These days I find myself talking with our founders often about the perils of pricing to perfection: Founders need to balance the desire to optimize in the short-term against potential long-term fundraising complications.

Imagine you are a “hot” early-stage startup and have $500K in ARR. VC’s are keen to invest and you get two offers:

A) $6M on $30M

B) $12M on $60M

Seems pretty obvious which one you should take, right?

You might ask, “Why would anyone choose anything other than B? You’re literally getting 2X more money for the same dilution?”

I call this kind of short-term optimization “pricing to perfection,” and while it is satisfying at the moment it creates many downstream problems.

E.g. If you raise the $12M round and burn the money growing ARR from $500K to $5M over the next two years, there’s a good chance your investors will be underwhelmed!

If you raised the $6M round, and make the same or even more modest progress, your VCs will likely be excited about the business and eager to put another round together.

Expectations management matters!

This is one of the hardest conversations I have with founders.

Taking less capital seems illogical. However, unless you can efficiently use the extra capital, the valuation premium comes with costs. Very few companies get twice the results from burning twice the capital.

Here’s what you stand to lose when you get an unrealistically high valuation:

⏱ ️More Money Does Not Equal More Time

More capital isn’t for more runway. They expect you to hire & burn the money in an 18–24 month timeframe in the hope that it accelerates your startup’s progress, and puts you in position to raise a much larger round.

The pressure to grow at all costs will be immense and you’ll be encouraged to spend on underperforming activities to boost growth. As a result, your burn rate will rise, giving you less time to respond to challenges in the market or to fix problems in your execution.

This post explains the dynamics involved in greater detail, but in short, high valuations will increase your stress levels and eliminate most of your margin for error — a costly tradeoff for excess capital you don’t yet know how you’ll use.

😢 You lose VC support

When founders can command high valuations it’s usually because their story-telling/reputation precedes their startup’s results. VCs believe they are investing in a rocketship. Slow progress shatters that illusion and creates discontent.

Think of the initial hypothetical from the investor’s perspective. They paid a premium price and are seeing disappointing performance. Is it surprising they are impatient with the founders and don’t want to continue funding an underperforming asset?

If you raise a smaller round and have solid results, there’s a good chance that goodwill & a revised narrative can unlock another round of funding from insiders. If you raise at a higher valuation, have a higher burn & not much better results, inside support will evaporate.

😍 You lose the VC you want

If you’re optimizing for price, you’re getting the investor who was willing to pay the most and that’s seldom the investor you really want to work with — this is short-sighted optimization that often proves irresistible.

🚪 You lose exit options

Imagine after two years you get an offer to buy your company for $100M and you think it’s a good idea.

If you chose option A, you’d stand to make tens of millions of dollars!

If you chose option B, your VCs wouldn’t likely support the deal.

Founders tend to have big dreams at the early-stage, but running a startup is *really* hard and you may appreciate the exit optionality earlier than you think. Don’t give it away casually.

Startup failure is less frequently the result of bad product decisions or poor financial management. In most cases, what separates failure from success is an extra year or two to get product/market fit or go-to-market dialed in. More capital makes this harder, not easier.

Valuation metrics are extremely generous right now, but they are still primarily driven over time by user/revenue growth. Building metrics that keep up with sky-high valuations is incredibly difficult.

Benjamin Graham famously said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” This is ultimately true for private market valuations too. What will happen when your once-popular high-priced startup is inevitably weighed?

Growth flywheels can be powerful, but they take time to get going. When you raise at a higher valuation you are trading precious patience for money with diminishing utility while simultaneously raising the hurdle you must clear to raise your next round.

Raising at the highest possible valuation is the startup equivalent of buying more house than you can afford. You may be able to make the payments for a while, and you’ll enjoy a more comfortable lifestyle, but any minor shock could put you out on the street.

At a startup there is so much that is out of the founder’s control — Playing the long game and not inflating value in the short term is one of the few levers entrepreneurs can and should guard jealously.

In summary:

🎰 “Pricing to perfection” increases founder risk by increasing burn rates, shortening runway, decreasing investor patience & eliminating lucrative exit options.

😡 High valuations feel “founder-friendly” but actually create profound misalignment between entrepreneurs and investors that is only seen long after the “awesome” financing deal is closed.

How do you bootstrap a $1B+ hardware startup?

SimpliSafe founder Chad Laurans recently shared some wisdom with our portfolio:

🪤 Avoid the “trap of perpetual unreadiness”

🎯 Have a hiring “hit rate”

♻️ Start succession planning from day one

Here’s more…

🎯 Have a hiring “hit rate”

If you’re scaling quickly, you’re not going to hire perfectly. However, many managers fear losing face by admitting they made a bad hiring decision. Give them a permission structure to end poor fits before they poison your organization.

☑️ Reference people early

Chad urges hiring managers to call references as soon as they’re first excited about a candidate. Leaving calls until too late in the process leaves you susceptible to sunk cost biases and robs you of the ability to get insight on negative feedback.

🔐 Know thy market

The home security market has many attractive qualities, but few typical markers of VC-backed startups — No network effects, winner takes all dynamics, etc.

This meant Chad didn’t have to raise a ton of capital to compete in an effort to “get big fast.”

🪤 Avoid the “trap of perpetual unreadiness”

One of the hardest things to do as a founder is to ship a product that feels unfinished. However, it’ll almost never be truly “ready.”

Solve for the key value proposition and fix the rest in version 2.0.

🔽 Focus on the bottom of the funnel

In the earliest days, you are better off focusing on the lower portions of your marketing funnel.

Focus on getting more of the people who come to your site to convert rather than trying to get orders of magnitude more people to visit your site in the first place.

📞 Customer service > Consultants

Make your executive team answer customer service calls and probe online reviews before hiring expensive market research consultants.

Your best users are probably telling you what you need to know — and certainly what you need to fix.

🏠 Visit your customers

Users will find workarounds for shortcomings in your product that you could never imagine. Whether you sell SaaS or consumer goods, learn from your users where they live and work.

📢 Internal communication won’t scale itself

When Chad’s entire team was crammed in a single office it was easy to perpetuate the culture he envisioned. When the team grew to hundreds of staff, internal comms became a mission-critical project that had to be managed closely.

♻️ Start succession planning from day one

Everyone on the team should be preparing to pass something on — be it responsibility for the email newsletter, to the CEO chair. In order to foster a culture of advancement, people have to be prepared to let things go.

Founders, if I told you that you could:

🧱 Increase productivity

♻️ Reduce turnover

🤗 Build loyalty

All in 15 minutes a day, you might think I was peddling snake oil.

There’s actually an easy way to do it.

Show gratitude.

Your best people *are* being recruited.

They’re being offered better titles, better pay, and the rush of being courted.

If you’re not making them feel recognized and valued at your company, they will take one of these offers.

Don’t lose them to a lack of attention.

I understand why founders let this slip. They have urgent fires to put out. They feel put upon by VCs, customers, and even their own teams. These are all good reasons to make appreciation a process. Start by booking 15 min a day to thank people for the work they’re doing.

I mean this literally. Block 15 minutes on your calendar *every day* and use it to find ways to thank your team. Even a specific email thank you can make a huge difference and make someone’s day.

