Fatal Distraction: The True Cost Of Venture Capital

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Fatal Distraction: The True Cost Of Venture Capital

 

I’ve had several requests in the past week to post an article with my views on venture capital for software startups. This was driven partly because I often make casual and vague references to being “generally against venture capital for software startups, in most cases”. I’ve not written on the topic yet, because there’s a lot of good writing on the topic already on the web. But, there seems to be interest, so here we go.
There has been a lot of negative sentiment regarding venture capital, most of it which centers around two basic notions:

  1. Venture capital is often the most expensive form of capital one can raise (when looking at the cost of capital)
  2. Venture capitalists themselves are often seen to be predominantly arrogant, self-absorbed, heavy-handed, jerks (though, as always, with exceptions)

Though both of the above points are broad generalities, I think they’re more or less accurate. VCs (on average) are very, very smart and have very, very aggressive (“type A”) personalities. This, combined with the fact that they hold the purse strings and generally have much more “power” in the negotiation than you, the entrepreneur, do – often leads to the stereotype of “jerkiness”. Further, VCs can rationalize their behavior claiming that they are responsible for investing other people’s money – and they’re just doing their job. Though they could rationalize this way, they generally don’t (the personality type doesn’t lend itself well to having to explain anything). In any case, it is what it is. There are some nice VCs out there, but I really do think they’re the exception. But, this article is not about VCs being jerks. That wouldn’t be particularly interesting.
So, if you’re looking for additional content to reaffirm your views on VCs being jerks, feel free to do a search on “vulture capitalist” or other similar terms and you’ll come across plenty of amusing and educational reading on the topic. You can then feel comforted in the knowledge that your views have been validated and go about your life with some well-deserved satisfaction. Peace be with you.

If, on the other hand, you’re somewhat interested in digging a little deeper and figuring out what the true costs of venture capital are, read on.

For purposes of our discussion, I’ll assume that you have not raised significant capital from VCs before and that we’re talking about “early stage” capital.

So, here, in no particular order are what I believe to be what contributes to the *true* cost of venture capital:

Understanding The True Costs of Venture Capital
  1. Sub-Optimal Use Of Founder Time: When you decide to try and raise venture capital, you are basically committing to expend a fair amount of your time in the process. This time is spent on documenting your plan (either an executive summary, PowerPoint, business plan – or all three), “pitching” your opportunity (i.e. VC meetings) and follow-ups to those meetings as VCs ask for more detail, other meetings, etc. Assuming for a minute that you get a yes/no answer relatively quickly from VCs that you pitch to (which you generally won’t), you are still spending a lot of time trying to create a “story” that is fundable. More often than not, this wasn’t the story you started with. Now, if your prospects for success were actually improved as a result of doing all of this work and having all of these conversations, this wouldn’t be such a bad thing. You could then think of this as free consulting from really smart people (and trust me on this one, VCs are really smart people). However, unfortunately, this time spent is rarely worth it (for you). Most of the time you spend putting your story together has minimal positive impact on your actual business. I can’t prove this, but I still think I’m right. Now, given that the most common answer you get from a VC pitch is “maybe”, you will generally spend a lot of time trying to “fill in the blanks” and respond to the questions/concerns/issues that the VCs have. Though some of this work may actually be useful, I’ll still categorize it as “sub-optimal” because it is not the best time you could spend to improve your odds of success.

  1. Non-Fundable Ideas Are Not Always Bad: Lets assume that your odds of actually convincing a VC to fund your business/idea are really, really low (which they are). If they were simply rejecting ideas that had no chance of succeeding anyways, then they’d be doing you a favor. Rejection simply means they saved you a bunch of future grief. Unfortunately, this is not the case. Simply because an idea is not VC-fundable provides little information regarding whether or not it could have been a successful business. The VC benchmark is often so high that even rational, reasonable business ideas get rejected. So, the cost to you here is that you automatically assume that your failure to raise capital is conclusive proof that you had a failure of a business. Though indeed, your idea/business may suck (I’ve had many, many ideas that ranged from mediocre to bad), rejection from VCs is not a way to reliably determine that.

