Funding

A Game of Venture Loans

Game of thrones venture capital startups entrepreneurship investing

The premiere of the final season of Game of Thrones is tonight. I am sure it will not surprise you to learn that I am a massive fan. I have read the books and watched and rewatched the series. One of the major overarching themes of the show is the zero-sum competition all characters experience in Westeros.

In the game of thrones, you either win or you die.

At a much more benign level, we see this zero-sum phenomenon play out in our world too. One of the reasons I have never been particularly enamored with the public markets is that there is someone “on the other end” of every trade. What this means, is that if you are purchasing a stock, the person who is selling you that stock almost always expects it to go down. If the stock goes up, you win and they lose.

I love venture in part because it is not a zero-sum game. There isn’t anyone sitting on the other end of our “trade.” When done well, there is enough incentive alignment to ensure that no party is succeeding at the cost of anyone else. Investors in funds win when VCs win when entrepreneurs win (say that fast five times). Perfectly in balance, as all things should be <<insert Thanos meme here>> (speaking of Thanos, it’s kinda wild that GoT, Avengers, and Star Wars are all concluding in 2019. I am firmly aboard each respective hype train, but it will be a bit bummer when all is said and done).

The one area that this does not necessarily hold true is getting into a hot round. The dynamics are such that in venture, entrepreneurs are always trying to thread the needle between raising too little (short cash runway) and raising too much (dilution). This means that for a given company, at a given valuation, there is going to be a cap to the amount of money the entrepreneur is going to want to raise. For most entrepreneurs, the worry is getting enough dollars in the door to close out the round, but for the hottest deals with experienced entrepreneurs or in a sexy space, rounds can fill up quickly. This can lead to significant competition between investors trying to get into the round. While not as competitive as Stark vs Lannister, things can heat up pretty quickly.

I should note that I have only ever witnessed this competition second-hand. My experience so far has mostly been centered around investing in the Midwest where the focus is much more on getting enough money around the table than trying to elbow to the front of the line. The simple fact is that there are not nearly the same numbers of investors here as there are in a bay area or a New York. That is changing as more and more people start paying attention to the exciting things being built in cities like Columbus, Pittsburgh, Kansas City and more.

I am thrilled for this increased attention and I think that it will be hugely beneficial to the region as a whole.

My one hope is that midwestern investors can maintain the same collaborative nature that they have cultivated thus far.

Because zero-sum competition is not a ton of fun.

Just ask the Starks.

Is Venture Capital right for your Business?

Is venture capital right for my business

So you’ve built a business. You’ve got an interesting idea and you think there could be potential for growth. In this post I am going to help you think through whether or not venture capital funding might be right for you and your business.

What is Venture Capital Financing?

Venture Capital is the riskiest of risked capital financing. It is chiefly used to support technology startups. VC firms receive money from investors such as high-net worth individuals, pension programs, and corporations and invest that money into companies in exchange for a portion of the ownership of said company. VCs are compensated with management fees on the amount of money they are managing (usually around 2%) and they also share in the gains on each investment in the form of carried interest (usually 20% of any gains). Carried interest (allegedly) got its name from ship captains who would receive 20% of the cargo for any goods that successfully completed the journey. Carried interest comes into play whenever a gain is realized for an investment. This occurs when A) the company is acquired by another company or B) when the company goes public. That’s it. There are other fringe ways for a investors to get liquidity (fancy word for their money back), but for the most part every investment is taken with an eye towards one of these two scenarios eventually occuring.

I note the incentive structures at play here because it is important to understand one key tenet of Venture Capital:

When the company wins, everyone wins.

Now there is obviously a TON of nuance to this statement and a host of different scenarios that can play out in the chaotic adventure that is investing into startups, but it is important to understand that at the core of any investment, the entrepreneur and the investor’s incentives are, by-in-large, aligned.

Different VC firms invest in different types of companies across a variety of stages. Stages represent how mature a business is. There are three important buckets of stages to remember. Seed stage companies (Pre-seed, Seed, Seed+) are in their infancy and usually have yet to successfully deploy a product at any sort of scale. Early stage companies (Series A, Series B) have successfully launched their product and are starting to ramp up their scaling efforts. Growth stage companies (Series C and later) have an established business and are focused on expansion. After growth you get into the world of more mainstream Private Equity. My focus is on the Seed and Early stages.

