The billion dollar curse
Not every startup is meant to be a unicorn, and that may be for the best.
Be careful what you wish for
A problem I often see in early-stage venture capital is that sometimes the nails chase the hammers, even if the nails aren’t a good fit.
The point here is that many new entrepreneurs will blindly opt for VC funding.
At surface level, nothing might seem wrong with this. But venture-backable companies should be of a certain nature and have certain characteristics.
One of the commonly required characteristics is to have the potential to be a billion dollar company — to have a very large addressable market and opportunity.
This selection criteria makes sense for VCs because by default their strategy is to invest in very high-risk companies, many of which will fail. So they need to be sure that they invest in companies that can actually become worth billions of dollars. This is how they can end up making a profit despite having many failures in their portfolio.
A market problem
Many of the startup success stories we witnessed over the last 10-15 years made it sexy to be ‘VC-backed’, creating a strong desire for aspiring entrepreneurs to seek VC funding.
At the same time, this also created greed, overhype, and misalignment. Founders saw an opportunity to gain funding and ‘paper wealth’ more quickly. It became in their interest to position themselves as a company that fit VC fund criteria.
For example, a common one is Founders inflating their addressable opportunity.
In all fairness, Founders—especially those less experienced—are not solely the cause; this was simply the narrative they saw celebrated by the media and industry.
And if this was the path that led to success, why not follow it?
The tourists
Many of the VC industry’s top voices talk about how such markets attracted new entrants that are not meant or designed to be in the category. These are often called ‘Tourists’. The new entrants create noise and more supply, driving up hype and market prices as a whole.
This makes it harder for those who are in it for the long-term to compete; profits erode.
Most importantly, it also muddles up priorities, causing distraction from what’s actually important: building healthy and successful businesses that solve a real problem and that can deliver financial returns to investors at all stages.
But there’s more to it
An issue (and another cause) that I’ve seen in the early-stage market is that there is a lack of formally available funding alternatives. This leads to a funding gap for startups that are not a good fit for VC.
Here are some of the common characteristics these startups have:
Their market and/or opportunity size is smaller
They have development and growth trajectories that do not fit the ‘exponential growth’ curve
Their business may be better off raising debt capital
The time horizon for their business to achieve the desired return profile exceeds that of a venture fund’s
So we can see how these characteristics resemble a type of company that would usually sit outside the VC playbook. But the fact that a formal funding gap exists explains why a surplus of startups flock to VCs even though they aren’t a good match for them.
My argument is that businesses don’t need to be billion dollar companies in order to be successful, or for the Founders and Investors to make money, but they do need to have a realistic TAM, and be structured and valued fairly at the outset.
Be realistic about your prospects. The way you position and build initially will heavily impact your longer-term health and success.
I think there is an opportunity for other types of investors to fill a gap that cannot be served by VCs. And I think this can work out better for certain startups, even if they were able to achieve VC funding.
So who are these other funding candidates?
Family Offices
Experienced Angels
Specialized Syndicates
Corporate Venture
Know your investor
To these other types of investors, success can look very different. Why? Because there are inherent differences in how they are structured, and how they can operate:
They don’t need to take moonshot level risk
They might not have LPs
They might not feel disincentivized by a smaller ticket and a fairer valuation
So why is investor fit a crucial part of startup success?
The need to take high risk
When it comes to VC Funds, there is a fundamental difference:
A venture capital fund’s core business is venture capital, and therefore they need the large, high risk, and high reward types of opportunities in order to make their core business work. We discussed this above.
The alternatives however are likely to be investing in venture as a form of diversification from their main business activities or other core investments.
Investors such as Family Offices, Corporates, and Angels, might be using income from separate businesses or wealth to invest into startups. So the venture portfolio is likely to represent a minority of their overall portfolio.
And given that this is not their core business, and that they are not dependent on these investments as their main source of income, they don’t need to take moonshot level risk; they can accept different return profiles.
The benefit is that this gives startups the opportunity to plan, structure, build, and grow differently at the outset. This is an advantage to those who see it.
Autonomy
A lack of LPs (in many cases) will mean that these other investors might have more flexibility and autonomy in the way that they are able to manage the relationship.
They can choose to take a patient and longer-term view more easily than VCs can.
VC behavior is often affected by pressure and expectations that come from LPs (the fund’s investors). And these expectations follow the standard but increasing 7-10 year time horizon of a VC fund. This is the timeline along which investors expect to get their money back.
Ticket size
The alternatives may also be able to offer smaller tickets, not pushing you to take too much funding or bloat your valuation to a point where it becomes unrealistic and counterproductive.
A somewhat counterintuitive but enlightening thought is that—if done right— many of these opportunities, even if smaller by stated size, can probably end up being more profitable and successful to the Founders and Investors in the end. Why? Because they might actually make it.
Half-baked
I will challenge the popular convention that: a small piece of a bigger pie is better than a large piece of a smaller pie.
Not always. In my view: a smaller pie is better than a large pie that can never be eaten.
If the pie never actually becomes large—and if this was predictable from the start—then this is a waste of capital and opportunity.
Not every pie is meant to be large, and by trying to force it to be large you can ruin the baking process, and the opportunity that you might actually have.
Accept that some pies are better off small or medium sized. Just because investors want to see a huge pie, it doesn’t necessarily mean that the Chef should bake one, or that customers will buy it.
Chefs should think about who the ideal restaurant owners and investors they want to work with are.
Points for Founders
Why take this into consideration?
Although the pie may be smaller, you may end up with a larger share of it, and an actual exit
Some startups simply need more time to grow. Taking capital from patient and longer-term investors allows you to build in a more steady and confident way
The mentioned alternatives might be able to provide both equity and debt funding. This makes them a versatile partner
They may also be strategic if they operate a core business that is related to what your startup does; they may be able to offer advice, market experience, and access to industry networks
You may be a future acquisition target for them
Ecosystem evolution
As software becomes a default component of business operations, everything is becoming a ‘tech business’.
Infrastructure is readily available, costs have come down, tech savviness has increased, and overall usership is high.
Ecosystem development and maturity mean that there is more opportunity in the middle—the niches are growing. Good opportunities don’t have to come only from businesses that are huge or totally disruptive.
I implore the startup and venture industry to think about how we can nurture a tier of healthy and investible small and medium sized tech businesses, as we’ve been doing with traditional SMEs in the offline world for much, much longer.
Concluding thoughts
As software becomes the operating backbone, not everything has to be a moonshot.
There is a market opportunity for other types of early stage investors to step up, fill a formal funding gap, and grow certain types of startups in a better way.
Founders, remember, the larger the plan and opportunity you set, the more you will have to achieve in order to succeed. Instead of trying to aim as big as possible, think instead of how you can build a successful company and how you can find the right types of investors, the ones whose game it is to play the same one you’re playing.
If you take a long and broad view, you can see that building a successful company will give you options to move forward in any case—whether it’s to then aim higher from a position of strength, or to exit and start another business with a positive track record behind you.
So remember, if done right, less… might just lead to more.