VC Funding Can Be Bad For Your Start-Up

More than two generations ago, the venture capital community — VCs, business angels, incubators, and others — convinced the entrepreneurial world that writing business plans and raising venture capital constituted the twin centerpieces of entrepreneurial endeavor. They did so for good reasons: the sometimes astonishing returns they’ve delivered and the incredibly large and valuable companies that their ecosystem has created.

But the vast majority of successful entrepreneurs never take any venture capital.

Take Claus Moseholm, co-founder of GoViral, a Danish company created in 2005 to harness the then-emerging power of the Internet to deliver advertisers’ video content in viral fashion. Funding his company’s steady growth with the proceeds of one successful viral video campaign after another, Moseholm and his partners built GoViral into Europe’s leading platform to host and distribute such content. In 2011, GoViral was sold for $97 million, having never taken a single krone or dollar of investment capital. The business had been funded and grown entirely by its customers’ cash.

In fact, venture capital financing may even be detrimental to your start-up’s health. As venture capital investor Fred Wilson of Union Square Ventures puts it, “The fact is that the amount of money start-ups raise in their seed and Series A rounds is inversely correlated with success. Yes, I mean that. Less money raised leads to more success. That is the data I stare at all the time.”

Wilson’s observation reflects the fact that there are a number of serious drawbacks entailed in raising capital too early, drawbacks that have profound implications at all stages of the investment cycle:

1. Pandering to VCs is a distraction. Trying to get a fledgling venture off the ground is a full time job, and then some. But so is raising capital, which demands a lot of time and energy on its own. It will distract the entrepreneur from doing the more important work of getting the venture onto a productive path. As Connect Ventures founder Bill Earner argues, “Finding the right customers and getting them to fund your business [constitute] a great step-by-step guide to raising venture capital — build the business first and the investments will follow.”

Why spend your time trying to convince investors to invest, when you could spend the same time convincing prospective customers to buy — or perhaps learning why they won’t — before you burn somebody else’s money! Besides, as customer-funded entrepreneur and investor Erick Mueller recalls, “It’s a lot more fun dealing with customer needs than pandering to investors.”

2. Term sheets and shareholders’ agreements can burden you. Investors don’t like risk any better than you do. If you’re raising money before traction is in hand, so-called “market risk” is higher than if demand has already been proven. To protect their downside, investors will require what are often seen by entrepreneurs as onerous terms. And when the concise prose of the term sheet is fleshed out into the fine print of the shareholders’ agreement, the terms get even worse.

3. The advice VCs give isn’t always that good. According to an analysis of venture fund returns by Harvard Business School’s Josh Lerner, more than half of all VC funds delivered no better than low single-digit returns on investment. Worse, only 20 per cent of funds achieved 20 per cent returns (or better), a figure that they might be expected to deliver. Incredibly, nearly one in five funds actually delivered below-zero returns.  Given this performance, you would be forgiven if you wondered just how helpful most VCs’ support or “value-add” is likely to be! Unfortunately, you will very likely to be obliged to follow their sage “advice.”

4. The stake you keep is small — and tends to get smaller. When you raise angel or venture capital early, as Jobs did to fund Apple, you start giving away a portion the company — often a substantial portion — in exchange for the capital you are given. And that portion grows over time, as additional rounds of capital are raised. Dell, on the other hand, used his customers’ pre-payments for their PCs to fund his start-up and its early growth. Claus Moseholm and his partners, who managed to go the distance at GoViral without ever raising outside investment, retained their stakes in the business (bar one co-founder, who sold his stake to a growth capital investor) until they eventually sold.

But the best news is this. If you raise money at a somewhat later stage of your entrepreneurial journey, you’ll find that many of the drawbacks have largely disappeared. Why? Because with customer traction in hand, you’ll be in the driver’s seat, and the queue of investors outside your door will have to compete for your deal.

5. The odds are against you. Even worse, perhaps, than the difficult terms, the questionable advice you may get, and the dilution you will incur if you raise capital too early, are the difficult odds faced by companies that do win VC backing. In the typical successful fund, on average only 1 or 2 in 10 of the portfolio companies — the Googles, Facebooks, and Twitters of the world — will actually have delivered attractive, and occasionally stunning, returns. Facebook alone accounted for more than 35 per cent of the total VC exit value in the United States in 2012. A few more portfolio companies may have paid back the capital that was invested in them, but most of the rest are wipeouts. In the VC game the very few winners pay for the losers, so most VCs are playing a high-stakes all-or-nothing game. Are these the kind of odds with which you’d like to put your new venture into play?