Why do you want VC money?
A critical question for founders
Last week, I spent my Friday afternoon at the finals of the College New Venture Challenge, the University of Chicago’s startup accelerator program for undergraduates. There were six fascinating founding teams working on everything from Stage IV cancer treatments to parmesan cheese puff snacks.
They were all very impressive.
During one particular pitch, I found myself wondering why the team was even seeking VC funding?
This question hasn’t been in my normal list of coffee chat questions that help me build conviction in a startup and its founders. It was typically something I’d ask about in due diligence, if at all, because the overwhelming majority of founders I’ve engaged with are students. As a group, students are typically quite liquidity-constrained, so most student founders had pretty clear reasons to pursue venture capital.
I think it’s time to add this to my list of questions I ask everybody.
Venture capital can potentially do great things for founders. The baseline thing VC funds provide is capital — which should, if employed properly, unlock massive growth in the founders’ firm.
Many modern VC funds go beyond capital in support of their founders. In pursuit of growth in their investments, they provide introductions to prospective customers, talent acquisition support, marketing advice, and more. Some of the largest funds today became differentiated sources of capital precisely because of their unique platform offerings.
It’s also pretty normative for VCs to pursue growth, and protect their investment, by imposing some structure on founders. These structures are outlined in the term sheet, and appear mostly in the control provisions of that document.
The biggest example is probably the creation of a Board representing shareholders in the firm, some whom will have a fiduciary duty to their own investors. The startup’s leadership team is ultimately accountable to this Board.
The Board can make certain key decisions about the startup and its direction. They typically have to approve any future fundraising, secondary sale, employee equity plan, or sale of the company. That last point is particularly important; members of the Board will have a view towards what a good exit opportunity looks like, as well as a perspective on the timeline for one.
VC funds, as a group, are in the business of generating outsize returns for their investors by investing in early into companies that generate gigantic exits in the future.
However, taking venture capital doesn’t necessarily increase the likelihood of a successful exit. The biggest and most famous VCs in the business, the ones who have large enough platform teams to really make winners out of their best investments, only have investment-to-exit ratios on the order of 22%.
Looking at data with a slightly shorter horizon, F22 Labs suggests that bootstrapped startups have a 5-year survival rate of 2.6-4x that of VC-backed startups.
When very large sales of successful startups do happen, the company being sold is much more like to be a VC-backed firm.
The result of this is that venture capital has one of the highest costs of capital for a corporation — without getting into the math of it, the high failure rate of startups with any source of funding, especially those that have not raised a Series B, makes VC dollars very expensive for the existing equity holders (founders).
From a founder’s perspective, owning 100% of a startup worth $50 million at exit is financially equivalent to owning 10% of a startup worth $500 million at exit. As an investor, I want to understand why founders are interested in taking this increased risk of failure, for a potentially greater exit opportunity.
There’s good reasons to do this both in terms of the outcomes the founders are pursuing for themselves, and the outcomes the founders are pursuing for their startup.
But they have got to be well-understood and articulated at least internally before deciding to go out and raise from institutional venture capitalists, or enter a pitch competition.
I think this is a particularly important question for first-time founders, especially those early-career founders who’ve never worked full-time in a startup with (or without) VC backing.
Personally, I think the tradeoff is worth it in many cases. That’s why I’m pursuing the VC career path — but this choice also means I’m biased.
Having said that, if you’re a founder considering this decision, and you want to chat about it, please reach out!
Alternatively, if you invest in startups, like my writing, and want to chat about possible career opportunities, don’t hesitate to be in touch. The best way to get ahold of me is via email:
As an investor, my goal is to serve the people who allocate capital to me by growing their wealth.
At this point, I believe the best way to do that in the context of startups involves screening founders who otherwise fit the thesis I’m pursuing for why they want venture capital, and what alternatives they’ve considered. I’ve noticed a strong correlation between founders who I think have potential to build massive firms, and founders who have a rock-solid explanation for this.
The founder-friendly thing to do is to check for this sooner rather than later.