Apparently, Most Entrepreneurs Don’t Understand the Real Purpose of Venture Capital
Startups are always thinking about fundraising, but very few of them spend much time thinking about whether they should.
I was meeting with a founder who’d been struggling to fundraise for a few months. His company was profitable and growing fast, and he couldn’t understand why venture capitalists weren’t interested.
Conversely, I was struggling to understand why he was fundraising.
“But we have ‘hockey stick growth’,” lamented the frustrated founder sitting on the other side of my desk. “Isn’t that what investors want? Why aren’t any interested in investing? What more can we do?”
“What do you mean by ‘hockey stick growth’?” I asked.
“You know,” he said, angling his arm vaguely upwards. “The past few months have looked like a hockey stick. We’ve got big growth.”
“What about the months before that?” I asked.
“We only launched four months ago,” he said. “We’ve been growing fast and steady since we launched.”
“That’s great,” I said, “but that’s not hockey stick growth. Hockey stick growth has the long, ‘stick’ part, and then it starts to dramatically curve up as it nears the ‘blade’.”
“So we skipped the long, slow part,” he said, adding an eye roll to further emphasize his lack of interest in what appeared to be a pedantic distinction. “Isn’t that a good thing? We’re growing fast and steady. Who cares if it’s not exactly ‘hockey stick’ growth?”
“Investors care,” I pointed out, “otherwise they’d be investing, right?”
Linear versus exponential growth
The founder thought about what I’d just said. “That’s a good point,” he replied after slowing down long enough to consider my point. “Investors don’t like the growth I’m showing. What’s wrong with it?”
“You’re showing linear growth,” I explained. “Linear growth is great. But it’s not the kind of growth startup investors are looking for. They’re looking for exponential growth, which we sometimes call ‘hockey stick growth,’ even though it’s a slight misnomer. Exponential growth curves up.” I drew a line in the air showing an arcing line upward and to the right.
“So what’s the difference?” he asked. “And why does it matter?”
“Think about it from the perspective of investors,” I told him. “Investors don’t invest in startups because they’re magnanimous people who just like helping entrepreneurs succeed. They invest in startups to help themselves make money. How do they do that?”
“By owning part of your company,” the founder answered.
“Exactly,” I responded. “But it’s more than just owning your company. They also care about the projected growth of your company in relation to how much they own. That’s why exponential and linear growth represent two very different value propositions for investors.”
“Why does projected growth matter so much?” the founder asked.
“It matters because it impacts how much they can buy of your company at the beginning,” I pointed out. “If a company is steadily growing month-over-month in a predictable, linear fashion, founders can usually keep up with that kind of steady growth. A lot of times, they don’t even need VC money. In contrast, true exponential growth will quickly overwhelm a company. The only way to keep up with genuine, exponential growth — a.k.a. ‘hockey stick growth’ — is with huge infusions of cash. That’s what VCs want. They want companies that need to give up large ownership stakes in exchange for the kinds of huge capital infusions necessary for sustaining exponential growth.”
“I see,” the founder said as he nodded. “A company with exponential growth is more desperate and has less leverage to negotiate, so investors can get more of the company.”
“Exactly,” I said. “But it’s about more than how much of your company they can buy. Exponential growth is helpful at the other end of the investment lifecycle, too. That’s when VCs are looking to exit, and companies exit based on multiples of their revenue. How do you think those multiples are calculated?”
“In relation to growth projections,” the founder said, with a knowing nod.
“Right again,” I confirmed. “And companies growing exponentially have more attractive long term projections, meaning they can exit for higher multiples on earnings.”
“I get it,” the founder said. “Investors want exponential growth — hockey stick growth — because it deflates a company’s revenue early when VCs are trying to buy, and it inflates projected revenue later when VCs are trying to sell.”
“You’ve got it,” I confirmed. “Exponential growth is good for investors because it makes them more money.”
Remembering the purpose of venture capital
“This makes so much sense,” the founder said. “I’ve never considered fundraising from the VC’s perspective. But, you’re right… from a VC’s perspective we’re not an attractive investment since we’re too profitable. Does that mean we should slow our growth temporarily and then increase it exponentially for the next few months in order to show exponential growth when we’re out fundraising? Or should we start spending a lot more money to try and grow faster.”
I laughed. “Those might be some of the stupidest ideas in the history of startups.”
“Why?” he asked, surprised by how much I didn’t like his suggestions.
“What’s the purpose of raising venture capital?” I asked.
The founder thought for a few moments before saying, “To get the resources we need to build a successful company.”
“Then why is your suggestion stupid?”
He thought for another moment before a look of understanding slowly spread across his face. “Because it’s forgetting the purpose of venture capital. We shouldn’t raise VC just for the sake of raising VC. We should only raise VC if we need the money. But getting money through revenue is much better, and it’ll make us a better company.”
“Exactly,” I confirmed. The founder finally understood what so many entrepreneurs struggle to appreciate: venture capital isn’t a goal. Instead, VC is a tool. More importantly, it’s a tool that comes with lots of problematic tradeoffs focused more on making investors wealthy than making startups successful. Because of those tradeoffs, entrepreneurs shouldn’t pursue VC just because they’re building startups and feel like they’re supposed to fundraise. Only fundraise when it’s the best way to make your company successful.