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Should You Raise Venture Capital?

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If you have read any tech publication within the past year, I’m sure you’ve read about the “tech bubble” or “the Series A crunch.” Tech blogs make raising venture capital seem very sexy. It’s easy to get caught up in the hype surrounding venture funding. But building a business is far more than just the amount of money raised and who gave you the money. It’s easy to forget this if you’re in the Silicon Valley echo chamber.

I can’t fault anyone for dreaming big and wanting to go for it all. Acquisition stories like Instagram or Whatsapp, where they raise a minimal amount of money and get acquired for billions, are what startup fairy tales are made of. But the reality is, you’re more likely to join the deadpool. Just ask LayerVault, Viddy, and Finally.io. Heck, even GigaOm closed down recently, and they seemingly had a viable business going for years.

For all the stories of startup funding (just scan the first page of Techcrunch), there are many companies and founders that can’t raise venture capital. Many of these founders waste time trying to raise venture capital because it’s sexy and seemingly the only option. Venture capital is a very small asset class and appeals to only a small number of entrepreneurs. There are far more entrepreneurs building successful companies that don’t raise venture funding.

I’m not here to dissuade you from following your dreams and going for it all. If that’s what you choose, great! Let me know how I can help (brand, content, distribution, user acquisition, etc). This post is merely to educate and lay out options outside of venture capital. Let’s examine whether or not venture capital is really right for your company.

Understanding VC Economics

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Let’s first try to understand where your venture capitalist is coming from. Here are cliff’s notes on how a venture fund is set up.

Venture funds vary in size, some are $55 million others can be greater than a billion dollars. The size of the fund affects its management structure, but largely the venture capital business is linear. There isn’t a steep hierarchy like a big corporation has, but rather a small nucleus of general partners that make decisions together. (This obviously is different when you’re dealing with larger funds like KPCB).

Venture capitals raise their funds from “limited partners.” These can be comprised of pension funds, university endowments, other investor funds, and individual investors. These limited partners know their money will be illiquid for anywhere from 5-10 years (or more). But they also expect a return of 5-10x at the very least. Unlike larger asset classes, venture is built for high risk, high reward.

Venture capital is a “hits” business. Meaning, a firm might make a ton of investments in different companies, but only a handful, sometimes only one company, will return the fund and profit back to the limited partners. Venture capitalists have to be founder friendly to attract new investment opportunities, but their fiduciary responsibility is to their limited partners.

Understanding how a venture capital firm makes money will give you better insight as to how they make decisions, and whether or not your interests truly align. Venture capital firms are paid a management fee, typically 2% of the total fund size (unless you have a great track record and can demand more). If you have a $100 million fund, that’s $2 million every year you have for operating costs, which includes salaries, staff, overhead, etc. In addition to a management fee, venture firms are paid a carried interest on profit.

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The standard carried interest (or carry) for a VC firm is 20%. The carry pertains to profit only. If a $100 million fund only returns $90 million, then the partners don’t get paid on the carry (they probably won’t be able to raise another fund). But if the firm’s gains are $400 million, that’s $300 million profit from the original $100 million fund. Take 20% of that and you have $60 million to divide among the venture firm partners. Not a bad payday.

While you are most concerned with your business and how you can keep it alive and grow it, this is important to know. If you are a one of thirty investments a venture firm’s portfolio, your individual success isn’t as vital to their success. Just because they’ve invested $2 million in your business, they’re not guaranteed to keep investing in your business if you’re failing. They have a whole portfolio of companies, with a few that do well, that they can better invest their money in. One Google can make up for dozens of Viddys.

The Case For Venture Capital

With a better understanding of venture capital, it’s safe to say that it’s not totally evil. There are definite benefits to raising venture funding. As prominent venture capitalist Marc Andreessen tweeted:

I think this tweet perfectly encapsulates venture capital. Far too many young entrepreneurs think that the only way to fund their company is through venture capital. It’s not. (There are other ways and I’ll touch on them in a bit.) But venture capital is the best capital if you want to grow fast and get really big. Venture capitalists have the risk appetite needed for early stage companies. A venture capitalist will fund a company with as little as a prototype, while other investors (like private equity) usually require a company have anywhere from $5-15 million in annual revenue (at least the ones I’ve spoken with). 

