Founders Can Just Say No to VCs

The New York Times ran an article last week that triggered a Twitter storm in the venture capital (VC) community: “More Start-Ups Have an Unfamiliar Message for Venture Capitalists: Get Lost” (by Erin Griffith, who used to write for Fortune magazine’s well-regarded VC-focused Term Sheet newsletter).

The article argues that VC’s demand for rapid growth has a downside. “For every unicorn, there are countless other startups that grew too fast, burned through investors’ money and died – possibly unnecessarily,” writes Griffith. VC can make startups “accelerate straight into the ground” and works for only “a tiny, tiny fraction of companies.”

Venture capitalists, as you’d expect, came out firing. Uber-successful investor and blogger Jason Calacanis said that limited partners (LPs) want better options than the single-digit returns investors get from dividend-paying stocks or real estate investment trusts. “There are zero LPs interested in funding startups with modest to normal growth prospects,” he says.

Fred Wilson, partner at Union Square Ventures and nearly always the voice of reason, argues that you can’t just blame VC investors without looking at the role of startup founders.

“As entrepreneurs have had more negotiating leverage over the last 20-plus years, they have pushed valuations up significantly, and the capital markets (i.e., VCs) have reacted to that by accumulating more capital,” he says. Bigger funds, you see, require bigger winners that can come only from hypergrowth.

It takes two to tango, says Wilson, and I’ve seen no better example of this than the “ratchet” terms that benefit both investors and entrepreneurs – but also contribute to valuation inflation.

Ratchet terms protect investors from future down rounds. So let’s say an investor paid $10 per share for a 5% stake and new shares were issued at $8 per share. If you think the investor is down 20% on their investment, then think again. They have the right to convert their current shares to $8 per share, increasing the shares they own by 25% to maintain their 5% stake.

That’s a relatively risk-free investment that still presents a potentially big upside. And founders get a higher valuation for their company.

It’s these kinds of deals – more than hypergrowth demands – that have led me to call the VC ecosystem “broken” more than once.

But at the end of the day, startups can choose whether or not to play the VC game. I’m constantly impressed by the founders of the remarkable companies we recommend to the members of our paid First Stage Investor service. But I’m not all that sympathetic to their plight of being force-fed hypergrowth.

Founders who don’t want to subject themselves to the unrelenting VC hunger for unicorns (startups valuated at $1 billion or more) have a pretty simple and obvious choice to make.

Just say no.

Founders don’t need to sell their souls (with options and warrants thrown in, of course) to those devilish VC firms. Here are three alternatives:

  1. Bootstrapping. There’s a proud history of founders launching their businesses from their basements or bedrooms and becoming incredibly successful. When they don’t sell a majority of their shares to outside investors, they can make a ton of money if their company grows into a colossal world-dominating giant.
  1. Launching an initial coin offering (ICO). ICOs emerged as a way (in part) to raise money to avoid VCs. ICOs have a bad rap because so many were frivolous undertakings that collected and squandered tens of millions of dollars. But with greater regulatory clarity coming soon (hopefully) and a wiser investor base, ICOs will re-emerge as a legitimate way for founders to source funding.
  1. Crowdfunding. Private equity crowdfunding at the early stages lets companies raise $1 million under Regulation Crowdfunding and up to $50 million under Regulation A+. It turns investors into customers and customers into investors. They become evangelists for the brand and help the startup grow.

This year, I believe crowdfunding will take off and reach new heights. Compared with VC money, crowdfunding is still small-time – raising tens of millions annually while VCs raise tens of billions of dollars a year.

But portals have gotten much better at reaching potential investors. The crowdfunding deals are getting better every year. We had to pass up some excellent deals last year simply because we’re set up to recommend only 15 to 20 investment opportunities a year to First Stage Investor members. It’s the first time I’ve felt that there are just too many great deals out there for us to capture all or most of them.

Yet, despite the growth and improvement in crowdfunding, it seems that crowdfunding has yet to enter the American consciousness.

In the great kerfuffle The New York Times article triggered, nobody mentioned crowdfunding. Amazing. And there was just one tweet that mentioned ICOs in passing. That was it.

It’s frustrating. But I have to remember that private equity crowdfunding began only in late 2016. It simply hasn’t had time to develop huge attention-grabbing companies and unicorns. But it will.

Entrepreneurs need to see that there are paths to success outside of VC money. Investors need to see that you don’t have to be a VC to invest in high-quality startup deals. And the evidence that that is already happening is beginning to emerge.

The future is bright for startups and crowdfunding. But you won’t find that in The New York Times.

Good investing,

Andy Gordon
Co-Founder, Early Investing

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Source: Early Investing