Why (and how) more tech entrepreneurs are raising money outside the unicorn/VC model
There’s a necessary and growing conversation about how tech-native entrepreneurs can raise funding without being locked into the unicorn-VC-path. Successful bootstrapped companies like MailChimp and Basecamp have been around for a while, and crowdsourcing is kinda still a thing, but where’s the middle ground?
While others and myself have advocated for these alternative hybrid models for years, there’s still a lack of success data points and funding process/legal learnings in the startup community. So we’re sharing to help you consider this path for your own venture.
I recently raised an alternative round of angel funding for a side-hustle passion project that struck a chord and deserved to grow into a Real Thing. Although we could’ve raised VC, this business (and our personal desires) weren’t a fit for the typical Valley-VC-unicorn startup model — yet I still wanted some capital to subsidize growth before profitability.
The Prepared is a content-driven-commerce company that helps you get ready for emergencies, ranging from daily stuff like car accidents and home heat loss to big Shit Hit The Fan events like natural disasters and epidemics.
Millions of people of all types are increasingly worried about the state of the world and want to take action to be more responsible, self-reliant adults. Because being a dependent victim sucks.
Modern prepping has evolved beyond “doomsday prepping,” and is increasingly popular with sane people who just want to protect their life, home, family, and community when bad things inevitably happen — without quitting society and moving into a rural bunker.
How the conversation around venture capital is changing
I first raised VC in 2009 as a woefully-unprepared 23 year old. At the time, a lot of the meta conversation around venture capital focused on the general bad behavior of VCs. The feeling was that too many VCs were net-negatives and didn’t treat founders fairly or ethically.
For example, Vinod Khosla, founder of Sun Microsystems and a top venture capitalist, said 95% of VCs add zero value and ~75% do more harm than good.
That’s a common secret-but-not-really-a-secret among experienced founders who’ve taken VC. It’s just that no one talks about it outside of trusted personal conversations because entrepreneurs depend on VCs thinking highly of them — “those with the gold make the rules.” This whisper network lead to The Funded, where entrepreneurs could leave anonymous Yelp-style reviews about VCs in an attempt to speak truth to power and balance the market.
Although there’s still much to criticize about the culture of venture capital and the people in it, things have greatly improved in the decade since. More funds think of entrepreneurs as their customers, rather than the old model where founders were their product/livestock. Terms are fairer. The process is more transparent. Diversity is growing. And other good things are happening.
For example, many investors used to scoff at the idea of founders putting a little money in their pocket by selling a fraction of their personal stock (called a ‘secondary’) at the point the company is legit and growing, but before the company itself is acquired. VCs used to incorrectly (and quite hypocritically) say that if founders put some money in their pocket too soon, they wouldn’t be motivated anymore.
Thankfully the ecosystem has evolved and secondaries are now common. I sold some secondary just a few weeks ago in another project, which was encouraged by the new VCs and only took five minutes of effort.
Fast-forward to 2019 and many of those low-hanging fruit, no-brainer changes to VC have been implemented and are doing well.
VC is a specific (and costly) tool for specific jobs
In 2019, the meta conversation around VC is focused on who raises money and why. The ‘who’ is about diversity. The ‘why’ is the focus of this post.
I’ve had the privilege of mentoring thousands of founders in over 30 countries, creating the Defense Innovation Unit as the US Department of Defense’s sorta-VC-fund based in Silicon Valley, and working with governments on their entrepreneurial ecosystems in places like the Netherlands and UAE.
Without fail, the most common question among tech entrepreneurs is “how do I raise VC money?” I even got this question in North Korea!
Yet almost no one first asked themselves if they even should raise VC money (and when) — while the majority of startups I meet should not raise VC or waste time fantasizing about it.
VC is a particular tool for a particular scenario. It works great when applied correctly.
But too many founders aren’t eyes-wide-open enough when making these critical decisions — which usually leads to painful conflict, derailed companies, and abysmal physical and mental health.
(Did you know that founders suffer from depression at 2X the already-high norm, bi-polar disorder at 10x the norm, and commit suicide at 4X the norm?)
Some people hear my talk on this subject and assume I blanket-hate VC. I don’t, and have been fortunate to work with a few wonderful investors, have become an investor in some of my previous VC’s funds, and they’ve personally invested in The Prepared. I almost became a VC myself a few years back and am still an active angel investor in VC-scale companies such as Rappi, Unsupervised, 3D Hubs, Patreon, and PebblePost.
