posted: October 28, 2017
tl;dr: VC and VCs do not guarantee success by any means, but there are a few things they can help with...
As Uprising Technology, the startup where I’ve worked for almost two years, transitions from being a bootstrapped (a.k.a. customer-funded) company to a partially investor-funded company, I find myself back in the world of venture capital (VC) and venture capitalists (VCs: the principals at the VC firm who make the investment decisions). Having VC investment does not guarantee a startup will succeed long-term, nor it is always a positive. There are downsides to VC investments, some of which I will mention here and more of which I will save for a later post. In this post I will focus mostly on the positive, by describing the actual ways that I have seen VCs help startup companies.
VCs get more publicity, and more credit for successful startups, than they should. To cite one extreme example, Forbes Magazine’s annual ranking of the top 100 venture capitalists is called The Midas List, as though VCs are King Midas and only have to choose and touch a startup in order for it to turn into gold. The reality, of course, is far different, as even the most egotistical VC will admit.
VCs that make a large investment in a company typically demand and receive a board seat, and in that way help oversee a startup, but they do not have any day-to-day operational responsibilities for the business. There are some newer VC firms such as Andreessen Horowitz who have crafted a model that tries to provide additional operational assistance to their portfolio companies; I can’t speak directly to that model, as I have not experienced it. In the more traditional VC model, the VC provides money, advice, and guidance, and monitors his/her investment. It really is up to the people working inside the company every day to figure out the best path forward and make the company successful.
The two major areas where VC and VCs can potentially help are:
Money, obviously, is the main potential benefit. A bootstrapped startup can only spend as much money as comes into the company via sales to customers; almost by definition a bootstrapped company is a breakeven business. In the beginning, when there is nothing yet to sell, and a product needs to be developed, this can of course lead to some very lean times for the people inside the company; they likely will have to live frugally off money they’ve saved up or borrowed from friends or family. An entirely bootstrapped company can only grow its expenditures as fast as it grows its revenue. While this enforces a wonderful cash discipline and forces the company to pursue only the most promising opportunities, it also means the company can only grow at the rate supported by the organic growth of sales.
Outside investment changes the equation by providing the company money that can be spent to build up the business in advance of sales. Startups that take VC investment almost always operate at a cash loss; if they weren’t burning cash, they wouldn’t need the investment. The company spends the money on additional product development, marketing, and sales activity, all with the goal of growing sales and someday achieving “cashflow breakeven” and becoming profitable. If the money is spent wisely on activities which generate future profitable sales at a high enough rate, the company can grow more quickly than it could as a bootstrapped company. But if the money doesn’t generate profitable sales at an adequate rate, the breakeven point is never achieved and the now unprofitable company now has to try to find other investors to continue to fund the losses, or shut down.
Capital can either help or harm a startup, a point made very well in this article by Eric Paley, who often speaks out about the downsides of VC investments. It is somewhat analogous to giving money to a beggar on the street: the beggar might spend the money on food, clothing, shelter, or something else which improves the beggar’s situation in life; or the beggar might spend it on drugs or alcohol which furthers the beggar’s despondency. The money in and of itself is not guaranteed to help; it depends on how it is spent.
Introductions to follow-on investors
It is rare for a startup to take in just a single round of investment. Even very successful startups, which may not need any cash to operate the business at its current size, will often continue to take in money to grow even faster. One of the primary jobs of an early-round VC is to provide introductions to later-round investors, and to shepherd the fundraising process. A good VC will help ensure that the company doesn’t run out of money before additional funds can be raised. This is the primary task that a VC does as a startup board member.
These next areas aren’t nearly as impactful as the first two:
Credibility with customers
Customers, understandably, can be somewhat reluctant to do business with a young startup company, as they will have doubts that the startup will be around in the years ahead. Personal relationships between people inside the startup company (typically the founder(s)) and inside the customer’s organization can help overcome this reluctance. It can also help for the customer to know that one or more outside VC investors has chosen to invest in the startup. This lends a certain credibility to the company, in the customer’s mind, and can make them more likely to buy. Name recognition of the VC or the VC’s firm does help here.
Similar to credibility with customers, an investment from one or more well-known VCs can help attract applicants and can make them feel more comfortable about hiring into a young startup company. Additionally, VCs are well-connected businesspeople who meet with a large number of people in all types of different companies. When it comes time to hire various senior positions in a startup, such as a CFO, the VCs may be able to provide some good candidates and also help land them. There is a downside here, too: a VC may bring in the wrong person, or the VC may upset the people inside the company by pushing too hard to have the VC’s candidates hired.
Sounding board for the CEO
Sometimes, but not always, a VC will have been a founder and/or CEO of a successful startup before becoming a VC, and can offer the startup CEO some hard-earned wisdom. Even if a VC has not been a founder, the VC will still be filled with advice based on what the VC has seen at other companies. The startup’s CEO reports to the board of directors, which will have one or more VCs on it once investment money has been raised, so it is natural and potentially beneficial for the CEO to use the VCs and other board members as a sounding board for ideas and solutions to problems. Ultimately, though, these challenging decisions are the CEO’s call.
Exiting, or moving on to the company’s next stage
A VC investment can be viewed as setting a timer that is going to go off at some point years down the road, when the VC will want to realize a financial return on the investment. Although some VC firms have been around for decades, the money they invest comes from closed funds with a finite lifespan, typically ten years. So after a maximum of ten years (less if the money comes from a fund that’s already been around for a while), the VC is legally obligated to close out the fund and distribute the proceeds. VCs much prefer to distribute cash as opposed to illiquid stock in still-independent startup companies. So they have a selfish interest in helping their startups achieve some sort of exit, whether that be an IPO (often the most positive outcome, but also the rarest), an acquisition, a sale to a private equity firm, or a sale of stock to latter-stage investors. VCs maintain a network of people at other firms who participate in all of these outcomes, and they will activate that network on the company’s behalf. As long as the company itself is interested in the exit path at that point in time, this can be helpful; if not, it can be a major source of tension and division.
One more area where VCs will definitely try to be helpful is in providing introductions to potential customers and business partners. This can occasionally help, but often the startup will spend time chasing after a potential opportunity that doesn’t ultimately amount to anything.