Is Venture Capital Funding Right for your Business?

My favorite metaphor for venture capital is from Josh Kopelman at First Round Capital. He says that venture capitalists are like jet fuel salesman. Jet fuel is awesome when you are building a jet. It is significantly less awesome when you are building a motorcycle. There is nothing wrong with building a motorcycle. In fact, motorcycles are pretty sweet. They are just not built to successfully and sustainably use jet fuel. Similarly, Venture Capital funding is not right for every business Here are some of the characteristics that a business needs to have before a VC will consider it for an investment.

First, a business must have the potential for an exit. Remember, for a VC to get their money back to their own investors (and hopefully make some money themselves) there has to be a pathway to that company eventually having an exit to an acquirer or to the public markets. There doesn’t have to be (and usually isn’t) an obvious acquirer, but there has to at least be the potential for an acquisition one day down the road. What about the public markets? Going public through an Initial Public Offering is the holy grail for venture capitalists. Like the holy grail, it is an outcome that is very difficult to find. While this exit strategy is often discussed, it is rarely focused on (or at least should be rarely focused on), especially at the seed and early stages. Having a company IPO is a fantastic outcome for investors, but there are so many things that need to align perfectly for this to occur, that it is rarely worth focusing on too much before the company has some serious momentum behind it.

The second key characteristic is that the company must be scalable. Scalability can take a lot of different shapes, but at the end of the day, there must be significant potential for a company to grow before any venture capitalist will consider it for an investment. Growing the business is what a VC will want their money to go towards. Profits are not the goal in early venture capital. Many startups that could be profitable, choose not to so that they can pump their money into the growth of their business. An initial upfront investment of time, money, and resources can propel a company to significantly greater heights much, much quicker than it would be able to achieve on its own. A company doesn’t need to have its entire growth plan figured out to receive an investment, but it does need to have the potential for growth. A business that is overly reliant on the expertise of the founder will have a difficult time attracting venture capital investments because individual humans don’t scale. Technology scales. Business models can be designed to scale. But people don’t. This simple fact is why the bulk of venture capital investments goes to software companies. Software takes a lot of upfront effort to build, but once it is built, it is relatively easy to duplicate and distribute it.

The final key characteristic is that the company must do or make something of value to someone. This may sound obvious, but I can assure you that, in practice, it is anything but. I have seen startup after startup come along that may be doing something novel or interesting, but it isn’t creating any real value for anyone. The best framework to think about whether your company creates value or not is to consider what problem your company is solving. How many people are experiencing that problem? How acute is the pain they are feeling? Is it a “hair-on-fire” problem, or is your product a “nice-to-have” item? Thinking through these questions will help you pinpoint who your potential customers are and whether they would be willing to pay for your good or service. You can build a successful business if the problem you are solving is experienced by a large number of people or if it is a Top-5 pain in the lives of whoever is experiencing it. The best companies solve problems that are both. Companies solving problems that are neither will not be successful as venture investments.

Is Venture Capital Funding right for YOU?

Even if your business is perfect for venture capital funding, venture capital funding may not be right for you. As an investor, I assume that every investment I enter into is going to be at least a 10 year relationship. When a company takes a venture capital investment, it is a lot like a marriage, and it can be even harder (and more painful) to get out of. If you take an investment from a VC firm, you are ultimately giving up control of your company’s destiny. The where and how are all up for discussion, but at the end of the day, your new investors will eventually require some sort of exit of the business. And they have the power to make this happen. VC’s investments have controls built into them meant to help them safeguard their investment. This may sound severe, but it is important to remember that VCs are, for the most part, managing other people’s money, not their own. They are managing money that comes from college funds, firefighter pensions, and government coffers. VC’s have a responsibility to responsibly manage their investors’ money and they put protections into place to make sure that they can do this. If this lack of control sounds like a deal breaker for you, venture capital funding simply may not be for you. The system works great when all parties have a shared vision for the company. It works considerably less well when a founder has a different vision for their company than their investors. That is why it is so important to know exactly what you are getting into.