Just a few words can make an outsized impact:

“The new slide deck looks great!”

“Your analysis of the competitive landscape was insightful.”

“I’m glad you pushed back — you raised important points!”

“This new ad copy is hilarious, and it’s converting; keep going!”

You don’t need to compliment everyone. However, assuming you are decent at recruiting, 80% of folks at your company are probably doing good work — some even excellent work. How many regrettable losses are you willing to bear over the failure to make those people feel valued?

This practice will come naturally to some, but I find it doesn’t for most. If you’re the type who is reflexively uncomfortable with this idea, it is all the more important to set up a system to make up for this costly shortcoming.

You may balk at the idea of scheduling something that should be heartfelt. Most founders will find that it soon becomes an organic habit after they make time to do this programmatically. If you focus on making the comments heartfelt, that will come through.

“Programmatic appreciation” can work wonders. It becomes contagious. When senior managers see the CEO express appreciation, they do the same. At some point, the inevitable outcome is a company with a positive culture where employees feel valued.

For those founders reading this and rolling their eyes, here’s a different frame: your employees are all working hard trying to make you a billionaire. It shouldn’t be hard to appreciate that hard work and find daily reasons to offer gratitude.

These small gestures take minutes and cost quite a bit less than a retained search to find a replacement for a single regrettable loss or the raise that you give someone to keep them at the company when they got a 50% higher offer elsewhere after feeling undervalued.

Raises, bonuses, and stock options signal appreciation in a material way, but don’t underestimate the ROI on a small act of kindness!

Capital First Companies

November 20, 2020

🤖 Product-first companies are inspired by a breakthrough in technology or UX.

Awesome!

📈 Market-first startups are built in response to glaring inefficiencies.

Awesome!

🤑 Capital-first startups are catalyzed around access to capital.

Beware!

Capital-first startups start with a hazy sense of a problem, a rough idea about how a product could solve it, and a crystal clear conception of why they should raise maximum money, now, and at the highest possible valuation.

Spotting these startups is easy:

🏀 They build teams before they’ve tested a hypothesis

🏙️ Space is leased before wireframes are crafted

📜 Press releases are issued before customer personas are fully baked

📢 Buzz campaigns are ramped before any sales

This approach is seemingly enviable!

The founders who can pull this off have often had early-career success. They’re enmeshed in networks that make connecting capital easy. Crafting compelling pitches to suit the themes of the day is second nature.

I say this is “seemingly enviable” because building your startup on your ability to attract capital is dangerous. This approach allows founders to get out of the gates quickly while almost certainly spelling their doom.

Here’s how:

🔥 The Burn Rate is Too Damn High!

In the earliest days of your company, time, not money, is likely to be the gating resource. It takes time to understand the market. Iterating on the product requires cycles. Testing channels and price discovery can take a while.

It’s much easier to undertake these projects with a skeleton crew. But the dynamics of the typical capital-first startup won’t allow for that. They hire rapidly to try and solve these problems in parallel and live up to lofty capital infused expectations.

This rarely works.

💣 Pressure Mounts!

Capital first companies start with high valuations paired with high burn rates. This removes any margin of error and leads founders to chase vanity metrics over value creation. And to be fair, this can work for a time!

But it only works as long as you can keep your investors excited. Invariably, their enthusiasm will run out, and you’ll be left with the husk of a company.

These startups end up saddled with debt from short-sighted product/hiring decisions that were made in order to juice short-term growth…and no understanding of how to grow organically.

More importantly, the promising concept at the core of your business will be wasted. There are cases and classes of entrepreneurs that do need capital early in their lives in order to get started, but that is seldom the case in these scenarios.

In many of these scenarios, the founders I’ve talked to have the financial capacity to get started without investment or a tiny pre-seed, but the status that comes with venture dollars and the attendant perks — team, offices, etc. — is too tempting to pass up.

🥦 The solution is simple but unattractive

I sometimes worry I sound like a doctor telling people to eat their broccoli. Unfortunately, I don’t have a flashier message. When it comes to building companies that last, there is no school like the old school.

Capital can’t find your market, identify real problems, forge deep solutions, and create lasting value. Abundant capital is a multiplier when you have these things and compounds negative value when you don’t. Remember, capital has no insights!

Redefining dilution

July 20, 2018

Everyone generally agrees that dilution should be avoided. VCs insist on pro-rata rights to avoid the dreaded “D” word. Executives often complain, after a new financing, that they should be “made whole” to offset the dilution that came with the new round. Founders work as hard as they can to maximize their valuation at each financing event to avoid painful dilution. Dilution = bad.

And yet, entrepreneurs want to raise money. In many cases, they want to raise lots of money. There is great pride in the amount of money that is raised and a larger raise is typically celebrated as a greater success. This is a bit confusing, given that a larger raise should also mean more of that awful dilution that everyone is trying to avoid.

Financing events are misleading

Most people in the startup ecosystem think of dilution as the percent of the company that is sold in a financing transaction. If your startup completed a $5 million Series A on a $20 million pre-money valuation, (option pool aside) you would have 20 percent dilution, and everyone will own 20 percent less than they did before the transaction. This is very misleading.

While every equity holder may own 20 percent less of the company than the day before the financing, the company is worth more than the day before the financing. Even if you assume that the valuation was an objective measure of the value of the company and was flat from the previous financing, everyone now also owns their percentage share of the new cash that was added to the cap table, which wasn’t part of the company’s value prior to the financing. Here’s an example:

Company ValueYour OwnershipYour Dollar Value
Pre-Series A$20M10%$2M
Post-Series A$25M8%$2M

So if you owned 10 percent of the company, and the day before the financing that was worth $2 million, the day after the financing you own 8 percent of the company, which is still $2 million. In dollar value, which should be the only value that economically matters, you own the exact same amount of a company that is now worth more overall. Where is the dilution?

Financings are usually accretive, not dilutive

I believe the startup ecosystem is confused about the impact of financings. Rather than being dilutive, any up-round financing (with a caveat that I’ll address below) should be a demonstration of value accretion. Let’s add some context to our previous example.

If the previous round had $10 million post-money valuation, and you owned 10 percent, your ownership was worth $1 million at the time of the seed financing. With this new $5 million financing on a $20 million pre-money valuation, you may now only own 8 percent of the company, but your value in the startup has actually doubled to $2 million. That’s amazing!

Company ValueYour OwnershipYour Dollar Value
Post-Seed$10M10%$1M
Post-Series A$25M8%$2M

Why would anyone focus on the 2 percent reduction in percentage ownership when the value of their holding appreciated from $1 million to $2 million? It’s always better to own less of something worth much more than own more of something worth much less. That’s a trade I’d make every day of the week, and it isn’t at all dilutive to my ownership. Complaining about dilution on that transaction is totally illogical. We should all be celebrating the accretion of value when we have an up-round financing.

If VCs want to purchase their pro-rata because they believe in the long-term value of the startup, and buying pro-rata is part of their strategy, by all means, they should do so. However, if they are doing so to avoid dilution, I think they’re missing the point completely, given that they haven’t been diluted. If a founder receives more stock options because their performance is outstanding and they deserve more compensation, that’s terrific. If they are being “made whole” because they own a smaller percentage, which has doubled in value over the larger percentage they previously owned, that’s simply faulty math.

