funding

The Benefits Of Raising Less Money

A couple of weeks ago, TechCrunch published an essay called "Raise softly and deliver a big exit" by Jason Rowley. In this essay, he set to explore the relationship between the amount of funding startups raise, and the success of the exits, measured by the ratio of exit valuation to invested capital (VIC).

The analysis, unfortunately, doesn't provide a breakdown by space the startups operate in, and thus is relatively high level. It also raises some questions about the validity of using VIC as a metric to compare to the amount of capital raised or the valuation: as both of those are in fact used in the calculation of VIC, any inferences about the correlations between either of them and VIC aren't really meaningful.

Still, even if the conclusions aren't statistically meaningful, the analysis itself raises some interesting points, all of which can be summarized in a single phrase: "raising a lot of money makes getting high return on investment less likely".

One could argue that this is a fairly obvious conclusion that doesn't require looking at any specific data, and she'll be right about that: making high returns (meaning a percentage of capital invested, not absolute numbers) at scale is often harder compared to a situation when you invest relatively small amounts of money.

For the startups raising venture capital funding, that appears to be particularly true. Selling your company for $50 million is a success, if it only raised $5 million in funding; it becomes much more complicated if it attracted $100 million in funding - in this case, to deliver the same multiple you'll need to sell it for at least $1 billion, which drastically limits the number of potential buyers (and also the chances that the company would be able to get to the stage when it could be solved for such an amount of money).

So why are we so focused on the huge rounds raised, "unicorn" startups and the outsized exits?

Part of the story is tied to the business model of the VC firms: most of them receive a fixed percentage of the assets under management (AuM) as a management fee (typically, 2% per year), plus carry (say, 20% of the overall proceeds from exits, once the investors in the fund are paid the principal back). Both of those pieces are directly tied to the AuM, creating the incentive to raise more money from the limited partners.

What that means is that there is a misalignment between the interests of limited partners (who care about returns as a percentage of capital invested), and those of general partners (whose compensation, and especially their salaries, is to a significant extent determined by the AuM size, followed by the absolute returns).

This compels the general partners to raise larger funds, which in turn means that they need to pour more money into each startup (or do more deals per fund, which brings the risk of spreading your resources too thin). And investing more money per startup creates the obvious pressure for larger exits.

While VC piece is relatively straightforward, the situation for the startup founders is more complicated. Unlike the general partners of VC firms, the founders do almost exclusively care about the returns: the founders' compensation isn't really tied to the amount of money they raise, only to the proceeds from selling their companies. Another interesting point to consider is that for the vast majority of individuals, the amount of money required to completely change their lives is much lower than the amounts that might be deemed satisfactory for the VC firms, especially the larger ones.

To illustrate this point, for a firm with $1 billion under management, selling a company they've invested $5 million in at $10 million pre-money valuation, for $50 million, isn't really attractive: even though they'd make a decent return on this investment, the absolute gains are too small to make much of a difference.

For the founders of that same company, however, such a deal can be very attractive: if there were 3 of them, it would yield them more than $11 million apiece - a huge sum of money for any first-time entrepreneur. Accepting a deal like that would also leave them free to pursue their next ventures, knowing that they can now take bigger risks, with their financial security already established.

So again, why does the entire industry pay some much attention to the largest deals and exits?

Well, for once, it's just more interesting for the public to follow those deals - they create a rock-star aura around the most prominent founders and VCs, something that is obviously lacking for the smaller investments and exits. Next, some of the more exciting ventures do require outsized investments: that is often particularly true for some of the most well-known B2C startups (e.g. social networks, or on-demand marketplaces) - that, however, certainly isn't the case for a lot of companies out there. Finally, the VC agenda certainly plays a role there as well.

And yet, while all those reasons might be legitimate, it's worth remembering that for every $1 billion exits there could be dozens of $50-100 million sales, and while such deals don't always sound as cool, there surely do have the potential to change the lives of the entrepreneurs involved in them.

Why ICOs Probably Aren't The Future Of Early Stage Financing (At Least, Not Yet)

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While catching up on the recent posts on avc.com, I came across this video from the Upfront Conference, in which a number of VCs and entrepreneurs discuss the pros and cons of ICOs and tokens in the context of early stage funding.

