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Raising money in 2022 was a slog. CB Insights reported a nine-quarter low in Q3 in terms of deal value and a concurrent reduction in the number of deals. Y Combinator released a memo in May warning companies in its network to conserve cash and avoid fundraising if they could. Some startups were able to hold off until things improved. Others had to press on, accepting smaller amounts with investor-friendly terms in order to keep the lights on.
Heading into 2023, the market does not look to be improving, but that doesn’t mean founders should despair. In every crisis lies an opportunity, and this may be a needed reality check for start-ups to reassess precisely what kind of a business they want to build, as that could change their capital strategy.
For many start-ups, pursuing VC funding seems like a rite of passage. And with good reason. Few founders have the personal wealth nor immediate revenue to bootstrap their company for long. Even the most dedicated early employees need salaries at some point (you can’t buy groceries with stock options), and building a product requires some upfront investment. Venture capital serves an important economic role in helping these risky businesses bring ideas to fruition.
However, there are also downsides to institutional money. First, venture deals are expensive. Savvy VCs are skilled negotiators who routinely secure investor-friendly terms—preferred shares, pro rata rates, MFN clauses, board seats and so on. New or naïve founders can easily get swept up in the deal and their loss-aversion sensors kicking in, give away more equity and control than they intended in order to close. Second, taking VC funding sets in motion an engine that is difficult for founders to control. Once you raise one round, there are strong incentives to raise additional rounds, each one involving further dilution of the founder’s equity, and ensuring that those future rounds are up rounds. This, in turn, incentivizes startups to prioritize rapid growth in pursuit of ever-higher valuations, sometimes at the expense of a sustainable business model and a clear path to profitability.
Yet a high-growth business that runs in the reds for years, funding its growing burn with larger and larger venture cheques, is not the only path for a new start.
Another approach is to pursue profitability and then use these retained earnings to invest in further growth at a sustainable rate. In this scenario, companies would raise just enough capital from independent sources, like friends and family or angels, and put all their effort towards profitability by dominating in their core competency. This can help avoid the institutional pressure to grow fast and continue raising funds, and once profitable, companies are in the enviable position of having control of their own destiny.
This approach involves three key steps: a product strategy, operational excellence and a fundraising plan.
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Product Strategy
Before founders even think about a pitch deck, they must know exactly what product they’re building and for whom. This is easier said than done, as an early business is all potential—there are myriad products one could pursue, so a company has to drill down into what they are best at, their “Google search,” and then pursue that with maximum effort.
A good place to start is to talk to customers. What is the primary value customers get from your product? Once you have a sense of this, lean into it—hard. Make the product even better, focusing on adding value to make your product indispensable. If profitability is the end goal, it is better to be the dominant fish in a small pond than a small fish swimming aimlessly in larger and larger oceans.
Operational Excellence
This essentially means running a lean ship and minimizing burn. If you can support remote work, do so, as office space can be a big cost center. Take the time to go through your accounts every month to ensure there are no rogue subscriptions you forgot to cancel. And build a simple projection to track the delta between your revenue and expenses every month to see how close you are to breakeven—that can tell you how much investment you need. Roughly speaking, you should raise what you need to achieve breakeven with a healthy margin to account for surprises.
Fundraising Plan
The final step is to identify funding sources. There are ample options outside the traditional VC route. Aside from crowd-funding from the general public on a site like Kickstarter, another common approach is to find angels on Angelist who are accredited and can cut bigger cheques, but who will not have the same pressure to generate returns for LPs as institutional VCs.
Another option worth exploring, especially if you have a satisfied user base, is to crowdsource directly from your users using a platform like Dealmaker. This can be a highly valuable option, as not only will your users be familiar with your company and product, minimizing the effort needed to pitch, but they can also form a network of advisors and advocates, as many might be investors or successful businesspeople by day.
The great thing about pursuing a profit-over-growth strategy is that it does not preclude institutional money down the road. Once profitable, a company can still raise VC (or PE) money to accelerate growth with new products or new geographies. But it can also take dividends to reward early investors and employees and run a comfortable lifestyle business indefinitely. Or it can look for a financial or strategic buyer and plan an early exit.
The VC world has many attractions to early ventures, and it can be a feather in a founder’s cap to secure funding from one of the big firms. But especially in the current economic climate, founders should beware that their fundraising plans are not driven by ego but are instead guided by good business strategy. Ultimately, profitability is never a bad state to be in. Bonus if it means retaining more control in-house.
