This is a guest post by Christopher Beselin, who is a multi-exit company builder that resides in Vietnam. Christopher was part of the founding team of Lazada (acquired by Alibaba), Intrepid (acquired), Fram (IPO’d) and Endurance Capital Group.
Guest Author: Christopher Beselin
“It’s very hard to raise capital right now” – so we’ve been told. Most people take it for granted that this increased difficulty raising capital is set to hit right at the heart of all capital-hungry startups and that the venture capital funds (a.k.a. “VCs“) can then comfortably pick and choose, while driving hard bargains on valuations.
Indeed, this might be the short term first-order effect that we see play out right now. However, it’s worth taking a closer look – the second order effects of this hard-to-get capital might be somewhat counterintuitive.
Talking to founders, company builders and also looking at the companies where we are directly involved, we see a strong counteracting movement gaining momentum. As a reaction to endless fundraising processes working with non-committal VCs that seem even more herd-like in their behavior and preferences than ever before. It seems like all VCs over night decided that they only invest in profitable, fast-growing and sizable companies, ideally in AI, and nothing else 😉
As the saying goes “when the same people do the same things in the same room, we should expect the same outcomes“: manic overvaluations. Only difference between today and 2021 is that the overvaluations are ever more concentrated as the VCs are chasing ever more tightly defined set of companies – i.e. the “profitable, fast-growing and sizable companies, ideally in AI“ are now suddenly bid up in value to the moon. Nothing new under the sun.
On the flipside, in the world of company builders, the builders are getting ever more frugal, building ever more operationally efficient companies with ever lower breakeven scales. Regardless of fundraising environment, VC capital in most cases comes with very significant “indirect costs” to the company builders – significant dilution, one-sided term sheets, preference shares wiping out founder-equity in case of any material setback, external board members (with in most cases little to no direct experience of building companies), significant amount of time away from the business required to prepare material to educate the VCs regularly on the business, etc.
Before 2022, the VC money was easier and significantly less time- consuming to raise and hence didn’t require the company builders to also (on top of the above mentioned “indirect costs”) invest quarter after quarter in frustrating fundraising processes. Today, we see that the base case fundraising process requires at least one founder to invest >60% of her/his time for 9-12 months to complete.
To put it mildly, this is an unacceptable sacrifice to make for an early stage company for just a handful of 100kUSD or even a handful of millions of USD, especially when that money by design comes with “significant dilution, one-sided term sheets, preference shares wiping out founder-equity in case of setback, board members with in most cases little to no direct experience of building companies, significant amount of time away from the business required to prepare material to educate the VCs regularly on the business etc.“.
Source: Venturerock
Herein lies the interesting second-order effect – the direct and indirect costs of the VC capital is no longer close to making sense for the founders. Once the full ramifications of raising VC capital is fully understood by the company builder, the equation is unfortunately broken – in the post 2021 fundraising world, the costs of raising VC capital far outweigh the benefits. We see it happening already very clearly in the companies we follow most closely – they have all focused on driving profitable growth in order to stay away from external capital. Lately, we have also come to realize that this is a broad-based global trend shift.
A large group of company builders (most likely the ones who realize they have the best chances of making it on their own – i.e. perhaps also “the best ones“ that the VCs all aspire to invest in) shun away from VC capital and simply skip raising capital for one or several rounds (potentially never raising at all).
What many of these companies also realize when they have instead explored to grow profitably on their own without VC capital is that a) it’s significantly easier/more doable than they thought/had heard and b) the VC capital had been like a drug for them that made them addicted for more via perpetual losses that need to be refinanced by never-ending VC rounds.
Once the circle of addiction is broken, the cost base right-sized and the focus reset on profitable and sustainable growth, many company builders even find it puzzling how they ever could have wanted the VC capital and the side-effects of “significant dilution, one-sided term sheets, preference shares wiping out founder-equity in case of setback, board members with in most cases little to no direct experience of building companies, significant amount of time away from the business required to prepare material to educate the VCs regularly on the business etc“.
In this sense, we are witnessing a massive adverse selection movement where primarily the least capable founders and less attractive early stage companies are willing to accept VC capital as a growth capital source. The best ones know the cost-benefit does simply no longer make sense for them.
For the VCs, the critical takeaway here is that the way the VC operating model is set up (with its very long closing periods of 9-12 months and its long range of side-effects hitting the companies and the company builders in a negative way) and the way they are now mostly afraid of investing into anything but “profitable, fast-growing and sizable companies, ideally in AI“, exactly like most of the VC peers, has created a dangerous feedback loop where the core target audience for their investment capital (i.e. “the best company builders“) are no longer interested in their “product”.
In its extension, this negative feedback loop has the potential to become an existential threat for the VCs – driving down their returns and in turn eroding the interest from their investor bases. Ultimately, the snake devours its own tail in a giant ouroborus. Luckily, their are ways out of this death spiral, but that requires radical rethinking of the VC operating model and that’s a topic for another discussion!