There’s plenty of reading you can do on the pros and cons of VC. Some of the prominent cons:
- Taking VC reduces your optionality. That’s fine when you’re laser focused on a specific path with a “ride or die” gambling attitude, but giving up optionality is a very meaningful choice that most founders don’t give enough weight to.
- The economics of VC funds (“VC math”) means that VCs have to invest in businesses that can generate massive “home run” or “unicorn” returns. For example, WhatsApp raised ~$50M in VC funding and sold for $18B. Vice versa, you’d never expect a 10,000% return from investing in a local services company.
- So when you take VC money, it comes with a whole bucket of expectations and molds that you have to fit your company into. VCs like pattern matching. So they expect and nudge you to fit in their pattern, even if they’re doing it unknowingly.
- There are countless startups that could’ve been wonderful six-, seven-, or eight-figure businesses without VC. But since they raised VC, that “low” result wouldn’t be good enough. Which caused them to ruin themselves by making bad decisions for the sake of possibly hitting a home run or pruning their vanity feathers for their next VC raise and the Valley echo chamber.
- Part of that pattern are expectations around work-life balance (namely the lack of it). I once had a VC call and scold me that we weren’t working hard enough because they drove by our office on a Saturday evening and didn’t see lights on.
- You typically have to be in hotspots like San Francisco. But for many people, cities like SF have become poop- and needle-infested, overpriced, overtaxed, soulless dumps that they can’t wait to escape. What if you want to build a great business elsewhere, travel, buy a nice house to raise a family without spending $4M, or not pay crazy expenses and fight over talent?
- VCs often try to block acquisitions of their companies when it’s “too soon.” For example, when I first raised in 2009, VCs asked me if I was going to “pull a Patzer”, shortly after 28-year-old Aaron Patzer sold Mint.com “too soon” for $170M. But taking that early offer could be life changing for founders — putting a few million in the bank when you have nothing is almost always a good decision. Once, when considering a healthy-but-early exit offer (that in hindsight we should’ve taken), a VC on my board said: “When it comes to acquisition offers, founders do what the fuck we tell them to do.”
- Profits (if there are any) are almost always kept in the company to subsidize more unicorn-goal growth. That keeps founders and employees poor until a bigger company (hopefully) decides to buy the whole thing.
- It’s extremely difficult to raise VC but then later decide “nah, we don’t want to be on the unicorn path.” Although there are a few recent examples, like when Joel from Buffer bought out his investors.
- Tim O’Reilly: The fundamental problem with Silicon Valley’s favorite growth strategy
- Basecamp CEO Jason Fried: Venture capital money kills more businesses than it helps
- Bryce Roberts of Indie.vc talking about their term’s evolution
Building a sustainable tech business without VC funding
The interest in alternative startup funding models has really hit a tipping point in the last year or so — like this recent viral hit from the New York Times about founders rejecting venture capital, the successful growth of Indie.vc (an unusual VC fund designed to back these kinds of companies), and the launch of TinySeed (an “accelerator for bootstrappers”).
It’s not a brand new conversation, but rather a collective awakening about how the tech startup world shouldn’t be limited to just two extreme ends of the spectrum.
We’re in the phase where the interest is there, but not many companies have successfully closed a round this way. There aren’t even good labels to describe these companies, although you’re starting to hear zebra (a play against unicorn, except “real”), indie, proportional, equity efficient, and sustainable.
Rand Fishkin, founder of VC-backed Moz, is intentionally building SparkToro as a zebra company and explains how their goals lead to that model on their about page.
Do you know of any other notable companies or founders to add to the list?
Founders should consider the hybrid path when they want to:
- Actually enjoy the ride. Trying to build a unicorn is enormously, incomprehensibly difficult. Too many elements of the unicorn path suck the joy out of the journey — the rollercoaster is much harder to ride (and more likely to fail in the end) when you’re not having fun.
- Build a company that generates a “small” (by VC standards) but personally life-changing amount of money, whether it’s through profit distributions, a nice but sustainable salary, or an exit that might “only” be a few hundred thousand or a few million dollars.
- Work on projects that, due to the nature of the product/market, aren’t a fit with VC math yet also aren’t smaller lifestyle businesses. This typically looks like a startup that can get early validation through bootstrapping, but needs a limited amount of efficient capital to “get over the hump” quickly on the way to sustainability.
- Work on projects that VCs normally don’t want to touch — think cannabis circa 2014, hunting, sex toys, education, etc.
