Early Stage Funding and My New Set of Allergies…

Ready for some new-found religious fervor?  This was conjured up by a combination of recent events, ancient history and good old fashioned navel gazing while my newest daughter gets the hang of sleeping through the night.

In short, I believe I’ve become allergic to early stage funding, especially VC funding.  Before I get to the nitty gritty, I should state for the record that there are a number of VCs I’ve met that I have a great deal of respect for.  They add a lot of value to the companies they fund and the world is definitely a better place with them around.  But I am increasingly convinced that early stage VC funding is simply a terrible idea for the vast majority of  startups.  

I’ll get to the kinds of companies that might need VC money in a bit.  First, let me run through three recent events that triggered my new found allergies.

 

EVENT 1 — OMG, SERIOUSLY?? 

On April 18, Venturebeat had a great article about the state of Venture Financing deal terms.  Here’s a juicy exerpt:

In recent months we have seen a resurgence of term sheets calling for preferred stock with a senior liquidation multiple (e.g., 2-3 times an investor’s initial investment), often together with “full participation” with common stock after the liquidation preference is paid out. This means that when a company is sold, the holder of preferred stock (i.e., venture investors) will be entitled to 2-3 times its initial investment before any holders of common stock (i.e., founders and employees) receive proceeds, and then will share any remaining proceeds with the common holders on a pro rata basis.

Let’s do the math here.  Say a VC puts $2M into your company based on a $4M pre-money valuation i.e. they own 1/3 of the company when the deal is done.  Along comes an exit offer for $30M.  Normally you might wait, but in today’s uncertain times you decide to take the deal.  You might think that 1/3 goes to the VC and the remaining $20M goes to you and your buddies…  But not if you’re stuck with the newly resurgent liquidation multiples.  Under the kind of terms mentioned above, $6M comes off the top to the VC, leaving $24M, of which $8M (1/3) also goes to the VC (and possibly more depending on all kinds of details in your deal).  So out of $30M, $14M is gone before anyone on the team gets a look in.  That’s also before legal costs and other gems that will quickly eat through the balance.  If you’re holding 5-10% of the company, you might have been expecting to see $1.5-3M from the deal. In reality you’re looking at a best case of $1.2-2.4M, or 80% of what you expected.

Okay, $1.2M doesn’t sound so bad, right?  But wait…  You probably had options so that there were vesting periods etc.  If you’re holding options instead of actual stock, you’ll be paying personal tax rates, not capital gains tax rates.  The difference can be a lot.  Personal tax will be 35% at the Federal level and you can bet your state will want a bite too. So already your $1.2M is down to $700k or less.

Now I know that $700k is nothing to sniff at, but if you went in to the deal thinking you were going to get $1.5M, you’d probably be pissed off.  And when you consider all of the effort that goes in to a start up, the lower salary you made and the opportunity cost of not being elsewhere it starts to look a lot less attractive.  $700k is nice, but it’s not going to change your life.  You might be able to pay off your mortgage but you’re not going to retire…

And remember, my assumption was that you held on to 5-10% of the company, which means you were most likely a co-founder and have been at this for 3-4 years…

 

EVENT 2 — OMG, SERIOUSLY?? PART 2… 

A colleague of mine recently had his company torpedoed by a wayward investor.  The investor allegedly committed fraud and so the rest of his two-part investment evaporated overnight.  That left the companyunable to fund their day to day operations and in the current economic climate no one would lend them money.  And this was a reputable investor with references…

Instant death by insolvency.  Ouch.

 

EVENT 3 — OH THE PAIN…

When I was pitching VC’s, I didn’t pitch that many compared to some folks.  But I still pitched more than enough.  The entire process is massively distracting from the business of building your business.  It eats in to every hour of every day, time that could be well spent elsewhere.  If you’re fundraising, you’re not doing anything else.  Everyone “knows” that focus is key in a startup and being focused on something other than building your business is probably not that smart…

 

So…
VC funding gets a lot of press.  It’s easy to become convinced that you have to have an investor before you can start your business, but I believe (with only the smallest number of exceptions) that if your business relies on VC funding to get started, your business idea is fundamentally flawed.

