Today I posted a guest article at OnStartups titled "Why VCs Avoid Innovation: They Like Making Money". I urge readers to "Note the cruel irony here. In the VC business, a business that claims (with heartfelt feeling) to be devoted to furthering innovation, innovation is deadly. "
On this blog I'd like to address an issue that is more important to our users, who are generally founders, and not VC's. VC investment is risky for founders. Even in cases where the investors do well, the founders often find themselves with minimal payouts. In the other cases, the founders are out on the street.
I was discussing this last night with a friend who works in the VC business, and her comment was "Most entrepreneurs don't understand the pressure that they will be under to generate a hockey stick". In this jargon, "hockey stick" = "uninterrupted exponential growth curve".
Her comment leads us to a clear explanation of why VC investments are structurally not compatible with innovation, and how to deal with that. Innovation takes an unpredictable amount of time. You have to try a few things to see what will work. VC investors, on the other hand, need immediate and predictable growth, and rapid exits.
Fast exits are important. A friend of mine once asked me to join with him in putting together a seed-stage investment business. I looked at some papers that studied VC returns, and it jumped out at me that in that time period, typical VC exit multiples were basically the same, regardless of how long it took to get to an exit, at about 4X. So, an investment will typically return 4X whether you hold it for one year, or ten years. If this statistical quirk is true, the IRR (Internal RATE of return) is much higher for fast exits and lower for long projects. Seed stage is furthest from exit, so it's a tough business.
Founders see the same time effect, amplified. If a new venture grows in a straight (logarithmic) line from a VC investment, to an exit, in a short time, the founder will make money. If it takes a long time and more investment rounds, the founder will be diluted and won't make anything for all the work of founding. He/she will make about the same amount that a new executive will make off options. If there is ever a "down round", the founder will be out. This is likely to happen just through random motion if the time to exit is more than a few years, or if you try to innovate.
This gives us a plan for how to use VC money effectively, from the founder's point of view. Let's look at some cases:
1) If you are supremely confident that you are on the hockey stick and you can grow sales exponentially without interruption, then go for it. You and the VC's are going to do great. If you need any innovation that will put uncertainty into this schedule while you try a few things, your confidence is probably not justified, and the odds are against you. However, fortune favors the bold. It worked for Larry and Sergei.
2) You are already set up for an exit. If you know how you can get to a fast exit, you know you are already in a good case for a founder, and you can avoid the bad cases. This is a very useful rule, because you can act on it. Before you start fundraising, you can adjust your business plan and talk to a few people about assets they might be interested in acquiring. If you see possible acquisition offers, that might make you more likely to take an equity investment. That's what we are seeing in silicon valley now, with stories that Yelp etc. turned down acquisitions in favor of equity investments.
3) You are diversified with other assets and projects and you can afford to take a big risk. This puts you in the same position as the VC's, and you will get along. Ironically, VC's will try to increase your concentration of risk and disrupt this harmony of interests.
4) If you can get more money than you need. This can happen because there is a lot of money floating around in the macro environment, or because you have a particularly hot deal, or because you are profitable and don't need the money. It's what happened with "hot deal" Dharmesh, once a proponent of capital efficient startups, and his $33M of fundraising. In this case, as they say, you "take the goddamn money". Then, you are insulated from further investor pressure, and you can try a few new things. From a financial point of view, this situation is wasteful and inefficient. However, I have a suspicion that it often works out well for the investors because it creates the conditions for true innovation.
And, that is the goal. Truly big innovations need big and bold investment. Sometimes, the stars are aligned, and it works.