Why (and how) more tech entrepreneurs are raising money outside the unicorn/VC model

Short version

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?

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.

Vinod Khosla

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.

The power law of VC math
  • 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.

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”).

The mythical zebracorn
  • 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.

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.

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.

  • 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.

Basic terms

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.

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.

  • Shareholders can’t be foreign
  • Draw “guaranteed payments”, which are kind of like a W2 and count as an expense against the company

Atypical Silicon Valley founder and investor. Founder of The Prepared, DIU (DOD), Nomadic Mentors (acq), isocket (acq). Innovation advisor to Obama White House.