 

So what makes a company “right” for early stage VC funding?

 

1.  There’s a huge cost of entry into the market.
Pharmaceuticals take a lot of money to get to market.  They need the funding.  Building a new chip plant takes funding.  Companies that need massive consumer traction probably need funding too to pay for all the advertising they need to do.
And when I say huge, I mean huge and unavoidable, not huge and nice to have.

2.  You need to get to market fast 
Everyone wants to get to market quickly, but do you need to get to market quickly?  Usually needing to get to market quickly means a short shelf life and a lot of potential competition… and that’s not a good long term position if you’re trying to build a business.  Rushing to market also compounds risk.  Every startup moves fast.  You need to really have your ducks in a row to win while doubling down on that kind of risk. 

3.  It’s a big idea that you can really execute on (because you’ve done it before).
There’s a company based in RTP that was founded by an experienced group of entrepreneurs.  Their last company sold for $300M+ and it was in a very similar line of business to the new company.  Their dev lead is acknowledged as one of the top guys worldwide for what they do.  They’re solving a painful and expensive problem for a customer that is very willing to pay.  In short, they should be able to build something good, profitable and big.  And they can probably do it quite quickly.  With the kind of exit they are likely to have, a few percentage points won’t make a tangible difference to their individual outcomes.

 

So if you can exit “big”, conversion preferences and taxes etc become much less important.  But of course, there’s a snag… 

 

While everyone wants to believe that their idea will be huge and their company will get bought for a lot of money, that simply doesn’t reflect reality.  As the price tag for your company increases, the number of acquirers will decrease rapidly.  In one exit I was involved with, we first started shopping the company based on a value of ~$30M.  We had 12 companies express interest. Based on a significant increase in revenues, the price increased to $50M+.  The number of suitors dropped to 3. When you’re looking at a price tag in the hundreds of millions, buyers are rare.

4.  You actually have a track record managing million dollar budgets
Money can be a terrible pollutant in a startup.  A lack of money drives focus.  Without it, every day is a fight to survive.  Every decision and every purchase is critical.  With a cash safety net you are far more likely to make bad decisions, procrastinate on key decisions and invest the money poorly…  Unless you’ve done this before and know what you’re getting in to.


So What Would I Do?
This is all very well, but you want to build a business and you have no money.  What do you do?

 

For most businesses, the answer is actually simple.  Put the enormous amount of effort you were going to spend on VC funding into a simple goal: Get a paying customer.  Even if you only have one customer and they’re not paying much money, I firmly believe it’s better to have one customer than one investor.  

 

Bottom line: if you can’t find a customer who’ll buy in to your product idea, you’ve got a problem that VC funding is unlikely to solve.  Ideas are always easier than execution.  If you can’t find a customer for your idea, get a new idea…

3 comments for “Early Stage Funding and My New Set of Allergies…

  1. April 29, 2009 at 3:20 pm

    Have you heard of OpenNMS? They're a small company based in Pittsboro that provides an open source network management solution. Their software is under the GPL so all their money comes from services. They started up in 2002 and have been profitable that entire time. From what I understand, they've been approached by VCs but have so far turned them all down (although, I know they were considering it a few times). It sounds like they would probably agree with everything you've said here.

    BTW, did you realize that your comment box has white text on a white background? I had to type up my comment in an editor and copy and paste it into the comment form (I hope it comes out ok!). I wonder if the fact that I logged into Intense Debate has anything to do with it….

    Finally, good to see you, if briefly, yesterday!

    • Nick
      May 1, 2009 at 5:19 am

      Hadn't heard of OpenNMS, but there are plenty of companies out there that don't do the VC thing… It's just that some of them are more vocal about it than others (Craigslist springs to mind)…

  2. April 29, 2009 at 3:52 pm

    Actually, disregard the white text on white background comment. It appears that the problem is with my Google Chrome browser.

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