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If Not Venture Capital, Then What?

Most of Silicon Valley is financed with venture capital, and its success there has made it attractive in other industries. The model isn't always transferrable: media companies have raised using VC dollars to very little success, for example.

That's because VC depends on scalability. The core idea is that an investor - or more usually, a collection of investors, all investing on the same terms and at the same time, in a round of funding - will put money into a company while it's relatively small and unproven, and the investment is therefore relatively cheap. The company will then hopefully grow enormously quickly, proving out its hypotheses and gaining value at a rapid rate. Venture capital investors deploy money from a fund, itself invested into by their limited partners (rich people and institutions like pension funds). They have usually promised their partners that the fund duration will be ten years or less, and correspondingly, they want to see returns from their investments very quickly. The goal in many funds is to return 3X the value to their limited partners; because most investments will fail, they're looking to invest in companies that have the potential to return 30-40 times their money.

Although secondary markets exist, VCs only typically make money when an investment is acquired by another company or when it IPOs on the stock market (an exit). So in addition to enormous growth expectations, there's a built-in timer on these investments. You can think of most VC-funded Silicon Valley startups as being financial vehicles more than they are product or service companies. That's why advertising has been such a popular business model: stopping and asking people to pay for your product slows your growth, and therefore your attractiveness to investors.

For some companies - Facebook, say - this model works exceptionally well. For others (like those media companies), not so much. But VC has become the de facto funding model for internet services, because of its abundance, and because that's what a lot of the tech press chooses to talk about. In turn, the parameters for venture capital funding have become misunderstood as the parameters for starting any kind of venture on the internet at all. Because VC won't look at a venture that doesn't have a potential market of billions of dollars, it's become understood that ventures with smaller market sizes are not going to survive. Because VC needs high growth, it's become understood that all startup ventures should aim to be high-growth. And because exits are most often acquisitions, it's become understood that market consolidation and a trend towards monopoly is actually a good thing.

Venture capital has, inadvertently, created a template for what can be built on the internet. It's harmful, and it's a lie.

This is going to become even more problematic if predictions of a downturn turn out to be correct. As Fred Wilson wrote:

However, I do think a difficult macro business and political environment in the US will lead investors to take a more cautious stance in 2019. It would not surprise me to see total venture capital investments in 2019 decline from 2018. And I think we will see financings take longer, diligence on new investments actually occur, and valuations to come under pressure for even the most attractive opportunities.

A common, and correct, critcism of alternative funding models has been that they don't adequately describe the upside for potential investors. For example, in a revenue-sharing model, investors put money into a company in exchange for a percentage of revenue up to a cap, which might be 5X. If an investor puts in $50,000, they expect to receive $250,000 back, in payments that constitute 10 or 20% of the company's total revenue (usually once the company is making enough annual recurring revenue that these payments aren't an existential threat). Notice that this is dramatically lower than the 30-40X expected from VC - and while it could be argued that a revenue-focused company is less likely to fail than a growth-focused one, there aren't actually any numbers to back that up yet. So it could just be an investment with a smaller upside for the investor.

For the startup, the numbers start to look daunting after it takes more than even a small amount of seed funding: while repaying $250,000 to investors is potentially reasonable for a profitable company, a $1M investment might need $5M to be returned from revenue. That might be fine if we're talking about a VC-sized investment opportunity - but if we are, why wouldn't the startup take VC money and forgo paying dividends?

The answer, I think, is to think smaller and more specific. Rather than trying to build something that addresses a large portion of the internet, build something that addresses a highly niche group that has been thus far unspported because of the industry's focus on growth. Instead of being the next Facebook or Uber, think about being the next MetaFilter or The Well.

Lifestyle businesses have a bad reputation because it's harder for the financial ecosystem to make money from them. But for their owners, save for a very small number of outlier founders who ride VC to high net worth valuations, they can be every bit as lucrative. And you get to do it on your terms, serving a community that you genuinely care about, rather than following a paint-by-numbers path to success. The irony is that by serving a smaller community well, in a way that doesn't lend itself well to scaling fast, founders are probably setting the groundwork for a company that really could be VC-scale, if they wanted it to be. (The choice is theirs.)

As for the investment return question, I think you have to adjust the scope and definition of investment and returns to be about more than money. Communities can be stakeholders in other ways. Consider the Kickstarter / Indiegogo crowdfunding model, where investors don't get equity at all - instead, their rewards are early access to products and services, and even more than that, the social aura of having helped something they care about to be birthed into the world. By deeply understanding the community they're serving before you build anything, making connections, and getting to know them as people, founders can motivate them to help provide the seed funding and momentum they need.

VC is going to continue to be one part of the funding landscape. But I think we need to see it as just one part. There is nothing wrong with building something that is smaller and more focused. There's nothing wrong with bringing your community into your venture more deeply. And there's nothing wrong with considering how to remake the tech industry as one that is less monopolistic, inherently more inclusive, and more resilient, through rejecting unicorns in favor of lots of small pieces, loosely joined.


Photo by Markus Spiske on Unsplash