I have a friend who sold his first company for approximately $10-15 million. For his second company, he raise between $8-10 million in venture capital, including from top firms in the Valley. To paraphrase a conversation we had, “Lifestyle businesses* are nice, but they (he and his co-founder) want to go big. They want to build a venture-backed, billion dollar company.”

My buddy was a perfect candidate for venture capital. He had a “win” under his belt to prove to investors he could build a product/company, but it was financially small enough that he was still hungry. If you want to go big and fast, go venture capital. 

*Lifestyle business typically refers to businesses that don’t have any type of funding and allows someone support their lifestyle while running their company. Fred Wilson just had a great conversation on the topic of “lifestyle businesses” on his blog

The Case For Angel Funding

Angel funding is usually a pre-cursor to venture capital, but not always. Angel funding is taking money from an individual investor. This person is an accredited investor, who does not have a formal fund with limited partners. 

Angel investments vary in size. But checks can be anywhere between $10,000 and $100,000 per person (obviously more or less as well). It’s not uncommon for multiple angel investors be involved in a seed round. For example, you could raise $500,000 a round from ten different investors, each giving you $50,000.

As aforementioned, these investments are typically a stepping stone to a larger investment from venture capitalists. But that is definitely not the rule. There have been plenty of businesses that have taken a small investment to get going and never looked back. There are even investors that are setting up programs who offer relatively small investments, aimed at entrepreneurs who are trying to build profitable businesses, but need some capital to start.

500 Startups Founder, Dave McClure

500 Startups Founder, Dave McClure

Terms for an angel investment are typically much friendlier than a venture round. Venture rounds are almost always priced, meaning the venture capitalist exchanges capital for a set piece of the company. I give you $1,000,000 and now I own 30% of your company. Angel investments are more commonly made as a convertible note.

A convertible note is a form of debt. You receive the money but do not assign a value to the company, thus not giving the investor a set percentage. This is done for several reasons. One, the paperwork is a little easier. Secondly, you don’t have to figure out a valuation. Especially when your company isn’t worth much.

Angel investors have more appetite for risk and are willing to work with young companies who don’t have much, if any, traction. Angel funding helps you build your company, venture capital will scale it. 

The Case for Bootstrapping

Most companies in this world are bootstrapped. You invest your own time and money into the company and you own it 100%. It gives the entrepreneur the most control and freedom. This tweet by David Heinemier Hannsson illustrates why someone who can raise venture capital might opt not to. 

Bootstrapping your business is slow. You have to get one customer, then another, then invest that money back into your company. Your cashflow is a top priority. It is unlike venture capital, which lets you run your business at a loss for years if you have to.

Bootstrapping your business should be your default startup option. It’s not sexy and you won’t get a write up in Techcrunch right away, but you will be in control, which, to some, is priceless. This Hacker News thread highlights the regret many had after raising money from investors.

The choice is yours. It all depends on your product, the business behind it, your experience, and what you want to build. But before you go down the rat race of raising venture capital, it’s imperative that you really understand everything involved with an investment.

Take this with a grain of salt…but if you are dead set on raising venture capital, I would suggest you bootstrap your company as long as possible (get it made, get a few customers), raise angel funding to help get your company up and running, and then raise venture capital to really scale your business.

Here are a few questions you should ask a potential investor before taking an investment. Also check out our post on Startup Stock Options, which has some questions/terms that will help you during your venture capital negotiations.

  1. Where is the firm in their own business cycle? Start of a new fund? Finding new funding? End of a fund with limited resources?How has the fund been performing? A better performing fund is able to take more risks.
  2. What type of companies do they (the fund) typically invest in?
  3. How can you help my business? Do you have relationships in our industry?
  4. How many boards/investments do you (the individual investor) currently work with?
  5. What are your return expectations?
  6. Under what conditions would you or have you provided bridge funding to get to another full round of investment?
  7. Who are some entrepreneurs you’ve worked with, where the investment didn’t work out? (You’ll want to chat with them to understand how that changed the relationship).

[Image 1 Courtesy of Money-Savings]

[Image 2 Courtesy of Heisenberg Media]

[Image 3 Courtesy of Robert Scoble]

[Image 4 Courtesy of Joi Ito]

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  • http://www.tummax.com Egbert Hennen

    hire a professional