What does your TEAM want? Dogma Reconsidered: Venture-Backing vs. Profitability.

By the time successful unicorns exit or IPO, their cap tables look like this: 70% owned by investors, 30% owned by the team. But of that 30%, easily 2/3rds of it is owned by C-levels. So “the team” gets a paltry 10%. And because of the amount of capital that has gone into the business, “the team” is normally very large, so that 10% is divided into tiny pieces.

Let’s face it. Venture capitalism has turned into venture socialism.

The social contract for most startup team members goes like this: take a slight to moderate discount in cash comp from “market,” but you’ll still get a solid 6-figure salary, plus benefits, plus an equity kicker. In exchange, you have the privilege of working for a startup that is “changing the world,” instead of putting your brain on a shelf at a big public company (no argument there — if you leave, the stock price won’t move). So we expect you to work hard.

(Sidebar: “market” means what you’d get at Google: usually a quarter million a year or more. How did that become “market”?! A bizarre and highly artificial bubble phenomenon.)

If the Startup Employee Social Contract reads like a “have your cake and eat it too” deal, that’s because it is. You might not make as much cash, but you’ll still make plenty, you’ll still get benefits, but thankfully, you won’t be bored, you’ll get to work on interesting problems, and you can entertain the narrative that someday, over the rainbow, your equity will be worth something.

This has been Normal, The Default State of Affairs, and The Done Thing for so long that we’ve forgotten what the phrase “working at a startup” used to mean. Today, I’m “working at a startup” means “I’m speculating with my sweat equity at the latest unicorn on the outside chance that this rocketship exits for $10B+ or more.” In the 20th century, the phrase was “I’m building a company”… meant “I’m committed to building this enterprise over many decades, and I’m not going to take money out of the business until it’s profitable, growing and secure.”

There’s always a catch. Our social contract removes risk, but it also minimizes ownership, both financially and culturally. Instead of an ownership culture with a small number of highly motivated partners, overcapitalized venture backed startups have a venture socialist culture with a large number of highly entitled employees.

How did it come to this?! In a word, incentives. To understand the developments in the market for capital and labor at technology companies since the year 2000, you have to trace macro economic trends back to WWII. And we don’t have time for that here. But I will point out that The State of The Market is not necessarily Game Theoretically Optimal from the point of view of building successful technology companies. Perhaps (although I’d argue even this, if I had the time), it is game theoretically optimal for venture capital funds. Certainly, VCs perceive it to be in their best interests.

VCs want large fund sizes so that they can collect management fees over a multi-year deployment cycle. With large funds to deploy, they want to overcapitalize their investments. By overcapitalizing their investments, they are actually increasing their chance of failure and creating a labor market bubble. But by owning a large percentage of a few of these overcapitalized companies that exit for $10B or more, a small percentage of funds generate incredible returns and can do it again! Those successful tech giants then further inflate the tech labor market bubble.

“Founder” (and executive) incentives have also been captured. Their social contract with VCs is even more truly a Faustian pact. Give up control. Give up ownership. But don’t give up your ambition! No, get us to a $10B IPO, we’ll give you all the capital you need, and if you get too diluted, we’ll issue new shares to bump you back up to 10–20%. 10–20% of a $10B company is $1–2B: you’ll be a billionaire! And if this really does become as big as you’ll say it’ll become (what was it you told us in the partner meeting: $100B?), then far more! If this doesn’t go the way you expect and we do an acquisition deal, founders & executives usually get protected with carveouts and earn-outs, so “you’ll be fine” either way. Whatever happens, if you stay in our good graces, we’ll make you an Entrepreneur In Residence and give you opportunities to invest in or join our portfolio companies. Welcome to the club!

What’s the alternative? A cap table that looks like this: 70% owned by the team, 30% owned by investors. A private company that never goes public, but recycles investor capital. Of the 70% owned by the team. Suppose the startup gets to a $20M run rate and is valued at 5X revenues, so $100M. The team is small, so even though it is meritocratic, every individual contributor owns a meaningful stake: the average is still possibly over 1%… so everyone has at least $1M in equity.

What do you think that does to a culture? Everyone gives a fuck! Everyone really, really cares. Everyone is tightly in sync. Everyone knows the income statement. Everyone sees the problems and opportunities. Everyone has manic/paranoid creativity: generating ideas and identifying new problems. Everyone holds everyone else accountable.

How do you think this culture reacts to a crisis? All hands on deck. How do you think this culture thinks about spending? Respect money. Justify spending with ROI analysis. How do you think this culture thinks about new investment? Skeptical. Desire to buy back investors, to make new capital dilution-neutral, if not anti-dilutive. Every new dollar at a higher price has a higher expected exit value, and adds pressure. How do you think this culture thinks about new hires? Skeptical. Revenue per team member should increase. The focus is on getting more done with less, on maintaining the advantages of density (agility, coordination, awareness), and on increasing the bar for performance. How do you think this culture thinks about

In other words, it’s a partnership culture. I’m describing the ethos of a private, closely held, owner/operator culture. I’m describing TRUE venture capitalists: the team and the investors in such companies. The venture socialists discarded this model, because they assume that it can’t scale. They’re wrong.

There are challenges in building a company like this.

The first and most important challenge is business performance. If you can’t find customers, convince them to buy, and keep them happy at a high-margin price, then you won’t be profitable, and you’ll need to keep taking investor capital, until even investors discard you. You’ll also have smaller R&D budgets as you have less capital to spend on engineering, so you’ll have to focus on features that support your immediate business, and reserve your bigger bets for later. If you’re a “visionary” this will feel like eating humble pie. But then you’ll realize that this is actually the secret to being visionary: being strategic; understanding how to make a small thing a big thing through adaptation and sequencing.

While hiring, you’ll meet a lot of entitled employees who want the standard venture socialist social contract. Filter them out to save yourself time. Make your TRUE venture capitalist owner/operator/partner social contract very clear, and you’ll attract the right talent.

While fundraising, you’ll be tempted to raise more money than you need, to give up too much ownership and control, and a lot of investors will reject you because you don’t fit within their model and because you aren’t following their playbook. The clearer you make your corporate strategy, the more capital efficient you are, the wrong investors will self-select out, and the right investors will emerge.

It’s a LIE that profitable companies cannot become giants.

Small teams can build huge companies. Think: Instagram. Rational owner/operators care more about revenue per employee and profits per share than absolute numbers. They care more about quality, resilience, optionality, agility, defensibility…

The TRUE venture capitalist social contract does not require any sacrifice of ambition. Your vision may still be to build a $1T company. What it requires is a certain mixture of patience, discipline and the wisdom of operating experience: particularly around strategy and sequencing.

Once you’re profitable, first of all, you can finance your company with profits. What a novel concept. You can spend more on marketing and engineering, for example, and if you’re making smart ROI bets, you’ll see payback over the time-horizon you intended. You can also buy back your investors and former partners, and give them a great exit. You can also buy companies and invest in companies and start new companies or start new business divisions in your current company. You can also pay out dividends. If you want to do more of all these things than you can finance with your current profits, instead of equity financing, you can borrow up to 3–4X EBITDA. Venture capital is the most expensive form of equity. And not just because of the dilution. But because of the terms, the loss of control, and the insistence on a dogmatic operating playbook, with a highly fragile risk profile, that narrows your strategic universe, and may not be Game Theoretically Optimal for you, if what you truly care about is building an iconic and enduring technology company.

With all that being said, by all means, raise a Series A!