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Standing outside of the Mercy Virtual facility in St. Louis on an unusually cold fall day, I was on the phone with two founders who were pitching me on a new blockchain startup. They had a few customers and some early traction, but nothing to indicate product-market fit. And yet, they had raised $3.5 million from crypto investors in an Initial Exchange Offering (IEO) to grow the team and build product. Remarkably, the $3.5 million they raised was non-dilutive, meaning they didn’t have to give up equity in their business the same way you would have to through traditional venture capital.
“We’re planning on raising traditional venture because it’s a great time to do so,” said one of the founders. “Our friends have raised at $45 million and $50 million valuations on Memorandums of Understanding (MOUs), and the money’s there.”
“Yeah, OK. I get that. Good strategy,” I responded. “But, do you actually need the money to grow the company? What is the use of proceeds?”
“If it’s there, let’s take it,” was the founder’s thinking.
This anecote exemplifes how, over the past decade, venture capitalists have plowed more than $500 billion into startups, and accelerator programs have proliferated as entrepreneurs from around the nation started looking to take advantage of healthy capital markets. If you wanted to build a startup, many founders believed the first step was to raise venture capital. Unfortunately, the data does not support this contention. Only 1 percent of entrepreneurs are able to raise any form of venture capital. Even more disconcerting, of those that do, only 42 percent are able to raise Series A financing and beyond.
Put simply: You do not need to raise venture capital to build a great business. In fact, many entrepreneurs are now refraining from raising venture investment because of both the pressure it places on founders, as well as issues centered on dilution of ownership.
Fortunately, there are some clear signals you will encounter indicating as much. Chief amongst these is asking yourself the question as to whether the type of business you are building is “venture backable” or not. Second, you should ask yourself: Just because capital is available, does your business need it? And third, you should look to understand how much dilution of ownership and control you are willing to accept.
Is Your Business “Venture Backable”?
Recently, I was sitting in the middle of a Blue Bottle with a friend of mine who was starting a mobile application for people looking to spend time with other owners’s dogs. No, this is not a joke. This founder was having trouble raising capital. I told him the market was too small and said that if he expanded the concept to include a market for pet food and services, he could transform his business into something “venture backable.”
What this entrepreneur failed to grasp was the difference between a “venture backable” business and a “lifestyle business.” A venture backable business is a company whose business model and technology have the potential to generate significantly outsized returns, often 100 times or more of the valuation of initial investment and a $1 billion plus valuation. By contrast, a lifestyle business is a company whose business may be successful, even immensely profitable, but lacks the opportunity to scale into a market dominant position. This may be due to limits in the overall size of the market, growth being related to adding team members rather than automating processes or lack of network effects.
Many first-time entrepreneurs fail to grasp the important distinctions between these two types of businesses. Just because an entrepreneur is passionate about a given market, idea or product does not mean it will automatically be “venture backable.” Founders need to ask themselves whether the scale of opportunity, the marketplace dynamics, customer acquisition opportunities and ability to generate network effects places their business in the venture backable or lifestyle categories. And if you are building a “lifestyle business” that you are passionate about, do it! Just because it’s not venture backed doesn’t mean it’s not a great idea.
Just Because It’s There Doesn’t Mean You Need to Take It
Let’s go back to my conversation at the beginning of this article. Repeatedly, the founders indicated that they were raising capital “because they could.” And yet, they did not indicate how they would deploy their capital. They just figured they should “because it’s there.”
For entrepreneurs good at raising capital, this is a bad trap to fall into. Smart investors look for a clear plan of action for use of proceeds, hiring, scaling sales and product investments. The best investors are looking to understand how capital raised today is going to be deployed to ensure the business’s capacity at raising capital tomorrow. Just raising “because you can” is not good enough. Entrepreneurs need a plan of action for capital deployment after fundraising.
Understand Dilution Before Raising
When raising capital, many entrepreneurs underestimate the amount of dilution they will face when including external investors on their cap table. Roughly, dilution is the percentage of ownership in your company offered in exchange for capital. Investors often drive a hard bargain here; their goal is to get into the company with the lowest variable valuation. This often results in a high level of dilution for the original founding team. If you a founder concerned about dilution or uncomfortable with the level of ownership you will have to give away, you should refrain from raising traditional venture capital.
There are other sources of financing available. You can raise angel money from friends and family. If you have some revenue, you can raise venture debt from Silicon Valley Bank or other specialized lenders. If you have real property assets, you can take out a more traditional loan or line of credit. You do not have to accept dilution you find unacceptable just because you want to raise capital.
When starting a business, entrepreneurs should understand the leading indicators demonstrating why they shouldn’t raise venture capital. Key among these is understanding the difference between a venture backable business and a lifestyle business, not taking capital just “because it’s there” and understanding the dilution that comes alongside raising venture money.