Venture Capital – A Necessary Evil?

Money Puzzle

by stevew on January 29, 2010

It’s now the end of Month #1 on my start-up journey, and some sort of progress report is in order.

But before doing so, I want to talk a little about the funding model I’ve chosen for the business. For any start-up, there are two basic funding models: externally funded (via VC, angel or similar), and self-funded, loveably known as bootstrapped.

Starting a business without outside funding is obviously more challenging. So why do it? Why not get some decent funding, build the next great Web 2.0 thingamajig and put the worry of paying the bills aside?

At Business of Software 2008, Dharmesh Shah (CTO of HubSpot) gave a great talk sub-titled Everything I know about start-ups where he talks about the funding choices facing start-ups. (He also covers a bunch of other interesting topics – whilst the video’s nearly an hour long (and a little disjointed in the middle), Dharmesh knows his stuff, so it’s worth watching if you have the time). In his talk, Dharmesh argues that it isn’t specifically the state of being funded that is the issue; it’s all the palaver of getting to that point. As he notes, whilst you’re spending all your time and energy trying to raise funds, you could just as well be out there building your product, signing up customers and getting a head-start on your competition (or perhaps even catching them up).

Another issue is around the odds of success. I have heard all kinds of stats regarding the expected success rate of VC-funded start-ups – the figure most often quoted is that one in ten to one in twenty make the big-time. Best case this gives you a probability of success of 10%. Using slightly more scientific data from this blog article by Mark Peter Davis suggests a 1 in 3 likelihood of real success (i.e., a genuinely profitable exit). That’s not to say that self-funded start-ups are guaranteed to fare better, but to set foot in the office each day knowing there is a 66.7% chance of walking away at the end pretty much empty-handed doesn’t sound like a great motivator to me.
[Post-publication edit: Came across this set of stats from a very interesting talk Heidi Roizen gave at Business of Software 2009 - makes the point all the more clearly.]

This probability game has other undesirable side-effects, as Joel Spolsky observes (emphasis added):

The fundamental reason [to avoid venture capital] is that VCs do not have goals that are aligned with the goals of the company founders. This creates a built-in source of stress in the relationship. Specifically, founders would prefer reasonable success with high probability, while VCs are looking for fantastic hit-it-out-of-the-ballpark success with low probability.

Of course, if you have got The Next Great Idea and you need to move extremely fast on it (once you’ve jumped through all the VC’s hoops), and you genuinely believe you can build the next Twitter, then don’t let me get in your way!

The Benefits of Bootstrapping

This all seems rather anti-VC, and it would be wrong of me to write off a fundamental plank of our capitalist society. My point is simply that it very often just doesn’t make sense to go down the venture route, and that for many start-ups, bootstrapping the business has a number of significant upsides. One of the not-so-obvious benefits is that bootstrapping tends to promote Sensible Behaviour, as Dharmesh points out in the video. The tendency to do stupid things with money just isn’t an option when you’re self-funded. Of necessity, bootstrappers are forced to be more creative to solve problems as they simply can’t throw money at the issue. (You might think this is a not such a big deal for VC-funded businesses, but every time money is wasted, obviously value for the founders is lost).

On the website to market his book Bootstrapping Your Business, Greg Gianforte offers eight advantages of bootstrapped businesses over VC-funded businesses. Following on from one of my themes in an earlier post, one advantage particularly resonates with me:

Bootstrappers have more freedom and flexibility. When you take external funding, you become a slave to your business plan and you have to constantly answer to third parties: banks, private investors, grant agencies, etc…

(Of course, I have to answer to a higher authority… …my wife!)

In short, it makes a lot more sense for Cornerstone to be self-funded; it’s just a matter of bringing in a customer or two to get the pump primed. As Neil Davidson of Red Gate says on the Business of Software blog, this doesn’t have to be a grand opportunity:

Our first product – an online bug tracking system – never followed the hockey stick curve of our business plan. But it didn’t matter. You don’t need stratospheric growth and a billion dollar addressable market to bootstrap a software company. A $50,000 market opportunity is enough to get you off the ground – once you get started you’ll figure out the rest.

