What determines how much money you -- an entrepreneur -- will make from your next startup? I think we can agree that it’s an important question.
Most entrepreneurs (and investors) would answer that question by rattling off catch phrases like market size, team, pain point and beyond. Few, however, would mention a “financing strategy”. Despite the fact that how an entrepreneur finances their business can be one of the single largest determinants of how much money they make, financing strategy is not at the fore of the collective startup consciousness.
Who wants to focus on how to finance anyway? It’s boring and there are really only two major options: 1) raise money from a big-name-deep-pocket VC, swim in lavish salaries, throw money at your problems and glow with prestige, or 2) eat ramen, get a day job, suffer your family’s accusations of insanity, sweat credit card bills and bootstrap your way to profitability.
Sounds like an easy choice, right? Well, sometimes the easier path is less fruitful.
The fallacy that underlies the lack of emphasis on financing strategy is the assumption that venture capital can be a good financing option for any type of company. An entrepreneur is always better off taking a VC’s money, right? Here’s the catch: that’s not true. Entrepreneurs who are running companies that are not poised to generate venture scale returns are likely to make less money when they exit if they raise VC.
First, when a VC invests they’ll have their sights set on a mid-to-large size exit -- small VCs seek $50M+ exits, larger VCs target $100M or more. A $25 million sale, as a result, isn’t interesting to most VCs. If the potential of your company falls short of those expectations, your VC investors will be disappointed. And, rather than take the small exit offer that doesn’t move the needle for their venture fund (but would give you a life changing payout), they’ll push the company to raise more money and pursue new avenues for growth in the hope of getting a bigger payday. Sometimes those new business ideas work, and sometimes they fail, leaving the founders diluted by the additional investment.
Second, if your company is likely to plateau at a relatively small (by venture capital standards) valuation, a standard venture capital round will typically put more money into your company than you need, over diluting the founders, as VCs often need to deploy a good bit of capital into each of their investments to make their own economics work.
Don’t get me wrong -- VC isn’t bad. In fact, it can be great if your company is poised to scale. If your company is set to scale and you don’t raise venture capital, you may be under funding your business allowing fast-followers to acquire your customers before you.
So how do you know if your company is poised to generate a large enough exit to justify raising venture capital?
The best approach is to calculate your addressable market. Your addressable market is defined as the total revenue that your company could generate if it captured 100 percent of its viable customers. To do this analysis correctly, you’ll need to be thoughtful about who realistically might buy your product -- factor in geography, age, wealth and behavior and make realistic assumptions about how much revenue you can generate per customer.
You’re not likely to capture the whole addressable market, but if things go well and your company is targeting a billion-dollar-plus addressable market, it’s believable that you could generate a $100M+ exit. If the addressable market is south of $100M, you’re probably chasing an opportunity that isn’t likely to be a fit for the expectations of today’s VCs.
The key is to align your financing strategy with your company’s potential. In a simplified world, that boils down to bootstrapping if your company’s potential is relatively small, and raising venture capital if you’re building a giant.
Hint: The other critical dimensions of the financing decisions relate to your capital needs and inherent barriers -- I’ll address those in my next post.
Mark Davis a NY-based entrepreneur, venture capitalist, blogger and community organizer. Mark is currently the co-founder & CEO of a stealth startup. Previously, he was a venture capitalist at DFJ Gotham Ventures and founder of the Columbia Venture Community and New York Venture Community. You can find him at www.mpd.me and @markpeterdavis.