I’ve talked to quite a few people who were considering founding their own startups. Many of them were quite inexperienced regarding, well, everything, as they were either fresh out of University or currently in a day job which was completely unrelated to startups, the economy and broader reality (mostly doctors).
All of them tell me that their first step would be to get some Venture Capital (VC) funding. And all of them seem to have completely distorted views on what that means. So this is my attempt to clear up the confusion. Then again, it could be me who has the distorted views. Anyway, read on and then it’s on you to decide whether VC funding is right for you.
First off, in case you didn’t know it, VC stands for Venture Capital and essentially describes a bunch of dudes who buy parts of companies. You often hear the announcements of these funding rounds in the startup news: “Company MagicalUnicorn receives 10m € funding from famous investor DudeFund! Great success! This will enable them to democratize food delivery by blabla scaling up blabla.”
Now, you might think “sweet, I would also like to receive 10 million Euros”, and I wouldn’t disagree with you. Everyone would like to receive 10 million Euros.
On a quick side note, let’s talk about lottery winners for a moment. Their situation might seem quite similar. After receiving their winnings, they often end up unhappy, broke, or worse yet, dead. Why is this relevant? Because, surprisingly, the words “unhappy, broke, dead” are also suitable for describing most VC-funded startup.
So, what about those 10 million Euros? If MagicalUnicorn were your company, would you as a founder personally receive that sweet cash when your company gets VC funding? Nope. So what’s going on here? What actually happened is that a part of your company got sold for 10 million Euros – yep, that’s right. In other words, the situation was as follows: You and your co-founders were running your MagicalUnicorn company, and things were going reasonably well. There was only one problem: Your company was not profitable. You know, in ancient times, when Peter Drucker, the Master Yoda of business books, was still roaming the planet (alongside dinosaurs, probably) and writing business books, the definition of a successful company actually included the fact that the company was making more money than it was spending – it was profitable.
That definition seems to have been forgotten, just like the dinosaurs, and nowadays the success of companies seems to be judged by other, totally arbitrary metrics. Those metrics go by many names. Maybe it’s the amount of customers a company has, or the speed at which that customer base is growing. Business dudes like to call it traction, but I’m not sure whether the business dudes actually know what they mean by that. Regardless, whatever traction may be, the minor problem is that, well, having traction doesn’t magically make your company profitable. If you spend more money than you make, you’re screwed. And once you’re screwed, that’s where VC funding comes in, and in all likelihood, it screws you even more.
VC dudes look at your company and will be like “hm, this business is currently not profitable, but if we give it lots of money, it’ll turn into a magical unicorn and everyone is going to be happy!”. Note that the VC dude’s definition of “happy” doesn’t include “profitable”. Their definition of “happy” actually translates to something different. I’ll get to that in a bit.
VC Funding Is Not a Success, It’s a Failure
The first and main takeaway is this: Companies which receive VC funding are not profitable. They would run out of money if they wouldn’t get the VC funding. So the news announcement that your company MagicalUnicorn received VC funding is actually not a message of success, it’s rather a confession of failure. You confess that you as a founder were still not able to make the company profitable with the resources you currently had. You’re bleeding money, and you need more.
So, we’d actually need to rewrite all news headlines related to VC funding. Instead of a headline like this:
“Company MagicalUnicorn receives 10m € funding from famous investor DudeFund! Great success! This will enable them to democratize food delivery by blabla scaling up blabla.”
We’d need to write:
“Company MagicalUnicorn has still not figured out how to perform food delivery in a profitable way. They’re going to run out of money soon. But to buy themselves more time, they sold parts of the company for 10m € to the VC investor DudeFund.”
Does this still sound like success to you? Is this the kind of news headline under which you’d like to see a picture of yourself and your co-founders, proudly posing in front of your company office, an office which you’re paying for with money your company didn’t make?
Whether you agree with me or not, I think we can agree that it’s a matter of perspective. Different people might rate these funding events on a spectrum anywhere between “crazy successes” and “crazy failures”. Many people might choose something in the middle. But, the weird thing ist that, for whatever reason, our mainstream media chooses to describe them as the most extremely positive thing on the spectrum, “crazy successes”. I think that’s very distorted and some more objective reporting might be in order.
