Can a VC transfer risk to a startup?
When you are an entrepreneur trying to build a product at a startup, you are in a pretty risky place. Usually you are not generating cash flow, you don’t yet know exactly which features are going to be required by the marketplace and you aren’t yet sure how you are going to market/sell the product (i.e. haven’t gotten product-market fit yet.)
Startup founders often see raising venture capital as a way to mitigate the risk of starting a business – basically, they get to play with the VCs money while they work out how to create a real business/get the product working. Having a salary is a great risk hedge (vs. no salary and working only for equity upside); a salary sure beats working for a couple of years w/o cash flow! If you spend the venture capital wisely, then you get to increase your cash burn to more quickly hit your target market and get your product to market. This is pretty much the thought process we had at OfficeDrop when we raised a modest amount of capital. It was becoming onerous to not get paid a salary, and we wanted to invest money in product development and marketing. And in our case, so far so good!
I recently read a post by Fred Wilson on CAPM, which describes the trade off between return and risk. There was a great comment by somebody named Julien, “I would love to hear about the current beta in the venture ecosystem. My bet is that it’s always very high, which induces stress for the VCs themselves, that they tend to transfer down to the startups in which they invest.” In other words, can VCs actually increase the risk of the startup? I believe that they can.
Venture Capital can make a startup riskier
How can this be? I want to make it clear that this is not usually the case – most VCs are actually helping derisk their startups’ business models. But raising money can make a startup more dangerous (for the founder in particular.)
The biggest way a VC can increase a startup founder’s risk is by not participating in a follow on round of financing. As herd animals, VCs look to each other for signals. An existing investor not investing in a subsequent round is a major red flag that something is wrong with the business. That’s why I’ve always recommended syndicating your Series A Round – you decrease the likelihood that no existing investor steps up. (Note that I have ignored my own advice with OfficeDrop.) There are other reasons that a venture capital firm will not invest – such as the fund running out of money or the partner who made the original investment leaving the fund.
IT Venture capitalists usually like to invest in “product” businesses – by product I mean businesses that generate revenue by selling something this is not based on billing out a person at a particular rate. I’m not describing this well, but VCs generally don’t like body based businesses that scale only as people are added (people who get billed out). But contrast this with a business that starts as a service and creates a product based on its own or its clients needs. A service based business can be profitable from day one for the founder, generating cash to pay the bills and cash to iterate to a product that the market wants. Great examples are 37Signals or FreshBooks (I know there is a great interview w/a 37Signals founder about why he doesn’t like VC, but I can’t find it this morning). Think about what would have happened if the initial products they created had flopped. If they had no venture capital, then they would have gone back to having great consulting businesses and maybe would have tried again later to create another software product. But if they had raised VC, their investors would not have been happy with them going back to having a couple of person business that looked like it could generate a couple hundred thousand $ in consulting revenue for the next few years – they would have insisted in putting massive amounts of development dollars into finding the next idea, even if the founders didn’t have a great one at that moment.
VCs also invest money with a pretty specific purpose – to build a company along the investment thesis the founder pitched initially. But if the initial product idea is failing, it becomes the founder’s responsibility to convince the investor that a pivot is needed. A good VC will act as a smart advisor, working with the founder to assess the situation and helping the founder find the right ways to pivot. The best VCs make introductions to potential customers before and during a pivot so that the founder can get smarter before the jump. But a VC may slow down the pivot, trying to get the founder to spend more time and money on the initial thesis. This can happen for a variety of reasons, but some of them may not be transparent to the startup. In particular, if the VC is having to play politics at his/her fund, they may not want to have to go back to the fund’s partnership and admit that their initial thesis was a failure. For a lot of startups, the road to success is paved with a series of small failures (i.e. learning experiences). Hopefully your VC does not mind these road bumps to victory.
Once you’ve raised a lot of money, there can be pressure to spend the cash. Even VCs with a lot of patience want to see their portfolio companies working hard to build a business. Everyone, from VC to entrepreneur, wants to see progress between board meetings. Recently I was hanging out with an executive of a locally funded startup who just admitted to wasting close to $100k on an Adwords campaign that she knew wouldn’t work. Having raised a significant sum of venture funding, the startup is getting pressure from the investors to spend the money to ramp up sales. Because the investors had experienced success with Adwords at a different portfolio company, they aggressively suggested a serious Adwords campaign. However, this particular startup’s space had very expensive PPC, and the basic math of generating positive ROI from Adwords just was never going to be there for the company. VCs need to see growth to justify their investment. I prefer to spend a little money and take a little more time to succeed or fail in my marketing efforts. Many VCs will prefer to spend big to determine failure fast. I’m not sure how much of your company you give up for $100k, but it’s probably a decent percent coming out of the founder’s pocket. Have a good conversation with your investor prior to the investment to make sure you are on the same page in spending the cash.
Venture capitalists make their money with big exits. For most VCs, making two times their investment is not considered a great use of capital. This means that VCs pressure companies to go big, which can destroy a great little business. As I talk about in my post “Don’t Raise Venture Capital,” make sure your goals are aligned with the goals of the investors before you raise money.
Venture capitalists can sometimes push out a founder. Fred once again has another great post, this one on parting ways with a founder.* While this may or may not be good for the startup, it does mean that the founder who gets pushed out will probably no longer vest equity. Since you are no longer working for yourself when you raise venture financing, you can increase your own personal risk if it is decided that you are no longer needed at the startup.
I’m not suggesting that you don’t raise venture capital for your startup. However, I don’t know if most founders consider the baggage that comes along with a check from a venture fund. The right venture capitalist can really help grow your business – but make sure you and your team are ready to go big when you bring all that cash onto your balance sheet.
*Note that I agree with Fred’s thesis; sometimes an early founder can be bad for a business as it grows. I can think of one example where the employees hated working with one of the co-founders of a startup because the co-founder was pretty much a jerk. When you lose great engineers because one of your co-founders pisses off everyone he interacts with you’ve got a problem. I’ve also seen a situation where one of the co-founders started spending a lot of time not working, which really de-motivated the other founders and engineers who were working 80+ hours to launch the product. If someone decides to no longer pull their weight, why should they continue to get paid and own a big % of the business – especially when it is a fresh startup that was just recently founded?