presented with an opportunity to get a 3x in 6 months they'd take it. Many VCs would not want this result and you might find some that encourage you not to sell. That's what I see as the main difference. But you're right that most angels expect a higher return. Thanks for your comments.

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  • http://cromotion.net BerislavLopac

    That's exactly the case — one (government boosted) attempt at founding a local VC fund has failed twice so far (hopefully it will have more luck the third time), and another practically abandoned venture investment whatsoever… We're now trying to build a better connection with funds abroad, but pitching to them also takes money, so we have the proverbial chicken and egg game again.

  • http://berislavlopac.tumblr.com BerislavLopac

    That's exactly the case — one (government boosted) attempt at founding a local VC fund has failed twice so far (hopefully it will have more luck the third time), and another practically abandoned venture investment whatsoever… We're now trying to build a better connection with funds abroad, but pitching to them also takes money, so we have the proverbial chicken and egg game again.

  • http://abstract-factory.com/ BerislavLopac

    That's exactly the case — one (government boosted) attempt at founding a local VC fund has failed twice so far (hopefully it will have more luck the third time), and another practically abandoned venture investment whatsoever… We're now trying to build a better connection with funds abroad, but pitching to them also takes money, so we have the proverbial chicken and egg game again.

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