Assessing Whether to Raise

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Venture capital can look dramatic. Bubbles, crashes, giant IPOs, $7B acquisitions, lecherous investors, and out-there founders with millions of devoted followers make starting a business seem like making the Kessel Run in less than 12 parsecs. This has led to a strange amnesia about how most startup business strategy actually works: selling a product to customers for a profit. This antiquated notion even has its own fancy new term: “fundraising from customers.” Contrary to the way it sounds, this does not refer to customers investing in the company. Rather, it’s encouragement for founders to consider selling their products to customers, rather than selling part of their company to an investor.

From the outside (and even from the inside, if you live in Silicon Valley), it can seem like venture funding is ubiquitous in the world of startups. The truth is, in 2013, .05% of startups received VC funding, while 57% were bootstrapped (these data from Fundable are compiled in a nice visual by Entrepreneur). In 2018, though individual investments were growing in size stateside, the U.S. held 50% of the global startup investment pool, down from 95% in the 1990s. (These data are summarized in Inc.; the full report was conducted by the Center for American Entrepreneurship.)

In the U.S., roughly 43% of public companies founded between 1979 and 2013 have been backed by venture capital firms.* But the majority of companies do not go public, and raising venture capital does not guarantee a company’s success. CB Insights even put together a list of more than 150 companies that raised venture capital and “failed,” some having raised more than $100M.* Venture capital is not the only form of financing for an early-stage company. There are several other sources of capital for startups, including revenue, debt, and revenue-based loans. In addition, a hybrid of VC funding, debt, and revenue is possible and likely.

Consider the highly competitive direct-to-consumer mattress market, which is largely dominated by startup Casper, founded in 2014. (Casper co-founder Neil Parikh made an angel investment in Holloway.) Casper’s dominance is due in no small part to the fact that they spend $80M annually in advertising, having barrelled their way into the market with over $200M in venture funding.* Contrast Casper’s rapid rise with Tuft & Needle, a startup that bootstrapped in 2012 with a $500K loan, became profitable in 2017 on $170M in revenue, and merged with mattress brand leader Serta in a deal rumored to have a value north of $400M.* At the far end lie the earliest entrants to the mattress milieu, Saatva and Amerisleep, both of which bootstrapped their new businesses in 2010, pouring the profits back into the companies and growing slowly. Until recently, neither had taken any form of external funding. (Saatva reportedly just took an undisclosed investment from private equity firm TZP Group.)

That’s just how I am built. I’d rather go slower and have more equity than gamble with someone else’s money.Ron Rudzin, President and CEO, Saatva*

Does Your Company Need Venture Funding?

From a founder’s perspective, there are two main considerations when thinking about whether venture capital is the right form of fundraising for their business: money and time. Venture capital can be a good option if your company needs a lot of money up front before it can bring in revenue—that is, if it’s capital intensive—and if the company needs to grow rapidly to beat other companies to market.

Capital intensive businesses often involve a J-curve, where the business needs to invest a lot of money in research and development before it can turn a profit. Today, biotechnology companies are still highly capital-intensive, as the period needed for experimentation and clinical trials—all before any revenue—can be years or decades. Software companies, on the other hand, generally require less capital than they used to—today, they can turn to cloud-based providers like Amazon Web Services and Google Cloud Platform instead of spending millions on their own servers.

But that isn’t to say software companies can’t be capital intensive. In some cases, companies need to lure particularly specialized—and therefore expensive—employees. Self-driving car startups, for example, need to hire PhDs and also need to purchase expensive hardware before they can even begin much experimentation at all. In other cases, a team will be close to finding a solution for a market, but they need time to iterate, test, and repeat cycles of exploration before finding something that works. If your company faces any of these challenges, raising venture capital may be the right fit.

Companies often raise venture capital to finance growth once a company has found a business model that works. The idea here is that once you’ve figured out how to sell a product successfully and repeatedly, you may want to go hire a larger team to improve and sell your product to the market before someone else beats you to the punch.