True dilution = burn rate – accretion of value

While financings reflect value accretion or dilution, the transaction isn’t where these values really change. Dilution is actually much more complicated and shouldn’t be viewed as a transactional event.

Dilution is a function of your burn rate relative to your accretion of value. It is often measured in financing events, but it actually plays out every day in the choices the startup makes and the work the startup accomplishes. Simply put, if you are accreting more value than you burn, there is no dilution. If you’re burning more cash than you’re accreting value, then there is dilution.

Put another way, you’re not being diluted because a VC decrees it; you’re being diluted because you spent money building features that your customers didn’t want, instead of the ones that they need. You’re being diluted because you kept scaling up an ineffective sales process because you didn’t want growth to slow.

Each financing event is more of a check-in point on the value of the company than a true dilutive or accretive event. It’s the time between the financings, when the company was burning cash to build additional value, that was truly the accretive or dilutive journey. In other words, the company isn’t worth $20 million because someone bought stock in a day. Its valuation increased from $10 million to $20 million because of the work that was done to increase the value of the company that greatly outpaced the cost of creating that value. If the cost outpaced the value of the work, that would have been dilutive, as demonstrated by a down round.

The paradox of overvalued financings

It’s the burn rate relative to the value creation, not the financing event, that truly determines accretion or dilution. However, I’d acknowledge that this equation is ambiguous at all times and the market determines that value, which is why it is fair to say that financing events are the measuring moment of the most recent period of work.

What’s particularly complicated is that financing events are incredibly inaccurate measures of value creation.

In the recent era of an overcapitalized venture capital industry, we’ve seen some extraordinary financing events across nearly every startup stage. So what is the implication of overcapitalized and overvalued companies? Are those transactions clear evidence of value accretion?

Unfortunately, this is a particularly confusing phenomenon. These financings are celebrated because they appear to be minimally dilutive and the company gets a stock-pile of cash. Unfortunately, I think they distort the economic equation of the startup and usually have the opposite result.

Imagine that same startup that rationally should have raised $5 million on $20 million pre-money is able to raise $20 million on $80 million pre-money.

Company ValueYour OwnershipYour Dollar Value
Post Seed$10M10%$1M
Post Series A$80M8%$8M

This type of round seems crazy to anyone who hasn’t experienced it, but we’ve been there with our companies many times. It appears that the company has just had an exceptional outcome. The person who previously owned 10 percent still owns 8 percent, but the value appears to have increased from $1 million to $8 million. Happy days! For the same 20 percent dilution, the company raised 4X the capital and stock is now worth 8X the last round value! Unfortunately, it is the embedded future implications of this event that are so misleading and undermine that value.

Because it is the burn rate and not the transaction that really drives dilution, typically these large financings end up being very dilutive to the company. As I’ve written about previously, these financings often come with unreasonable pressures to prematurely grow the business and incentives to chase the marginal dollar at great cost. The end result of these financings is typically that the burn rate will often outpace value accretion at the startup. This is extremely dilutive over time and typically will have the effect of conditioning a company for an indefinitely high burn rate, which will require much more cash and possibly a down round in the future. Or worse yet, the company fails as the investors lose enthusiasm and the company is depending on continued cash infusions that never come.

In other words, large financings are typically very dilutive, even if on paper they appear to be evidence of massive value accretion and misleadingly little dilution. Paradoxically, given the same stage of growth, the $5 million financing for 20 percent of the company is often more likely to be long-term accretive than the $20 million financing for 20 percent.

Words of caution

I would encourage startup founders, employees and investors to stop viewing up-round financings as dilutive and recognize that they are accretive (except when they incentivize future wasteful spend). Instead, they should obsess about the burn rate and ensure that the capital being burned is invested in high-confidence opportunities that yield true value that will be reflected in accretive future financings. If every dollar invested is showing demonstrable value accretion, by all means burn as fast as confidence allows! Profitability is important, but focusing on it too early can undermine value in the same way that burning too aggressively can. The point of venture capital is to make investments in confident areas of high growth. Venture capital is not the right tool for every job, but if a startup can use VC as intended, they should.

We had a saying at my last startup that “every dollar that we spend is a dollar of dilution.” While that was probably a good mindset, the wording suggests that investing in a business with strong return isn’t worthwhile. Today I’d revise that saying to “every dollar that we spend that doesn’t create more than a dollar of value, is dilution.”

May your burn rates be accretive and your financings increase your ownership value.

Venture capital should come with a warning label. In our experience, VC kills more startups than slow customer adoption, technical debt and co-founder infighting — combined. VC should be a catalyst for growing companies, but, more commonly, it’s a toxic substance that destroys them. VC often compels companies to prematurely scale, which is typically a death sentence for startups.

Venture-backed startups face great pressures to perform. The more money raised, the more pressure. One of the challenges well-funded startups face is defining performance. For mostly good reasons, the metric that matters most to VCs is usually revenue growth rate. Particularly for an early-stage startup, this is the right metric, because it is the most basic answer to the question of whether customers care about the company’s product and the company has the potential to become a large business.

Growth at what cost?

Unfortunately, growth without context quickly becomes more of a vanity metric than a success metric. The question that needs to be considered is “growth at what cost?” Few would dispute that growing 3X and adding $10 million in revenue by consuming $1 million in investment is terrific. Likewise, most would agree that growing 3X and adding $10 million in revenue for $100 million in investment is appalling.

Extreme examples are pretty clear; it’s the less dramatic examples that become very confusing. Unfortunately, founders and investors aren’t having the debate about high-quality versus low-quality growth frequently enough, and the wrong incentives can lead reasonable people to catastrophic rationalizations.

Not all growth is created equal. There is “good growth” that supercharges the business and allows for reinvestment into a virtuous cycle, and “bad growth” that ultimately leads to an unsustainable burn and a masked death spiral. Founders always need to be asking themselves, their teams and their investors: “Growth, but at what cost?”

The peril of “go big or go home”

Investors today have overstuffed venture funds and lots of capital is sloshing around the startup ecosystem. As a result, young startups with strong teams, compelling products and limited traction can find themselves with tens of millions of dollars, but without much real validation of their businesses. We see venture investors eagerly investing $20 million into a promising company, valuing it at $100 million, even if the startup only has a few million in net revenue.

Now the investors and the founders have to make a decision — what should determine the speed at which this hypothetical company, let’s call it “Fuego,” invests its treasure chest of money in the amazing opportunity that motivated the investors? The investors’ goal over the next roughly 24 months is for the company to become worth at least three times the post-money valuation — so $300 million would be the new target pre-money valuation for Fuego’s next financing. Imagine being a company with only a few million in sales, with a success hurdle for your next round of $300 million pre-money. Whether the startup’s model is working or not, the mantra becomes “go big or go home.”

The marginal-dollar problem

After this fundraise, everyone at Fuego agrees to hit the gas, hard. Burn rates jump from $200,000 a month to more than $1 million per month. Experiments that previously were returning $1.50 over time for every dollar invested start to return $1 as money is pumped into scale, but everyone agrees that’s okay. It just means that the customer pays back the cost of acquisition more slowly.

