Venture money ain't free

Here’s a question: if you’re penniless and I hand you a $20 bill, how valuable is that money to you?

It would probably be pretty valuable – it might allow you to buy a blanket to sleep under or a warm meal to keep you full for the night.

Imagine instead that you have $10 million in liquid assets and I hand you a $20 bill: how valuable is that same bill now?

Probably… not at all. That money likely doesn’t allow you to do anything that you couldn’t have done before.

This difference illustrates the fact that even though $20 may have the same absolute value in two different people’s pockets, it has a diminished marginal utility in the richer person’s pocket. “Marginal utility” just means “how much additional happiness can this dollar purchase?”

This same dynamic has interesting consequences for the incentives of investors and founders.

When interests align

One common reason that people start businesses is that they want to make money. Would-be founders can and certainly should have other reasons that they want to start a business, but I don’t think that Jeff Bezos or Mark Zuckerburg would have put in as much effort as they did without the potential of making a buck. Unfortunately, these businesses need a lot of money until they can turn a corner and start making a lot of money.

Thankfully, other groups want to make money too. Pension funds, endowments, and high net worth individuals already possess fistfulls of cash and sometimes have a fiduciary responsibility to grow that into entire armfulls of cash. They recognize that it’s lucrative to buy shares of new businesses being founded by promising teams. These entities give their money to venture capital firms and become “limited partners” of the venture capital fund. The VCs then seek out promising companies to invest in.

Importantly, the economics of venture capital rely on what’s known as the power law distribution. These funds are searching for whales: the single best investment in a VC’s portfolio is likely to outperform the rest of their portfolio combined.

Incentive-wise, if a VC doesn’t believe that an investment might be that single best result, they’re obligated not to make the investment.

Founders need money to start businesses: VCs need to invest that money to earn returns for their limited partners. This is the symbiotic relationship that makes the whole ecosystem spin.

When interests diverge

Let’s turn the table back around and look at things from the founder’s perspective.

If a founder is ultimately able to sell their business for $100k, that’s significantly better than selling it for $10k. $1 million is significantly better than $100k. $10 million is better than $1 million. $100 million may be better than $10 million… but it’s certainly not 10 times better. I’m skeptical that $1 billion buys you any happiness that $100 million can’t – and heck, it may buy you some problems.

Somewhere between $1 million and $100 million, there starts to be a very steep drop-off in terms of “what can I actually do with this money in order to make my life better?” In other words, the marginal utility of the money starts to quickly diminish. Somewhere in that range is a number where you don’t have to work again, you can pay off your mortgage, you can send your kids to whatever school you want, you can live in a big enough house in whatever neighborhood you want, and you can pursue future goals without concern for money.

Therein lies the tension: for the founder, selling a business for $5 million is a life-changing win. For venture capitalists, a promising portfolio company selling for $5 million is like lighting a lottery ticket on fire. This fact shapes both the types of businesses that VCs fund and the paths they encourage those businesses to take once funded.

To founders who spend money, that money has diminishing marginal utility. To investors who view money as a rate of return on an Excel sheet, money has no diminishing marginal utility.

Thinking about expected utility

Venture capitalists should treat companies in terms of expected value: “if I invest this dollar in this company, what can I expect it to turn into 5-10 years from now?”

Because of the diminishing marginal utility of money, founders should probably treat the opportunity cost of starting a company differently. “If I work hard for 12-18 months to get this company off the ground, how much happiness/utility can I expect that work to bring me in the future?” Whatever the distribution of possible outcomes is, their choices should factor in that having $100 million in the bank provides about as much utility as having $10 million in the bank.

The good news is that if you understand the fundamentals of customer research, idea validation, sales, and marketing, there’s a pretty good chance that you can find some software that should exist and build it if you can rope in a similarly capable friend or two. There are reasonable $5-10 million business-to-business software ideas laying around in plain sight that have a ~20% chance of success. Many of these ideas can either be discarded or bumped up to a ~50% chance of success with less than 40 hours of work of well-executed customer conversations (see: The Mom Test). Furthermore, many of these businesses can be easily sold once they’re off the ground.

This type of business is what the software bootstrapping world is all about: find an unglamorous but meaningful B2B SaaS idea that’s been overlooked and turn that idea into something great.

However, herein lies the rub: investors care about the expected value of the investment. Founders probably care about the expected utility of their efforts. Founders would probably prefer “real possibility of a life-changing outcome” over “infinitesimal chance of becoming the next Bill Gates”.

The gap

For bootstrapped businesses, there’s an undeniable and painful gap between “I have an idea that my initial conversations indicate could work” and “I have a functioning business”. Even if you have the necessary tools to get the business off the ground, it’ll likely be at least 12-18 months before that business is going to provide meaningful income.

I think this gap is one of the reasons that companies are often pushed towards the venture capital track: a small amount of startup capital is incredibly helpful to get off the ground, but once you’ve gotten on the investor-backed rocket it’s hard to eject.

In going down this route, the incentives of the business shift permanently towards “becoming huge”. You’ll be pressured to take on subsequent investment, attack larger-but-lower-likelihood-of-success problems and markets, and hire (and therefore manage) more. Because you’ll likely be pressured to hire more and move faster, chances are that you won’t have time to find the “right” employees that have an owner’s mindset about the business. Lower ownership employees lead to more time micromanaging and less time for strategic thinking.

Speaking from experience, “growing quickly” – particularly with lower ownership employees - skips right past the fun part of growing a business. You immediately have to spend more time thinking about “getting the right systems in place” rather than the probably-more-interesting questions like “where can I find more customers?”

Sprinkled on top is the fact that your company’s incentives inevitably shift towards pleasing investors over pleasing customers. How can I best share updates with my investors? What types of metrics are other companies sharing in their pitch decks these days? What investors should I try to bring in for my next round of funding? When should I raise, and what terms are fair? These are all hard questions that responsible venture-backed founders must think about that don’t have a damn thing to do with solving the core problems that provide value for customers.

That 12-18 month chasm of bootstrapped businesses is hard, but on the other side lies a company in which your attention can rest mostly on the inherent problems of the domain rather than the problems stemming from rapid artificial growth before product/market fit.

Speaking from experience: it’s incredibly hard to keep team morale and focus high in that time before a business finds its legs. On the off chance that you manage to hire a strong engineering team to build an MVP quickly, what do you do with them when you realize that your focus needs to shift outward towards talking with customers to better understand the domain? How do you keep them focused on the customer when the only “customers” are theoretical? I can’t say if “idle hands are the devil’s plaything”, but in my experience they’re certainly the plaything of company self-doubt – particularly by individuals who want to churn out steady, high-quality work. You can’t build or market or sell a product that you’re still trying to understand yourself. Navigating the time before product/market fit requires a kind of mental marathon that few people can or want to run.

In summary: I think venture capital is likely the only way to build a certain kind of massive business. However, there are lots of other types of businesses out there that require a lot lower risk tolerance, have a higher “expected utility” in terms of the money generated (if not absolute expected dollar returns, due to the power law distribution of returns), and frankly require a whole lot less bullshit.

The key to building these businesses is that you need to be more creative in how to bridge that pre-revenue gap: can you work nights and weekends? Can you raise funding based on early customer conversations from angel investors or friends and put sufficiently clear expectations on your future goals? Can you self-fund? These are worthwhile questions to ponder: venture capital certainly isn’t free capital and you should understand the cost before you accept it.

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