​controversy​ Taking venture capital almost guarantees that you will be pushed to grow as fast as possible. You may not agree with the strategy or tactics suggested; some founders have opted to bend or even break the laws to achieve this growth, and many founders and venture capitalists ignore rational economics (such as making sure you aren’t spending more money on acquiring a customer than you make in revenue from that customer), hoping it will all magically work out in the end. Here are a few examples of challenges related to growth in VC-backed companies:

• In 2014, investors in HR startup Zenefits called then-CEO Parker Conrad’s $10M revenue goal “bush league.”* Subsequently, the company went on to face multiple scandals, including a founder-sponsored program training employees how to cheat on state licensing tests, that ultimately resulted in Conrad’s departure.* Despite this, Conrad has since gone on to raise $52M for another HR-related startup, Rippling.*

• In 2016, e-commerce startup Nasty Gal filed for bankruptcy after bringing in nearly $100M in revenue at its peak. Much of Nasty Gal’s growth resulted from spending on advertising, which ended up being unsustainable.*

The most egregious case of misconduct in the last ten years came down to a case of flat-out fraud at Theranos. Now the subject of a book, Bad Blood, and an HBO documentary, The Inventor: Out for Blood in Silicon Valley, the fraud of Theranos was perpetuated in part because of investors’ (and media) focus on the scale of the company’s impact and market deterred the due diligence that could have revealed the fraud. In this case, the prospect of disruption and returns outweighed the discipline to make sure the innovation was real.

What Does Success Mean to You?

Venture capitalists are motivated—at least in part—by the prospect of huge returns on investments that will make them and their investors rich.

The fact that VCs need to return large sums of capital to their investors creates some incentives that may not align with a founder’s goals. To meet their investors’ expectations, venture capitalists seek to invest in companies they believe can be the biggest, most successful companies in their market.

Some firms out there are happy with smaller returns and smaller exits, and some investors work closely with founders to make sure no decisions are made that the founders are not comfortable with. Other investors are motivated by, in addition to high returns and big exits, the impact their portfolio companies might have on the world. (You’ll learn how to research and discover firms aligned with your interests in Creating a Target List of Investors.) But the VC business model is predicated on growth—there are countless stories out there about companies that were pushed by their investors to move too fast toward becoming a $1B+ outlier. What’s the downside of that?

​caution​ Capturing enormous market share is not in the best interest of many kinds of companies, particularly startups motivated by impact in smaller communities and in smaller sectors. Moving too quickly to grow may result in a company that lacks real understanding of its customers’ needs, and thus lacks staying power. Businesses with sky-high valuations have sometimes not reached profitability, making the future of those companies post-IPO uncertain.

If you’re an entrepreneur, your goal is at least to build a successful business. Economic value, as measured by valuation or price per share, is not the only way to measure a business’s success. Neither are fast growth or ice sculptures at your IPO party. Think on and discuss with your team what success means to you. Does success mean fame, fortune, and everything that goes with it? Whether or not you decide to take on venture funding, you and your team or co-founder can get aligned on your goals by considering the following:

• Impact. Many founders are motivated by a yearning to work in service of something larger than themselves. VC-backed founders who want to change the world still have to ask themselves: “But, will it scale?”

• Lifestyle. The average time from founding to IPO is eleven years,* and there’s a pervasive culture of workaholism among startups that is reinforced by investors. Many founders self-impose a work week of 60+ hours. There is a widely held belief among investors, however unfounded or unproven by data, that long hours signal commitment.

• Money. Entrepreneurship is hardly the best way to get rich. Given that most companies don’t succeed, think twice about starting a company before you quit your day job. That said, it’s OK to think about the numbers you’re comfortable with for now, and the numbers you want to get to. Would you be happy taking only equity and no salary for a couple of years? Do you have the means to do so? How about a steady salary of $75K a year? $1M after an exit? $100M? Make sure you understand the risks in taking venture funding that can affect the money you and your employees make even if the company makes it to exit, including dilution and liquidation rights.

• Control. Many entrepreneurs start companies out of a desire for independence. But don’t forget: raising venture capital means selling a part of your company. Often, that means other people now have a say in how you go about doing things. “Being your own boss” doesn’t really fly when you’ve committed to do your best to return your investors’ money plus a healthy return. Raising money from venture capitalists can mean giving up control of your company. Raising a priced round usually means agreeing to protective provisions for preferred stockholders or giving up a board seat, which can allow investors the ability to legally block certain activities (like selling your company, raising further capital, and more).

