In short: this author is endorsing a funding model focused on low initial investment and faster profitability. The benefits key benefits are that this funding model results in more women and minorities getting funding, as well as higher rate of companies surviving (10% vs. 44% [1]). The former is good, but probably isn't sufficient to motivate most investors. The latter doesn't necessarily translate into better returns on investment. Throughout this whole piece I was looking for a comparison on the net return on investment of the traditional VC model and this Indie.vc model. This comparison is never done. A high-risk high-reward investment model may still produce higher rates of returns than a low-risk low-return model.
Right now we're seeing a trend of larger companies taking an ever larger piece of the market share, and the total number of firms decreasing. While encouraging founders to form smaller companies with shorter time to profitability undoubtedly results in more companies surviving 3, 5, and 7 years after founding, that's not what we're optimizing for. An investment strategy with high rates of failure, but producing larger companies with those few successes is still yields the potential for larger overall returns.
1. What does it mean by 10% vs. 44% of companies surviving? Presumably it means that 10% of traditionally funded companies exist X years after founding versus 44% of Indie.vc founded companies. But this is a strange metric to give without specifying how many years we're talking about.
"In short: this author is endorsing a funding model focused on low initial investment and faster profitability."
-> so basically, Canadian "venture" capital. They don't even want to talk to you unless profitability is there or within a few months. So, basically, it distills to a barely riskier than usual bank loan, except you pay the loan with equity.
A cause or symptom (I'm not sure about causality here) is that the Business Development Bank of Canada (BDC) directly funds most private Canadian VCs. VCs now have public money as part of their LP base, with some strings attached. Most of these strings (eg. don't waste taxpayer money doing anything unethical or overly negligent) will nudge VCs to be more conservative. Plus, the VCs are guaranteed 20%+ of their 2% carry from BDC taking up that much of every fund and don't need to swing for the fences to make a good income.
I think both worlds can exist. You can have the "traditional" VCs going for the high-risk, high-reward model. And you can also have "new" VCs going for low-risk, medium-reward.
As an anecdote, in 2014 we looked for ~$250k investment. We had a business model that realistically took us to ~$5mm/year revenue in 5 years. We pitched various "traditional" VCs. The overwhelming feedback we got was that nobody doubted our team, the product, or the model. The problem was that the returns weren't big enough. The product was niche and could never become an "Uber" without really stretching the imagination. In the end, we found an angel investor in our space. We indeed did turn that $250k into $5mm/year revenue in 5 years and sold the company for 8 digits.
> We pitched various "traditional" VCs. The overwhelming feedback we got was that nobody doubted our team, the product, or the model. The problem was that the returns weren't big enough.
Sahil @ Gumroad has talked about this in good detail. The VC idea that "yes, your business/idea is/will be profitable but you shouldn't waste your time making money when you could be working on changing the world"
The "changing the world" business will also hopefully be profitable and make money down the road but they are looking for outsized returns from a market disrupting unicorn.
--
Regarding the "new VCs" concept. Alex Danco and others have discussed this and the funding model ceases to be VC when it is low-risk, medium-reward.
It's possible that many areas of tech are maturing to a point where VC will no longer be the optimal funding model, outside of high innovation specialties. As the industry matures, there are many businesses that might provide stable returns and have a risk profile that is different from that of the unicorn VC-startup. These businesses might be better served by debt funding and a debt-based investment vehicle/product might attract more investors and allow for greater de-centralization of tech funding.
Linking Alex's blog post below instead of rambling in this comment.
Is there any existing term for "funding for business that will never be a unicorn but can clearly become profitable and provide good returns"? Is there an equivalent of VC for "lifestyle businesses"?
If not, if someone can establish a term it'll be easier to talk about this.
VCs need to have a chance of "returning the fund". If they are investing out of a $200m fund, and they own 15% of your company at exit after 5 years and subsequent dilution, that 15% has to have a chance of being worth $200m.
This is an important point. It's not about what VCs want to fund, it's about the types of businesses that founders want to build. Founders have a lot more choices than they realize.
But isn't it a scale problem? If you happen to have Softbank-sized cash heaps to administrate and you try to invest them by the single million in almost bootstrapped companies you will inevitably become a handout machine. You can't industrialize investment decisions without exposing exploitable patterns and they will be exploited. Survival rate won't stay at .44 for long once people learn how to push your buttons. Unicorn-scale investments are far from immune to exploitation as well (what happened to Wework anyways?), but at least they can't hide in the masses.
