Build a Business, Not an Exit Strategy
This post was originally a talk I gave at PulsoConf in Bogota in September 2012. Reprinted here for my readers.
How many people reading this have a startup? How many people reading this are trying to raise capital for that startup?
Let me just lay out the odds for you. Only 1% of all companies will ever raise VC. And, of those who do raise institutional capital, only 2% of those companies will have an exit north of $100 million. And if that exit does come, the founders will own, most likely, one-third or less of their own company by that time. Because, by the time you get to an exit of that size, the founders have been diluted down by 3 or 4 rounds of capital. This means that the founders have a 0.02% chance of personally taking home $30 million. And if you have co-founders? Divide that number by 2 or 3. Now, you may be saying “but $30 million is a lot of money” or “hell, $15 million is a lot of money” But that is not the way you should evaluate the risk / reward proposition in this scenario. You have to look at the expected value of that $15 million.
For the uninitiated, expected value is the probability of an event, expressed as a dollar amount. For example, if you have a choice between a 5% chance of winning $1,000 or a 20% chance of winning $300, statistically, you should choose the latter, as that has an expected value of $60, while the first scenario has an expected value of $50.
So, let’s do the math: multiply $100,000,000 by 1%, which is the chance you have of raising VC, then by 2%, which is the chance of $100 million+ exit, then by 33%, which is the average amount of the company that the founders will still own after said exit, and then again by 50%, assuming there are 2 founders. That is an expected value of $3,300. Three grand.
Now, let’s say you start a small web-based SaaS business that solves a real problem for some segment of your market. Let’s say you help entrepreneurs with their taxes at a lower cost than an accountant would charge.
Let’s say you work on this start-up for 10 years, and it becomes profitable after 2 years on revenue of $1 million per year. Let’s say you have a profit margin of 20%, and you exit the business after 10 years for $2 million, or 2x revenue. You never take money, and you are the only founder. Maybe you give away a small amount of equity to your first employees, but you still own 90% of the business.
Still difficult to do, but certainly not impossible. Now, the survival rate for small businesses, according to the United States Small Business Administration is 44%. I know, that sounds really surprising, as many of us are used to hearing that 95% or 99% of all businesses fail. But, in reality, only about 56% of small businesses fail in the first 5 years. Now, not all of those business make $1 million or more each year in revenue, only about the top 25% of small businesses make more than $1 million per year.
Let’s do the math on this one, shall we? Ok, so add up your exit value of $2 million plus $1,600,000 in profit that you have paid out to yourself. That is $3.6 million, now multiply that times the small business survival rate of 44%, then again by 90%, which, in this scenario, is how much of the company you still own at exit. That is an expected value of $356,400. That is over 100x greater than the expected value of a VC-backed, high-growth tech startup. Granted, $3.6 million is not “fuck you” money, but it is certainly more money than I have ever seen.
Now, assuming you have bought into my argument thus far, let’s look at exactly what it might take to build this mythical $1 million run-rate, profitable, web-based business.
There are actually only two steps you need to take to build this business. First, you need to build a product that at least some small segment of the market wants. Ok, that is easier said than done, but if you focus on a sufficiently niche segment, especially if it is in an industry or space that you know well, you are likely to be able to find a problem that you can solve that no one else is solving in quite the way you are. Now, this does not need to be the most amazing business idea ever created, it does not even need to be all that revolutionary, it just needs to solve a problem for some people. How many people for which this product needs to solve a problem depends entirely on the second step.
Now, listen carefully, because this is really important. It may seem a little crazy, but trust me, this is the key to building a successful business: you have to actually SELL your product, you know, for money. Now, how much money? Well, that depends on what you are selling. Are you selling B2B SaaS solution that helps small businesses manage their taxes? Then maybe you charge $30 a month. Or are you selling a luxury consumer product, that only a few people want or can afford? Then maybe you charge thousands of dollars. Either way, the math is simple: number of purchases * price of each unit sold = revenue.
