Do you need a Venture capital investor at all?
By: Sergey Toporov
Tags: Vc Funding, Venture Capital, Startup Life, Startup Lessons, Founder Stories

“Bogatyr at a crossroads”. Author: Viktor Vasnetsov

On November 10, 2020, in the newsletter from Baremetrics (some of our portfolio SaaS companies use it to track their financial metrics), I read the news about the sale of the company. Baremetrics, which raised $800,000 from General Catalyst and Bessemer partners, and eventually was sold for just $4 million of which $3.7 million when to the founder. The story ended well for him, but it reminded me once again that the venture path is not for everyone. And in fact, there is nothing wrong with building a business in a different way.

Among many companies passing through our pipeline, quite often there are many cool medium and small IT businesses looking for venture investments. This primarily happens because more and more money is being poured into the industry. This obviously makes many entrepreneurs who read in the media about another startup that has raised whopping hundreds of million dollars, a natural desire to do the same. The available capital has its advantages: more and more entrepreneurs get the opportunity to implement their ideas and ambitions, and some of them even not only attract huge financings but actually manage to build billion-dollar valued companies: Unicorns, Decacorns, you name it.

At the same time, a huge number of entrepreneurs knock on the doors of Leta Capital and other venture capital funds and get rejected. VCs just don’t find anything unique about most of them. On average a venture capital firm receives applications from 1000 startups annually, investing as a result in only 3 or 4 companies a year. But from the entrepreneur's side, such a rejection is often perceived by them as our lack of understanding, lack of belief in the viability of the business, lack of faith in the team, or mistakes somewhere else in the standard paragraphs from the number of articles “What a Venture Capitalist Expects to See in the Pitch Deck”. But sometimes the situation is different: a good business for founders is not always a good investment; and vice versa. So, at the risk of shooting myself in the foot, I would like to encourage entrepreneurs to think about whether you need venture capital at all. Are you ready to accept the risks associated with having large capital in your company?

“Either win the horse or lose the saddle”. Main risks for the founders

No doubt, in the short term venture capital money significantly reduces the risks for the company associated with the financial position, potential cash gaps. It gives opportunities to experiment with more attempts to fail. With venture capital money some additional costs will not force founders to sell their car, mortgage the apartment of their parents, or get into debt. The founders and the team will be able to pay a regular salary and feel safe at least in the nearest future. But in the long-run risks with a venture capitalist on board can play a bad joke.

Burn after reading

In most cases, venture capital is raised to accelerate the increase in expenses, with the idea that eventually revenue of a startup skyrockets and overtakes all costs many times afterward. This is an excellent hypothesis if the business model has already been built up, there are clear ways for scaling both internal (hiring and training people; tracking performance metrics; etc.) and external business processes (expanding marketing costs while maintaining ROI; joining new market verticals with a deep understanding of its volumes, portraits of target customers, best ways to reach them; etc.). This is an ideal scenario for raising capital for growth, but it turns out that the founders frequently raise capital first, and only then raise the question: “Why do I need venture capital at all?”. More often venture capital is used either to find a product-market fit or to find a scalable business model; to open new verticals; to refine an existing product, and so on. Some hypotheses will fail, some won’t bring fast results. Eventually, venture capital is not used for growth but experiments.

Unfortunately, in such cases, it is too late to start the cost reduction and is quite difficult to raise new investments to achieve a distant dream in a company that is not growing. As a result, the project can crush into the wall like a fully accelerated steam locomotive. An example from personal experience is our former portfolio company Displair. The company put together a great team, received a lot of pre-orders, and it seemed that a cloudless future was about to happen. At the same time, the speed it burnt the money had not allowed the Company to shrink quickly when it became clear that the cash gap was inevitable.

There is also a lot of so-called “pre-A” and “pre-B” companies on the market which don’t have enough cash to reach the threshold for a new round of financing. They desperately need capital for further operations or risk becoming “zombie-mode” companies, which aren’t actually dying, but are unable to generate enough free cash for independent growth. According to statistics, only 2 out of 5 startups generate profits, while a third of them hang around operational breakeven, and the rest continue to “burn” the money of its shareholders.

