Why you shouldn’t raise money (yet)?
“The amount of money startups raise in their seed and Series A rounds is inversely correlated with success. Less money raised leads to more success. That is the data i stare at all the time” — Fred Wilson, Union Square Ventures.
Raising money is sexy. It is like getting chosen to be part of a very select club (only 4,520 start-ups received Venture Capital in 2016). It gives you press coverage, credibility (after all, somebody signed you a big check, which means smart people validated your concept) and the satisfactory feeling of having a bank account greener than green. So much horse-power!
How to raise money is a well covered subject. Interestingly enough, nobody talks about how not to do it (which concerns 99.4% of startups)! I’m a contrarian. So today’s post is about why you shouldn’t raise money (yet). Fasten you seat belts, you are on for a bumpy ride!
Everything is a lie!
You just won the battle for venture capital against thousands of other startups. What an accomplishment! It is time to celebrate. Or is it?! It is important to mention that “more than half of all VC funds delivered no better than low single digit returns on investment. Worse, only 20% of funds achieved 20% returns (or better), a figure they might be expected to deliver. Incredibly, nearly one in five funds actually delivered below zero returns” — based on Josh Lerner’s research. The story about how professional investors create tremendous value for start-ups with their capital, advice, domain expertise, mentorship programs, etc. is tumbling. It is even more depressing when you dig into those returns. Out of ten companies a VC invests in, an average of 6 will fail and be wiped out, 3 will break even (repay the invested capital) and 1 will deliver high returns. Don’t feel special, you are just part of a number’s game.
Raising money is a full time job
I know, it was my job for a few years! VC funds are like stars in high demand. If you want to hangout with them, you better get introduced by somebody they know. If you can’t get a referral, be prepared to spend countless hours trying to contact them one by one — by contacting i mean harassing them.
VC’s receive dozens of pitch per day (just to get a sense of how popular they are). To get yours on top of the pile, you will need to sell it hard. It is time consuming. Time is the most precious resource you have. You can’t spend it on anything else than making your business sustainable. A sustainable business is a business that creates value for its customers while being able to capture enough of it to yield a profit. Instead of chasing VC’s, chase clients, create value and think about how to capture part of it. You will always be better off working on making your business better than making your pitch better. Raising money is a distraction.
Raising money is (very) costly
There are many more start-ups in demand/need of capital than there is VC’s willing/able to supply it. Actively seeking investments from VC’s is basically giving them all the negotiating power. Thanks for the late Christmas gift!
Don’t get it wrong, VC’s are not playing the game for innovation’s sake. They have their own investors to please. We saw how very few investments will generate returns. Having all the negotiating power on their side, VC’s will be able to impose tough term sheets (high equity ownership, ratchet, preferred liquidation etc.). What it means is that you are giving away way more equity than you should. Would you sell your baby for few bucks? (everybody is looking at you for the answer…).
There is no secrets, banks only lend to people who don’t need it. If you are unemployed with no savings, getting a mortgage to buy a house will be really tough. Even if it is an amazing house. Come back with a $350k/year job, a $10M net worth and look at the change in attitude. They will call you Madam or Sir and the coffee will be ready for you. If you are lucky, some biscuits. This is the same thing with VC’s.
The point is you need to come up with a plan for your company to grow without raising any external capital — doing so will make you such an attractive target. You will be able to show traction and product/market fit. They will fight for you.
The plan is called bootstrapping. It is pretty simple: use whatever source of money you can put your hands on (savings, credit cards etc.) to cover the period when you don’t have clients. Use the operating cash-flow once you launched (and launch as soon as possible). See. Told you! Well, at least you are not giving away equity.
Bootstrapping is a state of mind (i’ll write about it more in depth later). You will need a lot of problem-solving skills and it might take your start-up more time to take off, but once it is off, you have a real business. Bootstrapping forces you to develop a sustainable business model and avoid working for years before figuring out that your venture doesn’t have any economic future.
Calibrate the amount based on the risk
Of course, sometimes bootstrapping won’t be enough (but doing it is an absolute best practice: you need to show that you understand the value of a $) and you will need additional funds. Keep in mind that raising money is a not an end, it is a tool. A tool to decrease risk.
On day 1 of a start-up, the company is just an addition of risks: founder’s team risk, product risk, launch risk, market acceptance risk, revenue risk, profitability risk etc. Raising money is a tool to peel off some of the risks.
Raising seed money is a way to peel off the first two or three risks: you can develop a working prototype (product risk) or finance the initial launch. The series A round will peel off the next set of risks: you can pay for talents and operations while recruiting your next hundred customers etc.
Each time you reach a milestone, your risk goes down. If your risk goes down, the value of your start-up goes up. It is automatic. Therefore, you should calibrate each and every round of funding to the risk you want to eliminate. The closest the amount raised is from the amount needed, they less dilution you get.
This is a more robust way to think about how to raise and spend money than “let me raised the more money I can so I can spend it on everything”. What matters in business is the execution. Don’t give away your equity because you are the one creating the value (though share it with the other key executive… and me, i’m a nice guy!)