As the investment keeps scaling up, soon only $0.80 comes back for every $1 invested. This poor return is upsetting, but growth is the mantra and Fuego’s executives and investors rationalize that this can be fixed later. Eventually, as the company scales further, $0.50 comes back for every $1.

Scale quickly reveals the inefficiency of a startup’s model. But does the overfunded startup take a step back and try to fix the diminishing return of investment? Rarely — until it’s too late. The desperation for growth drives the startup to chase the marginal dollar at increasingly greater costs, enduring rapidly increasing losses. We call this “the marginal-dollar problem.”

Money has no insights on how to fix a broken business.

This develops a habit that is hard to break, and the startup will get worse and worse at solving this diminishing returns problem over time. The problem is further exasperated as the return on most growth investments in startups (more features, more engineers, more support, more brand marketing, etc.) are much harder to quantify and take time to evaluate. The burden to grow at any cost drives the startup to accept exceptionally poor returns on its investments.

How the marginal-dollar problem kills you

Companies are pretty good at knowing what their best “hypotheses” are in product, sales and marketing. Each marginal investment, on average, will perform worse than the higher confidence hypothesis that was previously tested. As a company attempts to unnaturally scale, it will make lower and lower confidence investments that will typically perform worse and worse — all in the name of chasing the marginal dollar. If the startup wasn’t trying to triple an already ambitious valuation, they could proceed prudently, reject investments that don’t sufficiently return and harden their best thesis into a model that generates high-confidence results. Instead, they end up trying to spend their way out of the hole.

To illustrate this challenge with an example that affects many B2B startups, let’s consider the marginal-dollar problem from the standpoint of building a sales force (this is going to get a bit in the weeds — bear with me).

Imagine Fuego’s average sales rep is getting paid $100,000 and is bringing in $250,000 in sales — against a $500,000 target. On the surface, this looks additive — that’s still $150,000 in contribution! Except it doesn’t account for the cost incurred by product, sales engineering, account management, marketing, support, G&A and all the other teams this employee burdens.

Let’s assume the total loaded cost for a rep is $400,000. In a rational world, the cost of these reps couldn’t be justified; however, the CEO doesn’t want to lose that average $250,000 in top-line growth, despite the cost. If Fuego is largely encouraged to “grow at any cost,” losing $250,000 in revenue for each dismissed sales rep isn’t an option.

Worse yet, as the CEO struggles with the underperformance of the reps projecting toward missing the annual sales plan by a large margin, that CEO has a choice of whether to focus on fixing the problem or finding a way to close the revenue gap. How could one make up that gap? Hire more of the inefficient reps? Go big or go home! Sounds crazy, but it’s happening every day in the startup world.

Multiply that scenario across dozens of sales reps (and similar underperforming activities on other teams) and you quickly understand how chasing the marginal dollar of growth can kill a business. As the CEO keeps doubling down on a machine that isn’t working, Fuego shows growth, but at a cost that is unsustainable and will lead to its inevitable failure. This is how big venture rounds kill startups.

Capital has no insights — it is rarely the constraint

Fuego, like many startups, has financed the business on one big assumption — that capital is the major constraint to startup scale. If a company has more capital, it will scale faster. On this assumption, why not raise as much as possible and go as hard as possible at every startup? Our research suggests that this is rarely the case and that the most challenging constraints to growth and success are rarely capital.

Capital can be used to hide these constraints for a period, but typically capital only magnifies the problems over time. Money has no insights on how to fix a broken business. Great businesses solve these problems first and then use capital to intelligently scale models that are clearly working.

We’ll fix it as we scale

We often hear founders and investors argue that the problems in their companies can be fixed as the company scales. It’s not hard to imagine Fuego acknowledging the major problems with the economic engine of the business, but rationalizing that capital can be used to both scale the model and fix the model at the same time. This is very seductive logic, because it allows everyone to keep playing the grow-at-any-cost game while pretending that the problems will get solved later.

Unfortunately, we almost never see this work (for fairly obvious reasons). Scaling a business is hard and nearly always yields less efficiency over time. It takes so much effort to scale without losing yield on nearly any productivity metric that the dream of scaling while increasing productivity is typically a mirage.

Sell the dream, buy the nightmare

From the outside it’s so obvious — Fuego needs to hit the brakes. Returning $0.50 for every $1 invested cannot be fixed at scale. Unfortunately, in the pursuit of growth, people lose focus on the costs until it’s too late.

Fuego’s VCs invested with the goal of building toward a billion-dollar exit. They invested because they believed in Fuego’s potential — why would they go slow? That would be admitting to themselves and everyone else that the investment thesis was invalid. They convinced the partners at their funds that this was going to be the next home run; how can they pause now?

Every attempt at scaling up an inefficient experiment dramatically decreases the likelihood of success for a startup.

The burden on the founders is immense. The founders sold the VCs on this billion-dollar future. How can they get cold feet now that the cash is in the bank, even if the model is broken? If they cut back on the burn, talented people will get the sense the company’s prospects are dimming and leave. Appearances must be maintained!

This works for a while — everyone is drinking the same Kool-Aid — until the company needs to ask its investors for more money and inevitably hits the enthusiasm gap. One reason that scaling a bad experiment is so detrimental in the long term is that the incentive to keep scaling doesn’t go away, but the investors often become unwilling to fund it when the company inevitably runs out of cash.

Build a better engine or hope not to explode

Every attempt at scaling up an inefficient experiment dramatically decreases the likelihood of success for a startup. Capital is a multiplier of the good and bad at a startup. A startup can use capital to compound activities that are working or compound activities that are not working. Unfortunately, venture capital often drives founders to do that later. It is incredibly difficult to fix the multiplication of bad mistakes. This is why VC is so dangerous: venture capital incentivizes companies with good vanity metrics to start scaling bad experiments.

Think of your company as a car in a race to cross the country with an engine that’s leaking gasoline. The faster you accelerate the engine, the more the car leaks and the greater the risk of explosion. You have two options. You can slow down the car, pinpoint the problem and fix it; or, you can just keep pouring more gas into the tank, hoping for an infinite supply, and accelerate at maximum speed — all the while praying that the fuel leak doesn’t lead to a catastrophe along the way. So the car goes faster and faster with a decreasing rate of efficiency and an increasing probability of tragedy.

So about that warning label, perhaps it should be: “Founders: Burn Responsibly.”

Snorkie, Miniboz, Cavazoo, and Scoodle would all be passable startup names, but they’re actually relatively new canine crossbreeds and represent just a fraction of the entrepreneurial energy recently invested in designer doggies. The Labradoodle, a hypoallergenic mix of Labrador retriever and poodle, the favorite dog breed of Miley Cyrus, the Norwegian crown prince, and the Paley family, only bounded onto the scene in 1955. Humans have domesticated dogs for 15,000 years, but the first Silken Windhound wasn’t born until 1987. Like web portals, Chiweenies (that’s a Chihuahua/Dachshund mix), achieved huge popularity in the early 1990s.

We live in a heyday for hybrid pups and that’s why we’re proud to announce our investment in Embark, a service that deciphers doggy DNA for pet owners, breeders, and vets. Think of it as Github for Greyhounds.

