The myth of Venture Capital (VC) as the be-all and end-all for start-ups is quite common among entrepreneurs. It’s rare to see a publication about a new venture that doesn’t write about anything else but its valuation and how much money it raised. As a result, many entrepreneurs believe that raising money should be their first priority. With extreme successes of Google, Facebook and Twitter – all having been funded by VC’s – it’s natural to think that in order to build a major company, one needs to seek VC funding. However, that’s not always the case.
In fact, a vast majority of companies never see a dime of VC money. As reported by Bureau of Labor Statistics, around 600,000 companies are founded each year in the U.S., and according to PwcMoneyTree.com, only about 3500 VC deals are made annually. Although many of those startups never seek VC funding, the trend is quite clear – chances that your company will raise VC money are extremely low. But the main question here is not whether it’s likely to receive VC funding – it’s whether that funding is worth pursuing at all.
The number one priority of any business is to be profitable. And to be profitable, it needs customers. One of the biggest problems with entrepreneurs trying to raise money is that they spend way too much time, energy and other resources trying to figure out how to sell themselves to VC’s rather than how to sell themselves to customers. Instead of figuring out what should be changed about the product or the marketing strategy, they’re trying to convince the VC’s that their product will sell. In other words, instead of trying their best to become profitable today, they’re trying their best to convince the investors that they will become profitable tomorrow.
Another thing to consider is that the more funding a company receives, the less ownership the entrepreneur will have. In the early stages of a company, after receiving funding, the owner often loses a substantial amount of decision making power. Since the business is yet to become profitable, VC’s will want to “take the wheel” to secure their investment.
However, if a business manages to grow successfully and make money, VC’s will themselves line up offering their money. They will compete to partner up with the company and the entrepreneur will be able to choose the VC on their own terms. For example, I’ve founded one of the leading credit card fraud prevention services and have landed my first billion dollar contract without ever raising VC capital.
Another great reason to avoid funding for your company is that VC funded businesses show a very clear tendency to perform poorly. By the words of Union Square Ventures co-founder Fred Wilson, over the last couple of decades there has been a consistent inverse relationship between the amount of funds raised by a startup and their later success. In fact, only 1-2 out of 10 VC deals show adequate returns. This means that the whole VC business is reliant on those very few huge successes (Google, Facebook) that pay for the whole party.
What happens to the other 8-9 companies, though? Well, one of the reasons for such a huge failure rate could be that companies spend so much time learning how to raise money that once they get funded, they find themselves unable to use the investment to actually make money or get new customers.
This leads to a straightforward conclusion: the less experience an entrepreneur has and the earlier the stage of his/her company, the more he/she should be focused on increasing sales and getting customers. It is generally better to gain knowledge about the industry and experience as an entrepreneur with smaller ventures, which do not rely on funding. In that case one will acquire the necessary capital, connections and experience to go on and start bigger ventures that might potentially be worth millions or even billions.
Let’s take a look at a few examples illustrating some of the worst investments in VC history. The most notorious is probably the case of Amp’d Mobile, who managed to raise $360M since 2005 just to make a fatal strategic mistake and go bankrupt in 2007. What they did was to accept much looser customer payment safety requirements than their competitors: Amp’d mobile checked whether their customers have enough cash to pay their bills within 90 days whereas all of their major competitors only allowed a 30-day period. They also invested a lot into marketing their service to these riskier customers. The result? Almost half (80,000 out of 175,000) of their customers were unable to pay their bills. Now had they not received all of that funding, they would have grown in a much slower pace, but they would have plenty of time to figure out that customer inability to pay is something that needs to be taken seriously and they wouldn’t have to risk their company’s success to learn that.
Yet another story of a company that fell just as quickly as it rose belongs to Webvan, an online grocery delivery business. Founded in 1996, it covered as many as 8 major city areas in the U.S. in its prime. They had millions in sales, were planning to expand their business to 18 other metropolitan areas and their valuation peaked at $1.2 billion. However, their much promising beginnings would soon turn into a massive failure. In July of 2001, Webvan reported losses of $830 million and closed, firing all of their 2,000 workers. The reason for their spectacular fall was that they were way too careless with their money. Most of it went to expansion – more warehouses, more enterprise servers – which couldn’t generate enough new sales to match Webvan’s investment into it. They also spent money on unnecessary things like Aerion chairs (Webvan bought over 100 of those). The lack of Webvan’s judgement and experience can also be shown by their acquisition of HomeGrocer – an online supermarket – just a few months before the shutdown. I believe it is safe to say that although Webvan did become very successful, the impulsiveness and hyper-optimism of their leaders (brought by rapid success) combined with their inexperience in the market led to unnecessarily risky and unforesightful decisions which killed the company.
The last example that I’d like to share bears a very valuable lesson. A Sillicon Valley nanotech startup Optiva, who initially raised $41.5 million in 1997 when they were founded, were developing a new product – a revolutionary way to laminate LCD and crystal displays – which was supposed to significantly reduce costs for manufacturers when compared to the old method. However, they spent so much time perfecting their product, that by the time it was ready, the market already found yet another, cheaper way (which included use of scrap metal) to laminate displays. Thus, Optiva’s long developed product became completely useless. As a result, they had no sales, and after failing to raise more capital, they shut down in 2005. The lesson here is that if Optiva hadn’t relied so much on VC funding in the first place, they would have no other choice but to build a product with what they had and try to sell it as soon as possible. Instead of that, they had enough money to keep developing their product until they thought it was “ready” and ended up selling nothing at all.
All in all, do not raise money because ‘you are supposed to’ or ‘everybody is doing it’. Think twice whether it will really help your company grow and whether you know what to do with the money.