Shoehorning startups into the VC model

Tech startups go in an out of fashion. When they’re in fashion, as they are now, entrepreneurs and VCs get lots of attention. Most of this attention focuses on things that involve money, like financings and acquisitions. For some entrepreneurs, raising venture capital becomes a goal unto itself, instead of what it should be: a heavy burden that only makes sense in certain cases.

A startup should raise venture capital (or “venture-style” angel/seed funding) only if: 1) the goal is to build a billion-dollar (valuation) company, and 2) raising millions of dollars is absolutely necessary or will significantly accelerate growth.

There are lots of tech companies that are very successful but don’t fit the VC model. If they don’t raise VC, the founders can make money, create jobs, and work on something they love. If they raise VC, a wide range of outcomes that would otherwise be good become bad.

Unfortunately, many of these startups graft VC-friendly narratives onto their plans and raise too much money. Short term it might seem like a good idea but long term it won’t.

The best source of capital is customers. The next best is the founders (cash or forgone salaries), or investors who are less aggressive about returns than VCs. Every startup has its natural source of financing. Venture capital is the natural source of financing for only a small fraction of startups, despite what the press might lead you to believe.

Anonymous

Nice post. Too many aspiring entrepreneurs think bootstrapping is a dirty word. It’s not, and your words re: the VC model are spot on.
http://www.writeclickhosting.com jeremyleejames

This article should be a linked disclaimer in every single post that talks about seeking VC money. Well done.
http://www.jm3.net/ John Manoogian III (jm3)

The classic 37 Signals gallery of successful startups who didn’t raise venture capital: http://37signals.com/bootstrapped

http://www.cdixon.org/ chris dixon

I haven’t read all of 37Signals stuff, but some of the stuff I’ve read seems to be anti all VC. In my view it is right for some businesses, wrong for others. It’s complicated.
http://twitter.com/sethbannon Seth Bannon

Time to take GitHub off that list.

http://www.cdixon.org/ chris dixon

Github is an example of a company that js ok raising VC at this point. They are well on their way to being a multibillion dollar company.

http://twitter.com/menro robert reich

Chris

The amount raised and exits are two easy metrics people understand and can communicate quickly.

Last week for example I was at the Unreasonable Institute in Bouder Co. introducing myself and 1 of the founders asked why I used these 2 metrics to build credibility instead of talking about the number of people i have positively effected.

IMO we need some new metrics that can be verified before funding and or exits are no longer the ego play of a founder.

Robert Reich
Play Startup the Game http://bit.ly/CDSTGame

http://www.cdixon.org/ chris dixon

Agree. People do always focus on verifiable metrics. Counting the number of (quality) jobs created seems like it would be a good metric.

Anonymous

Refreshing post, customer growth and revenue are wins, raising capital isn’t. So why do you think people celebrate a $10m round but don’t really care about a company with $10m/year in revenue?

Anonymous

Vicious cycle. Technology blogs certainly don’t help. People celebrate the $10m round over the $10m in revenue because it’s what they read and the hype perpetuates…

http://arnoldwaldstein.com/ awaldstein

Timely for a personal project.

I’m presuming that raising and angel round of seed and a round of VC are different in your mind.

I’m raising an angel round now but while I have big aspirations I never think in terms of billions of dollars. Could happen. Not a planned number I would sell against.

http://procause.com/ matthewhughes

I was thinking the same thing.

I’m also trying to raise a modest seed/angel round right now for a viable, albeit niche business.

I do see the point about not raising money unnecessarily. In my case, it feels necessary.

http://arnoldwaldstein.com/ awaldstein

I’ll await Chris to weigh in but I think about this mostly in terms of a return.

The right investors for my project have two characteristics: 1) A reasonable 3-5X return is comfortable even if this turns out to be a $50M biz not a $500M; and 2) in my instance have a passion for wine and a belief in my background to make it happen.

http://www.cdixon.org/ chris dixon

If you find the right investors, a smaller outcome is fine. Some angels are happy with that. People like me tend to invest in businesses that VC would later invest in, so I’d be the wrong person for that. In short it’s about matching everyone’s expectations.

http://twitter.com/Eisenberg dave eisenberg

Last bit is my favorite bit. Of course venture folks are smart and realize that startups that get this last piece are often the most attractive investments as well.

http://www.cdixon.org/ chris dixon

And sometimes it works for everyone. E.g. Github was a great bootstrapped startup but has enough revenue and growth now to make sense in the VC model.

