I was in college during the first dot-com boom. It was nuts. Billboards would advertise a new, different, supposedly-world-changing dot-com every week. Brainstorming ideas for new companies was a campus pastime. The news was full of IPOs. English majors were switching into computer science (shocking!) to get in on the action. Everything I read and heard at the time was that the only way to start a business was to raise VC dollars — tens of millions of them. Bootstrapping was a second thought and considered riskier.
That message is still being preached today; just this morning I read the following passage in Entrepreneur magazine (see the footnote for a warning about this publication):
“To maintain control over Gonzo Game’s intellectual property, van Gool wants to grow with little or no outside funding, which means he has to plug revenues right back into the company, making growth slower and business riskier.”
Based on my own entrepreneurship experience, I argue that the opposite is true: Raising VC funding is far riskier than bootstrapping. By “riskier,” I mean “lower expected value.” I’ll explain this more later.
Isn’t the goal of starting a company to make a lot of money…or at least to make enough money to enable you to change the world with your idea? If money and/or executing your idea are the goals, why would you give up equity and control on day one? I’ll go on a limb and argue: Raising VC funding could signal failure for the entrepreneur. Too many people see raising money as the sign of success. Movies and other media reinforce this fallacy. Here’s why raising several million from a VC could be a bad thing for you as a founder:
- You’re “selling low.” The average VC-backed company takes $7.5MM in investment…usually before the company had much of an opportunity to build value. This means that founders give away huge chunks of equity.
- You’ll typically lose control over your company’s destiny. Together with huge chunks of equity go board seats and voting control of the company. The strategy is no longer driven by the founder’s schedule, the market’s dynamics, or the maturity of the product idea…it’s driven by the VC fund’s need to exit within a set number of years and show a high return.
- You’re no longer your own boss. I can’t say enough about the importance of this issue. Founders have to be passionate about their business. They frequently choose entrepreneurship as an alternative to cubicle-dwelling and reporting to a boss. Those who actually make the leap are typically driven, opinionated, and frequently stubborn. I’ve seen two examples first-hand where these personality traits didn’t play well when investors started changing the path of the company or exercising their voting rights…and a founder ended up being sidelined because he became too much of a pain in the arse.
I haven’t met him, but I have a feeling that Mark Pincus from Zygna has that type of personality:
“I would fight to the end for control, because if you do not have control of your company; you are an employee.” – Mark Pincus
Even consider Facebook, which raised VC money. Think about how different Facebook might be if Sean Parker hadn’t helped Zuckerburg retain control and thereby implement his vision for the company.
That said, however, if you don’t have the business savvy to run a company, sell, and make the tough calls, then you either don’t belong in the startup world or you need a VC-picked CEO.
We Need Some Balance
It could be that I have too small of a data set (1 VC-backed company went bust, 1 angel-backed company fizzled, 1 bootstrapped company is doing well, 1 VC-backed company is just getting started). My perspective might also be skewed because all these companies have built large, expensive, industrial-scale hardware products where cost and margins are important, not web software products where “eyeballs” and “freemium” are part of the vocabulary.
I do know, however, that:
Young and prospective entrepreneurs are not given a balanced perspective on their funding options, nor the necessary exposure through case studies, books, articles, and videos to execute a bootstrapping strategy based on best practices.
If you’re aware of good resources on bootstrapping, please leave them in the comments section for everyone to see.
Why VCs are Considered “Evil”
I’m not one of those who categorically hates VCs. They have an important role in the startup ecosystem and all the good ones create value in the work they do. There is a reason, however, that the industry has earned a certain reputation.
Let’s do a quick back-of-the-enveloped calculation. Say the VC general partners raise the average fund size of $150MM. The average investment per company is $7.5MM. Funds last for about 7-10 years and the LPs aim for an annualized 20% return on their investment. The partners want to avoid spreading themselves too thin, so they limit the number of companies to, on average, 20. (data from the NVCA)
Given these numbers, how much would the portfolio companies have to return? Let’s take the two extreme cases….
- All exit: Assuming that all the portfolio companies exit successfully (virtually impossible), they’d each have to sell for $15MM for the fund to return 20% annually.
