Thursday, July 29, 2010

3 (Sometimes) Stupid Reasons to Raise Venture Funding

I have had 3 entrepreneurs speak with me about their fund raising strategy in the last 3 weeks, and I realize that the once great art of bootstrapping a startup (i.e. building a business on cash flow rather then venture money) has been lost.

All 3 of these entrepreneurs had the opportunity to grow their companies off of cash flow alone.  And while in many cases it makes sense to raise money to accelerate growth (e.g. you have product market fit and want to ramp like crazy to beat your competitors, build network effects, hire a crapload of sales people, etc.), these entrepreneurs’ reasons seemed way off to me:

Some reasons the entrepreneurs said they wanted to raise money:
  • “Everyone is doing it”.  I spoke with one YC team that really wanted to raise money from a VC.  When I pushed on the reasoning, it was purely for bragging rights with their YC classmates.  I found this verging on ridiculous.  You want to give up a big chunk of your company so you could tell your friends about how you raised money?
  • “To get expertise”.  VCs can often provide great advice, discipline, and rigor to a startup.  However, there may be alternative approaches to tapping in to that expertise.  E.g. rather then sell 25% of your company in a seed round, why not find a few very qualified advisors or a board member?   Even if you give them 1-2% each you end up giving away much less of your company.
  • “I want to burn the boats”.  The thinking here is that a venture round would force the entrepreneur to shoot for the home run.  While entrepreneurs should always think big, sometimes the venture round locks you into a big exit that you may never reach.  E.g. a friend of mine started a company that was generating about $1 million a month in revenue.  They ended up raising a round instead of bootstrapping the startup (after they were cash flow positive).  This led them to (a) grow big and hire lots and lots of people = higher burn  (b) has prevented them from selling the company when they could have gotten the best exit (c) and my friend is now sitting in monthly board meetings charting and recharting company strategies with no exit in site (the business topped out at $20 million a year in revenue).  If he had not raised money he and his co founders could probably have pulled $10-$20 million each out of the company in cash by now and moved on to the next thing.  I don't think his current business has an obvious path to get bigger, and he is locked in.
There are many legitimate reasons to raise venture or angel money.  However, if you have a cash based business (rather then an equity business) in which you are throwing off more cash then needed for growth, you might want to think twice about what a venture round brings you and whether it is worth just bootstrapping your company.

By the way, some companies that largely grew off of their own cash flow:
  • Microsoft (grew largely off of cash, then raised a round with TVI late in their life)
  • Bloomberg (raised some money from an investment bank well after it was profitable)
  • Coupons, Inc (doing supposedly close to $1 billion in topline revenue)
  • GroupOn (raised from NEA to do something different, the pivoted and raised money largely for founder liquidity and advice)
Know of any other startups that bootstrapped their way to success?  List them in the comments please :)

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Thursday, July 22, 2010

Bootstrapping: Raise Debt From Your Employees

When we started Mixer Labs (acquired by Twitter in December) we were not paying ourselves and did not have any cash to pay others.  There were a number of people who worked for us part time while we were still figuring out what product to build.  We structured things with them creatively, and this ended up being a win on both sides.

Raise Debt From Your Employees, Not Investors
Raising money from investors can lead to a lot of value in terms of advice, ability to grow the startup etc.  but it is a good idea not to raise money too early.  We wanted to build a prototype of what we had before going to market, with the thinking that this would increase our valuation.  One way to be able to hire someone but not raise money is to effectively raise debt from the people who want to work for you.

The Option Vs Cash Approach
One of the things that was successful for us in the early days of Mixer Labs was to effectively raise debt from people working for us part time.  We structured the agreements as follows:
  • The people working for us as consultants would accrue $x per hour worked
  • Upon successful fund raising, we would pay the consultants either:
    • Cash if they did not join the startup (i.e. whatever we owed them)
    • Cash if they joined the startup and wanted to get paid in cash
    • Options if they joined the startup and wanted to participate more in the upside of the company
This gave the consultants a potential stake in the company without creating an instant shareholder -which paying directly in equity would do (we only wanted people committed to the long term success of the company to own equity and there are a number of other reasons to want to limit the # of shareholders you have).  It gave the consultant an additional reason to convert to a full time employee with funding.  And it made sure that whoever worked for us got to get paid in cash when we could afford to pay them (if that was their choice).

The True “Cash Only” Approach
Another option you can follow is the split payment method.  E.g. say a consultant wanted $80 an hour (using a nice round number for ease).
  • Pay the consultant $20 an hour now out of your own pocket.  The consultant will feel sure they will make something out of working with you.
  • Pay the consultant $80 an hour for accrued hours when you raise money.
This is more expensive then just paying $80/hour now, but if you don’t have the cash available you pay a little more in the long run but end up with much less personal outlay up front.