Planetary scale finance is FUBAR literally everything; all of civilization, resource allocation, etc needs to be rethought (re-evolved) for a world that is post light-speed communication. Power is now liquid and can be transferred from any random node in the human mesh to any other node instantly. Robinhood bailing out Hertz, Trump, Startup Not-Bubble, all the same root cause and it's barely getting started.
I think it's a bit short sighted to say that the high risk high reward model is superior to this model. While that may be true in a theoretical sense, you have to take into account market conditions and competition.
As an analogy, you can have an investment thesis that vending machines with bottled sugary water have extremely high ROI... but you are missing the elephant in the room which is you'd have to compete against Coke and Pepsi's infrastructure and brand.
Similarly, if you are raising a fund and want to play the high risk, high reward game, you need to consider what the market conditions are.
First, it's definitely not an even playing field. Connections and brand mean a whole lot. The leading VCs have all the best deals coming to them and have a bunch of management consultants in the backroom trained to spot large market opportunities. The volume of deals and strong connections allows them to pick and choose the best opportunities, and everyone else is left with scraping the bottom of the barrel.
Second, there's only around 15-30 billion dollar companies created per year in the US, and there's probably 30-100x the amount of incubators or venture firms. It's just a limited market overall.
That's the game. In a theoretical sense, yes high risk, high reward opportunities have better ROI, but only if you are at the top of the game. So I'd hesitate to say that this is an objectively inferior model because for some investor's positions, this strategy would probably yield a much higher return.
I found the point about minorities and women curious, is that perhaps due to the fact that profitable-ish business can be assesed more rigorously on the foundamental, rather thsn on VC's opinion of the founders?
Less is riding on personal promotion and networking, both of which men tend to have advantages in. Instead, the focus on business performance allows a less biased selection criteria.
> A high-risk high-reward investment model may still produce higher rates of returns than a low-risk low-return model.
So, this isn’t really my area, but if the market is efficient shouldn’t these come up about the same over a long enough period? In other words if one or the other has dramatically better returns that just means the risk was mis-priced to begin with.
The immediate objection I can see to this (without expertise) is assuming that private markets are at all efficient. But that would point to a fundamental problem with pricing in private markets, not the merits of one strategy or another.
Behavioural economics dominates the messy real world. Especially when we are talking about startups, new technology that is poorly understood, etc. These are the leading edges of the markets, they are the least efficient of all.
Cue theranos on one hand and probably many companies with potentially profitable innovations that never got funded and we never heard of.
This is one thing that the left social justice crowd does get right - Never forget that at the end of the day, the system runs on wetware - people with faulty ideas, preconceptions, biases and limited knowledge.
In an efficient market, investments that are more risky will produce higher returns. If they didn't, no rational investor would invest in them. Why invest in a venture that is more risky, unless you're compensated via higher returns.
You can already see this playing out in the public markets. Stocks produce far higher returns than corporate bonds, which produce higher returns than treasury bills.
There's further nuance here around systematic risk vs unsystematic risk, but I don't think it's as relevant to VCs since their number of investments is too small to diversify away all unsystematic risk.
As a founder of a bootstrapped & profitable company, I don't really get what's so attractive about this funding model.
It seems like it's just a really, really, really expensive loan. They make it sound nice with their anti-VC, pro-founder marketing angle. But at the end of the day, they are charging you 3x what you're borrowing.
Once you're already profitable, it's probably not that attractive. I've explained it to myself in the past by thinking about the would-be founder who's bootstrap-inclined, but who'd rather "go for it" now rather than doing nights and weekends for 18 more months before quitting their job. This person might not want or have access to traditional VC, and wouldn't be able to get a traditional loan. If all goes according to their plan, when that 18-36 months is up, they've paid back this "really expensive" loan and own 100% of their now profitable company.
This is the model for pretty much every new venture that's 'main street' and not 'VC'. There are many times more main street businesses than tech startups. While it's reasonable to bootstrap a sole proprietorship tech services firm from nothing, restaurants need buildouts, HVAC companies need trucks, retail stores need inventory, etc. Equity is absolutely the most expensive form of financing, but the bank ain't touching your new restaurant concept so there's the equilibrium.
