Five Ways Venture Capital Can Hurt Your Startup

Five Ways Venture Capital Can Hurt Your Startup

November 28, 2018

The venture capital world is often at odds with the goals of young startups — and in some cases, it can lead to their destruction.

I recently met a guy I’ll call “Tom.” After 7 years of “blood, sweat, and instant noodles,” Tom built his startup into an exciting enterprise. He raised a hefty round from a “top-tier” venture capital firm. And thereafter, he found himself in the final stages of an exit, with an $88m buyout offer on his desk.

The deal looked like a win all around. Tom, 31 at the time, would walk away a rich man — and the Venture Capital firm would more than double its investment.

But at the last minute the investor, who had veto power, killed the deal. “He told me to hold out for something bigger,” says Tom.

That “something” never came.

Over the next few years, the company lost momentum. Growth began to stagnate. Tom’s co-founders jumped ship. And eventually the company sold for pennies on the dollar.

Tom’s story is one of many cautionary tales of Venture Capital funding gone awry.

The Venture Capitalist Obsession

Today’s startups are fixated on fundraising, and it’s certainly there for the taking: last year, Venture Capitalist funding hit a decade-long record-high in the US.

Companies that raise a lot of money are seen, by default, as successful. It’s every entrepreneur’s dream to close a big round, get the customary newspaper write-up, and secure the support of an all-star investment team.

In theory, venture capitalists should provide the following to a young company:

  • Cash (to facilitate faster growth)
  • Validation (to attract talent and customers, get press, etc.)
  • Guidance (advice, connections, resources)

But venture capital can destroy startups. Why?

1. Venture Capitalists Take Big Bets, and Want a Big Payoff

As Tom learned, Venture Capitalists often aren’t satisfied with $10m, $25m, or $50m exits or IPOs: they operate on a “go big or go home” mentality — and they typically want to see an outcome well north of $100m.

Venture capitalists are highly selective, and it’s not uncommon for a fund or partner to only invest in 2-3 companies per year. Venture Capitalists look for startups with explosive growth potential that cater to multi-billion dollar markets. A company that sells for $50m (and nets them, say a 30% return) has very little impact on their portfolio.

Some Venture Capitalists would rather run you into the ground trying to make you a unicorn than entertain an offer under $100m.

Founders who raise Venture Capital often end up in a position where they have to reject an offer that would be great for them just because it doesn’t satisfy an investor’s grandiose return expectations.

2. Venture Capitalists Push Fast Growth at All Costs

Venture Capitalists are in the business of funding fast-growing companies — not inventors or inventions. They often want to make the start up a $100m company before it’s ready to be a $10m company.

This “go big or go home” mentality can be incredibly damaging

Venture Capitalists want to see 10x to 30x returns, and they want to see them within a fund’s lifespan (6-8 years). This timeframe often forces companies to attempt to solve complex problems before they’re structurally ready to do so on a large scale.

But the biggest issue with this growth obsession may be the marginal dollar problem.

There is such a vanity rush toward revenue and growth, that people stop looking at what the cost of that revenue is. Venture Capitalists will do things like double the sales force when sales aren’t even close to returning on their expense. Soon, you’re spending $1 just to get back 50 cents.

3. Venture Capitalists Severely Dilute a Founder’s Stake in the Company

In the pursuit of capital, a founder relinquishes a hefty percentage of his or her company to investors.

During seed funding (family, friends, and angel investors), a company typically gives away about 15% of its shares. An option pool (giving shares to early employees) takes up an additional ~15%.

But things really start to dilute when Venture Capitalists get involved. For the average Series A round, investors expect a 25% to 50% stake; for Series B, they expect around 33%. After a few rounds, a founder is considered lucky to be left with 20% of what he or she created.

These sacrifices should, in theory, give you a bigger payoff in the end — but that’s not necessarily true.

Take, for example, the case of Arianna Huffington (founder of The Huffington Post), and Michael Arrington (founder of TechCrunch).

Huffington sold her company for $315m, but multiple Venture Capital funding rounds left her with only a small percentage of the company. She walked away with a reported $21m. Arrington sold TechCrunch for ~$40m — one-tenth of Huffington’s exit — but since he didn’t raise external funding, his payday was around $25-30m.

4. Venture Capitalists’ Advice and Expertise is Often Overrated

There is a patently false understanding that venture capitalists have investment down to a science.

Vinod Khosla, founder of Khosla Ventures, has said that most Venture Capitalists “haven’t done sh*t” to help startups through difficult times,” and he estimated that “70% to 80% percent [of Venture Capitalists] add negative value to a startup in their advising.”

This is often coupled with poor outcomes.

5. Raising Lots of Money Doesn’t = Success

At some point, “valuation” (driven by inflated Venture Capital investments) became the barometer for success in the startup world.

But researchers have found that there is not a strong correlation between the amount of money a company raises and a successful outcome.

Founders are often tempted to raise 2 or 3 years of runway “just because they can.” This mentality can be a liability.

The fact is that the amount of money startups raise is often inversely correlated with success.

Venture capital is not inherently bad. But in the current fundraising system, there is often a misalignment between what startups need and what Venture Capitalists want.

For young startups, bootstrapping (funding a company out of pocket, and with the money generated from customers) is an ideal alternative. It enables founders to set their own pace and formulate their own concept of “value.”

But if you need outside capital, consider this rule of thumb: only raise enough to sustain operations for 18 months (plus/minus 25%).

And for the love of all that is holy, don’t waste it.

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