The “VC compatible” experiment

Last year I wrote a post, “The Rise of Non-VC compatible SaaS Companies”, explaining that due to the maturity of the SaaS industry, an increasing number of the interesting SaaS companies launched are not compatible with the traditional venture model (read the post for more details).

However, a major challenge is that, at early stage, it’s not always clear whether a company is VC compatible or not. It’s often not a “black or white” situation, and this status can even evolve (start as VC compatible and become incompatible later or the other way around).

Recently, Buffer and Moz are two examples that illustrate well this trend. Buffer is a very successful business, currently at more than $10M ARR, which took some VC money (around $3M). After a while it became clear that having VCs on board was not aligned with how the CEO wanted to operate his company, creating frictions that are well explained in this post. Ultimately he decided to buy out its Series A investors.

The story of the founder of MOZ, Rand Fishkin, is a different but an interesting one too. He recently left/was pushed out of the company he founded, and reading the various posts he wrote, you understand that the reason that lead to this situation is the money he raised from VCs and how it changed the way the company was operated. Interestingly, for his new company (SparkToro) he decided to come up with a new approach to early-stage financing that would enable him to “build an exciting, high-growth, high quality company that some venture investors might be excited to be part of… BUT, one that preserves the option to do things that wouldn’t fit with the outcomes venture investors need.”

One year after writing my article, my feeling is that the Seed stage in SaaS often looks like an experiment to test whether a company or a founding team is VC compatible. And if traditionally the outcome of this “experiment” was clearly in favor of VCs, I believe that things are changing (and this is why as VCs we should pay attention to it).

But before digging deeper into this topic, let me start by explaining why I think the Seed stage can be considered as a “VC compatible” experiment.

The seed “VC compatible” experiment

Let’s say an early stage VC firm invests in 10 companies. For the majority of these startups it’s unclear whether they are VC compatible or not ( = has the potential to be a fast-growing company that will be worth several hundreds of millions or billions of dollars). It can be because the bet was on a market or a product that finally cannot deliver such an outcome, because of the founding team that realizes it shouldn’t have raised money or for execution problems (etc.).

Let’s assume that after 18 months, four companies have died, five companies are doing ok (no growth / slow growth) and one company is outperforming (growing fast).

• Clearly the outperforming company is “VC compatible”. It will have no problem raising more money to fuel its growth and has a shot at being huge.
• I added a “?” label to the dead companies because at that stage it happens that a company was VC compatible but died for reasons not related to the venture model (ex: implosion of the founding team).
• What really interests us in this post is what happens to the five companies which are doing ok.

The possible paths for these five companies are:

• Death: they don’t manage to reach profitability or to raise more money.
• Acquisition: generally at that stage acquisitions are small or are acqui-hire. In the majority of the cases it means non-VC compatible.
• Outperforming: it often takes time to build a fast growing company. These companies either need to reach profitability first and operate in this mode before suddenly growing fast and raising more money later. Or they can go through several bridge rounds to buy time until they finally start to grow fast again.
• Profitable + average growth: a non negligible part of these companies will become profitable businesses that are growing nicely but will never be fast growing companies. Which is fantastic from a pure business perspective, but not compatible with the venture model.

This is why I consider the seed stage a “VC compatible” experiment. It often takes time and money to see whether a company is compatible with the venture model. Which, of course, can lead to several problems.

The growing problem of the seed stage in SaaS

A couple of years ago, when the SaaS market was still nascent, the two main outcomes of the seed stage were “death” or “raise more money”. Launching a SaaS startup required capital as building a product and distributing it were not as accessible as it is today. On top of that, founders very often had to “educate” their market, which takes time and money.

But now that the market is mature, the third outcome (becoming a profitable and slow-growing company after having raised a seed round with VC) is increasingly happening.

Various problems can emerge from this situation:

• Diverging visions: if the founders decide not to aim at fast-growth anymore, but rather at profitability, it can lead to frictions with VCs.
• Harder to attract and retain talents: if you are not growing fast and have VCs in your cap table, it can limit your ability to attract and retain talents with stock incentives (see Buffer’s post which briefly touch on that).
• Less VC support: some VCs prefer to support their fast-growing companies and spend less time with the others.

As Rand explains in his post, the traditional venture model does not “preserve the option to do things that wouldn’t fit with the outcomes venture investors need” when it turns out that the company is not VC compatible.

It doesn’t mean that these companies shouldn’t raise money initially(this why the seed stage is an experiment, they need the money to figure out whether they are VC compatible or not), but it means that currently the outcome of this “seed stage experiment” is clearly in favor of the investors. Once you’ve chosen this path, you are, in most cases, stuck on it even if you want to operate your company differently.

What is interesting is that there are also signs that the situation is evolving.

Where are the lines moving?

Over the past two years, I saw several changes/initiatives going toward a more balanced model.

1- Return via distributions and not via exits only. The traditional venture model, by design, generates a return for investors when an exit happens (the company gets acquired or goes public). This is a major reason why the VC model is hit-driven and looks for “above the average” companies (the majority of startups won’t get acquired and won’t go public). To offer more return options compatible with “normal growing” companies, a solution is to provide this return through profit distribution. When the company begins to generate profit, it can start giving back money to its investors until a certain amount is reached. Several “non traditional” VCs have adopted this model and I’m curious to see if more VCs will adopt it in the future.

2- Business angels syndicates. As I’ve explained above, the seed stage is often an experiment to validate whether a company is VC compatible or not. The problem is that when a company turns out not being VC compatible, it’s too late as they already have VCs on board. This is why it’s interesting to see SaaS founders raising their seed round with business angels only. They syndicate business angels to raise several hundreds of thousands of dollars. The difference with raising with an institutional VC is that business angels don’t depend on “exiting billion dollars companies”. Basically you conduct your “VC compatible” test with investors who are not VCs :-). This is what Sparktoro did by combining 1 and 2 (round with business angels only + return via profit distribution).

3- Debt or private equity. Another option is to do like Buffer and to buy out your existing investors. However, the majority of profitable SaaS are not as successful as Buffer and don’t have the cash in the bank to buy out their investors. This is why some debt providers lend money to founders for this kind of operation. Some PE firms are also buying out investors.

I think we’re still very early with these trends, and it’s far from obvious (to me at least) how they are going to evolve and how important they are going to be for the SaaS industry (niche or mainstream?). That being said, I believe that the two major forces behind these trends (and many others in our industry) are:

• Capital becoming a commodity.
• The shifting power from investors to entrepreneurs (entrepreneurs have more and more leverage).

And because of them, I don’t see how the environment will not evolve toward a more balanced venture model.

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