For venture capitalists, the last scenario is a normal one. We are prepared in advance for the fact that the majority of portfolio companies will run out of business or become “zombies”. The important thing for us is that among the dozens of risk-takers some have everything going according to their ambitious plans or even better. From an entrepreneur’s point of view, the picture looks different — they don’t have 20–30 businesses in their portfolio or the opportunity to make 20–30 simultaneous attempts. Entrepreneurs can destroy their only startup, not to mention the years of their lives.

So before going after venture money, founders need to decide for themselves is there internal readiness to trade efficiency for risk.

There’s no light at the end of the tunnel

In the U.S., the range of $50–100 million is still the most likely price to sell a software company for. See, for example, Solganick & Co study: US$87 million is the median acquisition price. In Russia, this scenario is even less likely. One of the local Edtech leaders Skillbox was acquired by Mail.ru Group for 1.6 billion rubles in return for a 60% share (it reflects about US$40 million company valuation). Another example — 2.5 billion rubles (US$30 million) for three companies at once, which is considered a huge success story for founders. This outcome doesn’t give much to late-stage venture capitalists or those who have agreed to invest in an early-stage company at a relatively high valuation. So many VCs would trade 100% chance to make 3–5x for 10% chance to make 30–50x.

We regularly see entrepreneurs fighting for the valuation at the beginning, complaining about the investment climate, bad investors, etc. In fact, they give up the most likely exit opportunities for the sake of a very unlikely scenario to be sold for hundreds of millions or billions of dollars. Entrepreneurs give up the current value, which could be used for great success. Usually, the share of a billion-dollar company is blurred along the way of growth and the founder of these huge amounts still cannot see. For example, Aaron Levy of Box owned 5.7% of the company’s shares at the time of the company’s IPO; Zendesk’s CEO owned 8% of the company in 2015 when it went public, and ExactTarget’s co-founder owned 3.8% at the time of the S-1 filing (before the IPO).

That’s where the new question arises — do all entrepreneurs need to build a billion-dollar company? I would advise the founders to ask themselves this question and to answer it honestly: why do I need to pick this track? Is there any opportunity in my area to build such a company at all? How much time and resources will it take and why won’t I jump down the path, especially if I have a small share at the end? After all, less than 0.02% of all startups eventually become unicorns.

What is better: 100% in a $5 million company or 30% in a $100 million company?

The main rule with venture money is that startups must be able to triple every dollar invested for one or two years after receiving the money. Therefore, founders should be able to grow their business at least three times during this time. If there is no understanding and no set of clear hypotheses in mind on how to do it, I would not recommend taking venture financing. An entrepreneur should think of venture capital as a rather powerful and expensive source of energy.

Venture capital is like a nuclear reactor. With the right way of usage, you can get significant improvement and acceleration of the progress. With the wrong one, you can burn everything around to hell, so for many years no one will step in that area again!

I want to emphasize again the importance of dilutions and valuations. An exit for the Company valued at US$1 bln is great, but even hundreds of millions of dollars are also more than great. Especially given the median figures for M&A I mentioned above. At the same time, from the financial point of view to the founder and the business point of view, this valuation is not always a measure of success. A successful company is a company whose products are adopted by a lot of clients. A Company should be able to maintain its existence from profits, but this is not always correlated with its valuation. Giant valuations are necessary for venture capitalists to make our business model work.

Simplistically, everything looks as follows:

There is a $50 million venture capital fund, which is split into about 20–25 portfolio investments. Approximately one-third of the investment we can lose, one third to return or slightly increase, actually paying off the first third. And the remaining third of the companies, with a total investment of $15 million, should bring us 150–200 million returns in at least 5–7 years. In other words, we should actually multiply by 10–15 times each (!). Taking into account that at the moment of exit we will have a maximum of 10–20%, any exit less than $50 million for a venture capitalist is an unattractive story. So keep in mind, that the size of the exit from your project for the venture capitalist should be at least equal to the size of the venture fund to “matter” in its yield.

Some funds bet on 1–2 companies that can bring 50x+ returns. At Leta Capital, we follow a slightly different logic. As a measure of success, we would prefer to have more medium successful entrepreneurs in our portfolio, who can then become investors themselves and launch new cycles. But the total return for the fund is about the same 3x+ DPI. This is why so much attention is often paid to huge valuations. It isn’t because such a result happens very often, but just otherwise, the VC model will not work.

Venture capitalists need hundreds of millions and billions of dollars exits, but whether all entrepreneurs need them is a huuuuge question.