Any other creative ways you have seen to get employees or contractors on board?  Feel free to write it up in the comments – would love to hear other approaches….

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Older posts that may be of interest:
What sort of people should you hire for the first 5 employees
How to get your first 3 employees

Wednesday, July 21, 2010

Should You Let a VC Invest in Your Seed Round?

During the prolonged frenzy of raising a seed round, many entrepreneurs wonder whether it is worth including one or more VCs in the seed as a part of the round (e.g. buying 10% of the company, as opposed to, say, the VC buying 25% of the company during the seed).  This has a lot more tradeoffs than one would initially think and is in part driven by VC economics, which I wrote about earlier.

I usually advise entrepreneurs against including a venture fund as a small part of their seed.  That said, there have been a number of successful companies seeded by a venture fund (e.g AdMob) and my own company, Mixer Labs, benefited from having a venture fund (Sequoia, who was very helpful) as part of the seed.  

It is very situation dependent and as an entrepreneur you should weight the plusses and minuses of having a VC in your seed round when making the decision.

Benefits of raising part of your seed from VCs:
  • You have a deep pocketed investor who can, if things are going well, invest more money in the startup (although if things go well, you will be able to raise money anyhow).
  •  Raise it fast!  VCs can deploy what they consider “small” amounts of capital quickly – e.g. $250K-$500K won’t impact a $400 million fund. 
o   Sometimes a decision to invest this little is left to a single partner or two partners versus having the whole partnership weigh in.  
o   This has a downside too – VCs will happily write off this amount and may not support a startup in which they deployed so little capital
  • Branding.  The VC brand may help you attract talent or get potential hires interested.
  • Advice & structure.  Some entrepreneurs could use the structure and advice provided by the VC joining the board (assuming enough of the company is bought to justify partner time).  A top tier angel can often fill this need as well.

Drawbacks to including VCs in your seed:
  • Signaling.  This is the big one.  When you go out to raise a series A, investors will wonder why you don’t raise the money from the venture fund that already invested in your seed.
o   If the VC in the seed does not invest in your series A, other investors will view this as a big red flag – i.e. why would the VC who knows your business best not invest?  This will lead to a lot of investors to pass on your company without really getting to understand the situation.
o   If the existing VC wants to invest and you go to other investors to get a competitive bid, the new investors will think you are using them to merely drive up the valuation you will get from the existing investor, whom they often assume you will chose for the series A (since you already know the VC that invested in the seed).  This means your valuation for the round may end up lower then it could have been.
o   There are ways to navigate the issues above, but it adds friction to an already time sucking process of raising money.
  • If you don’t raise money from a venture fund, you can get other venture funds to more actively work for you.
o   Investors always want to prove their value in case you raise a series A, so will spend time making introductions, meeting periodically to discuss strategy etc.  So not having a venture fund in your round will means lots of other funds may still help you out. 
  • Venture investors are more likely to stop supporting an early stage company if things don’t go well and the seed money is running out.
o   This is not out of malice, but rather a calculated business decision on the option value of the partners time.  Why have the partner spend a lot of time on a “bad” investment when there is always a new entrepreneur walking through the door.   Angels may have a larger vested interest in the company or be helping out for reasons other then just financial return.

What do you thinks?  Know of good examples of partial seeds by VCs leading to especially good/bad outcomes?

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Tuesday, July 20, 2010

VC Economics – Why Your $50 Million Exit Means Nothing

A friend of mine is working on one of the coolest startups I have heard about in a while.  We discussed whether he should have VCs  invest in his seed round.  He is thinking he may want to have the option to exit early and was curious why a VC wouldn’t want to put in $1 million for 20% of the company and get out $10 million (at a $50 million exit) – a 10X return.

The Economics of Big Funds
The reason is the economics of large funds.  Suppose you are a venture fund with $500 million under management.  If you are a top tier fund, you want an internal rate of return (IRR) of say 20-25% a year to your investors over the 5-10 year horizon of the fund (say 3-5 years of active investing, followed by another 3-5 years pro-rata/follow on investments in the company).

This means over the life-time of the fund, the fund will need to return $1.5 billion from investments.  I.e. the VC needs to make back the original $500 million that was invested, and then make an additional $1 billion on top of that.

This calculation does not include additional details, e.g. if you charge 2% in management fees per year for 5 years, that is another 10% of the fund you need to make up ($50 million).

So, the $10 million you returned to the VC as part of your startup’s $50 million exit is 1% of the total money they need to return the fund.  Clearly not worth the opportunity cost of the partner’s time who is looking to make $100s of millions per successful investment.

This is why some VCs have a “go big or go home” mentality.  The $50 million base hits won’t move the needle for a big fund.  This is why some VCs will push for the additional dilution of ongoing fundraising over a quick exit – a company that exists for $1 billion post dilution will still return more money to the fund than a small exit.  Unfortunately many companies go under during this process.

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