Startups that Would Do Best Without Venture Capital, by @DanShapiro

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In a post on his blog, Dan Shapiro, former Founder & CEO of Sparkbuy (acquired by Google) and Ontela (merged with Photobucket), and Founder Institute Mentor, explains the types of companies and entrepreneurs who should not raise venture capital. It is a very insightful article on how venture capitalists think that may not be obvious to many entrepreneurs. 

This post originally appeared on DanShapiro.com here. Below it is republished.

"I just got the following email.

Subject: Small taxi company looking to expand

Hello,

I run a small taxi company outside of Boston Massachusetts. My community has been targeted for casino development and I am looking to expand my business. Could you possibly provide some advice on how to find venture capital?

For someone who lives in the startup world, this looks pretty silly.  But I’m sure I’d say a lot of silly things if I were getting in to the taxi business, too.  So I figured I’d point him to a simple explanation of why taxi companies (actually, services companies in general) aren’t appropriate for VC.  I did the Google thing for a bit to find a good article.  And no luck.

Well, you know what they say: when the internet fails you, make more internet.  Here, then, are a very good set of reasons not to take venture capital (or – why venture capital won’t take you).

1.  You want to build a profitable company

First day of Founder's Institute I ask how many people want to raise venture capital.  Most of the hands go up.  I then ask who wants to build a profitable company.  Again, most hands go up.

The funny thing about this is – VCs don’t actually like their companies to be profitable.  Someday, sure, but not on their watch.  You see, profitability means that the company wont grow any faster.

This seems odd, but think about this for a minute. At the early stages, a company may be making money, but it’s almost certainly investing every penny it makes back in to the business.  If it has access to outside capital (e.g. a VCs), it’s investing more than it makes.  And that’s exactly what VCs like: companies that can grow at amazing speed, and never slow down their burn rate to amass cash.

They like this for two reasons.  First, VCs want to invest in companies that can grow explosively.  That means huge markets, executives who can scale up a business fast, and a willingness on the part of management to double down on a winning bet – over, and over, and over again.  Second, because it means the company keeps coming back to the VC for more money on positive terms.  That means the VC keeps getting to buy more and more of the growing concern.

Of course, this is something of an over-broad generalization.  I’m required to include one per post or I lose my startup blogging license.  In fact many venture backed companies are profitable, it’s very impressive to bootstrap your company to profitability in a few months before raising outside investment, etc. But if you are excited about a profitable business that can cut you giant dividend checks (not that most VCs can even accept divided checks  - long story), realize that VCs will not be pleased with that approach to running the business. They will want you to plow those earnings back in to the business. And when the day comes that a VC-backed business generates cash faster than it can effectively spend it?  They sell the company, or IPO (which is technically also selling the company), or replace the CEO with someone who can spend faster.

A taxi business should be run for profits.  That’s not VC style.

2. Your business has reasonable margins

As a general rule, VCs don’t like reasonable margins.  They are exclusively interested in outrageous margins.  Ludicrous margins.  We’re talking about sneering at 50%, and hoping for 80%, 90%, crazy astronomy stuff.  Venture capital is all about investing a little bit of money to create a business with massive scale and huge multiples – investing tens of millions to build software that then can be duplicated or served up for virtually nothing extra per-person with a total market size of billions.

In particular, VCs don’t like businesses that are people-powered.  Software businesses are awesome, but their evil twin – software consultancies – are near-pariah to VCs.  If adding revenue means adding bodies, they don’t like it.  In fact, enterprise software companies, which can tread a fine line between software consulting & software development, sometimes get really creative to come down on the right side of the line.

So the rule of thumb is that VCs like product companies: software, drugs, cleantech, and so on.  And they don’t like the manufacturing, service industry, and consulting businesses that often are just a tiny shift of business model away.

Every new taxi requires a… well, a new taxi.  And a new taxi driver.  Not the right business for VC.

3. You are going to double your investors’ money

I’ve covered this before, but VCs really don’t want to double their money.  Strange though it sounds, their economics make that look like a failure.  They need to target a 10x return on their investment, and that means – depending on stage and fund size – that you company has to grow to somewhere in the hundreds-of-millions to billions range to be interesting.

That means taking your taxi business from $20MM in annual revenue to $40MM just doesn’t do it for them.  Particularly because the valuation multiples on the aforementioned lower-margin businesses are smaller.

4. VCs probably don’t want to invest in you

Here are the people VCs really love to invest in:

• Entrepreneurs who’ve already made them lots of money
• Their closest buddies

Here are the people who VCs can be convinced to invest in:

• People who have been wildly successful at high-profile past jobs that are related to their new business  (e.g. a former executive VP at a Fortune 500 company, inventor of thingamajig that everyone knows)
• New graduates from top-of-the-top tier schools who have built something amazingly cool already
• Extremely charismatic type-A personalities

Anyone else is possible, but our taxi driver is going to have a devil of a time.

5. You have better things to do with 9 months, and you will probably fail

That’s how long it took me to do my Series A for Ontela.  9 months before the first check came in.  Average is 6-12.  That’s because a busy VC will look at a few companies a day, and will make a few investments a year.  The math says the hit rate is well under 1%.  That matches my experience – I pitched over 100 times during our Series A investment.  Not only that, but most of the companies pitching the same events and people that I saw worked just as hard as I did, and did not get funded.  And fundraising is a near-full time job; you won’t have much time for actually driving your taxi.

6. You will have a new boss

You know the great thing about working for yourself?  Well, if you raise VC, you probably don’t have that thing any more.  Raising VC usually means forming a board that includes your investors, and that board is charged with, among other things, potentially firing and replacing you.  I’ve worked with a number of boards and have been lucky in that they were all awesome and I would recommend those folks to anybody.  But if you like your freedom, then bringing on VC may feel somewhat familiar – in an “I have a boss again” way you probably won’t enjoy.

What are my alternatives?

VC is really only appropriate for a tiny fraction of a fraction of the companies in the US.  But there are numerous alternatives.

• Angel investors are individual investors who can invest larger amounts, on more flexible terms, and with less onerous restrictions.  Many companies that take VC money actually start with angel investments – but lots of companies never do VC, and just grow off of angel investment.
• Traditional bank loans are always an option if you have a sufficiently traditional company – while they may not be right for many purposes, they’re definitely the best terms you will find for bringing in capital.
• A Revenue Loan from a company like Lighter Capital is a way for companies with revenue to bring in capital with a debt structure – without giving up control to outside investors.
• And, of course, Bootstrapping is arguably the best way of all – re-investing your company’s profits in your own growth, and building a strong company based on the revenues from your business.

…So does this mean I shouldn’t raise VC?

Look.  I’ve raised over $30mm from 7 different firms in the course of my two startups.  I will tell you: if you are the right kind of company, and find the right kind of investor, then VC is awesome.  It’s an instant infusion of cash, connections, experience, credibility, and confidence at the stroke of a pen.  It accelerates everything.  It focuses the mind.  I can’t recommend it highly enough.

But most companies are not the right kind of companies.  And the only thing more frustrating and time consuming than raising a VC round is failing to raise a VC round.

So think hard.  Make sure it’s for you.  And if not – keep on driving!

(Update: Mike Carter from Revere Taxi has pointed out that if I’m going to use his email to write my blog post, the least I can do is give him a backlink.)"

Dan Shapiro currently works at Google following their acquisition of his most recent company, Sparkbuy, a comparison shopping website that offered unprecedented depth and accuracy of information. Before that, he was founder and CEO of Ontela, a pioneering mobile imaging company that merged with Photobucket, where he was named CEO of the Year by MobileBeat. He blogs at DanShapiro.com, and you can also follow him on Twitter at @DanShapiro.