(Curiously, my first firm bought that product. It wasn’t very good, but that didn’t stop Red Gate going on to be one of the leading tool vendors for .NET. Thanks to Jason Cohen for pointing this quote out in his blog.)

Captain’s Log, Star Date January 29, 2010

Anyway, I promised a status report. Despite being self-funded, I have rented some modest office space 2.5 miles (4.02336 km according to Google) from my home. Although it’s local and therefore reasonably inexpensive, I decided to take the hit to avoid any loss of domestic bliss at the family home. I learnt this the hard way last time around – the excitement of your shiny new start-up soon wears off on the other half when the dining room is full of PCs, servers and papers with no light at the end of the tunnel. I also needed the discipline of “going to work” each day, despite not having a real job.

I have acquired some second-hand hardware, joined Microsoft’s BizSpark programme (highly recommended – it gives the business free access to Microsoft platforms and developer tools) and got myself ready to build software professionally (to a large extent, at least). I’ve met with quite a few ex-colleagues and contacts, exploring business opportunities, and a few ideas have come up – nothing that I have confidence to pursue yet though. Hopefully over the next month some of this will crystallise and I can get on with the serious business of ensuring the business doesn’t run out of money before next quarter.

Are there other advantages or disadvantages to self-funded businesses I’ve missed? Or if you have relevant experience with either a self-funded or a VC-funded business, please leave a comment and let me know.

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{ 3 comments… read them below or add one }

Jason Cohen January 30, 2010 at 5:14 pm

Great post, and thanks for the shout-out.

You’ve got the major arguments covered, but there’s a new argument based on what’s changed since Joel wrote that piece, Neil wrote his, and I bootstrapped Smart Bear.

Today if you’re a first-time founder you have a very hard time raising money on any idea, especially since there are second-time folks with a success under their belt in front of you in line.

The conventional wisdom says that ideas are worthless (I agree), and therefore before you approach VC you’ll need at least a (shaky) v1.0 built (to prove you can do so), a few customers giving you money (to prove that can happen), and some small but visible growth (to prove it wasn’t a fluke).

But of course by the time you get to that point, do you need VC? If yes, at least you can get a much better valuation, but probably the answer is no.

Another thing to be cautious about with bootstrapping is that the starvation, although leading to good habits like thrift, also lead to bad habits like being distracted by consulting offers (cause you need the cash) or not being able to capitalize on some opportunities just because you don’t have the cash or manpower.

This is OK if you’re working on a business that doesn’t need big attention to be successful! It’s bad if your business aspirations aren’t compatible with slow growth.
.-= Jason Cohen´s last blog ..A Tradeshow Checklist, born of experience =-.

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stevew January 31, 2010 at 7:05 pm

Jason – many thanks for the feedback. I wasn’t aware of this issue – that getting funded as a first-time entrepreneur is getting more difficult due to the number of second-time founders on the scene. Interesting dynamic – but then ten years ago there was no such thing as Y Combinator – if I was twenty years younger and had no family commitments, I’d be on a plane tomorrow to the West Coast, looking to dream up something Paul & Co would be prepared to jump-start. (I know that cuts across everything I said above, but of course when you’re young and have no commitments, you’re in a better position to tolerate risk, and I reckon the opportunity to learn from the wealth of experience out there is probably unmatched.)

Regarding bad habits caused by lack of cash, I couldn’t agree more – in my first business we spent nearly a year on a BizTalk consulting project with a large corporate which added nothing to our product repertoire, just because we needed the money. The lesson for me there was not to grow your cost base faster than your product revenue can easily sustain, but as you point out, that means maybe missing out on real product development opportunities. I think you just have to face that the self-funded route is more tortoise than hare.

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Doug Grossman February 3, 2010 at 7:11 am

Steve,

You had responded to one of my Questions at Answers.Startups a month back and I have been checking out your blog since then. Ive found your posts, images and YouTube links very informative. Looking forward to seeing what direction you end up taking the new venture. I’ll be breaking away from the corporate life myself before year end and have found all this information quite motivational.

Doug

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