Fame VS Money

It is very cool and prestigious to be in the club of founders of at least $100M+ valued companies. An entrepreneur often immediately becomes an expert in everything, at least in all matters in his or her industry. Media and people reach out for advice, they are called at every conference. But if the goal is to earn money, the price of exit does not always correlate with the founders’ earn. It is quite possible to sell a startup for a billion dollars and earn less than the one who sells it for $200 million. The above mentioned Aaron Levy, CEO of Box, had a 5.7% stake at the time of the IPO. It was also really good, given the company’s valuation.

But in the case of smaller valuations, there may be two scenarios:

It is possible to have a medium IT-business with revenues of US$2–3 million, without rapid growth, and with Net Profit, for example, of $1 million annually. To earn as an owner your US$7 million in 5–7 years and live a great life.

Or to take venture capital and accelerate all stuff. To be unprofitable for many years and in an average successful scenario to sell the business for $50 million, getting in your pocket about half maximum. I will say it again. In a successful scenario.

The question here is more about personal ambitions and the desire to be recognized by society, rather than the economic result. This is what VCs are waiting for in the founders — “Go big or go home”. But this is not the only way. To build a hundred million dollar business, the founder must first build a ten million dollar business. To feel the craving for a billion, the founder shall break the five hundred million valuation.

It is quite good to build a business for decades if it can feed the founders and the team. It’s just not the scenario that suits a venture capitalist whose task is to give such results quickly. Sometimes it even can go against people’s life principles.

I am sure that many companies that have been bootstrapped for a long time, at a certain point, having accumulated expertise and knowledge, will quickly become the most visible market players. One of the most recent examples is UIPath, founded in 2005. It received its first external financing in 2015(!). This summer, the company closed its seventh round of financing with a total of more than $1.2 billion, valued at more than $10 billion. So in the end it is still possible to become the biggest player. For this purpose, founders do not have to give up the confidence present in favor of risk. “Billions or Collapse” from the beginning is not a road for everyone. There are many such examples — Epic, Atlassian, Shutterstock, Mailchimp, or the canonical Minecraft.

Minecraft was originally a hobby project for its founder, who managed to achieve the first $1M of revenue without a single employee, financing the project at the expense of $10 from users for an alpha version. The company reached the $10M revenue level in less than 2 years without raising outside investment and being a Java application (not an MMO), i.e. almost the whole revenue was the net revenue of the company, which the founder reinvested in growth and development. In 2014, Mojang (Minecraft developer studio) was bought by Microsoft for $2.5 billion. Mojang generated revenue of $259 million and $126 million of net profit. This example shows that it does not always take a lot of money at the very beginning to build something big.

BTW. To learn more about alternative financing methods, check, for example, “Founder Power: Venture Debt & Other Alternatives to Equity in 2020+ with Nathan Latka” from the latest SaaStr summit. There are many roads to growth, and venture capital is just one of them.

The right time to leave

Recently I read a thread on Twitter from the founder of Reddit, in which Alexis regrets the mistakes of the past and the exit of the $10 million. He regrets the absence of an investor who would have told him not to do so and avoid other mistakes of youth. In fact, even such a seemingly “modest” exit can have a huge impact on the life of the founder and his family. However, I would not call such a scenario a mistake. It is always a balance between the risk of the future value of the company and the value of the company today. And here it’s like in a casino — you have to be able to leave on time. Maybe with unrealized ambitions, which in the future may push you to new much bigger projects, but with cash on YOUR hand. Could a new big round for Reddit lead to more success specifically in his hands? This is an open question. We’ll never know.

In my opinion, it is much more important to focus on smart growth and use venture capital mostly to support that. Effective entrepreneurship as a style of making business should be the foundation for companies. If you have a clear need for capital, increase it. But you should weigh the different sources of funds a hundred times and then make a decision. It is definitely not worth it to raise venture capital rounds for the sake of newspaper fame. The money raised at the beginning of the road is a burden of responsibility on your shoulders till its end.

Venture capital is not the best choice for most companies, but if used properly, it can become a nuclear reactor. Hope I didn’t scare you too much with the previous reasoning. If you already understand how to accelerate your business and not to destroy yourself and your company, then “Welcome to the venture world!” And don’t forget to reach me and our Leta Capital team.

Read also: