Venture Capital’s Biggest Fear

March 1st, 2011

I enjoy running my own business. One of the things I find most interesting is learning about business mechanics from a completely hands-on perspective. While I would not classify my education as nearly complete, in the several years I’ve run Red Sweater I have a learned a few objective truths about all businesses, and many subjective preferences about how my business should be run.

One of the most important questions any business deals with is how it will be funded. If you’re thinking of starting a business, you should probably decide how you want to be funded early on, so you can orient your business towards being successful in the context of that funding.

Broadly speaking, a business will either be “bootstrapped” or funded by outside investors.

The goal for a bootstrapped business is to come up with your initial funding, be it in the form of cash, free time, raw materials, or some combination, and parlay these resources into a service or product that generates revenue from customers. Once the revenue from customers pays for the founders’ initial investments and sustains the recurring expenses of the business, theoretically including your salary as a founder, the company is profitable and poised to grow. The huge benefit to bootstrapping your own business is that, once the company is profitable, you retain 100% control of the business’s strategy and resources.

Another method of starting a business is to seek outside investment in the form of angel funding or venture capital. You give up some clearly specified percentage of the company’s ownership in return for cash, guidance, and social connections. From here, the goals are basically the same: to become profitable, but at the end of the day you end up with a smaller stake in your own company than you would have if you bootstrapped it yourself.

I think there are good arguments for both approaches, but I am strongly disinclined to seek venture funding for my business. When friends ask for my opinion, I almost always strongly discourage them from seeking it as well. Why? Because venture capital doesn’t speak to our priorities, and is unlikely to build the kinds of companies we want to run.

I was listening to the always-inspiring This Week in Startups podcast when an interview with Tony Conrad led to a perfect synopsis of why venture capital is not right for me. Jason Calacanis and Tony Conrad were discussing the state of venture capital in the technology world, and observed that consumers are spending a ton of money online, but there is a “risk” that the money is being distributed among too many companies. In a nutshell, they said, the online business world was becoming more like “Main Street,” with too many small businesses, and not enough “Walmarts” to pay back the massive returns.

This, Tony Conrad said bluntly, was his “biggest fear.”

Venture capitalists would rather fund a single billion-dollar company than a thousand mom-and-pop million-dollar shops. I can’t say that I fault them for this, but it cuts to the core of where their priorities lie: they gamble on high stakes, massive returns, while shunning the concerns of any business that wants to maintain a mom-and-pop Main Street business ideology. Personally, I prefer the Main Street shopping aesthetic to Walmart, and I know which part of town I want my business in.

If you want to be Walmart, by all means seek venture funding: you’ll need lots of it to stand a chance at succeeding. If, on the other hand, you want to build a company guaranteed to preserve your values, fund it yourself and maintain control. You’ll own something to be truly proud of while helping to scare the crap out of venture capitalists.

7 Responses to “Venture Capital’s Biggest Fear”

  1. Mike Says:

    Well put, I never thought of it broken down this way, where small software shops, such as Red Sweater can be thought of as a “business that wants to maintain a mom-and-pop Main Street business ideology”. That really clicked for me. As someone who buys more than my fair share of items from Amazon, when it comes to a new product or service that I will require a support infrastructure, I always look local first, that is hopefully more “mom-and-pop”, than “Walmart”. In the “mom-and-pop” situations, I expect the incentives of the owners will match up against processes that provide for a better customer experience, otherwise they will not survive.
    As an aside, if I was to start my own company today, I would try to bootstrap, if at all possible. I believe that bootstrapping forces you to listen more closely to your customers and develop features and fixes that they are specifically asking for. That should build more loyalty from your customers and lead to marketing of your product by them.

  2. Devin Says:

    I liked this article. Simple, straight forward.

    vc’s should be scared that “bootstrapping” is becoming increasingly easier and cheaper (especially w/ software companies). a mom-and-pop store can effectively grow into “walmart” without the need for a VC to fund it. setting quality/values are becoming ever more important too (and i think a lot of mac/iphone devs like that).

  3. Chad Says:

    I think there’s one area where outside investment might make sense, and that’s a business model where a product doesn’t have much revenue until it hits a ‘critical mass’ of users. Think social network type stuff, where there’s a chicken-and-egg problem of nobody participating until everybody participates.

    Of course, the typical VC golden goose is a product with no discernible revenue strategy that for some reason looks appealing for a big-company buyout.

  4. JulesLt Says:

    The other thing to remember with VCs is that they have a relatively short term objective – which is to make a big return on that investment within 5 years, tops.

    And the only way they’re going to get that is by either a flotation, or more likely, by selling out to a bigger player. At which point decisions get made that are about making the company look a lot better on paper at the point of sell off – i.e. cutting back on investment to boost profit in the short term.

    The odd thing is that my view of the online world is exactly the opposite – that Google, Amazon, Apple, ebay, Facebook are far too dominant. If iTunes was a store, it would be Tower – huge, diverse, but at the same time lacking personality.

  5. R Says:

    If you are bootstrapping a company that will provide resources for free (aka twitter or facebook) and has chances to grow easily. Wouldn’t you need venture or angel capital to grow? Specially on the web space, wouldn’t you need money for more servers as the site grows? If you don’t have that much money saved, I guess bootstrapping has its limitations and it’s mostly ideal for the mobile app like space where the technical expenses are pretty much none…

  6. Kevin Hoctor Says:

    Well stated Daniel. As usual, you do a great job of breaking down and explaining a concept.

    Having done both bootstrapped and investor startups, I much prefer the former. Unless you have a severe need for an initial cash infusion, you really don’t want to lose control of your business.

    There’s no such thing as a silent investor. They are expecting a large return on their investment and will insist on a say in your operations and products. You will be functioning in a fishbowl with less room for mistakes.

    Also, don’t forget about the risk of having too much money. You won’t operate as efficiently if you don’t feel the stress of limited cash flow. There’s a lot to love about bootstrapping.

  7. Steve Madsen Says:

    Great article, Daniel, although I disagree that the goal of the VC-funded company is the same as a bootstrapped one. VCs aren’t interested in modestly profitable businesses. They need big hits to cover their 90% failure rate. And profit isn’t even a requirement if the company can IPO or be acquired for a large sum.

    @R: I’ll argue that an entity focused entirely on providing free services is not a business at all, but a charity. If the definition of success is an IPO or buy-out, that’s speculation and gambling. You’re relying on the greater fool theory, not on your own decision making and ability to execute.

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