Avoiding VC Funding

This week I felt enlightened by a class discussion about not obtaining financing from venture capitalists.  Prior to this week, I assumed that the majority of startups followed a process of 1) building a prototype, 2) developing a business case for the product, 3) obtaining financing through angels and/or VCs, then 4) growing fast and failing/succeeding.  From the tech blogosphere I heard the message, “If you don’t get funded right away, you fade into obscurity.”

But that process was tossed out the window when Dr. K put up a chart showing the number of VC deals done each year.  The number of deals is two orders of magnitude smaller than the number of startups: Though 600,000 startups are founded each year in the US, only about 3,000 businesses get funded by VCs.  That means that either 99 percent of startups fail right away, or most forge ahead with no VC funding.  As is well established by research, the percentage of failures is more like 25 in the first year and 50 after five years, so it must be the case that the latter is true.

It’s useful to think through the logic of a startup obtaining financing:  Why would a startup need financing?  The primary reasons would be to get over a big hurdle (e.g. build a $30M manufacturing plant), to grow as quickly as possible (e.g. hire 60 software engineers to build out the app in six months instead of twelve), or to pay the rent next month.  A startup probably needs funding to get over a big hurdle like constructing a plant, but few need to overcome any such hurdle.  Growing quickly can be good, but it is also very risky in terms of product quality, not to mention the fact that if a startup has 60 more engineers at launch than it would have had without funding, then it somehow has to manage and pay 60 more engineers on the back of the same product.  In other words, pouring gas on the flames might get you noticed quickly, but the fire will die quickly unless you keep adding more gas.  But then, what about the risk of losing first-mover advantage?  In most cases, first-mover advantage doesn’t exist, as it is subsumed by market timing and product quality (note that iPod came three years after the first MP3 player, and Groupon came a year after LivingSocial).  Finally, not having to worry about paying the rent is nice for the owner of a startup, but rent pales in comparison to his wasting additional years finding out that his product won’t take off.

That point is another one that I hadn’t considered, but a great talk by David Heinemeier Hansson (best known as the inventor of Ruby on Rails) hints at it: If you don’t have the next Facebook of an idea, then VC funding will make you waste many years as opposed to the short amount of time you would waste on your own before you ran out of money.  What’s more, assuming your VCs included a liquidation preference in your terms, you will end up with at best nothing and at worst losing your possessions or anything else you tied to the business.

All of this leads to the conclusion that starting a business is a process that can take many paths.  The path including VC funding is incredibly risky and should only be used if necessary, so chasing after it is usually a waste.