Myth Busted: Not Every Company Needs Venture Backing

There’s a misconception in the Bay Area that if you’re starting a company, you need to raise outside capital to both operate and be considered legitimate. The process has been overly glamorized. Big rounds are celebrated, even though they don’t always translate into any exit, nevermind one that is meaningful for the founder(s).

I’ve always struggled to understand why peers and friends celebrate raising money, especially in their early stages (Seed and Series A).

At this stage, the only concrete thing you can “celebrate” is that you just gave away a portion of your equity, operating control, and the ability to draw profits from the business… permanently.

One of the biggest questions my co-founder, Dennis, and I keep coming back to when thinking about our next company is whether or not raising outside capital is actually a good idea. Beyond committing ourselves and our company to the timelines and expectations of investors, raising money might not be smart from a logistical perspective, depending on the business we try to build next.

As Rand Fishkin has said, VC backing often makes a startup grossly inefficient, not to mention your relationship with your next investors will likely be longer than the average marriage.

Here is some insight into our current thought process and the questions we are asking ourselves as we make this decision:

Question 1: What type of exit are we happy with?

• VCs want huge exits. Small exits just don’t produce returns VCs deem meaningful for their funds (even though they may be meaningful for the founders). So even if a founder has an acquisition offer they want to take, they might be prohibited from doing so by their investors, who want to hold out for something bigger.
• VCs have the power to “drag along” founders into acquisition offers they don’t want. I’ve seen this happen. It isn’t pretty. It’s often the result of a company not growing at an expected rate and the VC getting impatient due to their fund horizon.
• Sometimes VCs claim to be “founder friendly,” meaning that if the founder at any time wants to exit, they’ll work with them to help the process. But that might not always be exactly true. Consider it from the VC’s perspective: if the startup you’ve invested in proves to have rocketship potential, why would you want to exit early if your fund is depending on that company to bring in the lionshare of the return to your LPs?

What you need to be thinking about here is whether you want the freedom to exit smaller and earlier if need be, or if you’re OK riding a much longer rollercoaster like Dropbox did with its 10+ year journey to an IPO. Obviously it was an amazing outcome, but not every company is Dropbox.

Question 2: Who would our acquirer be?

A nice acquisition — adjusted for time and life circumstances — may be much more rewarding for both yourself and your team than a long and grindy road to an IPO. Even a “small” exit, in addition to giving you some cushion to live on, also makes it easier to launch something new and bigger again in the future — not to mention raise money as a “second-time founder” if you choose to go that route.

Even with a “small” exit, having some cushion can put you in a much better position to think your next venture through instead of balancing building an MVP and putting food on the table. Without any logical acquirer in mind (hopefully you have multiple), you are essentially banking everything on a very low probability outcome of an IPO.

• This is always helpful to think about, even from as early as Day 1. With Dairy Free Games, Dennis and I started off knowing that our most likely (and preferred) acquirer would be a larger gaming company. This informed many of our initial strategic decisions — including whether or not to raise venture capital, from who, and the people we sought to meet and form partnerships with.
• Who your acquirer might be will depend on what sort of business you’re running. If you’re a services company, like a design team or recruiting agency, you have to consider why a company would want to acquire you, especially if you offer services already to them or their competitors. Why would they acquire you if they already have everything they need from you by way of your service, and by acquiring you, they effectively remove all other revenue that comes from offering services to their competitors?

Question 3: What type of business do we want to start, and how long would that type of business take to reach profitability?

• Another reality of running a cash flow-oriented business — like a consulting agency, or a physical product-focused company, even, where you’re selling units at a healthy margin from day one — is that you could actually be profitable quickly. When that’s the case, it might be smarter to simply self-fund your operation and draw profits. If you know your business isn’t going to be profitable for some time, however, self-funding simply isn’t sustainable, even in the short term.
• Now, if your ambition is to build and launch an MVP to gauge initial traction and later bring on a larger team to add critical features and scale it, the better route would be something of a mix: self-funding until you can raise a large seed round or skipping straight to a Series A on much more favorable terms.

Question 4: How many full-time employees would we need to hire before we can reach a scale where we would be an attractive acquisition?

• Full-time employees are expensive. In fact, for a software company, they’ll be your biggest expense early on. Before you actually start your first company, you’re really only thinking about salary as a primary expense. But as soon as you start hiring full-time employees — especially in the Bay Area — your expenses balloon. There’s more paperwork, benefits, payroll taxes, office perks, health insurance, legal expenses for setting up stock option plans, etc. All in all, it’s another 30% or so on top of the salary that each employee will cost you. Plus, if they don’t work out, then you have to consider severance. All of which is to say, if you need to hire a lot of full-time people to scale, you’ll likely need outside capital.
• Of course, that’s dependent on your personal financial runway — if you’re Jeff Bezos, you can probably self-fund a 500-person team and sleep soundly. But even if you are worth, say, $10 million liquid, running a five-person team can quickly eat away at that amount.
• If you can scale something with just a few people or some part-time contractors, then you can likely self-fund until you decide not to. Sites like Examine.com are maintained by a team of less than 5 people with a founder who spends more than half the year traveling, and they’re doing just fine. Ultimately, this will prove a major factor in determining whether you have the freedom to bootstrap, or whether outside capital will be a necessity.

At the end of the day, while raising VC is sexy and glamorized in in the Bay Area, in reality, it can be limiting and even damaging.

Sure, it can allow you things like access to key industry players, partnerships with portfolio companies, and good advice. But often times, you don’t actually need those things, especially while you’re still proving out your product-market fit — and more often than not, the contract you have to sign to obtain them simply isn’t worth it.

The sad reality is that investors promise the world during the “term sheet phase” (after all, they need to sell themselves to you to get deals done), but unless you show fast traction, it’s just better business for them to focus on their rocket ships.

The only way to determine whether or not that’s true for you, however, is to take a hard look at what you want to achieve, what sort of business you’ll be running, and whether or not self-funding is a realistic option.