Be Honest with Yourself!

Venture Capital is a tool to help companies grow. As with any other tool, applying it in the correct circumstance will determine whether it is effective or not. Be honest with yourself about whether venture capital is right for you and your company. It is not without its downsides, and it is a train that is incredibly hard to get off of once you have hopped onboard. But for the right companies, there is no better way to build a business. Successful companies can be built without venture capital funding, but it is important to remember that these situations are the exceptions that prove the rule. The VAST majority of major technology companies utilized some form of venture capital at some point in their life cycle to accelerate themselves past competition.

There are alternatives. Companies can be built with nothing more than the blood, sweat, and tears (typically lots and lots of tears) of the founder. This is called bootstrapping and can be an excellent strategy for founders that are unwilling to give up control of their business or who do not have ambitions of making their business grow to its optimized potential. Small business that aren’t scalable can utilize small business loans to help them get going. There are even new alternatives for startups like indie.vc and Clearbanc.

However you decide to fund your business, make the decision with eyes wide open, knowing that there are pros and cons for every option.

Venture capital is an excellent option that you should absolutely consider.

Just make sure you are building a jet before you start pumping in the jet fuel.

The Globalization of Venture Capital: Is United States Innovation Falling Behind?

Photo by  NASA  on  Unsplash

Photo by NASA on Unsplash

There was a story doing the rounds this week about a new Center for American Entrepreneurship study about the globalization of Venture Capital. CAE’s study showed that the United States’ share of global venture capital investment had fallen 20% in the last five years and 50% in the last 25 years. These statistics were framed with alarming rhetoric from both the tech media and the Center for American Entrepreneurship.

VentureBeat stated that this report should give Americans “cause for concern.”

Richard Florida, one of the leaders of the study, stated that “[he] thinks for the first time, the U.S. is truly in trouble.”

Much of the discussion around this report has represented similarly disheartening views of the outlook for innovation in the United States. Media sites and commentators have worried over America’s loss of “edge,” and forewarned of dark days ahead.

My response:

Are we really so insecure that our place in the global order is threatened by the United States only receiving HALF of the globe’s capital invested into innovation?

The United States represents approximately 4% of the world’s population. By any objective viewpoint we are significantly punching above our weight to receive over 12x our share of the world’s risk capital.

But Erik, what about the relative decrease in our portion of venture capital investments? Shouldn’t we be worried about investment into our country decreasing by 20% in 5 years?

Short answer: No.

Long Answer: This is why Intro to Statistics is required coursework. Venture capital investing into the United States has not decreased by 20%, the share of global venture capital received by US-based companies has decreased by 20%. The difference is incredibly important.

Via NVCA. As of June 30, 2018.

Via NVCA. As of June 30, 2018.

2018 is, in fact, poised to be the largest year for venture capital investment into US startups since the Dotcom crash. At the halfway point of 2018, about 3/4 of 2017’s total investment value has been deployed. This means that we are on pace for a potentially record breaking year (for discussion of whether this should even be something to be celebrated or not, check out last week’s post.) Yes, our piece of the overall venture capital pie is shrinking, but the overall size of the pie is magnitudes greater than it used to be. That is what matters most. Innovation is not a zero sum game, our ability to innovate is not hampered by China’s or India’s. In fact, it is the reverse. Increasing levels of global innovation create network effects which the United States can take advantage of to propel us even further.

It is short sighted and, frankly, close-minded to believe that the United States has some sort of divine right to be the innovation capital of the world. Innovation, by its very nature, is meritocratic. The United States’ shrinking share of venture capital dollars should be met with fanfare, not rumors of our impending demise. The rest of the world is catching up, and that can only be a good thing. More innovation means more impactful technologies that can improve people’s lives for the better. Where that innovation occurs is far less important than the fact that it is occurring, and if we are being honest with ourselves, there are many parts of the world that need ground-breaking innovation a lot more than the United States needs a new social media app.

We are not facing an innovation crisis in the United States. We are the pioneer of modern technological innovation and the rest of the world is starting to build up their own capabilities on the back of 80 years of the United States writing the playbook.

This is a good thing.

For everyone.

To suggest otherwise is both alarmist and misguided.


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