Okay, so now your company has received VC funding. What does that mean? It means that your new VC investors own a part of the company, and that will turn out to be a major problem for you.
VC Funding Means You Will Sell Your Company
Remember when I wrote earlier that the VC dudes definition of “making everyone happy” after investing in your company doesn’t mean making it profitable? So now you might ask: Okay, so what do my VC investors want?
Well, most humans on this planet are incentivized in a capitalistic way to make more money, and VC dudes are no exception – quite the contrary. They want to make a lot more money.
How does this work? They’ll buy a certain percentage (business dudes call them “shares”) of your company, e.g. 10% of MagicalUnicorn, for a certain sum of money, e.g. 10m €. Their plan is to sell this percentage of your company for a higher price in the future – maybe 1000m €, that would be a 100x return, not too bad (but VCs might actually expect even more).
(Who do they sell these shares to? The most common scenarios would be selling your entire company to another huge company (think Google), or by “going public” on the stock exchange which essentially just means that they can sell their shares to random people on the stock exchange.)
Now, all of this might be none of your business, you might think. But it is! Because now the inevitable consequence, once you’ve taken VC funding, is that the objective of your company has changed: You’re no longer building your company the way you like it. You’re building your and the VCs company so that they can sell it, for a price higher than the one they paid. There are no alternatives. The course is set. You’re building to sell.
If you had any romanticized notion of building the company of your dreams with your employees becoming your best friends or family, well, now’s the time to let go of those ideas, because you’re about to sell your family for a lot of money. I often chuckle at VC-backed startup founders describing their startups as their “baby”. I mean.. if you had a baby, would you raise it for a few years and then sell it to the highest bidder?
Are you okay with that?
Most people are not. Then again, most people only realize this after they’ve taken VC funding.
Second-Order Effects
This leads to some really interesting second-order effects.
Because your goal is to sell the company later, it has to grow. That means that you will hire lots of people even though you might not want to hire them. For what it’s worth, you might prefer to work with 10 employees, but a company with 10 employees is not very valuable. You’ll have to hire many, many more. Besides the obvious effect that your company now becomes much slower as many more meetings have to take place, you’ll also have the non-obvious effect that you hire people who are not perfect fits for your team.
You’ll be spending much of your time on finding the next investors. Now that you’ve got funding, you’re all set and can spend time building your company, right? Wrong. Your funding only lasts you so long, say, two years or so. So before that time is up you’ll have to go and look for new funding again, either from DudeFund or from another VC. That might take six to twelve months. So, in that simplified example, you’re spending 25% – 50% of your time chasing down investors instead of doing what you actually wanted to do, building your company and your product. You’ll have to trust your employees to do that for you. Maybe that will work. But is that the setup you wanted?
You have to focus on large markets with many (or large) customers. You might encounter the opportunity of building a niche product for a small market – like, appointment scheduling software for Psychotherapists in Berlin. Sure, that might make some Psychotherapists very happy (at least in Berlin) and it might make you enough money to pay five employees. But it will make nowhere near enough money to pay for five hundred employees, and that’s what your VC investors want. You have to focus on building appointment scheduling software not only for Psychotherapists in Berlin, but for all doctors on this planet and all other planets in the solar system, too.
Making existing customers happy is less important than acquiring many more new customers. Your existing customers might be reasonably happy with your product. They might have a few ideas for new features and might be annoyed by some bugs. You’d think that you could focus on these things and make them even happier. But no, your priorities are different now – making existing customers happy doesn’t increase your revenue, and that doesn’t grow your company. You have to focus on acquiring new customers. Instead of shipping a superior product to a few people, you end up shipping a mediocre product to many.
Finally – and this is my biggest point – profitability takes a back seat.
Profitability Takes a Back Seat, And This Kills Your Company
Let’s take a step back and imagine a successful, old-school business for a moment. Let’s say your’re running a restaurant. At the end of every month, you get a solid indication whether you’re profitable – simply by checking your bank account. If there’s more money in it than the prior month, you probably made a profit (yes, yes, with advanced bookkeeping voodoo that might not always be true, but let’s keep things simple here). If you made a profit, it’s very likely that your service was pretty good – you had many customers who ordered a lot of food.
