When Raising Venture Capital Might Make Sense

March 28, 2006

Those of you that read my previous article “Fatal Distraction:  The True Cost of Venture Capital”, may have thought that I’m against venture capital and venture capitalists – neither of which is true.  VCs are generally smart, savvy people and serve an important function.  In fact, some of the vibrancy of the U.S. entrepreneurial market is attributable to our strong VC community.  My issue is not with VCs, but with the appropriateness of VC investments for most software startups and the lack of a true appreciation for the dynamics of the VC process within most first-time entrepreneurs.
Though I still stand behind my points in the earlier article, and continue to believe that venture capital generally doesn’t make sense for most software startups, there are indeed cases where raising VC might make sense.  So, here are some reasons that you may want to consider raising venture capital for your startup:
  1. Your Business Model Is (Somewhat) Proven:  You have already demonstrated that your business model works (i.e. there is clear evidence of customer interest in your product and that you have a reasonable chance at reaching profitability).  In this case, capital can often be deployed efficiently – which is just a fancy way of saying that you can actual use the money to expand and scale your business.  This is often by expanding the team, increasing the sales force, broadening the product reach, etc.

  1. You Need An A+ Management Team:  The business you are pursuing requires a proven, exemplary management team -- now.  Many proven professionals can be convinced to accept compensation that is less than fair market value (i.e. what they could make elsewhere), but there are limits to the risks they are willing to take – no matter how much they like you or your idea.  In this case, capital is often critical to attract the right people into the company.

  1. You’ve Started A Business Before:  If you’ve run a business before (especially one that had outside investors), you generally have a better understanding of what it actually takes – and  as such,  you are much less likely to make the “rookie” mistakes that plague many first-time entrepreneurs.  Your odds of actually successfully raising capital also go up (so the distraction risk is lower).

  1. You’re A Major Player At An Established Company:  This one is a little more subtle,  If you’re a high-powered executive at a major established company, chances are that you have industry contacts, domain expertise, etc.  This makes it more likely you will actually raise outside capital.  Also, this means that your “opportunity cost” is probably higher than someone less experienced.  As such, it may make sense for you to reduce your risk when launching a startup by bringing in some outside capital.  Instead of working for zero (or minimal) salary indefinitely, you’ll then be able to pay yourself something.  However, remember that this is not the “full” entrepreneurial leap that many associate with a startup.  You are in some respects replacing working for a large company to working (to some degree) for your investors.  This is not necessarily a bad thing, but its best to understand that you’re not fully your own boss as much as you might think or had planned.

  1. You’re Swinging For The Fences:  One of the biggest downsides to raising capital is that there is commonly a misalignment of goals.  You’re looking for a high probability of a modest exit and the investors are looking for a low probability of a fantastic exit.  However, if this is not the case – if you’re actually fine with having a small chance at a big win – and you believe your idea provides a credible story that VCs might believe, then it might make sense to raise capital.  Venture Capitalists are always on the lookout for big market opportunities (large, growing markets) as one of their fundamental criteria for investing.  If this sounds like you, then venture capital might be the right path.

  1. You’re Already Got (Real) VC Interest:  Much of the downside (in my mind) associated with the VC process is that the chances of actually closing a round are so low – and the time spent courting VCs can be much better spent elsewhere.  But, if for some reason, you already have real VC interest in your startup (they like the idea, you, one of your co-founders, etc.) then the decision is simplified as you can then focus on whether the investors are someone you want to partner with and the terms are something you can accept.  

Overall, its important to understand that VCs are looking for specific kinds of deals.  If you happen to fit into this narrow category and truly believe that your odds are well above average of closing a deal, by all means give it a shot.  It makes sense to consider all of your options.  On the other hand, if you’re not reasonably sure that you have the right mix of ingredients that will attract a VC, the points from my previous article still hold – chances are, you’re better off looking at other avenues.
If you’re an entrepreneur (or for that matter a VC), and have other reasons why raising venture capital might make sense for software startups, I would love to hear them.  Leave a comment here or email me privately:  dshah (at) onstartups.com

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