For just $199, Embark provides a report that calls out hundreds of interesting facts about your pet — everything from its geographic origins to a dossier on the personality traits it is likely to display. Consumer genetic testing is an amazing tool for genealogists and has fascinating long-term potential for modern medicine, but Embark moves in dog’s years. The Embark test can lead to a stronger, healthier litter of puppies in as little as two months and can shift the longevity of a breed in only a decade!

How Does Embark Help?

1. Pet Owners: There are 72 million dog-owning households in the US which spend over $66B on their pets each year. Besides offering incredible new insights on the origins and genetic makeup of a beloved family member, Embark can help golden retrievers better enjoy their golden years by giving owners a heads up on the maladies their mutts are genetically susceptible to and which foods and interventions might serve them best. Who wouldn’t want to give their best friend a longer and healthier life?

2. Veterinarians: There are 26,000 small veterinary clinics in the US. Vets armed with DNA test results will be able to more accurately diagnose the health risks their patients face and offer proactive solutions. Moreover, Embark is creating a genetic database of dog DNA which will surely lead to new discoveries in veterinary science.

3. Breeders: The benefits to breeders extend far beyond those that want to pioneer the next bespoke breed. With Embark, purebred breeders can use science rather than superstition to declare the pick of the litter and further refine the breed’s family tree. By investing in a DNA bank that will help improve the health and longevity of a breed, breeders can ensure the value of their dogs and businesses for generations to come.

Beyond the benefits to pet lovers and vets, Embark is a model of what we look for in a startup:

The Founders are Best in Breed

(Almost No One Else Could Start This Company)

There is a reason Airbnb and Facebook were started by recent college grads. TJ Parker, a 2nd generation pharmacist who loves tech and obsesses over user experience, is the perfect person to lead PillPack.

Outsiders can bring a useful perspective to markets, but all things being equal, we’d prefer to back founders who fit their markets. Co-founders Adam and Ryan Boyko are uniquely suited to understand dog DNA. Adam is a Professor of Veterinary Medicine at Cornell University with 41 journal articles to his name. Ryan studied Computer Science at Harvard and epidemiology at Yale. Together, they’ve been swabbing dog cheeks for years and have traveled to Peru, Uganda, and Egypt in pursuit of rare breeds to build out their model. How many teams out there have members that delved into doggy drool to earn a doctorate, the ability to design a database, and a demonstrable knack for consumer-facing design?

They’re Barking Up the Right Tree

(What we Mean by Weird and Wonderful)

We talk a lot about funding “weird and wonderful” businesses. People often take it to mean we favor or seek out bizarre-sounding ideas, but that’s a superficial read. What we look for are founders who see a crystal clear use case hidden in an industry or market that is opaque, or downright frightening, to most people and far from a current venture capital theme. We rarely invest in hot new technology platforms for their own sake, but we are willing to back great use cases that happen to operate in weird industries.

They’ve got a Nose for Business

(Good Founders Like Talking About Hard Problems)

To be honest, when I was first introduced to Embark, I was a bit skeptical; however, Ryan backed up a barking mad pitch with a barrage of information about the business and its early traction and market adoption.

And their success isn’t just a matter of sales. In a short period of time, Embark has truly become the leading DNA testing product for dogs despite that competitors have been around for years. Ryan and Adam are regularly interviewed by the New York Times, National Geographic, and other national publications as they’ve done a world-class job establishing their thought leadership on canine genetic health. They’ve done creative business development deals, like designing quizzes for the Washington Post and providing the genetic testing for the annual Puppy Bowl. They might be the most media-savvy pair of scientists I’ve ever met. It’s easy for science-focused teams to handwave past the tricky business issues, like pretending to throw a tennis ball to a Beagle, but the Boyko brothers have done the hard work of building a real business around their technical breakthrough.

Some people say all deals have fleas, but we’re wildly wagging our tails about leading this round of funding alongside Shana Fisher at Third Kind, Jenny Lefcourt at Freestyle, Bill Maris at Section 32, Anne Wojcicki who made a personal investment, and couldn’t be more excited to welcome Embark to Founder Collective!

The era of unicorn startups has created a distorted view of entrepreneurial success. All the talk about billion-dollar exits has inflated the numbers that define a win. Starting and selling a company for $100 million dollars is an outlier event in terms of pure entrepreneurial probability, but such outcomes are viewed as well short of success in many corners of today’s startup world.

This bizarre belief isn’t universal, but a surprising number of VCs and industry observers are thoroughly unimpressed by low nine-figure exits.

In our hype-driven society, this actually isn’t so surprising. Political reporters want to write about the president and the Supreme Court, not state government. Likewise, tech journalists want to write stories about companies that spell million with a “B.” Investors at billion-dollar funds want to deploy $50 million into winning companies, and $100 million exits are seen as consolation prizes instead of reasons to cheer. In this echo chamber, a $100-plus million exit seems like a jumbo-sized acqui-hire.

To put this reality distortion into context, we examined the outcomes of a special segment of the successful founders over recent decades — those who have become VCs. Looking at a broad cross-section of top VC firms, we identified 63 investors who have a background in starting companies. Only 11 of those founders-turned-investors have built enterprises that have IPO’d or sold for more than $1 billion.

Many of the most successful investors built exceptional startups, which only by today’s distorted standards look like “modest” economic outcomes. Y Combinator’s Paul Graham is one of the most influential venture capitalists of the last 10 years, yet his startup Viaweb sold for “just” $49 million. Viaweb was a success by any realistic standard, but perhaps not by today’s hyped success narrative and fundraising stockpiles. The company only raised $2.5 million before its sale — a pretty impressive return and an amazing precursor to what was to come for Paul Graham. It turns out that “small” exits can lead to big things.

Note: This isn’t an encyclopedic list, so if we missed someone, please let us know. Also, some of the dot-com-era exits are hard to value accurately, but citations are available. In the case of undisclosed amounts we assume the acquisition prices were lower than the materiality threshold of the buyer.

Belittling $100M success stories

Not only is selling a company for $100 million often scoffed at by VCs, at times it is outright mocked by the startup community. Aaron Patzer became famous for building Mint.com, and the site’s powerful UX was such a breakthrough that Intuit paid $170 million for the company. He didn’t buy into the “go big or go home” ethos; instead, he earned a fortune — and was roundly ridiculed for it. The disdain for “small” $100 million sales is so strong there’s even an Urban Dictionary entry for selling your startup for too little money — it’s called “Pulling a Patzer.” No seriously, go look it up. We’ll wait.

One of our portfolio companies recently sold to a tech giant for just over a hundred million dollars. The acquisition gave us an exciting multiple in a short period, and each of the co-founders made more money than LeBron James last year. This sale was quite possibly the best realistic outcome the company could have expected and a huge win for all parties.

In this unicorn-obsessed startup era, the lack of appreciation for these victories is a failure of vision at best, and unfortunate cynicism at worst.

“Go big or go home” is broken logic

We’re not suggesting entrepreneurs should look for quick flips or undervalue their company’s potential. We want to fund the next Uber, Google and Facebook. The reality is that not every business is suited for that. Part of the reason so many of these VCs had great outcomes at well below unicorn fantasy levels is that they raised the right amount of money for their businesses at valuations that maintained exit options.

Ideas that look like billion-dollar businesses at the seed stage can run into unexpected barriers. For modestly funded startups, these mistakes don’t need to be fatal. Unfortunately, most VCs are sized such that they can only succeed if they have several companies in their portfolio exit for more than a billion dollars. So VCs overfund startups with decent but uninspired progress, which cuts off realistic and enriching exit opportunities.

For example, you might have a company with $10 million last year in gross revenue that earned a $50 million valuation in its last round. This company hopes to double its revenue this year and is in a sexy category, but it has thin margins and a loose handle on its unit economics. In a normal environment, that company might raise $20 million on an $80 million pre-money valuation as the next step up.

Instead, in the current climate, a VC will see signs of progress, get excited by the market and convince the founders to “go big or go home.” This VC has $20 million burning a hole in his pocket (he needs to deploy this capital to raise his next fund) and convinces the entrepreneur to take $40 million (with half to insiders) on $260 million valuation instead. Now, with a $300 million post-money valuation, the company needs to sell for a billion dollars to be worth the VC’s time.

With only $10 million in revenue and very thin margins, the company has sold its option of a $500 million exit. If they had raised less money, a sale for half a billion dollars would have made everyone happy. Instead, they’ll probably increase their burn rate and raise more money. Eventually, this promising company could possibly go out of business when no acquirer wants to pay the inflated price and VCs lose interest in funding the excessive burn rate required to continue to fuel false hopes.

Fund size tells you everything

A lucrative $100 million exit is only possible if you don’t over-capitalize your business. If you want flexibility, you’ll have to fundraise strategically. This starts with choosing your investor. Founder Collective partner David Frankel often says, “fund size tells you everything.” As a very rough rule of thumb, your startup needs to be able to make a case that it can exit for at least the value equal to the size of the VC’s fund. Raise from a $50 million fund, you can sell for $100 million easily. Raise from a billion-dollar fund and you need to shoot for the moon. Choose carefully and make sure you know what you’re signing up for.

There’s no shame in a $100M startup

The vast majority of tech companies are sold for less than $100 million dollars. Raising a relatively small amount of money and selling a company for $100 million dollars should be celebrated. For most founders-turned-VCs, this was the definition of success when we sold our own companies. In some cases, selling for tens of millions of dollars can be more lucrative for founders than selling for hundreds of millions, or even billions of dollars.

Selling a relatively successful startup can create enough wealth to allow you to live comfortably for the rest of your days. It can put you in prime position to start another company — or perhaps the leading accelerator in the world. Many founders turn “modest” successes in the entrepreneurial realm into amazing careers in venture capital.

Welcoming Andy Palmer

May 3, 2017

Today, we’re proud to announce that Andy Palmer has joined Founder Collective as our newest Founder Partner (and be sure to read Andy’s post explaining his motivation for joining FC.) David Frankel recently explained what we look for in this role: entrepreneurs who are wholly-focused on building their own companies and partner with our firm on a part-time basis to invest in other entrepreneurs (and in Andy’s case, the Cambridge/Boston startup ecosystem).

Founder Partners are magnets for talent, insatiably curious, deal-savvy, and experienced angel investors. Andy couldn’t be a better fit for Founder Collective, as I detail below. For Andy, Founder Collective will help him continue the mission he started with Koa Labs — to support the Boston/Cambridge entrepreneurial ecosystem — while he maintains his primary focus as the CEO at Tamr, the company he co-founded with his partner and Turing Award Winner, Mike Stonebraker, PhD.

Andy built a unique career combining tech, life sciences, and data engineering that included serving as:

  • VP of Sales and Marketing at pcOrder.com during the dot-com boom
  • Chief information and Administration Officer at Infinity Pharmaceuticals
  • Co-founder and founding CEO of of database company Vertica (sold to HP)
  • Global head of software and data engineering at Novartis Institute for Biomedical Research
  • Founder of Koa Labs, a seed fund in Cambridge where he supported the founding of such great companies as PillPack, Recorded Future, Evergage, Kinsa, Desktop Metal, and dozens of others
  • Most recently co-founding Tamr, a data unification platform that reduces the time and effort to connect multiple data sources, with funding from NEA, Google Ventures, HPE, Thomson Reuters, GE and MassMutual

Andy is a nexus for entrepreneurs in Boston, and I’ve seen him change people’s lives and career paths by leveraging his experience and networks. The following attributes are just a small part of what makes him special.

Mission-driven

Andy learned how to program writing computer games in the 1980’s as a teenager. His love of computers and software has driven him throughout his career and fueled his personal mantra: “Getting paid to play with computers and software all day is too good to be true.”

Andy’s inspiration for being an entrepreneur came naturally: “My grandfather was an entrepreneur. He sold firetrucks — he loved everything about cars and big trucks. He supported our family, was an amazing role model and he got to play with trucks all day. I’m really just trying to be like my grandfather — but with me it’s computers instead of trucks.”

A Role Model

Andy is a sharp, deal-savvy investor, but he’s also one of the most generous people I’ve met in the Boston ecosystem. He’s made more connections that have led to lucrative deals and momentous career changes than most of the recruiters in Boston. Many investors use favors and intros as a form of currency while Andy proactively offers help with no expectation of return with great regularity. Personally, he’s been a role model for how to catalyze a startup community. Andy credits his long time partner and close friend Frank Moss for his behavior: “Frank taught me how to be a great entrepreneur while also being a great person and caring for others.”

Tech + Life Science + Consumer + Data

Like us, Andy looks for unique individuals working to solve compelling problems with focused use cases. More specifically, he’s deeply focused on the intersection of tech and data, with a special interest in companies that combine them with life sciences and consumer applications.

He’s all over these issues at Tamr and is working hard to improve the quality and actionability of data for his customers, explaining that “companies have spent 40 years collecting data, now they’re trying to use it. One customer thought they had a two hundred thousandmillion customers. It turned out they had half that number. If you’re wrong about your data is inaccurate, how do you do anything useful with it?”

Founder First

One of the many reasons we’re honored to have Andy on the team is that he has never been an institutional venture capitalist. Why? He loves building companies and playing with tech too much to give it up.

We designed our Founder Partner program precisely to accommodate polymaths like Andy so they can support other founders without letting go of their true passion and their primary interests. This structure gives entrepreneurs who take funding from us access to a team of professional investors that can help with general strategy, fundraising, etc. as well as founders like Andy who live and breathe big data and can offer deeper domain expertise.

“Entrepreneurship is a team sport; I believe that with my soul,” he says.

Humility

Humility and empathy with founders are core values at our fund. Andy is a kindred spirit in this regard. At Tamr, there are no assigned desks, and he’s as likely to be found at a table at a cafe as in an office.

When he built his co-working space, Koa Labs, the same thinking was at work. “We were very deliberate in building something rough around the edges,” he says. “One of the problems with most co-working spaces is that they’re too nice. You need intimacy, a rough lifestyle. You’re trying to do things that shouldn’t happen in a rational world. It’s hard to do that in a space that feels like corporate America.”

Andy rejects the notion that investors are kingmakers — it all comes down to the entrepreneurs. He elaborated “so many venture firms use a rule book devised by the early players in the business. They have all these assumptions about how much ownership they should have, what backgrounds founders should have, and most institutional venture investors have sold those assumptions to their limited partners. I believe we should question more of those assumptions. We don’t have to use that playbook. When you break the rules, question dogma, that’s when you get outsized returns. Coming out of grad school I worked for Joe Liemandt at Trilogy in Austin, TX. Joe is great example of an entrepreneur who doesn’t conform to other’s assumptions. I learned so much working for Joe at Trilogy.”

Welcome to FC Andy!

Venture capital is a hell of a drug. Used properly, it’s like adrenaline energizing many of the greatest companies of the past fifty years. Used incorrectly, it creates toxic dependencies.

The conventional wisdom in the startup community is that when building the very best companies, more capital can be leveraged to accelerate even greater growth. But does this “go big or go home” approach stand up to scrutiny? In the best case scenarios, do companies that load up on venture capital actually outperform those that more efficiently deploy capital? We looked at 71 tech IPOs from the last five years to find out.

Efficient Entrepreneurship

At Founder Collective we’ve been talking to our community about the virtues of what we call “efficient entrepreneurship.” We’ve written recently about the downsides of heavily funded companies, including the loss of exit optionality, and perils of unsustainable burn rates, but how does aggressive venture capitalization look on the upside? By studying the best cases of venture capital success, what can we learn about the benefits of raising lots of money?

The results were surprising — by examining the technology IPOs of the past five years, we found that the enriched (well capitalized) companies do not meaningfully outperform their efficient (lightly capitalized) peers up to the IPO event and actually underperform after the IPO.

Raising a huge sum of money is a requirement to join the unicorn herd, but a close look at the best outcomes in the technology industry suggests that a well-stocked war chest doesn’t have correlation with success.

Of the 20 most successful publicly-traded startups over the past five years (measured by current market cap), 14 raised in the neighborhood of $100M or less. Six raised less than $50M. One raised no capital at all. These are shockingly small amounts of money when you consider the median privately-funded unicorn has raised $284 million dollars.

Methodology

Evaluating startup performance is a messy business. Late stage companies are rightfully secretive. Acquisitions are messy financial affairs often engineered to obfuscate the true value of a transaction. The IPO market was the most transparent proxy we could find, and while imperfect, it is instructive. With notable exceptions, most of the biggest outcomes in venture capital are a result of IPOs. By studying the relationship between venture capital and IPOs of the past five years, we can get an idea of whether raising more capital in the best companies correlates to better outcomes.

The Data

  • The data includes 71 companies that raised a total of $10.2B in venture capital
  • Their combined market cap is $566B, or 55X the capital invested
  • The average startup on the list raised $144M in VC to build a company worth$7.9B
  • The median startup on the list raised $79M in VC to build a company worth $1.8B

Pretty exciting results overall! Of course this data set reflects nearly all of the best outcomes in the venture industry over the last five years.

Setting Facebook Aside

Acknowledging that there is only one Facebook and that it is an extreme outlier among outliers, we excluded the company from most of our analyses. Absent Facebook, the overall numbers still look pretty strong, but it is astounding to see how much one company skews the totals:

  • 70 companies that raised $9.6B in venture capital
  • Their combined market cap is $202B, or 21X the original investment
  • The average startup raised $137M to build a company worth $2.8B
  • The median startup on the list raised $79M in VC to build a company worth $1.8B

Exclusions

We only looked at companies that held IPOs between 2011–2015. It would be interesting to go back further than five years, but it is also instructive to examine what is effectively the “unicorn era” in which private companies raised unprecedented amounts of capital. We excluded companies that were founded prior to 2000 (e.g. GoDaddy, FirstData), companies with unorthodox financing paths (e.g. Match Group, RetailMeNot), and companies in Asia and Russia, because they have significantly different financing environments. The result is a dataset, available for review, that includes 71 companies. Most of the data was taken from Crunchbase, except where noted.

We also excluded late-stage private equity, secondary offerings, and debt from the calculations, though they are recorded in the spreadsheet. We were less interested in the money raised in the IPO, as we viewed as a graduation point from the venture capital game and is largely a direct function of company size. The data certainly contains imperfections, though we did our best to get it right, and we’re open to feedback on the dataset, which is why we’re making it public.

The Best Case for “Big VC”

This data might suggest that “go big or go home” makes some financial sense, especially for investors. The most heavily funded companies do have larger total dollar returns. Counted together, the 20 best funded companies on the list raised $6.7B in VC and have an aggregate market cap of $62B, for a ~9X return.

The 20 least funded companies on this list only raised $623M in VC, yet managed to return $48B to investors, or an 77X return.

That’s a $14B dollar difference in aggregate returns. That’s non-trivial, especially to VC as an asset class. However, ~$12B of that difference is accounted for by Twitter, who raised a little less than a billion dollars in VC. So aside from those Facebook and Twitter, venture capitalists spent ~$5B to make an incremental $1B. It’s important to note that the stock market is volatile and that over the course of writing this post, the 20 most enriched companies have fluctuated dramatically. Still, the variance is usually driven by one or two outlier companies.

It is true that there are a few companies founded each year that drive the bulk of the returns. It is also true that in the case of only a couple of outliers (Facebook and Twitter), heavily funding the best companies is a winning strategy for investors. However, It is not clear that VCs have been able to consistently identify the best performers and have instead overfunded even the most successful companies.

This isn’t a knock on the VC model — it’s an asset class predicated on risk. The best firms in our industry have shown an ability to run this high risk playbook over many funds.

It should be a lesson for founders though. Companies like Facebook and Twitter are critical for the health of the ecosystem, but are not a good model for other startups. Unless a founder is very confident that they are building the next Facebook scale business, they would be better served focusing on creating higher multiples instead of a higher exit value.

VCs Have a Portfolio, Entrepreneurs Get One Shot (At a Time)

VC can afford to risk overfunding a dozen companies in order to be a part of the epoch-defining winners, but entrepreneurs only have one shot. As a founder, are you willing to take 4X more risk for what, even in the best cases, results in a 24% premium? That’s basically what the companies on the top of this this list did:

  • The median enriched startup raised $193M to build a company worth $2.1B
  • The median efficient startup raised $37M to build a company worth $1.7B

The financial calculus for founders is even worse than it appears. Incremental funding will probably come with extra dilution, and pre-IPO preferences that will favor the VCs if the startup’s hot streak falters and it doesn’t get public. Beyond the magnitude or risk, more capital limits the number of possible exit paths. The founders of the 20 most efficient companies likely could have successfully sold their companies at any point along their development for a healthy return. Their enriched counterparts are locked into billion dollar exits with diminishing returns on capital.

Is this actually the best model for VCs?

It’s conventional wisdom in the VC market that investors should heavily lean into their winners, but are you better off doubling down on winners for diminishing returns or funding a new crop of startups with the potential to return 10, 20, or 30X?

Davids vs. Goliaths

Though it’s a ridiculously small sample, look at companies that raised an objectively large sum of money — say over $200M (nine companies in this sample), versus an equal number at the bottom of the list. The results are staggering:

  • The most enriched companies raised $567M to return $3.5B or 6X
  • The most efficient companies raised $12.9M to return $2.8B or 218X
  • The most enriched companies raised 44X more money to get a 25% better return

Power laws in venture capital are real, but fundraising is a poor predictor of them. A couple of great companies raised a lot of money, but more money doesn’t make runaway successes any more likely. If you exclude Twitter as well as Facebook, the top 10 most efficient startups actually outperform the 10 most enriched companies.

Less Money = Better Companies?

Market value at the IPO is important because it is often a marker of the venture capital exit value, but it’s also interesting to consider how these enriched companies compare to their efficient peers in the long term as public companies. Does instilling a sense of fiscal restraint early, where growth comes from disciplined customer acquisition, not a venture capitalist’s checkbook, lead to more sustainable businesses?

It turns out the efficient companies have performed significantly better as public companies than the enriched group:

  • The 20 most efficient startups have appreciated by 89% since their IPOs
  • Their enriched counterparts only grew by 22% in the same period.

This trend is even more startling from a modal perspective:

  • 8 of the 20 most enriched startups have actually declined in value since their IPOs
  • Only 3 of 20 of the most efficient companies have lost value since their IPOs

Our hypothesis is that too much capital over time creates a culture that substitutes cash for creativity and operational discipline. Big balance sheets allow companies to grow inefficiently, to paper over problems with headcount and spend, rather than confronting the core engine of value creation. Having less money forces a management team to make hard decisions early on and to cut off potentially wasteful problems that otherwise could linger indefinitely. This efficient ethos becomes part of the long term culture of productive performance that is difficult to infuse in the enriched companies that never operated in a constrained way.

There is a fair counter-argument that the enriched cohort had higher valuations at the time of the IPO and that the value was captured by private market investors rather than public investors. While possibly true, entrepreneurs and VCs should consider the implication of this argument is that public market investors may apply significant discounts to the increasingly large unicorn club that has raised large amounts of private capital prior to an IPO.

Shouldn’t There be a Positive Correlation?

It’s important to take a step back and consider how surprising this data set really is. The venture capital industry accepts as an assumption, that in the best outcomes, more money accelerates more success. Some would argue that it’s nearly impossible for a true winner to be overcapitalized — these companies are reinvesting the capital into their success economic engines after all. Capital gives you the ability to make more investment in drivers of the business — talent, R&D, customer acquisition, etc. Intuitively, it makes sense that enriched companies should do better than their lightly funded counterparts.

We would have expected to see correlation in these numbers and be debating the embedded causality assumption that we assume in the venture industry. In other words, we’d expect to debate whether the money caused the success (causality), but take for granted that the most successful companies were in a position to raise the most money (correlation with unclear causality).

It’s shocking that no meaningful correlation is present in the data. Although the best performing companies are in the best position to raise the most capital, they don’t necessarily do so.

With the exception of a few critical outliers, the better funded companies aren’t meaningfully bigger or better performing and actually become worse public companies. VC is an outlier business, a vocation premised on volatility, but the fact that highly-funded companies aren’t clearly outpacing their cash-restricted competitors shows there is a point of diminishing returns for capital even among the very best companies. The data suggests that VCs struggle to understand where that point is. The adage in VC has been that there are only 15 companies born every year that matter. If loading cash into companies is your game as a VC, it appears that there are only 2 companies over the past 5 years that actually mattered. That’s a nearly impossible game to play.

What About Acquisitions?

It would be fair to object that we’ve excluded acquisitions from this analysis, but they likely would have strengthened, not weakened, the conclusion. It turns out that many recent billion dollar plus acquisitions were efficient with their capital, e.g. WhatsApp ($60.25M), Oculus ($93.55), Nest ($80M), Instagram ($50.5M), Twitch ($35M), Cruise ($18.8M). Mojang — the makers of Minecraft — skipped fundraising entirely before a multi-billion dollar sale to Microsoft. Beats ($300M) and Jet ($565M) are exceptions in this group, but these companies dramatically underperformed their peers in terms of multiples.

Imperfect Data, Clear Results

We know this analysis is imperfect. Some of the companies that IPO’d in 2015 haven’t yet reported four quarters as public companies and even if enriched with VC, might have more positive long term results. Still, this data should give founders and VCs pause. Though increasingly unfashionable in the unicorn era, it is quite possible, and perhaps even advisable, to build a billion dollar publicly-traded company with under $50M in venture capital.

Looking at the data, 15 of the 20 best performing startups of the last five years raised less than $125M from venture capitalists. (We’re including Wayfair in this tally, which didn’t raise any capital for the first 10 years of the company’s life and whose deal was more akin to late stage private equity). Four, Atlassian, Shutterstock, Textura, and SkullCandy succeeded with no venture capital whatsoever. Splunk and Palo Alto Networks, combined, raised approximately $105M and currently have a shared market cap greater than $20B. Groupon and Zynga each raised multiple $100M+ rounds, nearly $2B in total, and are currently worth ~$5B.

Capital Raised Is a Vanity Metric

Fundraising is a strategic choice that needs to be as carefully considered, just like your product roadmap, marketing strategy, or hiring plan. Unfortunately, entrepreneurs tend to make funding decisions opportunistically, or even worse, out of a sense of pride or false validation.

If you’re enjoying success, money will be thrown at you. It’s flattering and having a strong balance sheet can be a good thing, but it does limit optionality and creates more difficult exit paths. Capital is rarely your biggest constraint or the biggest opportunity in front of you. Worst of all, the evidence shows that there is a limit to how much your balance sheet will help the long term value of your company even in the very best outcomes. Putting this data set in perspective, while the enriched companies underperformed, they were modestly financed compared to today’s unicorns. Our median enriched company (top 20 in terms of capital) raised $193M before going public. Today’s unicorns sit at a median of $284M in capital raised and they may yet need to raise more money to reach the public markets. Our data suggests that this is not a positive sign for long term success. Buyers beware!

The point of this isn’t to encourage bootstrapping; nor is it celebrating slow growth. We’re not advocating a “Just Say No” position on raising venture capital — we’re VCs after all. Though some companies are able to achieve huge success without fundraising at all, they are very unusual. Startups don’t get bonus points for trying to build a company on hard mode.

The founders of these efficient startups had the same ambition and hunger to build businesses as their enriched counterparts. They just did a better job of it. These more efficient entrepreneurs are building real, international multi-billion dollar organizations with far less risk and likely own much more of their companies. The surprise in this analysis is that it appears likely that being capital constrained to some degree was helpful, not harmful, in that journey.

This Isn’t an Attack on VC. It’s a Celebration of Entrepreneurs

The mystique of entrepreneurship used to be in the magical act of making something from nothing. Now, we celebrate founders who act like banks by raising huge sums from venture capitalists. We think this is unhealthy and needs to change. While the startup market has been flooded with capital, founders don’t need to raise huge sums to be successful, and it seems that even in the highest upside cases, raising less money leads to better companies. Yet today, most founders are convincing themselves to take the opposite approach.

We’re making an argument for the efficient use venture capital, not against the use of venture capital. Venture Capital is an essential ingredient in the success of many startups, and there are rare times when adding huge amounts of capital is justified. But like most drugs, there is a time and place for their use and the side effects should be clearly noted to potential users.

Our portfolio contains a number of companies that have followed the enriched model and others that were so efficient that they seemed fueled by the scent of a petrol soaked rag. The advice for both is the same. Think about how you would run your company differently if the money in the bank was the last you’d ever get? The answer to that question could make you a billionaire.