When I was fundraising, we talked to a few of these type of funds (IIRC, this exact fund was one of them). It just seemed like worse terms for less money. It's a valid model, but I don't understand the self-righteous marketing.
Why pay for a loan with equity when you can pay cash? The interest rate on equity payment is exponentially higher than it is for cash.
Plus, if you already have attractive traction, why do you need the "premium features" a VC offers versus a bank which are extra experience, some networking effects, and maybe some insider info on acquisition opportunities? So you can be forced into expedited aggressive growth and turn into WeWork or make less money if the company is acquired? No thanks, the business is already proven and working!
Traction for VC money makes no sense to me.
...Unless you secretly have ZERO intention of ever selling and just want to pocket some play money for the business.
I agree. This isn't quite an apples-to-apples comparison. But middle-market companies with okay-ish financials can easily get covenant-lite leveraged loans from the gigantic private credit market, for well under LIBOR + 1000 basis points. The current yield-to-maturity on the leveraged load index is 5.64%[1].
3X in 7 years implies a yield-to-maturity of 17%. Why would any company pay more than three times the cost of capital they can get from much larger, more liquid, and established Wall Street financing?
I think its pretty attractive if it reduces risk on the founder but gives the founder freedom to do whatever they want with the company at whatever time frame.
After experiencing it myself, I think that the push to grow big is a very big deterrent for me to take on VC money. The lifestyle is just not worth it.
Bootstrapping a company from the ground up works if you have the necessary skills and idea, but some ideas need access to capital, especially if they are operationally intensive. So I could see this model being pretty attractive in those situations.
From what I'm reading, The founder can choose to let the "anti-VC" keep its shares, or it can buy them back at 3x the investment. That's not equivalent to a loan, since it doesn't have to be paid back. With a conventional deal, if things turn out well, the VC doesn't have to agree to sell its shares to the founders at any set price.
Let’s see how long that lasts when follow-on financing doesn’t materialize and limited partners pull capital and give it to Unicorn.VC because their results are more “exciting”.
I say this as a founder that prioritized profitability and outlasted many VC backed competitors and was sick of VCs telling me to increase burn and growth and ignoring my warning of the long term perspectives and risks. We decided not to take VC and are smaller but killing it.
I am glad to see this perspective but it only lasts during a financial crisis then it’s right back to fetishized hyper growth.
As far as I am concerned go ahead and keep your hyper growth VC dollars, I’ll buy your bankrupt portfolio company in a few years with our profit.
As YC says, get to ramen profitability as early as possible and be a cockroach that will survive.
in my humble and unwarranted opinion (see also not having run a vc company or a company for that matter) profits should have been the idea from the get go: all of this effort to get large and then use economies of scale to defeat rivals and then start making a profit is just wrong
Consider that you want to make an App store where you add value by manually validating every app available through your store and build trust with your customers by only serving the best apps.
How can you compete with the Apple App store? You can't. At least, not without creating a hardware/software ecosystem with millions of users.
You could shortcut that buildup of scale by only targeting android users but then your competition against the Apple App store will be entirely dependent on the strength of Android ecosystem.
Our company, Qbix, is a poster child for the preaching of the Basecamp folks. We raised $107,000 from friends and family and then generated revenues, then another $135,000 and generated more revenues. We are up to almost $1MM in revenues now. Also we have attracted 8 million users and growing.
But many VCs have turned us down because they look for hockey stick growth and zero friction, and don’t like “the agency model” companies which make money. Actually, they’re just applying pattern-matching to reject the vast majority of startups unless they are hockey stick growing.
If your firm is making money (especially to the tune of $1MM -- is that per month or per year?), it might be a perfect match for the more old-fashioned form of non-dilutive fundraising: lending. There are a lot of firms out there which capped revenue based funding, but the biggest one I know is Lighter Capital [1] (no affiliation), and I believe there's a good amount of competitors [2] which do the same thing. Why not consider reaching out to them and seeing if you're a fit?
I remember this being a theme during the 2001 recession. I can't find the link right now, but I remember more than a few articles about this trend back then. I was able to find VC capital investment. [1]
Clearly there was more silly money being throw around in the late 90s and into 2000, but by 2002 the mantra in was "ROI, ROI, ROI!"
> Just four months after closing a $7 million funding round for his first startup RetraceHealth in 2016, Aderinkomi was pushed out of the startup by the new board. This was after he had spent three years and taken on $1 million of his own personal debt to build the company.
