I recently came across a good article by Jonathan Friedman at LionBird about why VCs pass on ‘good’ companies. The gist of it is that the VC model is based on slugging percentage, not batting average (i.e. a few big hits carry the returns while the rest can essentially fail). Accordingly, leaders of ‘good’ companies need to get their spiel down to convince VCs why they are ‘great’ (i.e. 10x or more return for the VC). The assumption, of course, is that securing VC funding is tantamount to success.
But this got me thinking. There are many ‘good’ companies out there that actually shouldn’t take VC funding, even if they can get it. In all of the hype surrounding VC-backed successes, this option can get pushed to the side or even off the radar screen.
In the past few months we’ve parted ways (amicably) with multiple ‘good’ tech companies with solid niches, capable teams and strong unit economics. In these instances we ultimately realized that, barring an extreme outlier upside scenario, a small exit was much more likely than a large one. There is nothing wrong with a small exit. It can still be life changing for the entrepreneur, but it won’t drive the economics required for a VC fund.
Here are some typical features I’ve noticed of ‘good’ growth stage tech companies that shouldn’t take venture capital:
- Sustainable advantage (proprietary technology, durable customer relationships, etc.)
- Growing at healthy but not blazing pace (situation dependent but probably 20-50% YoY)
- Positive cash flow dynamics (growth generates more cash which can be reinvested in business)
- Current leadership capable of driving next ‘crank’ of growth with minimal supplementation
- Sufficient runway but niche market (TAM < $500mm); honest assessment is critical here
- Exit (if that is the goal) most likely to come from strategic acquisition
- Cutting timeline to triple the size of the business by 50%+ doesn’t materially change company’s prospects (excluding time value of money)
Particularly in today’s capital environment, companies that fit the above description have a decent shot at securing some sort of institutional VC equity funding. But in most cases they probably shouldn’t… and that’s okay! Entrepreneurs leading these types of companies can still do remarkably well without venture capital.
Of course there are many cases where a VC equity investment makes a lot of sense for both sides (otherwise I’d be out of a job). But the rationale for these arrangements seems to be well treaded territory. I’m simply shedding light on another perspective that applies to some forgotten portion of the ecosphere. The important thing for entrepreneurs is to thoroughly consider the pros and cons as it relates to their specific situation.