Startups: Competing With Venture Funded Rivals

October 10, 2006

All of my prior startup experience has been with bootstrapped startups (i.e. no VC funding).  As such, I’ve had to deal the situation where I found myself competing with rivals that were much better funded.  For purposes of this article, I’m going to assume that the competition is another startup (and not a large company with much better funding).  The dynamics of competing with a large company are different and I’ll save that topic for another day.  

There is no pat answer to responding to this situation (if there were a standard answer for anything, it probably wouldn’t be interesting enough to write about anyways).  But, I do have some thoughts on the topic based on some of my own experience – both within my own startups and those that I’ve been involved in.

For example, my first startup, Pyramid Digital Solutions was in a small enough niche that it had little competition in its early years.  But, later, in 1996 we broadened our product offering and pursued a larger market (creating specialized web applications for our vertical within the financial services industry).  Eventually, we found ourselves competing with three other startups that each raised over $25 million in VC funding.  Even for that time, $25 million was a fair amount of money.  One of these startups was a direct competitor and the other two were indirect competitors.  As you might imagine, this had us a bit worried.  We were selling to large financial institutions and were constantly dealing with the issue of a weak balance sheet.  When we were enjoying a competition-free existence, this wasn’t a big problem (the number of alternatives was minimal, and we were clearly the best choice).  With VC-funded competitors, this changed.  Customers are rightfully comforted when dealing with startups that have venture investors.  It removes a lot of the risk from the equation that the startup will die in the near-term.  A lot of the sales we lost were not because we had an inferior product (we didn’t), but because we were a risky bet.

I’ll tell you how all this turned out for me at the end of this article.

Competing With Venture Funded Rivals
  1. Resist getting distracted:  When you first learn that one of your competitors has raised VC funding, it’ll be hard to ignore.  And, you shouldn’t ignore it.  But, you shouldn’t let it distract you too the point of inaction.  It’s important remember that just because they have fresh cash in the bank doesn’t mean that they’re going to be able to do something with it immediately.  But, you shouldn’t dismiss this event.  When a rival raises money, it’s a big deal. 

  1. Talk to your team:  One of the biggest challenges this kind of news has is the potential effect on your team – particularly your management team.  Though it’s possible that the competitor will use some of their new cash to try and lure members of your team away – this is not as likely as you might think.  The bigger issue is that your team may lose faith in your ability to compete in the face of well-funded competition.  Negative morale can become a serious issue.  I would advise having a discussion with key members of your team and keeping them aware of what’s going on.  

  1. Their incentives are impacted:  If a startup raises VC funding (particularly when it’s a large amount), the management team’s equity interest dilutes.  In the short-run, this will have little impact (because the team is still basking in the glow of the new cash).  But, as time progresses, you will find that it may get harder and harder for the team to be motivated as the chances of them making any real money have gone down.  For example, by raising $25 million, our competitors basically raised the bar for what type of valuation they would need to exit with in order to see significant cash at the time of a liquidity event (acquisition or IPO).  Based on the terms of the VC deal, they may have needed to exit with valuations exceeding $50 million for it to deliver significant cash to the founders or management team.  Once the going gets tough (and it usually always does), the team will figure out that the likelihood of a big exit is low.  This shifts their incentives. It’s important to keep this in mind.  This is one of the best things about a bootstrapped approach.  Even if you make a modest exit, you still make a fair amount of money.  This keeps the founders motivated the whole way through.

  1. Don’t compete on price:  One of the things your better funded rivals will likely do (very quickly) is focus on building market share at the cost of revenues and profits.  This manifests itself in two forms:  a decrease in price or a an increase in what is provided.  For example, if you’re selling into the enterprise market, your competitor may give away free services, customizations or implementation projects.  These can be expensive, but they can afford it.  It’s generally a bad idea to try and match their price and/or terms.  You won’t be able to outspend them (without raising capital yourself).  You need to find a different strategy.

  1. Determine market validation:  One potential piece of good news when a competitor raises funding is that it may be a sign of validation for your market.  VCs are generally very smart people and would normally not invest large sums of money unless they saw at least the potential for a large market opportunity.   This could be good news for you (particularly if you’re looking to raise funding too).  

  1. Check out the investors:  It is always a good idea to learn as much as you can about the investors that funded your competitor.  What other companies are in their portfolio?  Who’s the partner that is sitting on the board?  What is her background?  One of the biggest impacts a VC can have on a startup (outside of the cash) is the network and contacts that they bring to the table.  If the VC is well connected within your industry, you may see your rival closing some deals that you’ve had a hard time getting done.

  1. Be cautious of partnerships:  It’s possible that you’ll consider forging partnerships as a way to respond to the new market threat.  In fact, you may even enter discussions of partnering up with one of your rivals that just received funding.  Though you should always look objectively at such opportunities and judge their potential value to you, I will share one thought.  In my 12+ years of experience in startup-land, I have found that crafting a partnership that actually delivers value is very, very difficult.  Usually they end up being grossly asymmetric (one party needs/wants the partnership much more than the other) and as a result ends up not creating the outcome that was originally planned.  Not sure why that is, but it’s just been my experience.  Your mileage will vary.

This is obviously a difficult and complex topic (so it’s hard to provide any real definitive tips or guidelines).  Hope the above has helped.

As for my own story, I am pleased to announce that it had a happy ending (for us, not our competitors).  One startup shut-down completely.  One of the others scaled back considerably and ultimately shifted back into a consulting company.  The final one was put up for sale by the VCs that funded it.  I ended up being the winning bidder and acquiring the technology assets as part of the auction (and ended up paying considerably less than the capital they had spent to build their product).  Net result:  We essentially won that battle.  Not due to brilliant strategy or execution on my part, but I’ll take the win anyways.  I’d rather be naïve and win, than brilliant and lose (most of the time).
Moral of the story:  Just because you’re running a bootstrapped startup doesn’t mean that you can’t compete effectively with better funded rivals.  The key is to think through the implications and not get too distracted.  Chances are, even a smart competitor won’t use the cash as wisely as you fear.  Your goal is to survive the short-term because life usually gets harder for them in the long-term.  

Written by Dharmesh Shah


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