While I was at BarCampRDU the other weekend, I got chance to catch up with Dugald Wilson. Dugald holds a special place in my business heart as he was the first person ever to publicly admit to reading the disruptorMonkey blog…
In his blog just before BarCamp, and while I was talking to him in person, he posed an excellent question
I want to start a business that isn’t headed for an IPO or acquisition. Is there a place for me in RTP?
- A lot of the energy around new companies in the triangle seems focused on the startup pattern of developing a business plan, finding investors, developing product, heading for an exit event. There doesn’t seem to be a lot of support or resources for folks simply interested in starting their own business outside of that pattern. I’d like to start a discussion on this and hopefully identify the resources that are out there
Having tried to go down both the bootstrapped path as well as the VC path, I have fairly firm opinions about both (imagine that, me with a firm opinion).
First, let’s talk about some fundamental differences between the two approaches. As with many things in life, it’s all about the cash…
Most lifestyle businesses are completely bootstrapped. The company is built on a project by project basis, or maybe with some “friends and family” money or a loan. Everyone expects to get repaid their investment plus a decent chunk of interest, say 15% a year.
Now consider a VC-backed company. VCs have to answer to their investors (called “Limited Partners” or LPs) and they pretty much only make money if their LPs make money. The VC business is very high risk but offers the possibility of large rewards. The only reason a Limited Partner invests in a VC firm is to get those large rewards — there are much lower risk ways to get an okay return on your money.
So when a VC invests in a company, they are doing so on the assumption that the company can deliver a huge return on investment. Ideally, “huge return” means 6X or better. i.e. an investment of $5M needs to return $30M or more to the VC firm. The return has to be that good in order to offset the investments in companies that fail, or simply don’t deliver a good return.
But wait, there’s more. VC’s raise money in chunks, called “funds”. Each fund has a limited lifespan. From first investment to last is usually 5 years or less. The LPs like to get their money within a few years of the last investment.
So not only does the VC need a 6X return, they need it in 8 years or less.
Those of you with calculators or mad Excel skills will have realized that reasonable rates of compound interest are never going to deliver the kind of results you need to get. So you can’t just “borrow” money from a VC and pay it back with interest. Sounds a bit like a loanshark, no? 😉
The only way for the VC to get their money back is to have an “exit event” i.e. the company gets bought or goes public. Going public is tricky (especially now), so acquisitions tend to be more common.
Let’s run some very sloppy numbers that skip a lot of details… A company raises $5M based on a $10M pre-money valuation – i.e. the VC owns ~33% of the company. To get to a 6X return, the company has to be worth $90M when it sells in 8 years or less. Let’s go with a middle ground target of 6 years and assume that it may take a year or so before you start generating any sizeable revenues. If you are in a market where companies are acquired for 8x revenues (many acquisitions are done at 3-6x, so this is generous), your sales will need to MORE THAN DOUBLE EVERY YEAR FOR FOUR YEARS. Now it might be “easy” to go from $500k to $1M in sales in one year, but going from $5M to $10M in 12 months is incredibly hard to do.
So for a VC to want to invest in a company, it has to be a growth company that can have an exit. And to be a growth company that has a big exit, you pretty much have to have the kind of money a VC would invest. In other words, it becomes a self-fulfilling prophecy.
Back to Dugald’s question. High growth companies make for good news & gossip and they get a ton of coverage. Thanks to Google and many others, there’s an aura of glamor that surrounds the idea of the two guys (or gals) making it super big. But for every VC funded startup, there are hundreds of low profile “lifestyle” businesses making good money and just getting on with business.
In my opinion, a healthy entrepreneurial community has a good mix of both types of business. Both should be supported and the existence of both adds value to all.
What’s more, there’s a lot the two types of business can learn from each other. At the end of the day, it’s hard to build a sustainable business and doing it requires that you know who your customer is and how to sell to them. Just because one has more money does not mean it will be run better or smarter.
And there is nothing wrong with a business that makes you happy and pays your bills.