http://www.facebook.com/profile.php?id=673862097 Shivakumar Narayanan

Short but bulls eye article
http://twitter.com/cindygallop Cindy Gallop

As a bootstrapping entrepreneur with two non-VC-friendly startups, love this.
http://twitter.com/vincentleeuwen Vincent van Leeuwen

Good stuff. And unfortunately often very true.
http://abdallahalhakim.tumblr.com/ Abdallah Al-Hakim

I do agree with your premise but there is more to VCs than just capital. For many entrepreneurs, a good VC will bring networks into play, offer advice based on experience and help with some of deal flows or potential partnerships. At least this is my vision of a top quality VC.

http://www.cdixon.org/ chris dixon

I agree. Good VCs can help. But they still have a model that is incompatible with a lot of businesses.

http://abdallahalhakim.tumblr.com/ Abdallah Al-Hakim

Great point. So entrepreneurs should understand the choice between a good business model for their startups and good business model for VCs. There does seem to be a pull for the VC model because of the allure of getting VC money.

http://steamcatapult.com/ Dave Pinsen

” If they raise VC, a wide range of outcomes that would otherwise be good become bad.”

Bad for the investors, sure, but bad for the founders? What’s the downside of getting paid by OPM for a year or two and then not succeeding? Failure doesn’t seem to preclude founders from getting funded again.

The downside of bootstrapping and not succeeding is bigger, no?

http://www.cdixon.org/ chris dixon

It depends. I know lots of founders who wish they hadn’t raised VC. A sale was blocked, they were fired, or just they struggled for years to get their investors a venture return.

Anonymous

that happened to the company I worked at during the .com boom/bust — we had two offers on the table. One from AMCC for $480m cash. One from Lucent for $450m in stock. The VC’s chose Lucent because they thought it would open more doors for other companies in their portfolio. And Lucent soon after the deal closed began their descent from $80+/share to $3/share..
http://davidmcdougall.org/ Dave McDougall

According to a story that went up this week, this was what happened with Digg — the board blocked a $60 million sale in 2006.
http://www.businessinsider.com/digg-kevin-rose-untold-history-2012-7

Anonymous

I generally agree with this, but with the lofty valuations being placed on companies these days, anyone can convince themselves that they are a “billion-dollar valuation” company, so more emphasis should be put on “is funding necessary to fuel growth”? And what about revenues? People seem to be forgeting about that these days.

http://www.cdixon.org/ chris dixon

Yeah, maybe I should have made it clearer I meant a liquid billion-dollar valuation (IPO or acqusition).

http://twitter.com/mattKandler Matt Kandler

Can’t help but wonder if this was spurred by 500startups Demo Day. Many of the companies seemed to be “doing one thing and doing it well” but are they all really the sort of companies/ideas/founders that need to raise VC money? I found myself thinking there must be some more appropriate options – especially minding your two questions.
Great post!

http://www.cdixon.org/ chris dixon

No not at all. I was spurred by some startups I met recently but not 500startups. As I understand the 500startups model they are explicitly ok with companies not raising VC and e.g. selling the company at prices that make founders/incubators happy but wouldn’t make VCs happy.

http://twitter.com/mattKandler Matt Kandler

Poor assumption on my part – glad to hear that behavior is being encouraged.

http://blog.jedchristiansen.com jedc

From what I understand, this is Dave’s key insight. That if you give a lot of companies a little bit of money, it’s a lot easier for them to exit at lower valuations, and there’s a lot more opportunities for exits that are nicely profitable. It looks to be doing well so far.

http://twitter.com/ilamont Ian Lamont

This should be required reading for anyone applying to an accelerator.

http://www.cdixon.org/ chris dixon

I am generally a fan of accelerators (especially YC) but agree that some of them add to the sentiment that VC funding is necessary for success.

http://www.credii.com vammok

I see a lot of companies that could reach decent outcomes ($50mn exits in 3-4 years?) significantly faster with a onetime raise of 500k to 2mn instead of bootstrapping all the way. These are the unfortunate ones that fall into the neither-nor zone and are forced to shoehorn themselves into the VC model.

http://www.cdixon.org/ chris dixon

Agreed, and if that is the plan and they have investors who fit that model that’s great. But it takes a ton of discipline to go down the angel/seed funding path and then get to profitability. Usually have money raises their cost structure so much they need to raise more.

http://www.credii.com vammok

I wonder if a reverse PE model would work. Supercharge a high-performing small-market startup, bring in the right skills to make it a real threat to incumbents, and sell for a 3x return inside a year.

http://avc.com fredwilson

word
http://kidmercury.posterous.com/ kidmercury

VCs will need to adapt their model. they are dependent upon IPOs and bubble-inducing monetary policy and those days are coming to an end. the future is not in one world networks that seek to conquer the world, but rather in increasingly niche networks that survive through deep engagement and greater share of customer wallet.

