venture capital

An Alternative to Traditional Venture Funding

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Photo: Wally Gobetz

Yesterday I explained the pitfalls of too much venture funding. Whenever posting about a problem I will always attempt to follow up the next day with a potential solution. My idea is a Venture Capital funded bank account to be used by the startup where every X dollars spent translates into a percentage point of equity. The beauty in this model is that the startup receives the funding they need, but are incentivized to keeps their costs under control and become profitable in a hurry.

Let’s imagine a fictitious hot new internet startup looking for series B funding to take them to the next level. The offer they receive from KPCB is $10 million in exchange for a 40% in the company. Sounds great right: a ton of money from one of the best venture firms at what the founders feel is a generous valuation. Wrong! Take that same valuation but avoid the trap of taking more money than you need. Here is a potential counter offer:

  • $2 million immediately for an 8% stake
    • This amount will certainly be needed before becoming profitable.
  • The VC firm opens a bank account / line of credit for up to $8 million more where every $25k is 0.1% of equity
    • Forces the startup to watch their expenses rather than quickly burning through money without consequences
    • Protects startup from equity dilution (an excellent explanation) by only granting equity to the VC for funding used

If things start to go downhill for the startup there must be some protection from the VCs simply closing the account. Here are some potential rules:
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Too Much Venture Funding – When More Money is a Bad Thing

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Photo: Go Go Ninja

One pitfall for startups is taking on more funding than they need in exchange for a huge chunk of the company. It is obvious that the reverse is a problem — not enough funding means the young company has to be instantly profitable and will not be able to rapidly bring in new talent. Not as apparent but almost as dangerous is taking too much funding.

The examples are endless in the dot com boom. Webvan, Kozmo, RealNames, eStyle, Upromise, Priceline WebHouse Club, 800.com, Autolines, and Pets.com are some companies that had north of $100 million in funding and went out of business. After that debacle venture capitalists are more weary to hand out that kind of money. Only a handful such as Twitter, Facebook, LinkedIn, and Zenga have crossed a $100 mil. A further sign of caution is that in these latest examples the money often came well after the company had proven themselves with millions of users or by already being profitable.

Despite the regression in funding since the dot com bust, there still is too much money flying around for internet startups. Websites that are a good idea but lack a monitization strategy can raise tens of millions of dollars with good connections and a little luck. These aren’t large-scale manufacturing companies that need to purchase machinery or brick and mortar stores that need to purchase expensive inventory, they are websites that only need to buy a few servers. They have no need for tens of millions.

What happens when a startup receives more funding than they need?

  • It removes the sense of urgency to become profitable.
  • It makes it appear like the funding is a win, when really it is just a step in the process to having a profitable company, not the end goal.
  • The founders may become paper millionaires and lose focus.
  • The company loses control in the form of pressure from a VC firm with a huge vested interest.
  • The company owns less by selling equity for money they don’t need.
  • They spend the money foolishly because they can.  There were famous dot com heyday parties that cost over a quarter million.
  • They blow money on marketing. Obviously marketing is important, but cash strapped companies are forced to be creative with their marketing and still get more results than a Pets.com Super Bowl commercial.
  • Overaggressive expansion. Expanding before having a plan leads to unnecessary employees without direction.

Now that we all agree that too much venture funding is a bad thing, what can we do about it? Check back tomorrow for my idea.

Here is the second post “An Alternative to Traditional Venture Funding.”