  1. Misaligned Goals: What you would call a “success” is very different from what the VCs consider a success. What you’re looking to do is somehow figure out a path that leads to a decent chance of putting about $3-5 million in your pocket in 3-5 years (numbers vary, but this is as good as any). With this kind of money, you could invest it all in long-term investment vehicles and live a reasonable life doing whatever you want. You’re not going to be buying small islands, but (I’ve been told) this is highly overrated anyways. VCs, on the other hand want a small chance at making a lot of money (i.e. 10 times whatever they invested). Why the asymmetry? Very simple. VCs have a “portfolio” of companies (so their risk is diversified). They want 1 or 2 out of ten companies to succeed tremendously – so on average, they are making a great return for their investors. They don’t care, if any specific company (like yours) dies – as long as the portfolio of companies does really well on average. You, on the other hand, have all of your eggs in one basket. When your life savings is wrapped up in the company (which it will be), then it is in your interests to optimize for the modest exist – anything else would be bordering on stupid. Basically, you and the VCs are looking for different things – and thereby running different companies.

  1. Cost Of Capital Is Very High: Putting aside all the “softer” stuff above, its important to remember that the cost of selling your equity to a VC is actually very expensive. For discussion purposes, assume that you were offered a loan (I understand the difference between debt/equity – I’m just trying to make a point). Lets say the interest rate is 30%. Most people would think that was very “expensive” and would think twice about taking the loan unless they really, really had a strong belief that they needed the money and could do something with it to overcome this “cost of capital” and were desperate because there were no other alternatives. Unfortunately, raising VC money has a similar dynamic, its just not that clear at the time you do it what your cost is. If it helps you understand it better, remember that VCs are expected to return 30%+ to their investors. By definition, these returns (and the VC salaries and bonuses), can only really come from one place – the startup companies. Sure, you may not necessarily incur this cost – but on average, somebody is paying for it. I’m not a brilliant financial mind, but even I understand this bit.

  1. Limited VC Control: Yes, you read that right. I’m saying that VCs actually have very limited control in what they can do in regards to your company – and that’s a bad thing. Things VCs control include limiting founder compensation, limiting how much cash can be taken out of the company, how much debt can be incurred, etc. All of these are designed to protect their interests and are reasonably easy to understand. However, when things go badly, there’s very little they can do to “fix it”. Of these, the most drastic is pushing the “CEO eject button”. Basically, VCs can fire the founder/CEO should they choose to. This may be a last desperate attempt to turn things around and try to salvage their investment when things have gone wrong. Now, here’s the problem: In just about all companies, things will always go wrong. Its just a matter of time. The odds of you actually walking the straight and narrow path to success are near zero. So, the cost to you is that in any given year, you may be fired. Perhaps, you may need to be fired, but maybe you don’t.

  1. Fatal Distraction: This is the most subtle of all the costs outlined so far – but, still supremely important. Once you decide to raise venture capital, your reality is distorted. You no longer think in terms of talking to customers, narrowing your focus, building a product, etc. Instead, you become singularly driven by “building and pitching the story”. This tends to distort your reality significantly. Instead of working on figuring out the names of your first 10 potential customers, you try to find an analyst prediction that shows that you are pursuing an opportunity that could be $700 million. Or, when looked at just right, even $1 billion!! Instead of feeling satisfaction from hitting an intermediate goal of getting our product out there (even if its crap), you instead feel satisfaction because a VC called you back for a follow-up meeting. Instead of measuring ultimate success by shipping a product and generating revenue, you start thinking of ultimate success as being closing your round of capital. As it turns out, even if you do actually successfully raise VC money – you have created zero value. All you have is the opportunity to create value (and, you had that all along). This distraction is very often fatal and has killed countless startups.


Hopefully, the above represents something that is semi-useful and at least moderately objective and balanced. I have nothing against venture capital (or venture capitalists). I just think its important for entrepreneurs to understand the true costs (and risks) of raising VC money. Though being a VC-backed startup founder may seem like a life of glamour and intrigue – its really not. Raising venture capital, and running a VC-backed company is just plain hard.

