January 26, 2007

Are you sure you need VC money, asks a VC

VentureBeat has an invited article by Charles Moldow of Foundation Capital on why entrepreneurs should not be seeking VC financing unless they clearly want - and their product idea is big enough in scope - to aim for the "home run".
HotFeature.com has 10 employees and the founders each own 35% of the company. They pitch me on the idea and I agree with their assessment that consumers want and need HotFeature.com. They have raised $1.5M in angel money to date and have given up 20% of the company to investors. They require another $10M to grow their audience and build brand.

Here’s where things get interesting. I point out to the founders that they could probably sell the company today for $20-$30 million and that they would each make $7-10M which is not bad for a few years of work.

If they take $10M from VCs at a $15M pre-money valuation and create an option pool for the next 30 employees (assume 15%), they each now own less than 20%. To make the same $10M, the company must now sell for a minimum of $50M. Achieving this type of valuation is significantly harder, as it suggests that the company has established a brand, demonstrated a business model and proven consumer adoption.

In addition, my partners and I won’t be too excited about a $50M acquisition. This type of exit is not sufficient to ensure superior returns to our limited partners across a broad portfolio of investments-our returns are determined by home runs, not singles. As such, we‘re inclined to push for continued growth, market expansion and additional product development, which adds risk, requires more capital and creates additional dilution for the early employees (not always the win/win I seek).

Arun Natarajan is the Founder of Venture Intelligence India, which tracks venture capital activity in India and Indian-founded companies worldwide. View sample issues of Venture Intelligence India newsletters and reports.