Seems like you're doing something wrong if you raise seed and A rounds[1] and have given away enough board seats that they can push you out 4 months later.
Also, why would anyone take out a million dollar personal loan to fund a startup? I have heard of founders spending their own money to get things off the ground, but usually it's $50k or so, and it's never a bank loan.
I'd agree that this guy is rightly wary of going back to VCs, but his experience seems like an edge case (which is perhaps why it's featured in this article).
Readit News
Right now we're seeing a trend of larger companies taking an ever larger piece of the market share, and the total number of firms decreasing. While encouraging founders to form smaller companies with shorter time to profitability undoubtedly results in more companies surviving 3, 5, and 7 years after founding, that's not what we're optimizing for. An investment strategy with high rates of failure, but producing larger companies with those few successes is still yields the potential for larger overall returns.
1. What does it mean by 10% vs. 44% of companies surviving? Presumably it means that 10% of traditionally funded companies exist X years after founding versus 44% of Indie.vc founded companies. But this is a strange metric to give without specifying how many years we're talking about.
-> so basically, Canadian "venture" capital. They don't even want to talk to you unless profitability is there or within a few months. So, basically, it distills to a barely riskier than usual bank loan, except you pay the loan with equity.
I love this. I wish it were a thing, "The Canadian Model".
As an anecdote, in 2014 we looked for ~$250k investment. We had a business model that realistically took us to ~$5mm/year revenue in 5 years. We pitched various "traditional" VCs. The overwhelming feedback we got was that nobody doubted our team, the product, or the model. The problem was that the returns weren't big enough. The product was niche and could never become an "Uber" without really stretching the imagination. In the end, we found an angel investor in our space. We indeed did turn that $250k into $5mm/year revenue in 5 years and sold the company for 8 digits.
Sahil @ Gumroad has talked about this in good detail. The VC idea that "yes, your business/idea is/will be profitable but you shouldn't waste your time making money when you could be working on changing the world"
The "changing the world" business will also hopefully be profitable and make money down the road but they are looking for outsized returns from a market disrupting unicorn.
--
Regarding the "new VCs" concept. Alex Danco and others have discussed this and the funding model ceases to be VC when it is low-risk, medium-reward.
It's possible that many areas of tech are maturing to a point where VC will no longer be the optimal funding model, outside of high innovation specialties. As the industry matures, there are many businesses that might provide stable returns and have a risk profile that is different from that of the unicorn VC-startup. These businesses might be better served by debt funding and a debt-based investment vehicle/product might attract more investors and allow for greater de-centralization of tech funding.
Linking Alex's blog post below instead of rambling in this comment.
https://alexdanco.com/2020/02/07/debt-is-coming/
If not, if someone can establish a term it'll be easier to talk about this.
VCs need to have a chance of "returning the fund". If they are investing out of a $200m fund, and they own 15% of your company at exit after 5 years and subsequent dilution, that 15% has to have a chance of being worth $200m.
Otherwise the math does't work.
Also, congrats on your success!
As an analogy, you can have an investment thesis that vending machines with bottled sugary water have extremely high ROI... but you are missing the elephant in the room which is you'd have to compete against Coke and Pepsi's infrastructure and brand.
Similarly, if you are raising a fund and want to play the high risk, high reward game, you need to consider what the market conditions are.
First, it's definitely not an even playing field. Connections and brand mean a whole lot. The leading VCs have all the best deals coming to them and have a bunch of management consultants in the backroom trained to spot large market opportunities. The volume of deals and strong connections allows them to pick and choose the best opportunities, and everyone else is left with scraping the bottom of the barrel.
Second, there's only around 15-30 billion dollar companies created per year in the US, and there's probably 30-100x the amount of incubators or venture firms. It's just a limited market overall.
That's the game. In a theoretical sense, yes high risk, high reward opportunities have better ROI, but only if you are at the top of the game. So I'd hesitate to say that this is an objectively inferior model because for some investor's positions, this strategy would probably yield a much higher return.
Its probably better to compare the two models like Residential and Commercial asset types (a quick google search to show the comparisons: https://www.fortunebuilders.com/commercial-vs-residential-re...)
So, this isn’t really my area, but if the market is efficient shouldn’t these come up about the same over a long enough period? In other words if one or the other has dramatically better returns that just means the risk was mis-priced to begin with.