Let’s say you have a web-based business that helps small businesses manage their taxes and you charge $30 / month. That means you only need about 2,800 customers to make $1 million each year in revenue. That’s it, 2,800 people. And to do this in 2 years? That means you only have to add 3 or 4 customers each DAY! 4 people a day. You could do that by just cold calling your existing customers and giving them 6 months free if they get 1 friend to sign-up.
Now, I don’t want to make it seem like building a sustainable, profitable business with millions in revenue is easy, but it certainly a lot easier than most other founders and VCs would have you believe. And that is because, for founders trying to build billion dollar companies and VCs chasing the next Instagram mirage, it IS really, really, really hard to build a business to that size and growth rate. It is 0.02% hard.
But, if it’s THAT hard, why do founders and VCs keep going after these types of “go big or go home” investments? In order to understand why, you have to understand the incentive structure of venture capital firms. VC firms are just like any other institutional investor like a private equity or hedge fund. They have LPs, or Limited Partners, which are usually big insurance companies, pension funds, or university endowments that have billions upon billions of dollars that they must hold for decades. Usually, these LPs allocate some small percent of those funds towards “alternative investments” like venture capital. LPs decide how much and to whom money is allocated. LPs decide whether the Partners at a particular fund get to keep their jobs, and they base these decisions on one thing: returns. Ideally, extraordinarily high returns. These funds all have, basically, the same mandate. They raise a fund, maybe $100 million, and then they will have 10 years to invest, exit, and return the fund. The mandate is to return 3x or more to their LPs within 10 years. This creates some very interesting, and perverse, incentive structures.
First, in order to exit all or most of the fund’s investments within 10 years, the majority of this money must be invested, or earmarked for future investment in existing portfolio companies, within the first 4 years of the fund. Most funds only write 10-12 checks a year. And, with a fund size of $100 million, the partners cannot, logistically, invest in small, profitable, steadily growing businesses, because they would have to invest in hundreds of them in order to put all of that capital to work. It is just not logistically feasible for only 4-8 partners to do this within the first 4 years of a fund.
Second, LPs expect at least a 3x return on the entire fund at the end of the 10-year mandate. Now, consider that, on average, 80% of a fund’s investments will fail. Another 15% will return 2x or 3x. And the top 5% of the fund’s investments will return 10x or more. The fund will continue to invest larger sums in its most successful investments as those businesses grow, while the ones that do not meet expectations, will not receive additional funding, and thus, will have lost a smaller percentage of money for the fund than the big wins will have gained. Even accounting for this, most funds will return far less than 3x, most will fail. The only way to win is to be an early investor in the biggest wins, which, even if all of the fund’s other investments fail, will make up for all of those losses, and return the entire fund.
Once you understand this, you begin to understand why VCs hammer home the “pick a big market” and “network effects” mantras, because that is the only way they make money! I’m not saying VCs are bad people or are looking to manipulate you. I’m just saying that VCs are doing the absolute most rational thing they can: they are responding to their own incentive structure, it is human nature. But that does not mean taking VC is the best possible decision for you, or the only way to build a big or successful business. Quite the opposite.
You need to think about the lifestyle you want, and the goals that are important to you. People in this industry act like, if you are not working 80 hours a week and sleeping under your desk, somehow you are failing, or you are “not meant to be an entrepreneur.” Well, I am here to tell you that that is absolute bullshit. Look, if you are so extraordinarily passionate about what you are working on that you can’t wait to hop out of bed at 6am and head to the office for a 14-hour day, by all means, knock yourself out. But don’t do it because you think that is what you are “supposed” to do. Don’t think that, just because you have passions and goals outside of your startup, that somehow you aren’t committed enough or you aren’t going to succeed. I find that if you can just focus for a full 4 or 5 hours a day, uninterrupted, on your startup, that that is enough. Maybe when you have a release coming up, you have to put in more hours, but there is no way to be really productive for 14 straight hours a day, at least not consistently.
