One of the most exciting days for a startup company is the day they receive money from an investor. The day someone believes in your idea so much they show up with their checkbook. The TV show Shark Tank unabashedly captures the exuberance that comes with that financial backing.
This guy is not your friend.
However, the opposite should be true…
Instead of popping open champagne in celebration, a lonely evening with a bottle of scotch would be more appropriate. Getting VC money, particularly if your business is pre-profit, is practically a kiss of death.
You have a better chance of winning at craps in Vegas than your company does of succeeding and becoming profitable after your VC check.
Let me clarify that VC money and outside investors, are the same thing. Whether money comes from a major VC company or your father-in-law, outside investment too early is the real problem.
The facts are simple, 75% of venture backed businesses fail according to research by Shikhar Ghosh, a Harvard Business School lecturer.
By comparison, overall only 55% of business startups fail after 5 years. In other words, venture backed businesses are 36% more likely to fail than startups overall in the first 5 years.
So if you’re spending most of your time as a startup seeking out VC funding, you are, statistically speaking, setting yourself up for failure.
Why are so many startups obsessed with outside investments?
The answer is pretty simple. The VC’s want you to be.
Anyone familiar with silicon valley knows of Peter Thiel and how he made his billions on Paypal (a company he co-founded) and Facebook which he bought into in 2004 for $500k in exchange for more than 10% of ownership.
What most people don’t realize is that he’s also invested in over 40 other companies of which you’ve probably never heard of any of them.
This is how venture capitalists work. Even if only 1 out of 4 businesses last, they can still be way ahead of the game. More importantly, they can still win big with an IPO even if the business fails shortly thereafter.
In other words, they don’t much care if your business succeeds.
Why do VC-backed businesses fail at such a high rate?
The Business Genome Project studied over 3200 startups to find out why they fail and their results should be common sense…
The #1 reason 74% of startups fail is premature scaling.
In other words, pre-profit, pre-revenue, or sometimes pre-customer start-ups start hiring and investing in infrastructure.
This is, quite frankly, insane!
Until you can get a sale and a customer, you have no business whatsoever trying to “grow” your business through hiring.
The reason these VC-backed businesses fail is the same reason government is so inefficient. The startup is now playing with someone else’s money.
The founder now no longer feels the pain of losing everything or the need to scrape by on table-scraps when he has $1,000,000 in the bank today after having $0 yesterday.
In the 2 years since my internet lead-generation business started, I’ve had numerous offers from investors that I’ve never accepted for one main reason:
The only thing more money would do for us now is make us less efficient more quickly.
This is true of every business in the early stages.
Even the 25% of VC-backed businesses that succeed are made less efficient with large checks.
As a start-up, you lose either way.
If you get VC money, most likely you’re going to fail. If you don’t fail, then you just gave up a very sizable chunk of your business and control.
The whole concept that to be successful at business you must take risks is ridiculous. The greatest entrepreneurs rarely take major risks and any risks they take are painstakingly calculated. The Heath brothers discuss this in their free Kindle book, The Myth of the Garage.
High risk examples of VC-backed businesses
If you’re still looking forward to that first VC check, let me give you a few examples of businesses that went that route.
- SnapChat – Valued at $4 billion dollars with $0 in revenue and no plans for generating any revenue.
- 4Square – Valued at $600 million dollars with $2 million in revenue.
- Living Social – After being one of the hottest tech startups in the country, it posted a $566 million 3rd quarter loss in October 2012 and I wouldn’t bet on it being around in 10 years.
- Groupon – Which IPOed at over $26 to drop all the way to $2.60 only to now start rebounding back to $10.65 while still losing $.15/share.
- Yodle – Though this business is currently profitable and will probably stay that way, they took a major gamble when they took a profitable start-up with $700k in revenue and leveraged it until it wasn’t profitable again until they had over $100 million in revenue. That’s an extremely large risk to take. I do commend them, however, for proving the business model first.
- Zynga – IPOed in December 2011 around $9.50 before being hyped up to $14.69/share and since tanking to $2.09 and hovering between $2.60 and $4 for the last 52 weeks. Not surprisingly, it’s still not profitable.
Even when you take a group of industry veterans who should know better and put them together to make a “super team”, the injection of too much money too quickly inevitably causes inefficiency and often failure as we saw in the case of BlueGlass SEO.
