Should you raise money from VCs? If so, how should you pick your VC?
It has become part of the conventional entrepreneur wisdom that you should raise an angel round, then a first VC round followed by a few more before taking the company public, selling to a strategic or a private equity company. Most of the well-known Internet companies have followed this path: Yahoo, eBay, Amazon, Google, Facebook, etc.
However, it may not be the most logical path for most entrepreneurs. The vast majority of exits are below $100 million and most of those are below $30 million. You can’t raise a $5 million series A at $10 million pre to sell for less than $30 million. Not only will you disappoint your investors (most VCs are shooting for a 10x on their investment), but the liquidation preferences might eat up most of your return. If you have made money before and are looking to build something big for fun, then by all means raise as much money as you can at the highest possible valuation in order to maximize the probability of building a $1 billion company. You significantly increase the risk of making nothing, but in this context it’s worth it to increase the probability of building something big.
If you are a first time entrepreneur or have not made much money before, you need to be careful not to price yourself out of potential exits. There is a lot of temptation to raise money at a high price if it’s available. However, often you might just be better off just doing an angel round or a small VC round – say $2 million at $4 pre, to actually maximize your risk adjusted returns. Likewise, you might be better off trading off price for terms. A clean 1x liquidation preference at a lower price might be better for you than a participating preferred, especially if the company ends up taking 5-7 years to exit which is by no means atypical.
Having less cash might not make much difference to your outcome. Startups are much more capital efficient these days. You have companies that service your every need, eliminating most potential capital expenditures. Even ecommerce startups are relatively cheap to build these days as there are companies that will handle logistics for you and you can avoid taking inventory by drop shipping.
Just as importantly as figuring out how much money you need at what valuation, you need to pick the right investor to raise the money from. Let’s start by setting expectations: VCs are not going to help you execute. That’s your job! They may make a few introductions and might help you hire a few good candidates, but the reality is that you probably could have found a way to get introduced to whomever you wanted to meet and would have met good candidates to hire without them. This does not mean that VC selection is unimportant and that you should just pick whoever offers the highest valuation and the best terms.
Quite the contrary, VC selection is essential to your success. By sitting on your board, the VC will play an essential role in discussing and setting the strategic direction of your company. In fact, it’s probably the most important role they will play. By pulling you away from the day to day to focus on the strategic issue of what maximizes value creation they will hone your strategic thinking and steer the direction of the company. They will also play a crucial role in the exit discussions as they will play bad cop to your good cop (if you don’t have a VC investment bankers can also play this role).
Given the importance of the role and the fact that whomever you pick will likely be on your board for years, picking a VC is like getting married. It’s absolutely essential that you get along well with them and that you trust them. This means that the name of the firm is irrelevant. What matters is your relationship with the partner you are going to work with on a day to day basis.
Strategic investors are probably also best avoided. Not only could they have conflicts of interests as they may not want you to get too expensive for them to buy, but even when they have the best of intentions they have proven to be fair weather VCs – jumping in when the market is hot and retrenching when conditions are tough. They are least likely to be helpful and supportive in a downturn. (To be fair, Intel Capital and Naspers may be exceptions to that rule as they have shown staying power and have seemingly been fair to their portfolio companies.)
Now it’s your turn: go start a great company and raise the capital you need from the best partner possible for you!