TL;DR – Ideas for changing the economics so everyone wins!
Your time is precious, so don’t waste it living someone else’s life. — Steve Jobs
Nowhere in our society do we have more talent and raw brainpower working for bargain bin discount prices. How low? 50% of founders are making less than $6 an hour. More on these calculations later…
Founders of course are guaranteed nothing, and that’s the point. We sign up for the opportunity to earn large paydays while building game changing solutions.
So if it’s all consensual, then what’s the problem? Well, it’s not really. Those who have built venture backed businesses know we are not playing by our own rules. Once you take on institutional funding, the game changes.
I raised $15 million dollars for my last company led by a top West Coast firm. My company had tremendous success out of the gate. We reached a million in revenue in the first year and tripled that each of the next three. At that point the board was looking at me, as the CEO, to go out and raise another $20 million. When I failed to show excitement for that plan, I was eventually fired. The experience helped to set me off on a new path, which I detailed in a previous post titled Lost on Purpose.
A few years have past and I hold no ill will. Our investors are great guys and were doing their job. But that job is to maximize the returns for their investors. Homan Yuen in his VC Math post clearly shows why VCs are almost exclusively focused on unicorns (or those rare $1B+ exits). For them to generate an acceptable financial return, they typically require 2 to 3 of them per fund. “Small” $50 million or $100 million dollar exits do little for keeping their investors happy.
As a result, the system has grown to view “success” as little short of a billion dollar plus exit. Look at this post by Hiten Shah titled “Why Trello Failed to Build a $1 Billion+ Business”. While he does give some acknowledgement to the team for selling for $425 million, the article focuses on where they went wrong.
The current system — The Founder Lottery
Yesterday’s home runs don’t win today’s games. — Babe Ruth
As founders, we are essentially forced to play the lottery. The odds of a venture backed startup becoming a unicorn is less than 1%. Factor in that less than 50% of startups even raise venture capital and you are looking at less than a .5% chance from Day 1. So less than five out of every 1,000 founders “win” by today’s rules.
But what happens to the other founders? Depending on how much the company has raised and the preference they’ve given to their investors, it will often take $100M+ exits for the founders to see any significant money. Those exits are also rare. Approximately 57 out of 2,196 founders of startups will achieve those, or 2.6%. For the other nearly 98%, things look quite different.
How much do founders make?
For the other 2,143 founders, things aren’t as bright. Using public data from CB Insights and others, I evaluated how much founders actually make. I detailed the below calculations in this Google Sheet:
- 50% of founders make an average of $5.61 an hour. This accounts for the founders who bootstrap but fail before raising institutional funding or reaching independant profitability. The assumption was that this group of founders bootstrap for the first six months and raise some friends and family money over the next six months.
- 20% make an average of $14.12 an hour. This group raised seed capital but failed to raise a Series A or exit. At this point they’ve clocked 32 months well below the living wage for family of four with two working adults.
- 5.4% make an average of $21.23 an hour. This group raised a Series A but failed to raise additional capital or exit. They’ve spent an average of 53 months building their startups while just getting by.
- 4.4% make an average of $28.31 an hour. This group raised a Series B but failed to raise additional capital or exit. They’ve worked hard for six years at wages in line with a good administrative assistant.
- That leaves 20%. That 20% likely reached higher average hourly rates by raising further rounds of capital and/or exiting. But as discussed earlier, only about 2.7% of them likely had a significant windfall. The others still capped out at wages a fraction of what their talent likely would have garnered in the open market.
These numbers aren’t inspiring. The point is not to discourage entrepreneurship and big thinking. The world needs amazing founders building important businesses. Some of these businesses will take large amounts of Venture Capital in order to achieve. Uber for instance, requires enormous amounts of capital to achieve mass scale and revolutionize an entire industry. But most startups do not have the same capital needs as Uber yet they are forced to raise capital under the same rules.
Founders bear the brunt of the risk
VCs want founders to have skin in the game. They set maximum salaries which are meant to cover a basic lifestyle free of frills and savings. The thought by investors is that their upside should not come on the back of their investment, but by their production. To get paid, founders need to deliver big results.
VCs however do not apply these same rules to themselves. In fact, many VCs get paid well to lose money. They also have very little skin in the game. The market standard is that VCs put in 1% of the fund size in personal money. Founders are usually contributing 100% in forgone wages and personal savings to get their startups off the ground. Often these are the only funds they have.
VCs have built in income based on their 2% yearly fees. Despite 85% of VC firms underperforming, the majority of VCs are not living off ramen like their founder counterparts. Funds also typically have a 10 year window by which to deliver returns to their investors. A few years into a fund, VCs are already on to raising their next fund. This system offers little accountability for the VCs which means little motivation to shift the status quo.
A major shift is beginning
There’s no shortage of remarkable ideas, what’s missing is the will to execute them. — Seth Godin
We have gotten lazy with how we fund businesses. There is much more than unicorns that needs to be celebrated. We need to apply the same creativity and risk that founders employ to find new solutions. Many important $10M, $50M or even $100M companies currently being overlooked depend on it. As do so many lives of founders, their boyfriends, wives, kids…
Some like Indie.vc and Jennifer, Mara, Astrid & Aniyia are working hard to develop and test new models. I was also inspired by my personal experience to start 1heart. Our focus is to help founders build conscious companies collaboratively. While we believe that the next billion dollar company could very well come out of our model, we’ve built it to support the smaller successes.
