Roger Ehrenberg has an excellent post today on the question of whether there are too many companies or not enough venture capital. Roger’s answer, which I agree with, is “neither” - but there are too many companies that act as if they will raise venture capital. And Roger points out correctly that most of those companies would be much better off if they never put their sights on venture capital and behaved accordingly.
I find myself giving that out as advice a fair bit to entrepreneurs. I meet a lot of people who are starting perfectly good businesses that can be worth in the tens of millions of dollars. If the entrepreneurs own the bulk of those businesses the outcomes will be life changing events. In addition those outcomes can provide excellent returns for angel investors.
It is really useful to provide a numeric example. Let’s say you raise $500K for 20% of your business – that’s a $2 million pre- money and a $2.5 million post-money valuation. Five years later you sell the company for $25 million. Your investors will receive 20% of that or $5 million for a 10x return. And you and your co-founder will split $20 million for a $10 million pay day per person (assuming equal co-founders). I consider that life changing and if you don’t then you have a bigger problem.
Now assume instead that 1 year after your angel round you raise a $5 million venture round at a $15 million pre-money valuation and $20 million post. Well, you have just taken the possibility of that $25 million exit off the table. To start to get into territory that will make the investors happy and have them approve a sale of the company (and they will likely ask for such an approval right) you have to get to an exit value of $60 million or more. And instead of owning 80% of the business you will own something like 50% (after allowing for an option pool). And if you have participating preferred, the first $5 million will go to the VC firm.
Worse yet and this is the crux of Roger’s argument let’s assume that you spend your first year building up a burn rate that assumes that you will raise Venture Capital after 1 year but you fail to do that. Now you are most likely looking at a shut down unless you can convince your angels to give you a bit more money. That’s not only extremely unlikely but even if it happens you will have to restructure the business in a painful way (usually: lay off a bunch of people so that the burn rate is low enough to make a go with the additional angel money).
Bottom line: you are much, much better off operating as if you will not raise venture capital. Then if it turns out that you are onto something big you can always engage in a fundraising progress but you haven’t cut off any options prematurely or added big shutdown risk. If you are not on to something big you can get to cash flow positive on relatively small revenues and then grow from there entirely under your own control. To provide some guidance here, I think that you should avoid taking your burn rate north of 10% of the angel funding you have raised and it is best to initially keep it at 5% until you have some visibility into how well your service or product works.
