Should I look for funding?

While I was attending the recent inaugural Triangle Startup Drinks on Friday night, the subject of Venture and Angel funding came up. I figured it was worth a post…

Two different folks raised the question. One has an idea that they think can be big. They’ve been doing their research but don’t have a product yet. The other has a beta product and is looking to expand their business.

The first thing to realize is that in the context of funding, there are two types of business. For want of a better description, I’ll call them Lifestyle and Growth.

A lifestyle business is a perfectly solid small business. One of my former startups, 12 Inch Design, is a good example. It serves a relatively small market (tens of millions, not billions) and ticks along at a nice pace. Since the market isn’t that large, there is a clear upper limit to how big the business can and should be. And the ultimate size is simply not that big.

If you have a lifestyle business, you should NOT pursue VC or Angel funding. If you need financing, debt or friends & family will be by far the best route to take. Your business will not be able to provide the kind of return an Angel or VC investor is looking for.

So what if you have a growth company?

Well first of all, a true growth company needs to be a “sky’s the limit” kind of business. Your addressable market should be in the billions, or at least be likely to be in the billions at some point (search wasn’t a billion dollar business when Google got money, but it certainly had potential for very broad adoption).

Secondly, the business has to have an exit path. There are two: get acquired or go public. And that exit needs to be at a value where the investor can get 5-10x their investment.

Let me be very clear: if an investor puts $1M into your company, they expect to get $5-10M back. If they put $5M in, they expect $25-$50M back.

This may sound like a lot to you, but the numbers have to be like that because VC investments are high risk and many will fail to yield a return. Don’t get carried away with feeling bad for VCs, but they are in a genuinely tough business. I forget the exact industry stats (and I’m too lazy to look it up) but they go like this… Over 10 investments, 1 will give a great return, 4-6 will return 1-2x the investment, and the remainder may be a loss. So if a VC invests $50M across 10 companies, they can expect $35-50M from the hit and maybe $25-30M from the rest. So $50M invested may return $60-80M.

$10-30M in profit sounds like a good return, but it may take 5-7 years to see that. Doing some handwaving math, with those numbers over a 5 year period, the interest rate on the investment is about 10% annually. That’s no better than the S&P 500 index, and the VC’s risk is much higher.

So they expect a big return. And you will have to sell your company or take it public for them to get it.

Now presumably you want to make a buck or two out of your company also. But your ability to do that will be tied to the deal you cut with the VCs that are investing in your company. Simply put, the more risk you take off the table for the VC, the more of your company you can hang on to.

What does that mean? Well, if you have an idea, no product and no customers, you are (a) very early stage and (b) very high risk. If you have a product, some customers and even modest revenues, you are comparatively much lower risk. The closer you are to the second scenario, the better deal terms you’ll be able to get.

I’ll skip on details (this post is long enough already) but there are many different aspects to a VC term sheet. One that people tend to focus on is valuation. Let’s say you’re very early stage. Maybe the VC values your company at $1M. If they invest $1M, your “post money” valuation is $2M. $1M of that $2M is from the VC, so they will own 50% of the company. Or to put it another way, your ownership just got cut in half.

If you have customers and modest revenues, you may get a valuation of $2-$4M. With the same $1M raise, you have a post money valuation of $3-5M. The VC’s percentage is now more like 20-33%.

And of course, odds are good that you will need more than one round of investment to build your company, so the original founders can expect to end up owning 25% or less (combined) of the company at the end of the day.

I’m simplifying a _lot_ here, but you get the idea.

The point is that the VC investment should dramatically increase the overall value of your company. Without investment, maybe you can own 100% of a $5M pie. But with investment and a good outcome, maybe you end up with 25% of a $100M pie.

If your company can be a growth company and you’re willing to give up significant ownership over time, VCs and Angels may make sense. If you want to own it all, or your business isn’t going to give the right kind of return, VC/Angel investors are not a good fit.

One more thing on a related subject: it’s interesting how many early stage companies die because of squabbles over ownership. In one case that I know about, the dispute was over 5% of the company. Founder A owned 50%. Founder B owned 40%. Founder B wanted to be equal with Founder A and was very aggressive in their demands. But step back and look at the big picture. After multiple rounds of investment, A & B combined may end up owning 25% of the company. That disputed 5% is now 1.25% of the final pie. Is it really worth torpedoing the relationship with Founder A for 1.25%? What’s more, if two founders have a strained relationship, how much does that increase the odds of overall failure? Is a 1.25% gain worth risking the whole company?

If any of this sounds unfair, then the growth company/VC route is not for you. It’s a well trodden path and things work the way they work for some very specific reasons. No matter how good your idea is, the game will be played the same way…