For a long time now I have been sceptical of the venture funding route to creating businesses. Over my career I have worked for VC funded companies most of which no longer exist. I believe this has less to do with my contribution and more with the economics of startups. I have seen the problems that VC funding creates.

The startup scene is full of accelerators, courses and consultants encouraging you to be the next VC funded startup. It’s pervasive. A few years ago, I went on an entrepreneur course only to be told my ideas weren’t scaleable. It’s automatically assumed you need VC funding and you need the potential to hugely scale.

This post explores the implications of VC funding for those people thinking of starting a new business, the pressures put on VC startups and the consequent affect on their offered services.

The Economics of VC Startups

The economics of VC startups is such that the funds providing the money expect huge growth over a short time. They are expecting a large financial return from sales (unlikely) an IPO (slight more likely) or acquisition (slightly, slight more likely). This clearly isn’t always possible so a VC fund’s returns usually come from very few of their funded companies. Meanwhile, the others are put under extreme stress to try to achieve the impossible with the consequent failure of a business that would be viable if they hadn’t been expected to be ‘blitzscaled’.

The ‘blitzscaled’ term comes from the book ‘Blitzscaling‘ by Reid Hoffman and Chris Yeh. Tim O’Reilly of AlphaTech Ventures (OATV) says venture capital …

…venture capital, in its current iteration, has begun to make less sense for more founders who genuinely want to build sustainable businesses. The way he sees it, the venture industry is no longer as focused on finding small companies that might one day change the world but more on creating financial instruments for the wealthy — and that shift has real consequences

Alex Dunsdon, Partner at SAATCHiNVEST has a post on Should I Take Venture Capital where he says:

Chances are statistically tiny

There a useful article by Gigi Levy-Weiss Managing Partner at NFX, a seed stage venture firm in San Francisco, on How VCs Think: The Psychology That Drives Investing Decisions. He says:

VCs need really. large. exits

Andrew Chen of Andreessen Horowitz also explains Why startups are hard — the math of venture capital returns tells the story.

Venture capitalists ultimately end up being interested in companies that want (and can!) get big — and it’s not the right way to finance the vast majority of new companies, many of whom are more focused on smaller markets or slower growth business models

The Affects of Venture Capital on the Invested Company

So what happens if you are VC funded startup that can’t get big quickly? Here’s what I have seen:

  • Wasted effort and distraction while raising funding – The founders of the company spend too much time trying to raise the next round of funding and take their eye off the day to day running of the company.
  • Diluted ownership – With subsequent funding rounds, the founders and early employees with shares end up with diluted share holdings to the point that they can become demotivated to put in the extra effort required to keep the company going. A symptom of this is when these founders and employees move on to new ventures while the company is still running. Founders can also get fired.
  • Loss of control – The pressure to show revenue can affect business decisions such as purchasing, hiring, pricing and partnering some of which can be morale sapping.
  • Loss of original focus – If the startup pivots it’s usually a sign that the original idea hasn’t worked, it’s not going to be possible to scale quickly and the startup is much more likely to fail.
  • Wasted money – Raising too much money creates the situation where it needs to be seen to be needed and hence spent. A symptom is the hiring of people before the business is ready for them, leading to them rattling around the company looking for things to do and sometimes disrupting others who are 100% busy. Rob Go, partner of NextView, wrote about this as Goldilocks Capital Raises:

…locks companies into a financing or exit path that is unrealistic for the vast majority of companies … when a company has money, they tend to spend it. Burn goes way up, and discipline around prioritization of initiatives and resources goes down

The Other Options

At the start of this post I mentioned a scenario where it had been assumed I needed VC funding to be to blitzscaled. The next piece of advice I was given was that perhaps the business would be ok as a lifestyle business. It’s sadly usual that funding is considered as VC funding at one end and disparaging lifestyle business at the other. In practice there’s a very large number of companies that never had VC funding and aren’t a lifestyle business. In between are lots of companies that have sustainable businesses with good cash flow and profits. These are the ones more likely to survive when there’s negative investor sentiment during a black swan event such as the Covid pandemic.

Despite the pressure to go the VC route, because everyone seems to do this, assess your business and ask if it really is one of the small number that have the ability to scale quickly. If this really is the case then go for it as it’s the best and probably only chance you have to fund that scale.

If that’s not the case, think about other options such as starting off the back of another business (it might not even be yours), crowdfunding, angel funding and family & friends funding. Starting small and building from profits is more likely to create a less volatile, longer term business for yourself and your customers.