VC to aspiring entrepreneur: Are you sure you want our money?

VC money doesn’t make sense in every situation; start-ups are not “one size fits all” and nor should they be funded that way. Am I advocating entrepreneurs shouldn’t drop by for a talk with VC’s? Hardly.

I’m in the business of making solid returns for my limited partners. To deliver these returns, I’ve got to find great ideas and world-class entrepreneurs. Of equal importance is creating a relationship that yields positive results for these up-and-coming business leaders, in whose shoes I’ve personally been many times. This last requirement often leads me to counsel entrepreneurs with promising technology and a solid team to not take my venture money. Projects that can launch and grow with minimal capital infusion AND seek acquisition as the natural exit due to feature/function limitations, impending competition and/or limitations in the distribution model and market size are more appropriately funded by passing the hat. The minute venture dollars are put to work, the company will feel natural pressure to find ways to expand beyond what may be reasonable or optimal.

Here’s the type of math I consider every day:
HotFeature.com has 10 employees and the founders each own 35% of the company. They pitch me on the idea and I agree with their assessment that consumers want and need HotFeature.com. They have raised $1.5M in angel money to date and have given up 20% of the company to investors. They require another $10M to grow their audience and build brand.

Here’s where things get interesting. I point out to the founders that they could probably sell the company today for $20-$30 million and that they would each make $7-10M which is not bad for a few years of work.

If they take $10M from VCs at a $15M pre-money valuation and create an option pool for the next 30 employees (assume 15%), they each now own less than 20%. To make the same $10M, the company must now sell for a minimum of $50M. Achieving this type of valuation is significantly harder, as it suggests that the company has established a brand, demonstrated a business model and proven consumer adoption.

In addition, my partners and I won’t be too excited about a $50M acquisition. This type of exit is not sufficient to ensure superior returns to our limited partners across a broad portfolio of investments-our returns are determined by home runs, not singles. As such, we’re inclined to push for continued growth, market expansion and additional product development, which adds risk, requires more capital and creates additional dilution for the early employees (not always the win/win I seek). There are a number of good examples where entrepreneurs have made the correct decision regarding venture money; the most recent I’ve seen is Yahoo’s acquisition of Jumpcut. The purchase occurred after the startup had taken seed and angel money–no formal VC dollars. By keeping the company running thin, the founders reaped much greater returns than if they had traded some equity for venture money.

Of course there are VC firms putting money into these types of companies, but why would a VC fund a company that may not give them the double digit returns they’re typically looking for? Put yourself on our side of the table for a minute.

For microcap venture companies, these sorts of projects do make sense. An investment of a few million dollars can move the meter for a fund less than $50M in size. For VC firms with significantly larger funds, the partners are under a significant amount of pressure to do deals and put capital to work. Although the likely outcome may only be 2-3x, that’s still “putting points on the board”. Sort of reminds me of the fable of the Lion who had the choice of hunting antelope or field mice. He could catch field mice all day, but would burn more energy capturing mice than he would get from eating the mice and thus would starve to death. Only by landing the antelope could the Lion survive. Hotfeature.com is a field mouse. YouTube is an antelope!

To sum up, the point I’m making is pretty basic. When you’re looking to fund your young company, definitely consider venture capital, but also be aware that for your particular situation it may make more sense to explore alternatives to venture money, like angel investors or bootstrapping, with help from family and friends. We like to keep our focus on building successful, long-term companies of a certain scale. Not many mice ever grow up to become antelopes.

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