A little anecdote: I have a friend of mine who runs a relatively well-known startup in NYC. He literally LIVES at the office. I’m serious, he moved in. And before that, he slept on the couch most nights. And, after working this hard for almost 2 years, guess how much revenue this startup is generating? Zero. Not a fucking penny. After 2 years of work! Now, I understand that they are trying to build a massive user base with network effects, blah blah blah, but, I’m sorry, that is absolutely fucking insane. I could never see myself living my life that way. I am just not built for it. To put in that many years of your life, and thousands of hours of work, for what will most likely turn out to be an unsuccessful startup, is just crazy to me. But, from reading the tech press, you would think this is one of the hottest startups in New York!
Which brings me to my next point: don’t drink the tech Kool-Aid, it’s not good for you. And frankly, it’s not even that tasty. When all you read about is funding, after funding, after funding, you begin to believe that that is the only way to be a successful startup. How many times have you read a story about a startup that took no funding, has only 1 founder, worked quietly for 2 or 3 years, and is now generating over $2 million in revenue? I’m guessing never. That’s not interesting, I suppose. That story doesn’t sell papers. But you know what? Those are the truly successful entrepreneurs, the ones who spent years building a profitable, sustainable business, with not a lot of outside help and very little start-up capital. People like the founder of Subway, who still owns 100% of the company, which is now the largest franchise in the world, or Sara Blakely, who turned $5,000 and a pair of footless pantyhose into a billion dollar business called Spanx. Those are the people we should be talking about, celebrating, and looking up to.
Unfortunately, I had to learn all of this the hard way. In 2009, fresh off of a stint as an investment banker, I started my first company, called ToVieFor, which was in the apparel space, and also happened to be a total fucking disaster.
I think I was stuck in my career, and was really just more excited by the idea of running a tech startup, rather than building a real business. And we did well for a while. We won the NYU Business Plan Competition and received a $75,000 grant from NYU, we were 1 out of only 25 companies invited to launch, on stage, at TechCrunch Disrupt in San Francisco, and then, most impressive of all, we were selected as 1 out of 11 startups to be a part of the inaugural class of the TechStars accelerator program in New York City. Almost 1,000 companies applied, only the top 1% were chosen. I still consider this to be one of my greatest professional accomplishments.
And TechStars is really an amazing program, you meet people you would never otherwise meet, you have access to some of the top investors in the world, and you make lifelong friends with the other founders. But TechStars stays true to its promise of being an accelerator. It accelerates your company in exactly the direction you were already heading. Have a little bit of tension among the founding team? Expect for at least one founder break-up during the program. Putting a ton of money into acquiring users with little success? Expect to get absolutely grilled by every investor you meet and have your competency questioned. Hired an engineer that is not totally committed? Expect her to leave when things get tough. TechStars, like many accelerators, accelerates both the good and the bad. It, like VC funding, is rocket fuel, and if you are not ready, your company will explode upon impact.
And that is exactly what happened to us. A spectacular explosion that included: a very public founder break-up, horrible gossip pieces in the press, and a reality TV show to document it all. Lovely.
So, my choice at that point was either: head back into the safe, warm arms of Corporate America or, take the lessons I learned and use them to build a real business. You can guess that I choose the latter.
I started my latest company, Elizabeth & Clarke, by myself, bringing on a part-time technical co-founder several months in to help build the first product. With only $75 dollars in start-up capital, and 1 month spent building a minimum viable product together, we began to generate revenue. Now, 1 year in, we just hit profitability. I estimate that I sunk in an additional $5,000 of personal savings this past year. But that’s it, I own 95% of the business, have never taken money, and we are profitable and growing at 20% a month.
So, at the end of the day, what does all this mean for you? First, you can do the same thing I did, you can build a profitable, small web-based business in just a few years, take a great salary and work 30 hours week. But more than that, my message is not, “do as I do,” it’s “follow your own path.” Don’t listen to investors or the press or even me. Take advice, sure, but do what you really want to do, and don’t feel bad about it because somebody else may not call it “success.” Second, solve your own problem. No matter what path you take as an entrepreneur, small business or large, this is really the best way to find success. And, whatever you do DO NOT drink the Kool-Aid! You can trust me on that one.