Raw, early stage startups often watch way too much TV and see shows like Startup.com and others where there is some kind of achievement when they get a “funding event.” Well, what they do not see is it is more accurately called a dilution event.
VCs are not the friends of the raw startup. Sure, if you have just mediocre technology and you are not going to be that hot anyway, go ahead because all you are doing is funding your job until you get fired and diluted out.
But what if you do have a very hot, differentiated, protected technology? Well then, you need to stay away from private equity (what VCs call themselves) as long as you can.
Why?
First, just do the math. A VC wants 20%-40% or more of your equity for an early round. They tell you all about the “risk” they are taking.
Then they will tell you they really cannot invest $1 million or $2 million, they need to invest $6 million or $8 million to make it worth their while. So here you go. Sounds great. Sounds like you are off to the races.
But then the ugly reality sets in.
You give up 30% or more of your equity thinking you will then use that money judiciously over several years to grow your company in a sane way. You think you are going to build your company with great products, wonderful customer service and change the world.
Welcome to your second or third monthly board meeting.
The VC or VCs with whom you are working want you to spend that money as fast as you can. Hire, hire, hire. Bring in that very expensive VP of Marketing, costing maybe all in $350,000 a year. And a VP of Sales, same amount. And each needs a staff, programs, product enhancements, events and of course massively expensive CRM systems.
This is what “acceleration” looks like AFTER you get the dough.
But, wait, you aren’t really ready to expand that fast. And fast, very fast expansion always makes lots of mistakes. Bad hires, marketing programs launched by some 28-year old MBA who has been at your company 90 days who has all the answers.
This is how you get diluted.
The VC makes you accelerate. It is like taking a promising 11 year child and trying to get him or her to play semi-pro sports. It works one time out of 20. And the VC knows that. They make their money “accelerating” your business to the breaking point and if it becomes a home run, they get all their money out, then they take their “preferences” and take even more money out, screwing you and your employee option holders.
That means the VC gets paid several times over for the “risk” they took on your business. But the risk is all yours. Your company has a 1 in 20 chance of succeeding and will then have to take in another equity round to support all the madness you were force to pay for.
Then what happens?
You miss your number. Another 40% comes out of your equity. Then you learn the alphabet of A round, B round, C round, D round. A, B, C, D spell dilution in VC terms.
Dilution, if you haven’t figured it out, means you are screwed. You have little equity. Preferences mean you get paid last. 1 in 20 means you may get lunch money out of your equity. Employees will probably get zero.
And that great customer service you wanted to deliver? Those new enhancements you were so proud to bring to market?
After you throw away tons of dough on sales, marketing, marketing programs that suck, sales turnover, massively expensive CRM systems, trade shows, staffs, of course the yearly company meeting ($500,000 or more), you look at your spouse and say, “wow, I lost my company.”
There is a much better way.
Go more slowly, sell your way to success. Keep your equity, you earned it.
And remember, a raw startup is looking for the innovator, the early adopter, and all those expensive marketing programs cannot find them with a roadmap.