The immediate objection I can see to this (without expertise) is assuming that private markets are at all efficient. But that would point to a fundamental problem with pricing in private markets, not the merits of one strategy or another.
Cue theranos on one hand and probably many companies with potentially profitable innovations that never got funded and we never heard of.
This is one thing that the left social justice crowd does get right - Never forget that at the end of the day, the system runs on wetware - people with faulty ideas, preconceptions, biases and limited knowledge.
You can already see this playing out in the public markets. Stocks produce far higher returns than corporate bonds, which produce higher returns than treasury bills.
There's further nuance here around systematic risk vs unsystematic risk, but I don't think it's as relevant to VCs since their number of investments is too small to diversify away all unsystematic risk.
It seems like it's just a really, really, really expensive loan. They make it sound nice with their anti-VC, pro-founder marketing angle. But at the end of the day, they are charging you 3x what you're borrowing.
Why pay for a loan with equity when you can pay cash? The interest rate on equity payment is exponentially higher than it is for cash.
Plus, if you already have attractive traction, why do you need the "premium features" a VC offers versus a bank which are extra experience, some networking effects, and maybe some insider info on acquisition opportunities? So you can be forced into expedited aggressive growth and turn into WeWork or make less money if the company is acquired? No thanks, the business is already proven and working!
Traction for VC money makes no sense to me.
...Unless you secretly have ZERO intention of ever selling and just want to pocket some play money for the business.
3X in 7 years implies a yield-to-maturity of 17%. Why would any company pay more than three times the cost of capital they can get from much larger, more liquid, and established Wall Street financing?
[1] https://us.spindices.com/indices/fixed-income/sp-lsta-us-lev...
This would be very attractive to someone who wants to grow their business without taking (more) personal risk than they have already.
Personally I'd be really excited to see better loans being offered to startups, but this isn't it.
EDIT: Also you're assuming a 7 year payback period, and I would guess it's a lot shorter than that for the average indie VC customer.
After experiencing it myself, I think that the push to grow big is a very big deterrent for me to take on VC money. The lifestyle is just not worth it.
Bootstrapping a company from the ground up works if you have the necessary skills and idea, but some ideas need access to capital, especially if they are operationally intensive. So I could see this model being pretty attractive in those situations.
I say this as a founder that prioritized profitability and outlasted many VC backed competitors and was sick of VCs telling me to increase burn and growth and ignoring my warning of the long term perspectives and risks. We decided not to take VC and are smaller but killing it.
I am glad to see this perspective but it only lasts during a financial crisis then it’s right back to fetishized hyper growth.
As far as I am concerned go ahead and keep your hyper growth VC dollars, I’ll buy your bankrupt portfolio company in a few years with our profit.
As YC says, get to ramen profitability as early as possible and be a cockroach that will survive.
Consider that you want to make an App store where you add value by manually validating every app available through your store and build trust with your customers by only serving the best apps.
How can you compete with the Apple App store? You can't. At least, not without creating a hardware/software ecosystem with millions of users.
You could shortcut that buildup of scale by only targeting android users but then your competition against the Apple App store will be entirely dependent on the strength of Android ecosystem.
Our company, Qbix, is a poster child for the preaching of the Basecamp folks. We raised $107,000 from friends and family and then generated revenues, then another $135,000 and generated more revenues. We are up to almost $1MM in revenues now. Also we have attracted 8 million users and growing.
But many VCs have turned us down because they look for hockey stick growth and zero friction, and don’t like “the agency model” companies which make money. Actually, they’re just applying pattern-matching to reject the vast majority of startups unless they are hockey stick growing.
[1] https://www.lightercapital.com/
[2] https://www.owler.com/company/lightercapital
Clearly there was more silly money being throw around in the late 90s and into 2000, but by 2002 the mantra in was "ROI, ROI, ROI!"
[1] https://en.wikipedia.org/wiki/Dot-com_bubble#/media/File:US_...
Seems like you're doing something wrong if you raise seed and A rounds[1] and have given away enough board seats that they can push you out 4 months later.
Also, why would anyone take out a million dollar personal loan to fund a startup? I have heard of founders spending their own money to get things off the ground, but usually it's $50k or so, and it's never a bank loan.
I'd agree that this guy is rightly wary of going back to VCs, but his experience seems like an edge case (which is perhaps why it's featured in this article).
1: https://www.crunchbase.com/organization/retracehealth#sectio...