Note: Much of my thinking on this topic is not first-hand experience. I have raised institutional capital for startups before, but not early-stage money, and not from traditional VCs. However, I have seen my share of VC pitches, talked to many VCs, sat on VC panels, read the books, took the courses at MIT and even befriended a few (of the nice ones).




Posted by Dharmesh Shah on Wed, Mar 22, 2006

COMMENTS

Not all software startups can be run by two or three people each with a PC. Think about the telecom software world, server startups...

VC's may be 'evil' but they are a necessary evil. Even Google went the VC route-- do you think they had another alternative?

posted on Thursday, March 23, 2006 at 7:54 PM by zoran milanovich


Zoran: Thanks for your comment.

Just a note that I really do not think that VCs are "evil". I'm simply suggesting that many (but not all) software startups are likely better off not trying to raise venture capital. There are, of course, software companies where capital is essential. Also, VCs serve an important function in helping fund these kinds of startups. I'll plan to write a follow-up article on when raising VC is appropriate (and desirable).

posted on Thursday, March 23, 2006 at 9:03 PM by Dharmesh Shah


Zoran: Thanks for your comment.

Just a note that I really do not think that VCs are "evil". I'm simply suggesting that many (but not all) software startups are likely better off not trying to raise venture capital. There are, of course, software companies where capital is essential. Also, VCs serve an important function in helping fund these kinds of startups. I'll plan to write a follow-up article on when raising VC is appropriate (and desirable).

posted on Thursday, March 23, 2006 at 9:03 PM by Dharmesh Shah


One should not infer from this article that bootstrapping is a slam-dunk. Bootstrapped companies have a very high death rate, too.

I suppose that you've got to pick your poison. Or, better, your mix of poisons. It is probably best to leave all your options open and, at each stage, really scope it out and make a decision about how to fund yourself for the immediate future. What are my chances? What are my risks? What are the long-term effects?

Ideally, don't commit to a certain course of action on moral grounds; do it on pragmatic grounds. What are my chances of getting venture capital now? What are my chances of bootstrapping and being able to see it through? Which is better?

posted on Sunday, April 09, 2006 at 12:09 PM by Daniel Howard


I attended an E-net meeting last week and I was amazed to hear one of the panelists, an angel investor say how hands off he was after providing seed money. His target is an 80% failure rate on all deals. The reasoning, if he does not hit that number, he's not being agressive enough in funding deals. As the VC is happy to make his money on the 20%, so is the Angel. Somehow the label "angel investor" just sounds less threatening to an entrepreneur. Maybe VC's should change their label to create a change in their reputation. The repubicans did well to attack the perception of the estate tax by calling it the death tax. How about venture partner?

posted on Wednesday, April 12, 2006 at 11:54 PM by Doug Lindsay


Dharmesh, I'm very late in getting to this post (having discovered your insightful blog only in Oct 2006). I think this is the best article you've written to date (that I'm aware of). Best in that it provides a good reality check for budding entrepreneurs contemplating alternative source of funding and for introspective venture capitalists (if there's any left out there) on how to reconcile their portfolio approach with the entrepreneurs' best interest.

Please do consider posting an update or follow-up to this article if appropriate additional insights avail themselves.

posted on Wednesday, December 13, 2006 at 3:58 AM by Chris Hong


It has come to everyone sometime or another when you must seek out side help in financing your project. 
 
Needless to say I have never used venture capitalist. 
 
So, her goes, I am 73 years young and my wife is 72. We are inventors and hold many patent. 
 
We have developed a device that uses no fuel does not pollute and all it does is produce electricity, 24 hours a day, 7 days a week 52 weeks a year. 
 
Is it possible that you can help market this device. 
 
It sits on approx. 2 acres of ground. It is capable to providing 36,000 homes with electricity.

posted on Saturday, October 25, 2008 at 7:36 PM by BILLY HENDRIX


Billy...shoot me an email of your executive summary, and or your business plan. We may be able to provide you funding for your Patented invention.

posted on Friday, March 20, 2009 at 6:52 PM by Demetri Skokos


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