- Build a company that isn’t solely focused on shareholder returns or cash flow. Some zebras are for-profit “social good” companies. The Prepared is an example, because we truly care about helping people prevent and survive emergencies (which has already happened and feels awesome!) while also generating a reasonable return — but when faced with a profit/growth vs. “doing what’s right” decision, we want to be able to choose the latter.
- Avoid the world of VC altogether, often due to a dislike for the never-ending and awful fundraising process, expensive deals, working with “bosses” they dislike and can’t divorce, etc. There are valid reasons why many successful VC-backed founders have nostalgia for “the early days” or fantasize about working on a “real business” while avoiding VC again.
- Live a healthier life. My mentorship nonprofit typically worked with Valley founders in the phase immediately after they stopped working on their company (due to acquisition, failure, etc.), and almost every one of them commented how it took over a year of not working just to repair their mental/physical health, relationships, drug dependencies, etc.
- Live a flexible life. Take time off without guilt, work less than 60 hours per week, have a long lunch on a sunny day with their spouse, travel, work from home, build a remote-only team, etc.
- Control and optionality. Sell (or don’t) when they want to. Grow (or don’t) when they want to. Maybe the market changes along the way or they learn something new that changes the game. And so on.
- Build a company that works for them, rather than ending up as just an employee to their own creation. Although the Rich vs. King tradeoff is real in the Valley, one isn’t inherently better than the other and there is nothing wrong with choosing to build a company the way you want to!
- Be an artisan, not an assembly line. When you don’t have to make decisions based on uber-compressed timelines or huge scale goals, you can focus on doing things in a way you’re proud of — even if that means a smaller result.
- Forget Unicorns. We Need More ‘Zebra’ Startups
- Zebra companies offer an alternative to the unicorn fantasy
- Unicorn or Zebra: Redefining Success at Startups
Learnings on raising money for this model
Standardized legal documents (such as Y Combinator’s SAFE) and a wealth of free info about the VC fundraising process are huge ecosystem improvements made over the last decade. New entrepreneurs can learn the ropes and close a deal for a fraction of the time and money it used to take.
The hybrid model, where you’re building a more traditional business model in tech startup clothing, is not nearly as developed.
Rand Fishkin / SparkToro open sourced the legal documents for their similar raise in 2018. They’re fine, but didn’t quite fit what we wanted, so we spent weeks working with lawyers to figure out a plan.
It wasn’t easy finding answers to some of these questions. Most info found online is geared towards traditional lifestyle businesses (eg. a local repair shop), thus missing key parts like early-employee stock options or how to give tech investors the protections they look for.
Pitching and finding the right investors
On the one hand, there isn’t such a thing as “the tech industry.” Tech is everywhere. The Prepared is more of a media and product company than a tech company. But, on the other hand, many of the best practices and talent for building a digital-native business are still held within the “tech” community.
So instead of finding non-tech investors who understood the sustainable model but not tech, I focused on tech investors who might appreciate the sustainable model. Although my existing network was mostly in the tech world, I think that still would’ve been the right choice in a vacuum.
I didn’t even try to pitch traditional funds. Every single investor is an individual. Some may invest through an entity, but it’s still their personal vehicle.
The vast majority of investors interested in the model were experienced entrepreneurs or people who’ve been a legit part of building something. Which makes sense, because they already understood (if at least subconsciously) the spirit through their own experiences.
Those who weren’t active builders were investors who work with early-stage companies and have a personality/ethos for empathy and understanding more about the journey than your typical Banker-type investor.
Some of the quickest investors to sign on:
- Gokul Rajaram: Creator of Google AdSense, CPO of Square, former head of FB Advertising.
- Danielle and Kevin Morrill: First employee at unicorn Twilio, VC-backed and exited founders through Mattermark, investors.
- Nick Heyman: In the first 20 employees at Facebook, exited founder, director of engineering at Twitter.
- Dorion and Liz Carroll: VP of Mobile Shopping at Amazon, PM at Pandora and Redbox, etc.
- Connor Gillivan: Founder of FreeeUp, a successful (and non-VC funded) web business.
- Todd Sawicki: VC-backed and exited CEO/exec/founder, investor.
- Kristian Andersen: Built and sold multiple tech businesses in the Midwest, investor.
(Notice a pattern? They’re all legit builders. And every one of our investors is a bonafide Good Person that founders actually want to work with.)
About half of those pitched got and liked the spirit of the model. Some just couldn’t wrap their heads around it and would say things like “if you’re passionate about it, you’d go bigger” or “I assume you’re not going to work on it full time since it’s small.” Others assumed top talent wouldn’t join an “unambitious play.”
