Five Reasons Not To Raise Venture Capital

You are more than three times as likely to crash your startup as you are to ring the NASDAQ opening bell.

by Rachel Chalmers on April 4th, 2014

The Flammarion Engraving, via Wikipedia.

Let’s just get this one out of the way.

1. You probably won’t get a fair hearing.

The seductive narrative of Silicon Valley stars a genius-hero who goes on a journey, overcomes myriad obstacles, has a flash of insight and is rewarded by wise and benevolent investors with Series A funding.

This narrative is bullshit, but it’s everywhere. Take Marc Benioff’s bookBehind the Cloud. Not to pick on Benioff – I’m a fan, his foundation does good work and his book contains its own chapter on why you shouldn’t raise VC – but he started on leave from his executive gig at Oracle, with $6m in savings (!!!), $2m in seed money and the mentorship of Larry Ellison. That makes it difficult to buy into any portrayal of him as an underdog — but it also offers some insight into the kinds of people that do get funded.

Silicon Valley is a meritocracy in the same way that the Ivy League schools are: it helps to be smart, but it helps just as much or more to have the right connections. The game is rigged. The pathology of Silicon Valley is that the winners have so much ego invested in pretending that it isn’t. It’s hard for people who pride themselves on their exceptional smartness to acknowledge the fact that they are much luckier than they are smart.

Venture capital is not a rags to riches story. It’s the inspiring tale of redeploying resources from a lower- to a higher-performing asset class. There’s nothing wrong with that – I find it kind of magical – but let’s not pretend we’re doing something else. In particular, let’s not pretend that this is an engine for social justice. You need a separate corporate philanthropy branch for that.

2. Raising venture capital doesn’t make you a good person.

The purpose of life is not to raise venture capital. Not raising venture capital doesn’t make you a failure. And the purpose of venture capital is not to reward the clever or the good. It’s to (say it with me!) redeploy resources from a lower- to a higher-performing asset class.

Let’s unpack that a little. Some VC funds invest only their general partners’ money. More, many more, invest money on behalf of their Limited Partners (LPs). Typical LPs are city or state pension funds, college endowments and funds-of-funds. VCs raise a fund from multiple LPs, then the VC general partners make the investment decisions (that’s why they’re called general partners) and the limited partners stand by and wait for the fund to perform, or not (that’s why they’re limited.) Those general partners have to report back to their LPs regularly (in-person meetings, conference calls), and their fund has to perform if they are to have any hope of raising the next one (lots of nailbiting is involved.)

LPs may use VC as one asset class among many, balancing their risk with investments in lower-performing but lower-risk asset classes, like equities, fixed income and real estate. Or LPs may hedge risks across VCs, by investing in multiple VC funds. VC, in other words, puts capital to work in high-risk, high-reward ventures, as a way to balance other economic activities. A pension fund manager says to herself, OK, I will put this much into municipal bonds, and this much into VC. The municipal bond will generate a low but pretty certain return. The VC may come to nothing, or it may return a lot of money. Over time, the unlikely success of a VC fund should offset the unlikely failure of a bond.

The manipulation of these sophisticated financial instruments sheds about as much light on your intrinsic worth as a human being as your star sign does: none. Tech culture has come to equate raising venture with merit, but tech culture is wrong.

When you look at it through this lens, one thing suddenly becomes obvious:

3. Most companies won’t ever generate venture outcomes.

That’s okay! Start a company anyway. It’s (among other things) great fun. You can generate early revenue through consulting engagements and through sales or subscriptions. If you are thrifty and keep a tight grip on your expenses, you can continue to live within your means more or less indefinitely. Investors sometimes say mean things about these “lifestyle businesses” but you don’t have to care what investors think. See above.

Note that the opposite of a lifestyle business is a business without a lifestyle; in fact it’s often a business whose owners have no life, or a rotten one. Bootstrapping a business can be a great life, one in which you control your own destiny and have latitude to work on projects that speak to your heart.

Venture money is fuel for hypergrowth. We’ll dig in a little later and see what kinds of (enterprise software) businesses lend themselves to hypergrowth – essentially, broad platforms whose value proposition is applicable to potential customers across lots and lots of industries. Plenty of excellent companies, most of them, in fact, fall outside that definition. And that’s okay! There’s nothing intrinsically necessary about hypergrowth.

4. When you raise venture, you narrow your options.

A company without venture can trundle along for years, making a living for its owners. When an acquisition offer comes along, the decision to take it or leave it is up to the owners. No one else gets a say. This is not true of a venture-backed business. This will be important later.

When you raise a venture round, your investor is now a co-owner of your company. Are your interests aligned? Maaaybe. Your investor is optimizing outcomes for his or her LPs. A VC is the custodian of the LP’s money. Do you even know who your investor’s LPs are? You should, because they are now the boss of you.

Don’t imagine that the LPs are Scrooge McDuck. My best friend teaches high school in San Francisco. One of my LPs is the administrator of the fund that manages her pension. When I look at potential investments I am asking myself, How will this help San Francisco’s school teachers buy groceries in their old age? Which leads us to…

5. Venture math is a harsh mistress.

This is the biggie. VCs aren’t unintelligent. Nor are VCs evil (not all of them anyway). They’re not even necessarily misaligned with you. What they are doing is optimizing for a very specific outcome. Share that alignment, or don’t take their money.

Besides being custodians of the fund and therefore honor-bound to seek the best outcomes, investment managers are compensated in part by carried interest. Carried interest is a cut of returns to the fund after (a) all capital has been returned and (b) the fund has met an agreed-upon rate of return. Let’s say the VC firm has a $150m fund and a preferred return to investors of 3x, or $450m. The partners in the VC firm don’t even start earning their carry check until that $450m threshold has been reached. *

What does this mean for you, everywoman entrepreneur? Let’s assume this firm has offered to invest $15m in your company in exchange for 15% of equity. At that rate, said VC firm can make ten such investments. We all know that nine out of ten startups fail, so the VC is betting that one of the ten of you can return the fund, and then some.

What do you have to do to make the VC’s 15% of equity worth in excess of $450m? We are now talking about a $3bn outcome.

Whatever it is you have to do to earn this – take the company public, somehow impress Mark Zuckerberg – your investor/co-owner is now focused on persuading you to do. That’s why they’re starting to ask if you would consider moving aside to let an experienced public-company CEO take over.

By the way, the odds of achieving a $3bn outcome are so far from being in your favour, it’s absurd. Not winning-the-lottery absurd, but an order of magnitude worse than that old one-in-ten rule of thumb. Let’s leave aside the outliers like WhatsApp and focus on enterprise software, a business I know and one that’s slightly less subject to the whims of wanton Gods than consumer-land. As an industry analyst, I covered 1054 enterprise software companies over a 13-year span. Of these, 75 were incumbents or enterprise end users of other vendors’ software, so let’s say 1000-odd were venture-backed startups. Where did they all end up?

Well, 188 of them were acquired, in deals that ranged from the sublime (Citrix paid $500m for XenSource, which had trailing 12-month revenues in the $1m range) to the ridiculous (many, many face-saving exits of failed firms consisting of a nominal fee in exchange for their patent portfolio.) Note that an exit in the tens of millions, which is a champagne-and-confetti Retirement Level Event for the owners of a bootstrapped company (like Sleepycat Software or Platform Computing), can be a disaster for a venture-backed firm. In particular, since the investors own preferred shares (which means they get paid first) and the employees own common stock (which means they only get paid if there’s anything left over), the people who actually did the work can walk away from a multi-million dollar acquisition with nothing to show for it but sadder and wiser hearts.

Back to my cast of one thousand: 28 of them failed so hard they don’t even fog a mirror any more. Google their corporate site and get domain-squatter linkspam. No face-saving exits for them. I won’t name names. Eight went public: eight out of a thousand. Their names are Opsware, Rackspace,, ServiceNow, SolarWinds, Splunk, VMware and WorkDay.

What this means is that you are more than three times as likely to crash your startup as you are to ring the Nasdaq opening bell. Your chance of utter failure is around 3%.

Your chance of going IPO is just under 1%.

Still Want to Raise VC?

I will conclude by saying that if you’ve read all this and still believe your enterprise software company should raise institutional money because it’s the next Splunk, I will happily take a meeting with you, and I will give you a timely and compassionate reply to your pitch. That reply will almost certainly be “no”, but we’ll probably have a fun meeting anyway, so do get in touch! rachel -at-

Rachel Chalmers, the author.

Rachel Chalmers, the author.

* As several astute readers pointed out, 3x is an unrealistic hurdle rate that was chosen to make the numbers work out neatly. Carried interest more typically kicks in once the fund has been returned (in this example, at $150m.) 3x is more like a ratchet rate, the point at which the general partners’ share of the return may increase.