Founder economics 101 and the effect of taking venture money
Follow me @samirkaji for my random, sometimes relevant thoughts on the world of venture and start-ups.
The last few days have brought a lot of great conversation on the recent NY Times article that primarily conveys the cons of founders taking venture capital funding.
As I tweeted here in this thread, the real lesson to gather from the article isn’t whether or venture capital funding is good or bad for founders, but rather to remind founders of what it truly represents — — A supercharged financing alternative suitable for companies that appear to have potential for rapid and massive scale, and whereby the founding team is committed to this path (once founders take venture money, they are also taking the investor’s business model).
It’s true that most tech companies shouldn’t or cannot raise venture (venture funding over the last few years show a clear trend toward fewer deals), there seems to be a general predisposition, primarily in “Tier 1” tech markets that venture capital funding somehow represents the optimal financing vehicle.
Whether it’s a function of social biases or other reasons, this sentiment has somehow become ethos for too many aspiring entrepreneurs.
In practice, going down the non-venture path offers the mass majority of tech companies the best shot at durability and the optimal levels of personal and economic fulfillment.
To this latter point, let’s examine founder economics through a hypothetical example (one that I’ve seen play out plenty over the last two decades).
Let’s say ACME co. is a new enterprise SaaS company, and the founders are considering whether to pursue venture capital funding, and are having a discussion about their own economic outlook under either circumstance.
Scenario A — Bootstrapping
In this case, the company may take nominal outside startup capital (from non-VCs), and gradually grows using funding from profits.
The company gets an acquisition offer for $50MM in year 5, which the two founders accept. Given their collective 90% ownership of the company at the time, they each walk away with about $22.5MM each before taxes.
Scenario B- Venture Funded
In Scenario B, the company decides on the path of venture capital, and raises 4 rounds over 7 years, a pre-seed, post-seed, Series A, and a Series B, with the following characteristics:
- Pre-seed $1MM on a $5MM pre-money valuation
- Post Seed $3MM on a $12MM pre-money valuation
- Series A $10MM on a $40MM pre-money valuation, 10% option pool*
- Series B $20MM on a $80MM pre-money valuation, 10% option pool*
*Structured where dilution is taken prior to capital infusion.
With the same basic assumptions from Scenario A, this would leave the founders with ~34% post Series B ownership (I’ll save you from the actual math for the purposes of keeping this short).
In this scenario, the company uses the capital to scale, and eventually accepts an acquisition offer of $125MM (which to note is nearly 2X the average venture backed exit). In this scenario, the founders take home $21.25MM, nearly the same as the payout they would have received in the first scenario but requiring an exit value of 2.5X.
This of course doesn’t even speak to the increased complexity of having outside investors and board members. To be fair, Scenario B should in theory increase the probability of a larger exit (albeit increased dilution and “dirty” capital rounds could substantially alter common stockholder financial returns).
Again, this isn’t to say that founders shouldn’t pursue venture funding, but considerations like these must be carefully evaluated when making the decision.