Most of the process, timeline, pitch mechanics, deck, story telling, validation investors wanted to see, etc. is the same as a normal angel round — albeit with different context on what constitutes “the right validation.” A unicorn-path startup might need to be growing 10% per week, whereas The Prepared was organically growing 10% per month at the time.
I used some of the precious few words you have in an initial pitch to be upfront (even erring on the side of being scary) about how this is not a venture-scale play, calling out key differences like the lack of a board and VC-standard protective provisions.
Many investors ended up thinking of the opportunity (and I started to pitch it as) more akin to a real estate investment in a neighborhood that might gentrify soon. There were still meaningful risks, but it was somewhere in between a “safe” real estate investment with an 8% IRR and a unicorn gamble that is 5% likely to return 50% IRR and 95% likely to return 0.
One of the nice things about pitching this model is the capped downside, because these plays are not the all-or-nothing bets of unicorns. Continuing the “pre-gentrification real estate investment” analogy: If that neighborhood doesn’t appreciate, or even if it declines a little, you’re still holding a tangible asset that can likely recover a good bit of the investment when things don’t work out as hoped.
In The Prepared’s case, we had already received an acquisition offer for the same amount of the capital raised, which made us feel safe that even if we “fail”, we can be responsible to our investors.
Rather than wait for an investor to offer a term sheet and do the whole FOMO-lemming dance, we offered our own term sheet that was abundantly clear on these differences.
Although we didn’t use them in this round, similar rounds sometimes use mechanics around repurchase rights, a payback of X per product sold (think of Kevin O’Leary’s oft-used terms on Shark Tank), a percentage of revenue for Y years or until Z total cash is returned, etc. Those are all fine, just think through how it will work with the possible paths of your business.
Valuations should reflect the model. I raised this round in the same month I invested in a unicorn-path startup out of YC that had less validation than The Prepared yet had a valuation 1,000% higher. If you raise this kind of angel round at a $5M valuation, for example, even hybrid/zebra investors will be unhappy if you sell seven years later for $6M. Pre-money on rounds like this should often be in the six or low seven digits.
Because we’re an LLC, any paper profit generated by the company flows through to the shareholders for their personal tax liability, regardless of whether the company actually sent cash to the shareholder’s bank account.
So I put in our operating agreement that any year in which we have a profit, at least 35% of that profit will be distributed to cover their tax bill. Because no one wants to pay taxes on cash they haven’t seen.
Bonus: This also means the losses flow through, so investors get the benefit of reducing their personal taxes in the years before you’re profitable. Plus, one of the few nice things about Trump’s tax law is the 20% deduction against profits.
The decision of if and how much to distribute above that 35% rests solely with company management because we’re the ones best suited to make the decision between cashing out vs. investing.
Same with acquisitions, future financings (although we plan on not raising again), and business decisions — management is better suited to make those decisions than anyone else. If an investor didn’t agree with that mentality, they were encouraged not to participate.
There is no board, investors don’t have voting rights, and many of the “protective provisions” VCs ask for are not present.
It’s extremely rare that these governance provisions in VC deals ever actually matter — in practice, people leverage “soft power” and only utilize the legal weapons at their disposal when things are so bad that the company has effectively fallen apart anyway or things are so good that people are fighting over IPO billions (eg. Travis/Uber, Mark/Facebook).
There are solid arguments for why boards are a net positive for early stage unicorn-path startups (assuming you get the right people together). But for more experienced entrepreneurs, or those building these kinds of hybrid models, a formal board structure is not a prerequisite and can do more harm than good.
That’s not to say you shouldn’t raise from solid people and be proactive about humbly seeking out and acting on their feedback. A personal growth mindset is part of being a good entrepreneur no matter what.
Being a good entrepreneur also means not doing stupid or unethical shit like giving yourself a loan with their investment cash, cramming down other shareholders, making a massive pivot into something sketchy like online gambling, etc.
Be the kind of entrepreneur that doesn’t require corner-case legal protections!
So rather than waste time, energy, and money on legal friction that doesn’t matter in practice, we just skipped it.
However, to show people this was all still above board, I created an Advisory Council of three investors to “advise and consent” on a list of specific decisions where there could theoretically be a conflict of interest between myself and the rest of the shareholders. This helps investors feel safe that their shares won’t be treated differently than mine and that I won’t pay myself a ridiculous salary.
Speaking of, I specified my salary up front. It’s in line with what founder/CEOs of angel-funded startups make, but there’s a two-tiered cap built into the bylaws: one cap for now, and another higher cap that kicks in after we’ve been profitable for six months. Anything above that requires consent of the advisory council.
