Venture Capital for Software Companies: Does It Fit Your Startup?

Getting funded by a Venture Capital firm is one of the most discussed topics for startup CEOs in SaaS, mobile software and hardware companies. Venture Capital for software companies is the “Holy Grail” of the early stage set. To many, it implicitly means to people that you’ve “got something”. It’s considered an endorsement of future success.

No doubt raising a big fat round of institutional capital is a landmark event in the early life of startup software companies, and definitely makes everyone feel great – at least for the moment. And sometimes it really is exactly what’s required. But is it for every software startup? In actuality, most startup founders shouldn’t even think about it. Here’s why:

The VC business is generally misunderstood

Not by everyone, of course, but I find that many entrepreneurs lump VCs into the larger group of ” outside investors”. First of all, I don’t believe that the MAJORITY of software startups should even seek outside investment of any type! But that’s a discussion for a later time.VCs, in particular are very much limited in their applicability to a very, very small niche of the entire universe of software startups. They are looking for BIIIIG markets. They are also generally looking for LARGE strategic advantage vs. the potential competition. And more often than not, they are looking for management teams that have “been there, done that”. So the bar is very, very high for a software startup to clear in order to get real interest in an investment from a venture capitalist. I’m not talking about just an interest in a “chat”, mind you. There are many reasons that a venture capital partner or associate might want to enter into a conversation with you, as I wrote in 7 Reasons That VC Said No to Your Startup.

Many VCs will talk to you for a variety of reasons. But actual interest in investing in your company. I won’t go deeply into the logistics or why the bar is so high, but please take this as fact; they aren’t interested in that nice little $5M SaaS company in a nice vertical niche that could grow to $10M in 5 or 6 years (which may be a very nice business that can make a lot of money for it’s principals; nothing to sneeze at). They are looking to make unicorns or near unicorns, period. Not every company they fund will turn into one; in fact many if not most will completely fail. But generally, they are looking for that kind of potential in the companies that they fund. There are a bunch of folks operating around the margins of the venture capital business that are categorized as “seed funds” and number other similar terms, who call themselves VCs and don’t require this kind of potential to invest. But in terms of what I consider the mainstream venture capital business, they are looking for unicorn levels of potential in their investments.

Venture Capital for software is appropriate for a tiny segment of mobile software and SaaS

So while the discussion in the section above may be sobering to some folks, there are many, many good software businesses out there that are worth starting and running; the vast majority of them just don’t fit this description of a “potential near unicorn”. That’s ok! Roughly 1 in every 2000 startups in the US raises venture capital. That’s .05%! Many among the remaining 99.95% will build good businesses and have great, life-changing exits. You don’t have to be a unicorn to make a lot of money in the software business and have a very nice exit. In fact, I might argue that the non-unicorn businesses can be just as much fun. Maybe not QUITE the adrenaline rush that those lucky few might experience, but there is plenty of fun and drama to keep most folks occupied in even an “average” SaaS or mobile software startup. So don’t despair if the VCs don’t appear to be interested in what you consider to be a terrific idea or business.

I believe that it is important to mention here that the misconceptions about the VC business are largely not the fault of venture capitalists themselves. The vast majority of VCs would agree with this statement: they are not for everyone. Most would tell you that in fact they really are for a very select few and that there are many very good tech businesses that they would have no interest in funding.  The myth of venture capital as the Holy Grail for every tech entrepreneur is one that has largely taken on a life of it’s own, without anyone in the venture capital business itself actually pushing the narrative.

In the end, if you are able to execute, there will often be more for you in the end if you are able to go it alone than if you raise outside institutional capital. The most important advice that I can provide when considering how to capitalize your company is Know Who You Are! If you fit the criteria that VCs are screening for, AND you need the money for competitive or good other reasons, then by all means put that pitch deck together and start networking your way into the VC firms.

But BE REALISTIC; take a close look at your market size and competitive advantage. Say it’s a good-sized market, but not huge. And you’ve got a nice product, but not the next Google. Maybe you can do it with friends and family money, a couple of angels, or just “plain ole boostrappin”. One of the beautiful things about the software business is that it’s never been that capital-intensive, relative to many other types of businesses with far inferior margins. With the cost of software development having come down dramatically over time, as well as low cost marketing and sales methods available via the Internet, it’s never been easier to start and grow a software company than it is today. Notice I said “easier”, in a relative sense. There’s nothing easy about it!

VC funding is often romanticized – don’t do it

One of the big issues I see with entrepreneurs and Venture Capital is the tendency to romanticize raising VC money. I believe this is due to several reasons:

1. The popular and business media’s own romanticizing of the Venture Capital business. No doubt the VC eco-system overall plays a strong positive influence on economies in the US and worldwide. But it’s rare to see an in-depth article on the downside of venture funding at the individual company level.
2. Entrepreneurs who understandably are thirsting for “validation” of their new business in the early stages. While this is understandable, that validation should play only a small role in the decision to seek or not seek venture funding.
3. The common entrepreneurial notion that “if I only had A or B dollars” I’d be able to do XYZ and the company would become a rocket ship. In fact, every startup always feels they need more money, it’s almost part of the startup DNA. But if fact money doesn’t solve every problem, and too much can be a problem in itself (see below)

So I feel it’s very important to be as cold-blooded and objective as you can possibly be, when deciding whether or not VC funding is the right path for you.

Too much money makes you stupid

I believe that it was Anand Sanwal of CB Insights who originally coined the term the “Foie-Gras effect”. The term was created because like ducks or geese being overfed rapidly to be fattened to use their liver as a delicacy, venture-backed start-ups are force-fed funding to stimulate rapid growth at all costs.

So, can too much money really make you stupid? Well, it doesn’t make you stupid, but can cause you do stupid things. Some of those stupid things I often see in the application of venture capital for software companies are:

• Scaling up before product/market fit
• Chasing growth rates beyond what your platform will really support, with all the resulting inefficiencies
• Managing the business to get to the “next round” instead of having any focus on normal business metrics
• Hiring large numbers of sales reps before you have a repeatable sales process
• Going international before you have sufficient domestic traction
• Hiring big company folks at high salaries
• Hiring too many folks, too fast, too soon
• Applying too little scrutiny of marketing ROI in particular and ROI of all activities in general
• Making especially bad decisions trying to make those milestone numbers under pressure from VCs that have put in beaucoup money
• Entering markets that are too big/poor fit to try to stretch your addressable market, which lie outside of your natural strategic advantage

Before I close, I want to re-emphasize that there are real business cases where venture capital for software businesses makes total sense to raise, as I examined more deeply in the article SaaS Startup: 5 Key Bootstrapping vs. Fundraising Considerations and also in Strategic Fundraising Decisions. It’s just that these business cases just don’t apply to the vast majority of software startups.

That’s my dissertation on the merits of pursuing venture capital funding in various situations. Have you done the analysis yourself? If so, post a comment with things I’ve missed or gotten wrong. This is an important topic that tech startup founders need to consider from a 360 degree view.

Follow Phil Morettini and Morettini on Management via Twitter, Facebook, LinkedIn, RSS, or the PJM Consulting Quarterly Newsletter. Contact PJM Consulting directly at [email protected]

If you liked this post please share it with you colleagues using the “share” buttons below: