The New York Times generated some buzz last year with an eye-catching headline: More Start-Ups Have an Unfamiliar Message for Venture Capitalists: Get Lost. The article gave an account of a diverse group of entrepreneurs who all had one thing in common - they shunned the trendy VC route in favour of alternatives to VC funding. Mara Zepeda, co-founder and CEO of Switchboard told The Times, “The tool of venture capital is so specific to a tiny, tiny fraction of companies. We cannot let ourselves be fooled into thinking that’s the story of the future of American entrepreneurship.”
And Zepeda is absolutely right. While VC is an effective fundraising method and venture capitalists tend to monopolize the headlines in the startup world, that path just isn’t right for every founder.
In reality, there are pros and cons to venture capital, as with any kind of financing. Despite the cons, most founders don’t think it worthwhile to consider any alternatives to VC funding.
Is Venture Capital the Right Fit for Your Company?
Venture capital is the most well-known route to raise funding, and for good reason. According to the Pitchbook-NVCA Venture Monitor, the VC industry deployed $136 billion to almost 11,000 US companies in 2019, up from $27.4 million across 4,500 firms in 2009. Over the past decade, aggregate annual VC deal value grew roughly fivefold.
VC can be a great choice for companies that are:
Since VC investors benefit (significantly) when your company succeeds, they are incentivized to bring more than just money to the table. In that sense, they are one of the most supportive startup financing options. Investors provide key insights for running an effective business, marketing and sales advice, access to valuable networking opportunities and industry connections. The exposure that comes with scoring a big deal can help young companies cultivate demand for their products and attract top talent.
Although playing a prominent role in some of the biggest launches of the decade and truly explosive growth has made “VC” synonymous with “early business financing”, the reality remains that VC funding is the exception, not the norm.
Here’s the deal:
Much of the fivefold growth mentioned above is due to the deal sizes, not the number of companies receiving investments. In fact, only about 3% of surveyed U.S. business owners raised funding from VCs, according to a 2018 survey by Lendio. This could be attributed to a number of factors, with a fundamental one being that most VC firms have specific expectations and “types.” For example, Sequoia Capital focuses on finance, energy, healthcare, enterprise, mobile and internet startups.
What should you do about this?
Tools such as CB Insights and Crunchbase are valuable for identifying VC firms in your vertical.
This, however, is not just limited to the market segment. Investors are always on the lookout for startups that they believe will yield the biggest returns on their investments. Some evidence reveals instances of pattern recognition on the part of investors who are seeking out hot prospects in the startup ecosystem. Pattern recognition occurs when, in their search for fledgling businesses that could multiply their investment, VCs favour those startups that exhibit characteristics of founders and companies that have succeeded before.
The resulting bias makes it a terribly uphill struggle for companies that are not in the same traditional mould to secure funding. This unfairness, that shows no strong signs of receding, will persist for as long as VCs continue to focus on specific profiles and features.
That’s not all...
Increasingly, the actions and decisions of many VC firms are based on a “grow at all costs” mentality. The demand is for companies that are willing - and, ideally, are able - to grow exponentially, even if that growth comes at the expense of sustainability and profitability.
This is a high-risk approach that has resulted in the demise of promising businesses like Tink Labs and Brandless.
In fact, an analysis of 3200 startups concluded that out of the startups that fail, 70% fail due to premature scaling. That makes premature scaling the #1 cause of startup death.
While some businesses are not suited to a “blitzscaling” approach, others are simply not ready for hypergrowth. Given the dominant “go big or go home” VC culture, it seems best to pursue other sources of funding if you find yourself erring towards “go home”.
Why should your startup consider alternatives to VC funding?
#1: Low odds
#2: Spending expectations can make your startup grossly inefficient
#3: Contrary to popular belief, VC Funding is not necessary
#4: Profitable companies are built to last
#5: The myth persists because VC-backed startups are glorified
#1: Low odds
Even though the numbers don’t lie, the stats aren’t stressed enough. Here are a few important ones:
- Compared to taking a senior position at an established company, founders have a <10% chance of earning more money through their startups.
- About 1/167 startups reach $10M revenue.
- About 75% of venture-backed American companies aren’t able to return investors’ capital.
Every entrepreneur who raises venture capital believes that they are the exception. And of course, investors encourage that attitude. It makes sense for a VC to focus on the low-probability, high-reward outcomes.
If you are among the 200 to 500 founders in your investor’s portfolio, then they’ll certainly want you to be focused on the light at the end of the tunnel.
After all, it’s in your investor’s best interests to nurture your faith in the existence of this light at the tunnel’s end.
The venture model has low odds for you.
#2: Spending expectations can make your startup grossly inefficient
You will hear a similar story from most founders who have achieved their fair share of success - an infusion of capital (more than what they even needed at that time) occurred, and they felt pressured to spend it quickly.
But there’s a catch.
When you put that capital to use so quickly, there is a likelihood of a poor return on that investment with your system becoming inefficient. Consequently, the burn rate goes up (by a lot) but the gap isn’t completely closed with profitable earnings.
Therefore, in order to survive, you either need to cut your team and your projects significantly or raise a lot more money.
Oftentimes when you’re pouring money into a channel, you eventually reach a point of diminishing returns, even if it’s been successful in the past. Considering that you’re likely in a growth-at-all-costs mindset (which is what most VCs motivate), you feel pressure to pump more and more capital into the same channels that have worked well up to that point. But pumping in more money may not result in a proportionate increase in ROI.
In fact, the worst-case scenario that this leads to is the demise of a lot of companies that are unable to survive this process. Had they not been killed, these companies may have had a great chance of slowly growing into successful, bigger companies in the long term.
Bottom line?
VC backing can set you up for gross inefficiencies.
#3: Contrary to popular belief, VC Funding is not necessary
In the past 100 years, many companies have executed on tremendously exciting ideas without requiring venture capital. Additionally, many companies have raised venture capital and become extraordinarily successful without even using the VC funding they raised.
But this reality runs counter to the Silicon Valley narrative that if you want to be a successful startup (especially in tech), then you have to bag VC funding.
eBay is among the most famous examples of companies that never utilised the funding from the venture rounds that they raised. They just grew and became so successful that the money ended up staying in the bank.
Google has a similar story, where the founders didn’t need all the cash they had raised in funding.
There is a very limited number of companies for whom the model of VC funding makes sense and works well. It's a reasonable bet for VC investors to target these companies.
A better alternative than this is to find long-term, slowly profitable channels of investment, and only put aside capital for them once a decent ROI has been proven out. At the same time, even after you have proven the ROI, make sure to approach growth with caution of diminishing returns.
Want to learn more about the diminishing returns of startup growth? Check this post out.
VC funding is not necessary - contrary to popular belief.
#4: Profitable companies are built to last
The Growth vs. Profit dilemma
Once you condition yourself to value pure growth as the highest good, you tend to ignore efficiencies that could fetch you greater profit. You ignore efficiencies that could set the foundation for a better, sturdier, and healthier company that’s able to withstand downturns in the market, shifts in the model, competition, or fluctuation in demand.
In the high-growth model, you may develop a marketing machine that guzzles an incredibly high amount of external capital to get going. Once you’re operating within this model, you essentially place a bet on exactly what you are doing or moving towards.
The implication this carries is that you're going to have to face the consequences of any failure to hit those targets. This may lead to downstream developments like cost-cutting measures and layoffs which are: emotional for people, challenging for teams, and harmful for company reputation.
Founders who solidly focus on profit (in contrast to those who aim at explosive growth) build companies that are structured to last for a long time.
#5: The myth persists because VC-backed startups are glorified
What compels so many entrepreneurs to become venture-funded despite the conclusive data against venture-backed performance and numerous examples of companies that walked a different route and came out successful at the other end?
The answer is quite simple:
The culture of glorifying VC-backed startups. The startup world oftentimes equates venture funding with business success. Everyone in this ecosystem feverishly glorifies the phenomenon of raising VC money - the press, entrepreneurs, investors, employees, friends and family members.
And that's why the great VC myth persists.
Decide what you want, before becoming venture backed
The biggest issue with companies trudging down the venture funding route is that they seldom know the reality of what they are signing up for.
Here are 3 pointers for founders to consider before taking VC money:
Risk acceptance
Determine that this is what you want. Look at the statistics for survivability and look at the risk profiles.
You will notice that over 95% of venture-funded startups failed to see the projected return on investment (such as a specific revenue growth rate or the date to break even on cash flow).
Accept the strings
Are you comfortable with the strings that come attached with that funding? In other words, are you comfortable with knowing your personal financial benefit could be far lower than what you might think?
There’s a strong likelihood that you will be a shareholder but that your shares might not be worth much in an eventual sale, or that you might be pushed out of the startup some day. Because of the potential of your stock and stock options, you could also be asked to take an under-market salary.
Additionally, should you accept VC funding, this comes with often aggressive growth targets, which you may or may not be ready for at the time.
Accept the finite number of exit options
When you run a VC-backed company, your exit options are usually 1) acquisition or 2) going public. The idea of VC is to see a substantial return on investment which is usually achieved through these two exit strategies.
This may or may not work for you and is something you need to decide before accepting VC funding.
Conclusion
A lot of these same points are made by venture capitalists themselves - when they meet founders, and publicly on stages as well. A large part of the issue lies in a lot of us not internalizing this knowledge. A problematic role is also played by the culture of glorification which everyone from the media, to entrepreneurs, to VCs participate in.
That being said, VC is a great asset class for startups geared for high growth and scaling with clear exit expectations.
If you're convinced Venture Capital isn't for you, here are 5 alternatives you can consider:
- Debt
- Crowdfunding
- Grants
- Bootstrapping
- Other forms of Investors, including convertible debt, factoring, SBA loans, microfinance, angels, and friends and family)
Additional Resources
The Rise of Alternative Venture Capital | Entrepreneur
Checking Out Venture Capital Funding Alternatives | Visible.vc
Three Viable Alternatives To Venture Capital Funding That All Entrepreneurs Should Know | Forbes
Alternatives to VC Funding That All Founders Should Know About
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