• Ownership. Many venture capital firms seek to own 5–20% of your company or more.* In most cases, a company will raise several rounds of financing, which will further dilute the founders’ ownership. It is not uncommon for a company to raise large sums of money and then sell. Because of liquidation preference, the founders might not make much at all, if anything, in that event.

• Optionality. Investor money comes with expectations. Optionality, or having the option to sell your company but not the obligation to do so, means having control over your company’s fate. If you’re not sure whether you might want to sell your company in a few years, taking venture capital may not be a good idea. Given VCs’ incentives, modest positive outcomes (1–2X returns on the amount of capital raised) are not “venture scale” hence not interesting to most venture investors. In many cases they may be able to block a sale of the business that would be very lucrative to founders but doesn’t generate the outlier returns they seek.

How VCs Can Control Your Company

The goals of founders and their investors don’t always align. VCs aspire to return 3X their fund for their LPs, but what founders want is less straightforward and can change over time. When these goals get out of line—and they do—things can get ugly fast. Investors can remove founders, block the sale of the company, or hold the threat of these things over founders’ heads in order to strongarm the founders into certain decisions.

How does this happen? Despite the belief of many founders that the best defense to VC control is maintaining greater than a 50% ownership in their company, VCs can control a company via two other powerful mechanisms:

1. Privileges granted to preferred stockholders in protective provisions that are agreed upon in the investment term sheet.

2. Seats on the company’s board.

​danger​ The idea that total control of a company comes from maintaining ownership of more than 50% of it is a pervasive myth that is dangerous for founders. This myth comes from a fundamental misunderstanding of how voting rights work for stockholders in companies that grant preferred stock to investors.

Somehow, somewhere, people got the idea that founders and investors all received the same kind of stock. After all, why would there be different kinds of stock, and what would that even mean? Ownership is ownership, right? Wrong.

Investors get preferred stock, and founders almost always hold common stock. (We’ll discuss these classes of stock in greater detail later in our primer on ownership.) During an investment negotiation, investors frequently negotiate special privileges for preferred stockholders called protective provisions.

​Definition​ Protective provisions grant preferred stockholders—usually venture capital firms—veto power over certain decisions that could adversely affect their investment. They are different from regular voting rights because, in the case of protective provisions, preferred stockholders get to vote separately from common stockholders. Decisions subject to protective provisions must be mutually agreed upon, but generally fall into one of two categories: highly consequential decisions like acquiring another company, and/or decisions that could materially affect the value of preferred stock.

Protective provisions require a majority of the preferred stockholders to vote on certain decisions that could impact the value of their shares.

​danger​ After a company has granted protective provisions to preferred stockholders, investors with even 1% of a company’s overall stock could block a decision to sell the company for a profit to another company, because they want the founders to work for a few more years on the company so they can sell it for a larger return. While this happens, it is an edge case and would be the direct result of a poor negotiation on the founders’ and other investors’ part—as well as evidence the company’s lawyer was not paying attention.

Delaware corporate law (which covers the majority of startups established as C corporations) states that C corporations have to be supervised by a board of directors.

​Definition​ A board of directors (board or BOD) is a group of people who oversee an organization, including by guiding and supervising the organization’s officers, and have legal obligations to act in the organization’s best interest. For a corporate board of directors, this includes ensuring that the company serves the best interests of its shareholders. All corporations are legally required to have a board of directors. The board typically consists of a mix of individuals representing different interests. An inside director is any founder, executive, or individual investor on the board. An outside director is not an employee of or existing investor in the company, and they are recruited to the board to provide specific expertise. Individuals on the board are referred to as board members. A board member is said to have a board seat at the company.

When a company incorporates, the board is usually made up only of one, some, or all of its founders. Under Delaware corporate law, boards have the authority to control the day-to-day matters in a company. You should always defer to your legal counsel when determining what decisions need a board vote, but in our section on protective provisions, we cover the decisions that almost always require a board vote.

It’s rare for an investor to negotiate a board seat at the seed stage unless they’re writing a large check ($750K+). Boards of directors usually meet quarterly for meetings that can be as long as three hours; they’re a big commitment, and investors usually don’t want to sit on too many boards. But at some point beyond the seed stage, you’ll have to give up board seats to investors, and that means you’ll need the support of any investors with a board seat when making major decisions.