professional private equity investors will increasingly be characterized not be seeking investments that generate huge market caps, but rather by making a large number of investments and seeking to create network effects within their portfolio.

http://www.cdixon.org/ chris dixon

Creating network effects within portfolios- this has always been an intriguing idea but in my experience there are actually very little network effects within VCs portfolios, and I’m not sure how to make those stronger.

http://twitter.com/MedStartr MedStartr

We are already seeing a network effect in our niche (if you can call healthcare a niche) crowdfunding site. Our first 9 project’s CEOs are integrating with each other products and partners are coming in to connect them up with wireless devices and clinical study centers. Never seen anything like it.
http://the-makegood.com Matt Strazz

Other startups usually make for lousy partners. Neither has what the other needs: scale, a brand name and the resources to make it work. VCs encourage it but often its just a big time waster.

http://twitter.com/creativecarl Carl Thompson

Couldn’t agree more. Met quite a few startups here in Singapore that clearly don’t need to raise they just need to pull finger and DO IT!
http://twitter.com/pragmatic_rebel Yogesh Ramesh Sharma

“The best source of capital is customers.” — I totally agree!
http://about.me/johnmccarthy johnmccarthy

A must read.
http://martin.silbernagl.com/ Martin Silbernagl

true that
http://nabeelhyatt.com nabeel

Absolutely. It is a path, not a rung on the ladder.
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http://twitter.com/chrisyeh Chris Yeh

Nobody makes money off of fundraising (except for the lawyers). So why do we find it so exciting?

I think it’s a by-product of visibility. If startups reported revenues, that would probably dominate, but since revenues are rarely disclosed (but round sizes are), the press focuses on those financings.

http://www.cdixon.org/ chris dixon

“Nobody makes money off of fundraising (except for the lawyers).” << I think a lot of people who haven't raised VC don't understand this.

http://sparksvc.com/ Chris Sparks

Recently watched the TechStars NYC show on Bloomberg. I think this point was driven home for me when the studio audience was driven to raucous applause by the start-up who raised $5M of VC and remained silent when the next start-up announced $5M in revenue.
http://www.lylemckeany.com/ Lyle McKeany

It seems that many people glamorize getting VC funding. The press eats it up as well. It’s like the company hit the lottery or something. It’s good to read something real like this post to keep things in perspective. Thanks Chris!

http://www.cdixon.org/ chris dixon

Thanks. I think it’s telling that experienced entrepreneurs, while often willing to take VC, tend to do so more carefully.

http://twitter.com/MedStartr MedStartr

Word up! I blogged on same topic a few weeks ago “The best term sheet is a bill of sale” over on my FairCareMD blog. Disintermediating healthcare is pretty VC unfriendly and we definitely tried to shoehorn it, to no avail. To experiment with what people would pay for faster we went to kickstarter only to find they don’t accept healthcare projects… so we started our own to good effect. Now any healthcare startup can collect “bills of sale”, which oddly enough, is the best VC attractor we have found. oddly circular.
Jose G. Gonzalez

Thanks
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http://twitter.com/sonofakarma Matthew Williamson

“As to methods there may be a million and then some, but principles are few. The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring principles, is sure to have trouble.” — Ralph Waldo Emerson
To me funding type is a method unrelated to the principles of creating value with your business. If you create value, all types of funding will be available. That being said, when you are living on shoe strings and/or do not have customers funding you, the VC dealer may look pretty attractive. The key is to maintain your principles and to not fall prey to “grocery shopping while hungry” — you end up with a ton of stuff you do not need!
http://twitter.com/MedicalTraveler Health Travel Guides

great post
http://www.justanentrepreneur.com Philip Sugar

Great post. It would be really interesting to get the perspectives from people that have gone the other route. The reason that is so hard is that none of us really cares to be noticed, there is no upside to that equation if you are just cranking a successful tech business.
http://twitter.com/tech_news21 Science & tech news

My question is (I don’t know much about VC), if you don’t raise VC then how can an international student who can’t take loans like fellow Americans, is going to financially support the initial cost of the project, co-fonder and developing the prototype.
http://austinpreneur.com Joshua Baer

The first thing I usually do when I talk to a startup about raising funding is to try and talk them out of it and provide alternative options (customers paying in advance is the best!). At Capital Factory, we are focusing on tech startups that can reach $1mm in profitable annual revenue on less than $1mm of funding. They can get all of that from Angels and many won’t ever need to raise more funding from VC’s (and many will go raise more money).
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