The path to success means venture funding, or so say a huge number of entrepreneurs. However, that is not the case, and believing that it is can lead to potentially fateful decisions. It cannot be emphasized enough that some companies – perhaps yours – should never even consider funding from venture capital. We’ve seen so many founders blindly chasing venture capitalist (VC) money that we’ve decided to create a two-part article to help entrepreneurs make smart decisions about financing. First off, here are the reasons not to use VC-money.
How you finance your business is one of the most critical decisions you will make when starting and running a company. Of course, most small-scale startup operations aren’t sustainable in the long run without additional funding because of their limited revenue or high costs. The truth is, only a small number of companies become profitable solely as a result of the initial investment in them. That’s why, after receiving their initial investment, most young startups do need subsequent investment or fail in the lack thereof. Some 40% of companies that raised a Seed or Seed-VC round in 2009-2010 then raised a second round of funding. For these subsequent rounds, 17% of the U.S. startup budget comes from angel investors, micro VCs, or individual investors.
It is really interesting to see the contrast between expectations and reality. In 2019, 52% of U.S. startups expected their company’s next source of funding to be venture capital. On the other hand, if we check out the current unicorn companies in the States, we can establish that 94.1% of the billion-dollar entrepreneurs actually took off without VC, which means they did not use VC funding before Series A at all (Source: Dileep Rao & UCI Paul Merage School of Business: The Post-VC Entrepreneur presentation by David Ochi). That is a significant difference.
Considering that 77% of companies, according to CB Insights, are either dead or became self-sustaining, the latter being a potentially good outcome for the company but probably not good for their investors, you might as well try the second option. Our general view is you should try to solve as much as possible from cashflow, meaning via organic growth and subsequently other forms of financing.
How to finance your company is a decision you have to think about carefully, and it is easy to get caught up in the seemingly carefree world of raising huge amounts of VC money. Venture capital is no free lunch (even though you may often get one at VC-backed startups – confusing, isn’t it?). In fact, every entrepreneur should know that equity is the most expensive form of capital.
Let’s take a glance at why that is.
1. Loss of control
This is probably the most obvious reason. Everyone knows that once you secure VCs, you’re at their mercy. No money comes free, you no longer control the business. Even if you do manage to maintain a majority stake, you are giving up a percentage of equity for those shiny dollars – VCs essentially buy equity in your company, which makes them your business partners.
For those of you who like things to be proven by numbers and statistics, you will not be left empty handed, here are some figures that speak louder than words: in the past few years, VC-avoiders (those, who managed growth without venture capital) kept 52% of their wealth, while VC-delayers (those, who take off without venture capital and delay venture funding until their growth and potential are at the point where their chosen VCs finance them without seeking a new CEO) 16% and VC-Traditionals (those who get venture capital early on) only 7%. This means VC-Avoiders kept 7x the wealth of the VC-Traditionals. Just to strengthen our statements, we’re showing you how much wealth was kept or created among some iconic Founder CEOs: on one side there is Steve Jobs, who kept only 0,67%, but on the other side are Mark Zuckerberg, who kept 28%, and Bill Gates, who held on to 31%.
Of course, we’re not suggesting VCs are doing something terrible: if we consider things from their perspective, it is easy to understand why they insist on having control. They simply need to do their best to get their money back, which they have risked by investing in your company, just consider the 90% failure rate of startups. Even further, it is remarkable that only approximately 0.107% of American startups can actually provide any positive ROI to investors in 10 years. This means only 700 out of 650,000 new firms each year, which seems like an enormous risk for investors. That is why, in most cases, VCs will also ask for a seat on the board, resulting in them even having the opportunity to veto key decisions: you are giving control to people who may have a different vision and different goals from your own.
Even assuming you have aligned interests, you will still need to think about whether venture capital is something worth going for, especially if you can solve organic growth from cashflow and you have no need for a large sum to go to the market or to gain market advantage because, for example the entry barriers are high or on the other hand are too low and your unique value proposition can easily – yes, let’s face it – be copied.
2. You’re wasting time and resources looking for a VC
Think about it: you could be selling yourself to your customers, but instead you are focusing on trying to sell yourself to VCs. You’re allocating a lot of money and talent towards the VC-search project, your team needs to learn to pitch, sell the company, create your one-pagers, investor decks, and so on. All of this is a distraction from the most important part of your business: getting the customers.
Not to mention all the energy you put into finding the VCs you want to target. Doing your homework before you go VC-hunting is a must, but unfortunately, even the most careful preparation cannot guarantee success. You have to bear in mind that due to the high risk in emerging ventures, VCs are very picky. I am sure all of them would also agree that there are always more dreamers than successes. So, it might not surprise you to know that VCs finance only about one or two ventures from every 100 business plans they see. They reject the other 98-99 percent either because they are not in the preferred industries, or have not displayed potential or the proof of potential, or have not been referred by the right person, among many possible reasons.