How do we get there?
I don’t pay good wages because I have a lot of money; I have a lot of money because I pay good wages. — Robert Bosch
If the goal is to create an ecosystem that enables more founders and businesses to succeed, then how we think about early stage investment needs to change. These same changes should also help more VCs create sustainable models that consistently create good returns for their investors. A healthy ecosystem will help all parties create successful outcomes.
Change the metrics — Currently VCs (and ultimately the ecosystem) live by two core metrics. The size of the fund and the percent of return achieved. These metrics aren’t likely going away anytime soon but what if we could add another important metric: Total percent of founder successes a firm achieves.
This metric alone would provide transparency to founders as to how aligned the VC firm was with their success. Founder success would be aligned with a financial outcome that provides a significant reward for a founder’s time and risk (e.g. $500K+ per year). This could even allow VCs who performed well on this metric to take a higher percent of equity in return for more alignment with founders.
Raise less money — Perhaps to many this sounds counterintuitive. You have initial signs of product market fit, and now you want to slam on the gas. Plus, you need to get paid! But with each dollar raised through increased valuation, you are also increasing the size of the expected exit. This creates an all or nothing mentality that not only limits fundraising and exit options, but also handicaps the business.
Venture capital should come with a warning label. In our experience, VC kills more startups than slow customer adoption, technical debt and co-founder infighting — combined. VC should be a catalyst for growing companies, but, more commonly, it’s a toxic substance that destroys them. VC often compels companies to prematurely scale, which is typically a death sentence for startups.
Premature scaling is often cited as the #1 cause for startup failure. Our current system of glamorizing fundraising and unicorns creates the context for this to permeate.
Plug into an existing structure — Despite having started several startups, I find myself basically starting from scratch with each one. For first time founders, it’s even more difficult to navigate the early days of a startup. I believe this is why we are seeing a big rise in the number of startup studios. Attila Szigeti explains some of the stats and logic behind this recent trend in his Startup Studio Playbook.
Startup studios work by creating a central structure that provides talent and support across its portfolio of startups. Without studios, a founder needs to be largely focused on raising money, finding talent and operating areas of the business they have no prior experience with (e.g. accounting, legal or PR). Working within a studio, they can plug into the studio’s existing structure of top talent across various disciplines.
The knock on startup studios is that the founder needs to give up too much equity. Often the studio keeps the majority of the equity as they incubate, fund and provide ongoing high level talent and networks to fuel the startup. But an extra 10 or 20% of nothing is… well nothing.
Startup studios provide a potential model for the future. A model that can enable founders to limit risk, earn a liveable wage sooner and not have to go at it alone. They also allow founders to solve problems fast or fail fast. Both outcomes result in less time for founders working at minimum wage. Startup studios provide something between going to work for Google and starting a company in your garage.
Because startup studios maintain larger stakes of equity, they don’t need the massive exits that VCs do to return their funds. And because they can help founders grow more rapidly and efficiently, they can reduce dilution for founders in future rounds.
There are only a limited number of variables that can be changed in order to create a new formula for success. The variables are generally the amount invested, percent of ownership and success rate. The length of the fund also plays a major role but I didn’t factor that in here for simplicity.
Current model — a traditional institutional seed investor might invest an average of $500K per deal in total investment. This would leave them with somewhere around 4% ownership at time of exit. At the current average of 20% of investments returning capital, the VC needs the average of all their exists (including those that just return capital) to equal $215MM to achieve a 3x return for their investors.
New model — let’s examine a few tweaks to this equation. First let’s reduce total investment to $300K per deal. Now, let’s raise the ownership percentage from 4% to 17% at time of exit (a startup studio may maintain even higher). Now let’s assume that 40% of deals return capital given that the structure allows a much lower bar for successful outcomes. This would reduce the average exit required for a VC to return 3x to $27MM.
Perhaps this all feels far too hypothetical. Currently it is as few have been willing to experiment with new models. It is clear that this sort of change to the economics has the ability to enable many more successful businesses and founders. We certainly can’t do worse than a 2.6% success rate and 50% of founders earning $5.61 an hour.
This is why we created 1heart. We believe in democratizing success across a far greater number of founders and doing so with businesses that create societal value. We welcome others passionate about similar goals.
Everything should be made as simple as possible, but not simpler. — Albert Einstein
A shift has begun and founders are waking up. Nearly every founder I speak to knows that the current system isn’t working. So many good ideas are killed or never even started because they don’t fit the narrow parameters of Venture Capital. Founders feel overwhelmed with the loneliness, pressure and insane hours that currently appears to be the table stakes.
We are smart, innovative people born to trail blaze new paths. Yet when it comes to our own lives and happiness, we stop short. It’s time we all take note of what is truly important, what motivates us to do what we do day in and day out. For a few it’s the billion dollar exit. For most it’s the desire to make an impact, have financial freedom and achieve our potential and purpose.
For me, it took discovering all of this the hard way. For you, I hope this helps lead to more sustainable and fulfilling paths. For us, I hope we learn to collaborate more deeply, create more meaningfully and build a system together that works for all.
Source: The Mission