Posted: 7:40 a.m. Thursday, May 2, 2013
By John Warrillow
Bloodhound sold for $82.5 million -- and the original founders got $36,000. Six things you need to ask yourself before you take venture investment.
The story of Bloodhound Technologies provides an ugly reminder of the dangers of taking venture capital money.
As The New York Times reported this week, Joseph A. Carsanaro started Bloodhound back in the mid 1990’s. The company offered a fraud monitoring software for health care claims. Mr. Carsanaro raised $5 million through two rounds of venture capital financing in 1999 and 2000. The venture capitalists got preferred shares with dividend rights. When the company ran into trouble, the founders were booted and the venture capitalists took over.
The venture capitalists then went on to raise seven more rounds of financing. In 2011, Bloodhound was sold for $82.5 million, but the original founders got a total of just $36,000. One co-founder apparently got a check for all of $99. Not surprisingly, they’re suing.
Taking venture capital money is the very last thing you should do to finance the growth of your start-up. Here are six questions to ask yourself before considering a venture investment:
Do you want to be rich or famous?
The start-up world has gone Hollywood. A hundred years ago, businesses were run by serious men, and some women, who wore suits to work and avoided the limelight. Today, twenty-something founders show up on the covers of magazines with their Vans peeking out from under faded jeans.
It’s all led to a start-up culture of wannabe entrepreneurs who tweet about who they met at South by Southwest and how “moved” they were by the latest TED video. They dream of getting accepted into beauty pageants like TechStars. At bars they talk about raising an A round as their buddies nod and wonder where their drinks are.
Yes, Mark Zuckerberg is both famous and rich, but he’s in the minority by a wide margin. In their study, “Cash Flow Rights in the Sale of V.C.-Backed Firms,” Brian J. Broughman and Jesse M. Fried explain that in more than half of the venture-backed exits they studied, the founders got nothing. And in the examples where the founders did get something from a sale, it was almost always a fraction of what the professional money walked away with, thanks to the venture capitalist’s use of convertible preferred stock. In fact, after studying fifty deals, in only one case did the founders get more than their venture backers.
Ask yourself why you want venture money in the first place. Is it because you want to sound cool at the bar? Do you want to feel like a master of the universe with hundreds of employees at your command? As the Bloodhound founders would probably tell you, indulging your ego comes at a very high price.
Why not own 100% of a smaller pie?
A carefully built $3 million company in a sleepy high-margin niche might be able to throw off 30% profit before tax. Would you rather make a million dollars a year and answer to no one, or be the manager of a venture-backed company controlled by a investor? You may want to change the world, and a $3 million-a-year company doesn’t sound very sexy. Fair enough, but just asking the question can help clarify what you want out of an entrepreneurial life.
What’s wrong with being second?
On slide three of virtually every pitch deck used to raise money from a venture capitalist is the age-old mantra of the importance of first-mover advantage. Bullshit. James Dyson reinvented the vacuum cleaner more than a hundred years after James Hess invented it in 1860. MySpace was founded a year before Zuck & Co. launched “TheFaceBook.com.”
First-mover advantage is garbage they teach in MBA classes. If you think entrepreneurship is learned in a book, stay in school. You don’t have to be first.
Why do you need outside money in the first place?
Unwrap a new iPhone and you’ll see the words, “Designed by Apple in California” inside the box. The phone is actually manufactured in some Foxconn factory in China. Apple isn’t interested in being in the dirty, low margin business of actually making stuff. Nor should you.
Could you lop a zero off your financing requirements if you decided to outsource the most capital-intensive parts of your business?
Could you start smaller?
Starting an airline is one of the most capital-intensive businesses one could imagine, but Porter Airlines started competing with Air Canada on the relatively modest proceeds of a legal settlement. Instead of competing head on with Air Canada’s quasi-monopoly, Parter carved out one route (Toronto to Ottawa) and served it with one model of plane (Bombardier Dash-8 Q 400 turboprop). Today Porter flies to 19 different cities and recently announced plans to buy new planes that will allow them to fly to more destinations. They had a big vision, but they chose to start within their means.
Could you avoid a venture capitalist if you chose to fly to just one place?
Can your customers fund your start up?
Fellow Inc contributor Jason Fried co-founded 37signals, which makes web-based applications including the project management software Basecamp. But Fried didn’t go out and raise a bunch of venture money to create Basecamp; instead, he had his customers fund it. Basecamp is the project management software that 37signals developed as they were doing large complex web projects for corporate clients. The cash from the consulting work funded the development of Basecamp. It’s not sexy, but it is a lot more fun than losing control of your company to a venture capitalist.
Venture money is expensive and dangerous. While there are famous examples of companies like Facebook and Google that took venture money, there are a lot more examples of young founders whose dreams to eat at the big kid’s table were dashed by a cocktail of hubris and naivety. The best time to look for V.C. money is when you don’t really need it; when you already have a successful company and can afford to defend yourself with your own $900-an-hour lawyer who will paper the terms so you don’t give up control or allow an investor to dilute your common stock down to nothing.