The cruel reality is that most ventures do not qualify for venture capital and never will. According to the Small Business Administration, about 650,000 new businesses are started in the U.S. each year, and the number of startups funded by VCs was about 300. This means that the probability of an average new business getting venture capital is about 0.00046, and it also means that 99.954 percent of entrepreneurs will not get VC at an early stage.
Essentially what you’re doing is wasting time trying to convince VCs that your company will have tons of customers and be profitable – when instead you could spend this time and money to get those customers who will actually make you profitable. See the paradox? Get the customers first!
3. You don’t even need funding
You are doing fine on your own, but you’ve heard that it’s still good to get financing, even when times are good, because there will come a day when you might need it. In times like these, we see just how important it is to be financially prepared when crises arrive, and to build a healthy and stable company. However, the truth is that venture capital never comes cheaply and has many strings attached – if you don’t even need the funding because you could solve financing from other less restrictive resources, or even from cash flow, why would all the venture capital benefit you? It is definitely not in your best interests to have the VCs tell you how to spend the money, and make decisions for you, or to give up control when you were doing just fine on your own for the sole reason that bad times might be coming one of these days. Of course, we also advise you to be prepared financially for hard times, but think twice before you turn to a VC to achieve the financial stability you wish for.
4. Your end goal is focused on exit-oriented growth instead of building a company that will last
You can easily get stuck in a never-ending cycle of constantly having to raise more and more money, if your mind is on growth over profit. 22% of companies that raised seed money in 2009-2010 exited through M&A or IPO within 6 rounds of funding. If we consider the most common fund raising cycle of 18 months, the minute you have toasted the success of your investment round with your colleagues you can start going out again to secure the next one, because time flies, and without doubt the money will be spent sooner than you ever imagined. Founders tend to forget this rule, which leads to nearly 67% of startups stalling at some point in the VC process and failing to exit or to raise follow-on funding.
If you try to look at things from the VC side, you’ll easily understand how important it is for them to have at least one company in their portfolio that generates an extra multiple on the fund: a unicorn. However, for your company this is not necessarily the best route, as the outcome is what we have explained above: an accelerated growth, accompanied by spending huge amounts of money, racking up loss, and making it necessary to continuously raise large amounts of money.
Furthermore, the second you are no longer able to secure another round from VCs, the only direction for your company is downhill, and not only in valuation. This is fairly obvious if we consider that you have to achieve different KPIs and other factors often related to growth as conditions in the financing rounds set by the VCs. If things go sideways or differently from expected and planned, which can happen at any time in business, you can end up in a very difficult situation with your VC investors who will do their best to secure what is left for themselves. This can lead to premature exit which does not necessarily serve the best interests of your company, see below.
We agree with Yifat Oron, CEO of LeumiTech: instead of unicorns, we need “zebras”. It is much more beneficial to have these companies that are characterized by doing real business, achieving and demonstrating profitability for a while, and which help to solve a societal problem, instead of aiming to disrupt current markets. This is what we mean by building a company that will last.
5. May lead to under-valuation
Venture Capitalists are generally in a hurry to sell off their equity stake, and as a result they may pressure you, the founder, to exit. Exit ahead of time, or just simply not at the right time could result in under-valuation of the company’s shares, which – we probably don’t need to say – is a definite disadvantage for the owner.
Why VC pressure and an ill-timed exit could lead to undervaluation is a topic for another article that we are planning, but we need to mention some of the basics here for better understanding. Valuation of startups is tricky enough to start with – without enough history of financial performance to support and base the valuation on, one needs to work with a lot of assumptions and estimates, making valuation more an art than science. At the end of the process, an undervalued company will lead to less funds raised, or, in the case of exit, less, or in some cases, no money for the founder in the end.
While there is no shame in aiming for and ending up at a valuation that is less than a unicorn, exit too early and you can end up with even less.
A good exit, whether M&O, IPO, or any other, is the one you prepare for, ahead of time, not the one that you’re being forced to do. And the best timing for a sale is when you have lots of momentum. That is when you’ll likely get the most out of your efforts and investments, as a founder.
The truth is, however, that even though there are some serious drawbacks, and the VC-model might be outdated, in certain cases, VC money can be the right solution. Keep following our blog, we’ll soon post Part 2 of this article: reasons to choose VC funding, just to maintain balance and to check all angles in helping you along the road towards informed decisions.