The Case for an Alternative to Venture Capital
The venture capital industry has been around since the mid-19th century, and little has changed in the investment model since then. With the rise of so many new industries and the shift away from a one-size-fits-all mindset for CEOs, many founders and investors are beginning to reconsider the Silicon Valley, unicorn-driven model of entrepreneurship. For years now, many startups believed there is only one right way to build a company — rapid customer acquisition and high growth, at the expense of sustainable profitability. And this method can work, if you find yourself in a winner-take-all market with access to venture capital.
However, despite the success stories we all have heard, most technology companies do not meet the high growth requirements of VCs and therefore have limited access to growth capital.
1. The history behind the venture capital industry
The rise of industrial production in the 19th century paved the way for what we now call venture capital. Wealthy elites began to diversify their assets by investing in “high tech” industries. Unlike modern day venture capital, these investments were highly decentralized, flowing from wealthy families through intermediaries.
The beginning of the 20th century saw the creation of a more familiar type of investor — private capital firms began to pop up in cities like Boston, San Francisco, and, of course, New York. These firms consolidated funds from wealthy families and developed due diligence and portfolio selection practices to make the investment process more efficient.
The mid-19th to mid-20th century was a period of high levels of experimentation and growth for the venture capital industry. But the relationship-driven practices and risk analysis haven’t changed much, and the industry today is remarkably similar to the industry then.
2. The challenge for many entrepreneurs looking for capital
On its face, it can seem like there’s an expanse of capital options out there for founders. However, once CEOs actually begin fundraising, many find that it can actually be incredibly difficult — if not impossible — to find the perfect fit.
Traditional banks often have extremely risk-averse underwriting and look for a history of profitability and regularly require personal guarantees or a pledge of personal assets, making it difficult for entrepreneurs to obtain bank financing. This barrier has only grown. The Kauffman Foundation attributes this trend to 2 reasons: 1. The disappearance of community banks and 2. The rise of service-based businesses with no collateral.
Other options, like government programs, crowdfunding, and friends and family rounds aren’t accessible to everyone or do not provide meaningful amounts of investment that can support strategic investments in the business
The option most technology founders typically consider, venture capital, can be extremely difficult to access, given that venture capitalists focus on rapid, high growth and very large markets.
3. Venture capital isn’t for everyone
Venture capital can be a good fit for companies if building your product is capital-intensive. For example, if you are at the riskier early stages of your company, when you’re developing new hardware, doing research and development, or building your product.
However, venture capital risk analysis has gotten tighter, making it more difficult than ever for founders to access. Most venture firms look for investments that can individually return the whole fund, reducing the odds that you’ll get funding from a venture capital firm. As Series A and Series B funds grow, so too does check size and company spend. The Kauffman Foundation found that startups, at Series A and Series B, are spending 3x the cash as startups 10 years ago. Additionally, Correlation Ventures found that investors realized less than a 10x return in 62% of unicorn exits in the past decade.
That means venture capital firms’ risk analysis continues to get stricter, and successful bets need to return the fund in big ways. Any company a VC invests in needs to legitimately be able to return 50x-100x.
In 2020, global venture funding reached $300 billion, for a little over 20,000 rounds of financing, or 5000 financing rounds per quarter. For context, Statista estimates that 225,000 startups were formed in Q2 of 2020. Clearly, a very small percentage of companies end up receiving VC funding.
So, unless you’re a company focused on exceeding $500M+ in revenue, with less regard to capital efficiency and a path to profitability, or coming out on top in a winner-take-all market, you’re generally locked out of traditional venture capital.
4. Founders are moving away from the unicorn mindset
One result of the declining odds of raising venture capital is that in 2018, the Kauffman Foundation found that at least 81% of entrepreneurs do not access venture capital or bank loans. There’s been a rise in companies choosing not to raise venture, instead relying on customers or other sources of growth capital, rather than equity investments. For example, Mentimeter recently reached $21M in ARR and has raised only $500K in external funding.
This reflects a growing reality for the entrepreneurship industry — while it’s true that some companies do attempt to raise venture capital and are unsuccessful, an increasing number of companies simply aren’t interested in the growth-at-all-costs mentality that’s so prevalent in Silicon Valley venture capital today.
More and more founders are focusing on other measures of success, like sustainable growth and profitability. While this might not feel as sexy as growing at 100%+ year-over-year, most entrepreneurs find that focusing on running a profitable business, raising efficient capital, and bringing something useful to the market are equally important goals.
5. Not everyone lives in a traditional venture capital hub
Another big problem many entrepreneurs face is being located outside of traditional startup hubs, like San Francisco and New York City. A PwC/CB Insights report found that only 30% of 2018 venture capital investment went to startups outside of San Francisco, San Jose, New York, and Boston.
While some local VCs have begun to enter the picture, there’s still a massive gap between funding to the coasts versus everywhere else. And many entrepreneurs continue to be left out simply because they don’t live in a traditional startup hub.
6. So, what’s the solution?
Given all these reasons, one thing is clear. Venture capital is not the right for the vast majority of founders, and that isn’t going to change anytime soon.
In 2018, TechCrunch interviewed more than 200 investors and asset managers about alternative capital strategies, and by far the most popular option was revenue-based financing.
What is revenue-based financing? While it’s not necessarily a new idea, revenue-based financing is a way to access growth capital that most founders have never looked into before. Instead of buying equity and waiting for an exit, revenue-based financing investors make an investment and earn returns via a small monthly royalty payment based on the company’s cash collected from sales, with no equity dilution. Once a company hits a predetermined investment return cap, the company stops paying the royalty.
Revenue-based financing can be a good fit for companies who are seeking:
- A bridge to their next big milestone
- To increase their sales staff or marketing spend
- Quick access to meaningful investment
- Additional capital to close out a round
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