Venture capital may seem like a savvy choice for financing, but it's probably wrong for you. Here's why.
It seems like nearly every entrepreneur is on a crusade to raise venture capital. Among the ranks of Ramen-eating, credit-card-maxing founders, venture capital is revered as a start-up panacea. With venture capital, it seems, you can live lavishly, hire a platoon of PhDs, and virtually guarantee an IPO.
Chances are, though, you shouldn't raise venture capital money. Simply put, most start-ups aren't poised to grow big enough to satisfy the needs of venture capital funds. And, if your smaller company does raise VC, it typically won't be the best way to maximize your payout. Let me explain.
VCs Look for Huge Payouts
With a high failure rate in their portfolios, venture capitalists rely on winners to win big. To give you a sense of scale, medium-sized venture capital firms are going after exits on the order of roughly $100 million. Large firms often need to believe your company could be worth $1 billion.
Since you probably won't capture your entire market, in order for VCs to believe you can achieve an exit at this magnitude, you'll need to make a strong argument that you're attacking a very large market. For medium-sized VCs, a large opportunity equates to a $1 billion addressable market; big VC funds need to believe your market is in the billions of dollars, typically $5 billion to $10 billion (or more).
You probably aren't going after a large enough business opportunity, but you probably don't know it yet, either. An addressable market is defined as your company's revenue per customer multiplied by the customers your company can acquire. Where founders typically go wrong is in assuming too many customers are accessible.
To help you assess, I created something I call the "Fundraising Matrix" (below). It's a simple diagram that indicates which fundraising strategy you should pursue based on your capital requirements, and the potential size of your company. While I'm sure there are exceptions, generally companies fall into one of these four quadrants:
Venture Capital (top right):
If you're chasing a big $1 billion (or more) opportunity and need a lot of capital to take advantage of it, VC is probably for you.
Not Viable (bottom right):
If you're starting a company that requires a lot of capital, but would create a relatively small business, you should probably go back to the drawing board and cook up a new idea.
Bootstrap (bottom left):
If you are chasing a smaller opportunity and don't need much cash to get there, you should aim to bootstrap your way to profitability.
It Depends (top right):
If you have a big opportunity that doesn't require much capital, you need to consider the strength of your "barriers," those characteristics that could help you by preventing competitors from taking share of your market. Examples of barriers include patents, trade secrets, long-term contracts, and a large network of customers. If you have strong barriers, you might be better off bootstrapping the company and owning a lot of the business. If you have weak barriers, you're typically better off raising a bunch of cash, and ensuring you grab marketshare before future competitors do.
Please note that this diagram is not drawn to scale, as only a small percentage of start-ups should go in the top right quadrant, and are fit to raise venture capital.
The Fundraising Matrix
The mistake most entrepreneurs make is trying to raise VC when their market opportunity is too small. That's bad for both you and your investors.
Here are some examples of what might happen:
Scenario 1:Run It Into the Ground
When your company revenue flatlines at $5,000,000 dollars a year, you might find yourself raising more money, and having your ownership further diluted to pursue newly-concocted business models that carry a glimmer of hope for growth. But those often don't work. And when they don't, you'll probably find yourself dreaming about the pile of gold you would be swimming in if you had just bootstrapped the costs of getting to $5,000,000, which would have left you owning all or most of the company.
Scenario 2: Miss the Payout
Taking venture capital (particularly from large funds) is like taking a pledge to "go big or go home." So when your not-so-big business gets a not-so-big acquisition offer, your board might not take the deal. While your venture capitalists depend on realizing that $100 million exit you sold them on during your raise, you might have been quite happy with the multi-million dollar payout a $10 million exit can afford a founder.
So, the only entrepreneurs who should raise venture capital money are those chasing a big opportunity from day one. If you are in fact after a billion-dollar-plus-market, not taking venture capital and under-capitalizing your business could be a disaster. If a competitor secures more capital and executes, it could steal the market out from under you. So if you're going big, you'll probably want to bring in a venture capital partner sooner than later.
What do you do if venture capital isn't right for your company? Find ways to bootstrap it into existence. Bootstrapping can take many shapes, but most commonly they include taking money from non-institutional investors with lower expectations, keeping a day job, borrowing money on credit cards or from a bank, or finding a customer to front you money before you start.