- Only one exits: Assume, instead, that all but one of the portfolio companies go bust. That means the one survivor would have to sell for $300MM for the fund to return 20% annually.
It should now be obvious why VCs push founders to swing for the fences…and why they brush the founder aside when the company stumbles or doesn’t execute the strategy aggressively enough. The VCs themselves are under incredible pressure to deliver four one home-runs within 7-10 years, and preferably at least one grand slam. VC’s actions resulting from this pressure and these financial realities are what have earned them a certain reputation.
I’m not saying that the VC industry is “tricking” entrepreneurs to take their money, dilute themselves, and enter a losing game. VCs do provide value…and in some (limited) cases big money is needed to win in a market. Venture capitalist Mark Suster has several interesting blogs and videos showing that he, for one, understands the risks founders face when raising VC funding and respects the founders’s perspective:
There are hundreds of considerations when taking the bootstrap route. Here are just some of them.
- Learn to pivot. The main advantage to controlling your destiny is not being forced to hit a home-run during your first at-bat. You can change directions until you find the right product…as long as you don’t run out of cash. Always be looking for potential customers and solve their problems for them with your ideas.
- Win “free” funding, where you don’t need to give away equity, like SBIR and OEM product development contracts.
- Get loans, especially low-interest ones from state economic development agencies.
- Partner with universities for incubator space, lab space, specialized equipment, skilled technical advisors, and energetic entry-level hires.
- Hire entry-level employees…and cross-train so you’re not stuck when they leave in 3 years for a higher salary.
- Be stingy in spending cash…but not so much that you alienate your employees. Barter. If you’re not frugal at heart, don’t bother trying to bootstrap, go raise $20MM in VC money.
- Be generous with your equity. You’re bootstrapping in order to preserve equity, so be generous in giving some of that extra equity to all of your employees, especially the ones that are key to your success. Vest.
Doing these things is difficult, but we all knew startups are hard work, right? Guy Kawasaki, one of the early employees at Apple, said about startups: “If I had known how hard it was to start a company, I wouldn’t have done it.” Doing these things without a large infusion of VC cash makes them even more difficult.
However, taking VC money can limit your options. If your initial product idea is wrong (which it will likely be) or if your market isn’t yet ready for your innovation (which is also likely), then the VCs might not give you a second chance.
Which Route to Take?
Econ and finance majors learn about future expected value. Assign a dollar value to each possible future end-scenario and estimate the probability of each scenario happening. Multiply the probabilities times the dollar values and — voilà! — you get your expected value. (Learn why humans are inherently bad at doing this exercise from Dan Gilbert).
When you start your company, try this exercise for the following cases:
- The VC-funded route, where you manage to hang on to 5-10% of the company.
– 20% probability: You earn a decent salary and in 7 years you get 10% of $50MM.
– 40% probability: You have a moderate exit and in 7 years get 10% of $10MM.
– 40% probability: You earn a decent salary and in 7 years the VCs shut you down and you leave with zero.
- The bootstrapped route (possibly with angel support), where you retain 30-70% of your company.
– 30% probability: For the first 3 years you earn only 25-50% of market-rate and occasionally go without pay before being able to afford a full salary. After 8-15 years you sell the company for $10-20MM.
– 30% probability: You find a good niche and decide not to sell the company. Instead, you make being your own boss a lifestyle. You max out at around 50 employees and pay yourself a $150k+ salary for the rest of your career.
– 40% probability: You struggle to find your product niche. Since you lack the business skills and aren’t getting advice from an experienced VC or angel, your business runs out of cash within 1-5 years.
There’s much more that goes into this decision than just an expected value calculation…the people you partner with and those you hire, market timing, accuracy of your product focus, ability to correct your strategy, your desired lifestyle, etc.
At the least, I hope it makes a new entrepreneur think seriously about his options.
[Footnote: Bloomberg Businessweek recently reported that Entrepreneur magazine, which has the trademark on the word “entrepreneur,” has been actively protecting its trademark by suing any young company or entrepreneur-support organization that uses the term. They have driven founders into personal bankruptcy. This will be my last issue of Entrepreneur…I’m cancelling my subscription. It’s a hokey magazine, anyways.]