Between protective provisions granted to preferred stockholders and board seats, every founder needs to know what they’re giving up in a deal with investors. Some investors, like Mark Suster, are transparent regarding how they think about working with founders when incentives change. Going into a working relationship with an investor with your eyes open about the risks is certainly preferable to putting years of your life into a business only to be surprised by your investors’ decision to block an acquisition or replace you as CEO. Understanding a term sheet and carefully negotiating the terms that are important to you can help you stay protected—and at least know what you’re getting into.

Alternatives to Traditional Venture Capital

​important​Raising traditional venture capital, where you raise a pre-seed or seed round followed by a Series A, Series B, and so on, is far from the only path to building and growing a company. You can finance growth with savings and debt (by taking out loans or lines of credit), bootstrap, or crowdfund. Additionally, many alternative fundraising models have emerged in the last two or three years.

Where venture funding dictates that a company “move fast and break things,” choosing to bootstrap, crowdfund, or raise money via alternative investors can give you more control over your growth rate, which can often work in a company’s favor. Patagonia, for example, reported revenue of $800M in 2016, despite having never taken any venture capital funding.* That said, Patagonia took over forty years to grow to that size, and VC dollars work better for companies interested in high compound annual growth rate (CAGR), which translates to achieving high market caps and margins within five to ten years. Stories of other companies that chose to grow slowly can be found in the book Small Giants.

Other recent examples of successful alternative fundraising strategies include Buffer, Wistia, and SparkToro. After raising a total of $3.95M in angel and venture capital investment, Buffer announced in 2018 that they were buying out their investors through profits generated by their business.* Wistia did something similar, raising $17M in debt to buy out existing investors.* Also in 2018, Rand Fishkin, who previously raised $29M in venture capital for his company, Moz, announced that his new company had raised $1.2M on an alternative fundraising structure focused on profit sharing, citing, “There’s no opportunity for a ‘mid-range’ success in venture capital.”*

Alternative Investors

Choosing to fund your startup through alternative means has become something of a movement. Leaders of this movement have gone so far to call its constituent companies “[zebras]https://medium.com/zebras-unite/zebrasfix-c467e55f9d96),” goading traditional venture capitalists who are obsessed with so-called unicorns. A new group of alternative investors is emerging who believe they have a venture capital model that will align investors’ interests with founders who want to build a profitable business growing at a sustainable pace, rather than growing as fast and large as possible and ultimately exiting. These investments are typically made after a company has demonstrated that they can bring in revenue, and investors encourage companies to focus on getting profitable quickly, rather than continuing to take on venture dollars until IPO.

Investors interested in innovating the VC model each have their own motivations and specific practices that they believe will be better for founders, and better for the world. A small number of these innovators include Indie.vc, Calm Company Fund, Village Capital, and TinySeed. For a solid list of alternative investors, check out this tweetstorm by Matt Hartman.

Bryce Roberts founded one of the first ever institutional seed funds. He pioneered the VC practices of leading early-stage deals and taking an active role on the board. Today, while simultaneously directing venture firms OATV and the fund Indie.vc, Roberts is one of the loudest voices urging founders to be cautious when it comes to taking venture capital. In Meaningful Exits for Founders, Roberts rolls up research that shows how “a founder selling at the Series D price of $210M, would make the same amount of money at exit as they would have if they’d sold for $38M after having only raised a seed round.”

A good example of a contemporary company that raised a small amount of capital before becoming a breakout success is Halo Top.

New investment models also include new focus on who and what is receiving venture investment. Freada Kapor Klein, of Kapor Capital, is a leading voice in innovating venture capital through impact investing. Her criticism of venture capital centers around a belief that venture capitalists can and should do more to fight inequality. Impact investing does not seek to change how venture capitalists make money, but proves that investing in companies that want to do good is good for business. For many VCs, this is something of a reckoning. To learn more about the origins and economic rewards of impact investing, we highly suggest Recode’s 2019 ​audio​ interview with Kapor Klein.

Bootstrapping

​Definition​ Bootstrapping describes the challenging experience of starting a company with limited outside resources. If a founder uses their own money, reinvests revenue, takes on personal debt, and brings a business into being, without the help of investors, they can claim to have bootstrapped it.