For those of you who don't have time to go over the entire video (although I'd still recommend watching it, as it last only 7 minutes and is highly educative), here are a few quotes from it that I found particularly insightful:

Adam Ludwin, Chain:

"It's not surprising that you see the number of ICOs you see, because of the temptation to raise capital that's not equity, so there is no dilution, and is not debt, meaning you don't have to pay anyone back, so people are just giving you money, and all you give them is the hope that the thing they have will appreciate in price. That's a very tempting deal for any entrepreneur to take."

Jim Robinson, RRE:

"What I have to get right to win is I have to have a company actually work. It has to build what it's supposed to build, it has to find an audience, it has to have sales and repeats. What I have to get right if I'm speculating or investing in tokens is not whether or not they'll actually ever work, it's whether or not I timed it correctly."

Fred Wilson, Union Square Ventures:

"We're gonna invest in the sector for the long term, you know, we're thinking about it as a 10-year or 15-year investment opportunity, and so we try really hard not to get caught up in near-term price speculation... There is not enough reporting and accountability, there's not enough governance, there's too much early liquidity, there's misalignment between potentially the investors in the platform and the developers of the platforms..."

Tom Loverro, IVP:

"This is sort of constitutional democracy in 1776, like nobody really knows how to make this stuff work."

I believe those opinions offer a great perspective on why ICOs should be viewed with caution, and also why they probably aren't going to replace the traditional ways to fund early-stage companies anytime soon.

To be fair, I'm not going to argue with the fact that the cryptocurrencies and blockchain are creating some very exciting possibilities, allowing to rethink the way some things were typically done in the past. And, in case of ICOs, the idea of bypassing the intermediaries, such as VC funds, and the costs associated with them, and investing directly into the promising companies at the early stages (thus leaving potential for a huge upside, if the startup is to succeed) is certainly luring. However, the mechanisms governing such investments were put in place for a reason, and people willing to participate in ICOs need to have a very clear understanding of what they're getting themselves into.

Below is the summary of some of the good reasons to use ICOs to fund companies:

  1. For people who possess deep expertise in a certain field (thus allowing them to figure out what the most promising opportunities are) and at the same time are unwilling, or unable to invest through traditional channels, ICOs might represent an sensible (and cost-effective) investment option
  2. Some might be less interested in the long-term prospects of the companies having ICOs, and rather are hoping to earn high returns by trading tokens - for those, the speculative nature of ICOs, the lack of regulation around it and the low transaction costs can make ICOs quite attractive
  3. Also, in theory, there is nothing preventing the companies that have already gained significant traction from doing ICOs for some very valid reasons, the most famous example of that being Telegram with its huge ICO of $1.2 billion - given Telegram's ambitions to create an ecosystem of decentralized apps that won't be subject to regulation by any government, ICO appears to be exactly the right tool to raise funding; moreover, such later-stage ICOs are obviously less risky than investments made in very early-stage companies, and thus might represent a great niche for ICOs as an investment mechanism

At the same time, there are plenty of reasons for investors to be beware of ICOs (even after we exclude the obvious scams, such as pump and dump):

  1. The protections for the investors are often limited or non-existent: most ICOs today are much more similar to crowdfunding than to public offerings, thus leaving the investors vulnerable from the legal standpoint
  2. Pretty much anyone can invest in ICOs, which is not the case for most of the regulated investments that are typically considered high risk: the concept of accredited investor exists for a reason
  3. The governance structure of many companies having ICOs is often questionable at best, leaving the investors with limited say on the direction of the companies' strategy
  4. The fact that the tokens acquired in ICOs can be traded can be great in a sense that it provides the investors with liquidity; however, that also creates a conflict of interest between the founders and the backers
  5. To build off the previous point, given that the vast majority of the companies doing ICOs these days are early stage, there are often no objective ways to value them, which in turn means that the price of the tokens is subject to huge swings, often based on rumors or the quickly changing sentiments of the public

So, will ICOs evolve in a mature investment mechanism that'll revolutionize early-stage financing? To me, at this point the answer remains unclear: while ICO as a mechanism most certainly has a great potential, I think it'll most likely take years before it evolves into a more reasonable investment tool that the public can truly benefit from.