This reasoning can be flipped around, too: If your service deteriorates, maybe because your food sucks, then you’ll likely have less customers, make less money, and be less profitable (or maybe even make a loss) at the end of the month. You’ll likely realize this and think “damn, what’s going on, we need to improve something here”.
You might realize that you recently hired a new chef and that their cooking sucks. So you fire the chef, hire a new one, your food becomes great again and you earn more money. Problem solved!
This “feedback loop of profitability” is, in my opinion, the most important feedback loop any business can ever have. It’s the reason capitalism as a system works (mostly). It constantly forces you to question whether you’re doing the right thing. And “doing the right thing” usually means how you spend your time, and how you spend your money.
In your restaurant, would it make sense for your chef to spend their first six months on building a stove? No, that doesn’t make a lot of sense – your chef should instead be preparing food and supervising other people in the kitchen. Buy the stove, don’t build it yourself.
This may sound obvious. Yet, at VC-backed software startups, I see software engineers spending months on building “internal tooling” without shipping an actual product.
In your restaurant, would it make sense to purchase gold-plated toilets for the bathrooms? No, that doesn’t make a lot of sense because those won’t bring in more customers. Good food, however, will.
This, again, may sound obvious. Yet, at VC-backed software startup, I’ve seen insane purchases. Phone booths for 10k€ a piece? No problem. Hiring a boutique designer firm to redesign your WordPress website for 50k€? Sure. Gold-plated toilets? Who knows.
Besides losing whatever remnant of cost control you had, the implications are even wider. Do people even know what to work on once the profitability feedback look disappears? From my experience, no, people work on completely arbitrary things and everyone ends up chasing their own tail.
One quarter the priority is “we need to ship our product”, the next quarter it’s “our investors want us to have customers, so let’s have some customers”, and after that it might be “no one is using our software, but our investors want to see traction, so let’s generate some traction”.
None of these are connected to profitability. Worse yet, these arbitrary metrics lead to even weirder things, for example handing out your product for free to show your investors that you have customers. So your arbitrary priorities might actually endanger your profitability. Crazy.
You think that’s all? Nope! Because priorities aren’t clear, discussions and meetings in your company also won’t be clear. People will no longer discuss things of immediate urgency, like in the restaurant (“why does our food suck?”) – instead, discussion topics will be all over the place, like which coffee machine to buy, which great feature was recently shipped (yet totally irrelevant), which rockstar developer you hired, or whose feature idea gets implemented next. Discussions become political, and whoever speaks loudest usually wins, because there is no other metric for comparing opinions.
So. Don’t take VC funding.
Addendum: “But This Company Is Only Possible With Funding!”
Now you might say “dude, all of your points make sense, but my company MagicalUnicorn is only possible with VC funding because it has huge up-front costs”.
Valid point, but I’d caution you to think again whether that’s really true. Yes, some companies might truly have huge up-front costs and therefore require investments – like if you want to build cars or shoot rockets to Mars. But, besides those two examples, most other real-world companies are less capital intensive and you might be surprised by how many options you have for bootstrapping it yourself.
My favorite method is to start with consulting – not because that’s superior, but because that’s what I did with my company OpenRegulatory and it worked well for me. Want to start a medical software company? Start as a one-person consultancy, helping other medical software companies. You could help them with product management or developing software. You’ll learn tons about medical software and build a great network of people. Most importantly, you’ll learn about the problems those companies are facing. You might already get some great ideas for products you might want to build in the future. Once you’ve saved some money, hire your first employee. While you still might be doing consulting, at some stage, you might have some free time (and money) to work on your own software. You try to sell it to your existing consulting customers. Some may buy. And then hire the next person. And so on. You get the idea.
Most product-based businesses can be “projectified” to something more akin to consulting. Give it a try. You’ll learn many things along the way which will be invaluable later on – meeting other companies in the industry and learning about their products, finding a good tax advisor, hiring and managing people, and yes.. being profitable.
This hit Hacker News #1 on July 9th, 2023 (cool!), here’s the link to the discussion. Oh, and now that there’s actually more than one person reading my blog (chuckle), check out our job openings at OpenRegulatory, specifically the Rails position. We’re not hiring right now (we’re 4 people and profitable), but might be looking for a senior Rails dude or dudess in the next few months. Feel free to reach out in any case if you’re interested!
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