Almost every quarter I have the same conversation with my corporate attorney. We’ll call him Bob because that’s his name. I say something to the effect of “I think I may need to get outside funding to make product X successful”. Bob then shakes his head and says some variation of “Don’t do it unless you absolutely have to.” Bob is brilliant, he lectures at the Wharton School and has 20+ years experience working with startups and VC’s so I highly value his advice. He’s been dead-on right so far.
People often associate startups with venture funding. They go hand in hand. Clever MIT grad and his buddy have an idea, they raise some money from Angels or Venture capitalists and the Forbes article practically writes itself. But venture money comes with risks and many strings attached. There are good alternatives. In fact the majority of small businesses don’t startup on VC or Angel money. They startup on owner’s capital and sweat equity. A business is like an engine for value. Resources have to be pumped into it for a period before it can come to life. Imagine an old time auto-crank engine. You have to crank it for a bit but once the engine is purring it outputs continuous power. For a business, that power is value and unlike the engine which is subject to the laws of thermodynamics, that value is greater than the value of the resources it consumes. The difference is called profit. The initial investment can come from VC’s or owners or government or any other source. Let’s discuss some of the drawbacks of VC funding.
1. Time is money.
The first concern is the time it takes to raise money. As an owner you have a finite amount of time and it’s one of your key scarce resources. If you are out beating the bushes for money, you are not out beating the bushes for new business or building your team or developing new product ideas or any of the dozens of other tasks that founders need to do to create opportunities, staff up with talent and execute flawlessly.
2. Meet the new boss, same as the old boss.
When people invest in your company they expect something in return. That something is a say in how the business is run and an equity stake. When you and your co-founder are the only investors decisions can be made very quickly; strategy can be re-cast over lunch. However, when you accept someone else’s money by telling them you are going to do X but you find out through hard effort that you should be doing Y, you have at the very least an uncomfortable conversation with your benefactors. I’ve seen VC funded companies in my own industry get locked into failing strategies this way. They took money and scaled too early on a business model that did not hold up to the market.
3. Businessman vs. fundraiser.
Accepting VC money can lead to another trap…thinking you are successful at building a business when in fact you are successful at raising money. A friend of mine has been in several startups as a founder. In his last one, his CEO was once asked how business was going. His response … “Great, we just secured our latest round of financing”. Don’t confuse business success with the ability to raise money. The correlation is weak. If it were not so then the more VC funded firms would be successful.
4. The money may make you soft.
Perhaps the biggest danger of taking money is that it will allow you to some extent to collect the trappings of success without success itself. This can lead you and your team to believe you have arrived and extinguish your animal spirits as Keynes might phrase it. A big stash in the bank can damp down that fire in the belly and subtly lead you and your team to take your foot off the gas. My uncle, a successful Wall Street specialist once told me that winning people are the ones who are hungriest, they are the ones willing to work hardest for their goals. He was right. Stay hungry and stay lean.
5. Less pie for the team.
When VC’s invest they get a piece of your company through equity that can be typically in the wide range from 20% to 80% depending on the maturity of the enterprise. This is equity that is not available for you to distribute to your team. Bootstrapping and self-funding allows owners some added flexibility to distribute larger and more compelling chunks of equity to employees. One of the factors that can send a company into a death spiral is successive diluting rounds of financing that leave the owners with a small fraction of the company and employees with even less. It’s difficult to command the kind of dedication and perspiration that is required to make a startup succeed when outside investors own a large majority of the company.
If not VC money they how do you start a company? I have a few suggestions. The first is to use money you generate from services. Service companies can get up and running relatively quickly. It’s not an easy road but if you traverse it correctly you can fund product development from service profits. A discussion of the differences between service and product businesses is the subject of a future post. The second wild suggestion is to use your own money. I was able to start SRT because I could do it with my own capital. One thing I did was to borrow some startup capital at 0% from a credit card offer. Those 0% offers were more common pre-2008 and credit has tightened considerably since then so this may not be a viable option at the moment. Mainly, however, I started SRT on what I call spousal financing. That’s where you quit your job and live on your spouse’s salary. It’s probably wise to inform your spouse about the job quitting aspect of this plan before you do it. I can’t overstate how powerful a weapon you have if you can subsist on one salary and draw little or no compensation from your company as it grows. Even later in its development it may become necessary to skip salary to span a gap in cash flow. When a company is young, it’s like trying to start a fire on a windy day. You have to protect that young flame, shield it from the hazards of wind and elements, steadily feed it oxygen (money) until it takes off.
Finally a message to young people just out of school…you have a powerful asset over us middle aged and older folks. Without dependents and with relaxed standards of comfort you can subsist on much less. There is no better time to take risks and invest in yourself than when you are young. The capital needed to start a software based company whether it be web, PC or mobile has never been lower and costs continue to drop. Hardware is cheap, development tools are inexpensive and web-based and you can lease access to your backend servers through services like Amazon EC2. You are accustomed to working hard, living simply and dreaming big from your time in school. The worst that can happen is that you will fail. In that case you’ll have some great stories to tell and you can always get that job at a large company like Google or Facebook where you will now have real life and hard fought experience. This last gives me a good excuse to end with one of my favorite quotes:
“Far better is it to dare mighty things,
to win glorious triumphs, even though
checkered by failure… than to rank with
those poor spirits who neither enjoy
nor suffer much, because they live in a
gray twilight that knows not victory nor defeat.”
Theodore Roosevelt, 23 April 1910