(You may have heard phrases like pull yourself up by your bootstraps. Ignoring the question of what bootstraps are, Wikipedians agree the phrase generally refers to an “absurdly impossible action.”)

Bootstrapping has a cult-like quality that is well deserved. Take MailChimp, one of the best contemporary examples of a bootstrapped business. MailChimp did $400M in revenue in 2016 without taking a dollar in outside capital.* Unburdened by the demands of investors, MailChimp’s founder, Ben Chestnut—who did a marvelous Creative Mornings talk in 2011, by the way—was free to focus on the customers he believed in.

On top of the decision-making independence, bootstrapping means you don’t have to share the success pie with anyone except the team who helped you cook the damned thing.

There are far more companies that bootstrap than those that raise money from angel investors or venture capitalists, but it’s not for the faint of heart. Lack of money can force founders to rush their way into financing by any available means, and some founders have gone into bankruptcy. The founders of Airbnb, before they took on investors, racked up more than $40K in credit card debt.* It makes for a compelling story now, but they got lucky. Founders can also take out personal loans against assets—mortgaging a house, for example. These options also come with serious risk. If you mortgage your house and spend your kid’s college savings to finance your business and you succeed, the media will call it a daring and brilliant bet. Fail, and you could end up in bankruptcy.

Jason Fried and David Heinemeier Hansson, founders of Basecamp (previously known as 37signals), didn’t outright bootstrap their company, nor did they raise traditional venture capital. Instead, once they were modestly profitable, they sold a minority no-control stake in their business to Jeff Bezos and have not taken outside investment since—Bezos takes his cut of Basecamp’s profits in proportion to his ownership.*

Many businesses successfully bootstrap, patiently learning how to deliver value to a market long enough to have multiple years of demonstrable revenue. At that point, companies can begin to turn to banks for loans to finance their growth.

Crowdfunding

If you decide to go the venture capital route, you’re likely to take money from a handful of investors in each round. Between venture capitalists and angel investors, a startup is generally raising hundreds of thousands to many millions of dollars from very few (usually less than ten, though often more) wealthy people or entities. The opposite of this model is being given a little bit of money by a whole lot of normal individuals.

​Definition​ Some businesses seeking funding in the early stages turn to crowdfunding, a financing strategy that allows a company or a founder to raise money from a large group of people, mostly strangers. Crowdfunding platforms are websites that connect entrepreneurs to large communities of supporters who can donate to a venture securely. In some cases, individuals donate to a company or founder because they believe in their mission. In other cases, the company may offer partial ownership or special privileges like early access to the company’s platform or product, in exchange for an individual’s donation.

Crowdfunding platforms can be divided into three types:

• Cash donation. In 2013, Patreon launched to give creators a way to get paid by their fans and has since become the most popular cash donation platform. Cash donation platforms fund creators, not individual projects or products.

• Cash-for-support. These platforms support individual projects or products. They popped up first with Indiegogo and Kickstarter leading the way in 2008 and 2009 respectively. Since its launch, Wefunder has also become popular for this sort of crowdfunding. On these platforms, individuals essentially donate money to the entrepreneur because they want to help them create their product. In most cases, after an individual pledges enough money, the entrepreneurs will promise to send them merchandise in exchange for their support.

• Cash for equity. In 2010, Naval Ravikant and Babak Nivi, the writers of the popular blog VentureHacks, teamed up with Kevin Laws and Stan Chudnovsky to start the most popular cash-for-equity platform, AngelList. AngelList initially started as a directory of active angels and founders, but has since evolved into a platform for startups to raise capital and recruit talent. Other well-regarded cash-for-equity platforms include CircleUp, FundersClub, Gust, SeedInvest, and Republic; even Indiegogo now allows a company to crowdfund via equity.

A recent study from the University of British Columbia found that crowdfunding helps entrepreneurs learn and make product choices based on the market, and this learning “improves an entrepreneur’s funding outcomes and reduces her likelihood of switching projects.”*

A study of over 50K crowdfunded projects found that firms that are successful at crowdfunding experience a significant increase in their likelihood of obtaining VC funding within two to six months.

​caution​ Not all crowdfunding methods are created equal. Some platforms allow companies to raise money from unaccredited investors (in line with SEC rules on crowdfunding). This can bring far more investors to a company than any of its peer companies have, which could scare away downstream professional investors.