In the weeds on legal entity absurdity
You’ll pull your hair out trying to find the perfect legal entity structure for these models. Each model has pros and cons with odd tradeoffs and contradictions that could only come from a government as broken as ours.
In the end, we went with an LLC with a heavy amount of customization.
Institutional venture capitalists — the paid professionals who raise formal funds — will only invest in a C Corporation 99% of the time.
Alternative models have more options: C Corps, S Corps, LLCs, and LLCs taxed as S Corps.
C Corps can work for this model — one Valley accountant suggested this would still be the best path — and have the benefit of being understood by most Valley-types. But we found the cost of ongoing compliance to be too high, with not enough of the flexibility you can get with an LLC.
You don’t get the 20% Trump tax law deduction on profits with C Corps, but the corporate tax rate is lower now anyway. You also get the benefit of Qualified Small Business Stock, something not available to S Corps, which can make a huge difference in the money you pocket when the company sells because you pay 0% tax in certain circumstances.
Right out of the gate, one of the problems with S Corps is that you can’t have multiple classes of stock. Investors typically want preferred stock so they get paid back first and have other special conditions. You can work around this, but it gets messy.
LLCs can file a simple form with the IRS that tells it to tax the LLC like an S Corp. Keep in mind that LLCs are a function of state law, so the IRS ignores them and treats them like a partnership by default.
There’s a number of benefits to this increasingly-popular hybrid, some of which are attractive to founders because it avoids silly taxes while keeping overhead costs low. Namely, you don’t pay self-employment tax on your salary! The company pays it for you (like a normal employer), which counts as an expense to the company. Any profit left over is taxed like a normal distribution. This could put a big chunk of extra cash in an entrepreneurs pocket every year.
The Prepared actually started off as an LLC-S hybrid, but changed in the financing because of two big limitations:
- Shareholders can’t be entities
- Shareholders can’t be foreign
The foreign thing is less of a problem for most (although we did have one Canadian). The entity restriction is a real bummer because many angel investors funnel their money through a personal LLC or trust. A third of the angels in our round did this.
Although it doesn’t seem like there’s a final IRS-approved answer, we came to believe that single-member entities — typically LLCs owned entirely by one person — would be exempt from that restriction since the IRS treats them as “disregarded” entities anyway. But many angels have multi-member entities with their spouse/family for estate planning reasons.
If you’re able to put funding together only from domestic individuals or single-member LLCs, then consider the LLC-S.
Unfortunately, owners of LLCs can’t also be W2 employees of their own company in most cases. So you can run the business, but you can’t draw a salary. Although we saw some legal analysis that claimed if all of the LLC owners delegate daily management functions to specific owners (which is very likely the case if you do this model), those managers might be able to draw a W2.
LLC-S hybrids don’t have that limitation. If you’re a plain LLC, you have two choices:
- Pay yourself as an independent contractor via 1099
- Draw “guaranteed payments”, which are kind of like a W2 and count as an expense against the company
I felt the guaranteed payment path was messy (it gets tricky when the company is burning money, as most startups do) and could be unfair to investors (or at least complicate the math), so management is paid via 1099 as a contractor.
Yes, that means our salary is subject to self-employment tax, but guaranteed payments are SE as well. And if the company pays health insurance premiums for people on guaranteed payments, the recipients also have to pay SE tax on the value of that “income.”
Another self-employment tax trap: When the company is profitable and distributes that profit to owners, the investors who wrote a check but don’t participate in the business will pay the better capital gains rate because they didn’t work to earn that income. But founders, who are both owners and actively running the business, will pay self-employment tax. Again.
In our case, we balanced this out by giving anyone who would pay SE tax on profits an extra 5% bump in their share of the profits. This effectively meant everyone agreed to spread the burden of SE tax across all the shareholders by shifting some of the money to those who take the SE hit.
Stock options are another issue. Although very common and understood in VC-model startups with Corporate structures, LLCs don’t have “stock”, they have percentages/units.
The spiritual LLC equivalent is “profits interests.” They’re kinda like stock options, but with mechanical differences. They aren’t an option that needs to be exercised with a strike price, as they exist in full form on date of grant.
Instead, profits interests say “you get X% of the growth in our business after this point in time.” So when you give PIs to an employee, they don’t owe tax because their value in that moment is zero since there hasn’t been any appreciation or profit yet. You can even file an 83b with the IRS with a value of $0 to start the capital gains clock, potentially putting more money in your team’s pocket when the company is successful.