This list could go on all day. The number of great business ideas and innovations that have been harmed by too much money too early is far larger than those helped.
The concept of riding your idea to change the world a la Mark Zuckerberg is so strong, here’s a list of companies who turned down $100 million dollar buyout offers including Viddy, 4Square, Qwiki and Path.
Keep in mind, many of the VC’s who invested early in the businesses above made a killing when those companies went public or simply sought additional rounds of funding. They made their money on the hype of the IPOs not on the profits of the businesses.
The point is, it’s good business for the VC’s but rarely good business for the businesses themselves.
Private Companies with Higher Profit than their Peers
Here are a few examples of how growing profitably has created great companies.
- Chick Fil-A – $400 million in revenue with no outside capital investments (privately owned)
- Leo Burnett – $600 million in revenue with no outside capital investments (privately owned)
- State Farm – no outside capital investments and now has over 18,000 agents.
- Northwestern Mutual – privately owned and the largest provider of individual direct life insurance in the US
All of these businesses were case studies from the book The Loyalty Effect.
What’s most impressive is that the author didn’t seek out privately owned companies with no outside investments when searching for the most profitable businesses within an industry.
Instead, once he found the most profitable businesses in an industry he realized those were a few things they had in common.
He then examined these businesses and their industries and learned that avoiding outside investments was a major factor in their successes.
Lessons from VC’s
As of the end of 2012:
Apple’s Market Cap was $392BN on Revenue of $156.5 BN for a multiple of 2.5x revenue
Amazon’s Market Cap was $115BN on Revenue of $61BN for a multiple of 1.88x revenue
Netflix’s Market Cap was $12BN on Revenue of $3.6BN for a multiple of 3.33x revenue
Facebook’s Market Cap was $64BN on Revenue of $5.1BN for a multiple of 12.5x revenue
Recently 4Square’s Market Valuation was $600 million on Revenue of $2M for a multiple of 300x revenue
In other words, to match the revenue multiplier of Facebook, 4Square will have to grow its revenue by 2,400% to $48 million.
Maybe 4Square has something up its sleeve to grow revenues 24 fold in the next few years… After all, these VC guys have made billions so they know what they are doing.
Not exactly.
It’s a gamble. A big one. One that’s reliant on public opinion more than actual business fundamentals. That’s what VCs bank on. That’s why Thiel quickly sold the majority of his shares when Facebook went public while making $1 billion dollars.
In other words, early-stage VC’s couldn’t care less if most companies they’ve invested in fail. All they need is for the company to go public to cash out. Even then they only need a small percentage of their investments to go public to make money.
Take the story Tony Hsieh told in his book Delivering Happiness.
After making $30 million on his first web venture, he became a VC and lost almost all of his money by investing in around 30 different ideas. He finally decided to take Zappos over himself and pour in everything he had left in terms of time, money, and passion.
Considering he grew Zappos to over $1 billion in revenue before selling to Amazon, you could say that one paid off. But he was extremely close to losing everything.
He didn’t have to drive himself to the brink of bankruptcy (something he seemed to learn as well) to build a profitable business.
Most ideas don’t need millions of dollars prior to turning a profit to prove a concept. That’s one thing that made Zappos unique. The founder who came to Hsieh with the idea actually proved that it worked by creating his own crude website, selling shoes, and then going down to local shoe retailers to buy the shoes and ship them off.
That method wasn’t profitable but it did PROVE that people would indeed buy shoes online. Once you know that, it’s a lot easier to determine how buying shoes at wholesale, eliminating expensive store fronts, and utilizing an efficient nationwide delivery system can make internet sales of shoes highly profitable.
Considering Hsieh seems to have forced out the original founder (a topic he doesn’t explain in his book) that’s also more proof that VC’s are rarely your friend.
Unfortunately, the rare stories of companies like Instagram and 4Square, along with Shark Tank and the Inc 500, do not put the focus on how to grow a business profitably. They put the focus on securing funding, top-line growth, and cashing out.
That’s how the VC and early-stage outside investors like it.
Unfortunately, that’s very rarely what’s best for your startup.
To your startup success, Bryan
P.S. People who point out problems without providing solutions rarely fully understand the issue. Hopefully my next blog on funding your startup will provide you ideas on some better alternatives to venture capital.
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