Ask the Wizard

As I mentioned in the last post, there are about 42 lengthy articles you could write about how to fund your company, and as veteran Chicago entrepreneur Al Warms points out in a comment on my previous post, I skipped right over Funding101 - What are your goals?

I had a different context in mind for my last post, but Al's great comment merits elaboration. As Al writes, if you only think you're ever going to need a little capital and your goal is to build a small business with less than ten employees that will throw off a million bucks a year in cash every year after year 3 until hell freezes over, then you shouldn't raise a bunch of venture money. Again, as Al points out, early stage VCs are looking for a significant multiple on their invested capital, and they'd ideally like to see that return sometime in the next 5-6 years (although the multiple is probably more important than how long it takes to deliver it) so that they can deliver profits to their investors, raise another fund, fund more companies, and lather-rinse-repeat. Al notes that you should ask yourself "Do i think this could be a 100 million dollar business?" and "Am I prepared to go for it with only that potential outcome or better in mind?" when you're trying to decide how to fund your company. Of course, in the early days of a new idea, you may think the answer to both of these questions is a resounding "Yes!" and then find yourself thinking otherwise a year later. I'll add some additional points and more context to Al's questions.

First of all, if you raise venture capital, the rights of the preferred shareholders are almost certainly going to include a blocking right on sale of the company. Huh? Why would they want to block a sale of the company? Entrepreneurs frequently bristle at this, especially on a first round deal where the founder still owns 70% of the company, however, a simple example highlights why you are almost always going to see this term. You raise 2 million vc bucks at a 3 pre-money for a 5 post. The vc's own 40% of the company, you own 60% (let's ignore option pool for now). You spend a bunch of money on infrastructure and upfront legal stuff, and then Shmucky.com swoops in a month later and says "hey, i'll give you 3 million cash for your company and a 1 million dollar personal signing bonus". You think "hey, 2.8 million to me for a couple months work, hooray for me!" You see the problem. Your investors are going to have a very bad LP meeting if they get into these kinds of situations, so they are always going to make sure they have a blocking right on sale. The point being, you don't want to raise money if you've answered Al's two questions "Yes, but I'll still own a majority so I'll just do whatever I want".

Even more important is the context underlying Al's two questions. You're not really asking yourself if you think this is a 100mm business, because of course, you have no idea at this stage if it's really that big. The point, however, is that you need to ask yourself if you really think this is such a big opportunity that you're willing to take on significant risk in multiple forms in exchange for the significant capital to pursue the opportunity. Certainly, there are any number of very successful entrepreneurs who have chosen the path of smaller company with steady and growing cash flow with limited downside risk. Here in Chicago, we can look no further than Jason and David at 37Signals who have created a) a huge following with significant notoriety for themselves, b) a profitable company in a short period of time with few employees, c) limited downside risk - Jason does not have twenty million of preferred hanging over his head. He owns some significant percentage of 37Signals and he can sell the company, keep watching it throw off cash every year, add another employee every 36 months, or decide to stop working tomorrow and tell his customers he's refunding their money for the year and shutting down the operation. While the last option is highly unlikely, Jason is afforded the luxury of having it available to him since he hasn't raised a bunch of institutional capital. The company he's built suits his goals extremely well, and it wouldn't suit him to raise a bunch of money and try to grow the company to 50x its current size because Jason doesn't want to have 100 employees, he doesn't want to have board meetings where he talks about how the quarter is shaping up, and he doesn't want to shut out any future options for himself.

So we can call this Al's rule number 1 of starting and funding a company- what kind of risk am I comfortable taking on vis-a-vis my goals for myself and the business? Once you've answered this, then you can move on to my previous post.

It strikes me now that I think of it that there are lots of great examples of successful or success-in-process companies that haven't raised institutional capital, and I'll try to talk about more of those here, so that people get a better sense for the different kinds of options you have.