85. How venture capital kills startups ☠️

VC investment is a double-edged sword. It can launch your startup like a rocket, but it can also cause it to explode on the launch pad.

How it succeeds is no mystery, you have mountains of cash to play with. I want to talk about how taking venture capital investments can destroy your company.

This article is part of our series on Fundraising.

No going back after VC

Taking venture capital investment is an irrevocable step. Even accepting angel investments creates certain expectations about market size and an intent to move quickly to an exit. With VC, the expectations are much higher. Think carefully about whether this is the kind of journey you want to take because once you cash the check, there is no turning back.

If VCs are interested in your A-Round (or later), you must already have a strong and growing business. VCs need to see rapid growth, a huge opportunity, and the ability to deploy significant money to sustain and accelerate that growth.

Example

Imagine that your company is ready for its first round of VC funding. Your sales/marketing has an ROI of 1.5, so for every $1 you spend, you generate $1.50 in revenues. In addition, your company is on a $5 million annual revenue run rate.

The VC agrees to invest $20 million on a $100 million valuation. That is high but not unreasonable. With $5 million in revenues, that is a 20X multiple, typical for high-growth companies. The investors want you to at least triple that valuation over the next 24 months. Anything less will start to look like a failure, and they might not invest in the next round.

That means your company needs to hit $15m in ARR in two years, maybe more if the market is cooling and multiples are dropping. No small feat.

How to grow exponentially

Burning Euro and Dollar Money Stock Videos by Vecteezy

How do you triple (or more) your revenue in two years? The obvious answer is to spend heavily on sales/marketing. The more you spend, the more customers you get, and the more revenue you generate.

However, you are already selling to your best prospects, the low-hanging fruit and ideal customers. To accelerate your growth, you need to expand your target market. But that necessarily means you are less targeted. Overall, you should expect your ROI to decrease as you ramp up your sales efforts.

Assuming you did a good job identifying your initial target market, each new population you add will have a lower conversion rate than the last. As long as your revenue exceeds your sales cost plus your COGS (cost of goods sold), you are gold.

The Problem

But, at some point, that revenue will drop below your costs, often driving your sales ROI below 1.0. Then you are losing money on every new sale.

You might hope to make that up over the customer's lifetime or through economies of scale as you grow. If that works, you can ride the VC rocket to the stars, but for many (most) VC-funded businesses, the money pit continues to grow.

“We lose money on every sale but make it up on volume” - a very old joke

This is the "marginal dollar problem." Each additional dollar you spend to grow the company returns less than the one before, so spending your way out of this deficit is effectively impossible. It is what creates unicorn or decacorn companies that are growing exponentially while hemorrhaging cash.

At this step, the answer seems obvious; you need to fix the underlying economics of the business. Either you need to re-focus on your ideal customers or improve your solution to reduce costs and improve conversion.

The Catch

But, if you stop to do that, then your company's growth will slow, and valuations will decrease in your subsequent funding round. That is utterly unacceptable to the VC, so they will put enormous pressure on the CEO to continue growing at all costs.

After all, marketing pays now, while reengineering takes time, is not guaranteed to produce results, and those results can be hard to measure.

It's nearly impossible for the founding CEO to push back on the VCs and refuse to continue riding that money-fueled, money-losing rocket. Unless you fix the marketing ROI, or you were right about those economies of scale, and things start to turn around, the next group of investors won't show up.

Your current investors will consider your company a worthy but failed experiment. They won't want to invest $5 billion in your F-Round to chase the $1 billion in your E-Round, that followed the $100 million they invested before that.

Eventually, they will walk away, and the money spigot will dry up. Because you don't have an endless hose of money fueling your growth, sales will crater, demolishing your valuation. Few companies survive this without massive damage. At best, you could get acquired for pennies on the dollar compared to your previous valuation.

The moral of this story is: don't take VC unless you know you can deploy vast amounts of cash effectively while maintaining a solid ROI.

Learning that means doing experiments. You need to test those larger markets to measure the ROI. Take time to validate your economies of scale. Plan out your whole growth curve and look for pinch points and likely growing pains.

Once you cash the check, you have committed to this journey. There is no turning back and no plan B. The more you can risk reduce this path in advance, the better chance you have of reaching the stars.

When VC works, it is the engine that makes headlines in all the business journals and generates the returns VCs are looking for. VC only need a few massive winners to make their whole fund a big success, and they are content to destroy a pile of companies along the way searching for those winners.

If you are not confident that your model will survive hypergrowth, you might reconsider VC and follow a slower and less perilous route to success.

TechCrunch wrote a great article on this called Toxic VC and the marginal-dollar problem.

Until next time. Ciao.

Next, you might want to read about problematic terms that investors might want to push on you.