August 5, 2019

enture capital funding should be a “nice to have” not a “need to have” for most businesses. There are some really exceptional businesses being built these days. However, there are more and more businesses that are being built predominantly with external capital.

Venture capital can be used to accelerate existing growth. Venture capital shouldn’t be used as a lifeline in itself.

How many start-ups are on a perpetual tour of gas stations? Going from one funding round to another with the dream of eventually getting acquired without ever becoming a self-sustaining business.

Arguably, there are two ways that you could look at building a business; 1) The Thiel way, and 2) The Rabois way. Thiel’s approach suggests that you should focus on a small market, dominate and then expand. This is prudent advice to first-time founders that are proving their mettle.

Rabois’ method is to go after a large market from inception and be willing to lose money until you’ve reached dominance. Once you’ve reached dominance you can exploit the economies of scale as well as pricing power that comes from owning a market.

This post looks at where external capital isn’t suitable, companies that have successfully scaled without external capital, and some of the issues that follow when start-ups take on too much external capital.

Stay away from subscale

Some start-ups are focused on applying the Rabois’ approach when acquiring a subscale market. This makes the unit economics that come with scale a distant mirage.

There’s nothing wrong with building a business in a subscale market. There’s a real niche for operators that are able to do it well and the returns on capital can be significantly higher than you could expect from other asset classes.

However, a lot of the time, these types of businesses don’t require external capital to scale. They just take time and effort.

Start-ups that weren’t reliant on external capital

There are a number of companies that have been successful and turned into billion dollar companies without raising external capital, such as:

  • MailChimp — Ben Chestnut was running a design consulting agency and had a stream of clients who wanted email newsletters created. The company is now easily worth over $2bn without ever going through the VC fund raising process.
  • Lynda: Lynda Weinman built the product tutorial-by-tutorial before the company was acquired by LinkedIn for $1.5bn dollars.
  • AdaFruit Industries & SparkFun: Two DIY kit companies that were able to find their market are now selling >$30m worth of kits each year.
  • Braintree Payments: Braintree helped users exchange money online without worrying about being robbed by the other side. It eventually raised $69m in two rounds before being acquired for $800.
  • Shopify: Went three years before raising its first round of external funding.
  • ShutterStock: Developed by a professional developer and amateur photographer, the company’s worth >$2bn and never needed to raise external capital.
  • Tough Mudder: Will Dean was able to create a company that has >$100m in annual revenue out of a small amount of personal savings.
  • Loot Crate: The company which create subscription boxes for geeks, didn’t raise any money for the first four years and it was still able to generate $100m in revenue before raising external capital.
  • Mojang: The company behind Minecraft employed only 50 people and earned over a billion dollars before it was sold to Microsoft for $2.5bn.

The above companies either didn’t raise external capital at all or they didn’t raise external capital until they had found a successful business model that they could scale.

There are funding solutions available for entrepreneurs to prove out product-market fit but unless the market is there and it’s significant, venture funding might not necessarily be the right fit for a majority of companies.

It’s getting easier to go nowhere

It has likely become somewhat easier to raise capital over the last capital cycle because “start-ups are cool” and there has been a lot of press about the companies that have knocked it out of the park — although, less press about all the people that have tried and failed.

The lack of returns available through traditional asset classes combined with the hype has created one side of the marketplace — capital seeking a home. A switch in culture from wanting to work for large enterprises to “grinding it out in a start-up to change the world” has likely created the other side — people willing to try something new.

Largely, this will be beneficial for society as a whole as people get closer to realising their potential and no longer operate under the agency constraints of larger enterprises.

However, a lot of these businesses should be built organically and aren’t the typical candidates for external funding as a stopgap for real customers. It’s important to note that there’s a downside to taking on external funding. In the situation where there’s an exit, if there has been too much dilution and there’s an aggressive capital stack, there might not be that pot of gold at the end of the rainbow for the founders.

The founders of Get Satisfaction didn’t get anything when they sold the company after raising $10m at a $50m valuation — the sales price was undisclosed.

Capital stacks

But how could this be so? Let me walk you through an example:

It’s important to understand the capital stack when looking at the last valuation.

  • Assume that a company raises $3m at a $10m pre-money valuation using preference shares in the first round and then subsequently $10 at a $50m pre-money valuation in a later round (total raised = $13m).
  • The later investors could have a 2x liquidation preference (let’s just assume that they were able to negotiate those terms).
  • The later investors might be willing to give the company a higher valuation because the headline number makes it look like the company is a rocket ship on a trajectory to the moon. This makes it easier for the company to secure future investors, customers, and employees — all important issues that need to be solved for a young business.
  • However, this also creates the issue of the overlords (investors) needing to be fed before the founders and employees are able to eat.
  • In the above example, $23m ($3m invested in the first round and $10m at a 2x liquidity preference) needs to be repaid to the investors who stand in front of the founders and employees.
  • The company is typically raising at a valuation that it will grow into, which could take months or years.
  • If the company is subsequently sold for $30m, then the other shareholders (not the investors but the founders and early employees who received equity) will receive $7m or only 23% of the sales price.
  • If the company is sold at $50m (the last valuation), then the other shareholders will receive 54%.
  • The company needs to be sold for at least $50m to ensure that the preferred shareholders have their liquidity preference repaid.
  • The important thing to note here is that while there was only 46% dilution (30% in the first round, which was subsequently diluted again and 20% in the second round), the founders and early employees only receive 23% of the sales price if the company is sold for less than the last valuation.

It’s difficult to understand capital stacks and early employees typically aren’t given that much visibility into the investment rounds and terms. They’ll typically only see the headline number, which doesn’t tell the whole story.

Summing up

The businesses that could look for venture capital should be looking to tackle a large market, have proven operators that can execute, and be able to scale quickly.

A start-up should have some idea about where the customers will come from and what they’re willing to pay before raising venture capital.

Companies that are reliant on external capital will lack the resilience necessary to survive an exogenous shock that could cause a rise in funding costs.