Raising venture capital doesn’t make sense anymore

In 2021, valuations for SaaS companies hit their peak, with many trading at 10-20x multiples or higher, with very little due diligence. Now that we’ve experienced a correction in the market, valuations have come way down, to 5-6x, and they will likely stay that way for years to come.

However, the survivorship bias makes founders think that raising venture capital is the only way to build a successful startup. We don’t read about all the failed startups that raised, or many of the super successful SaaS companies that haven’t raised.

How does VC work?

VCs raise money from limited partners, such as high-net-worth individuals and institutions, with the idea that they are better at picking winners than the average investor. 

VCs expect to find unicorns, which are companies that could sell or go public for over $1 billion dollars. They don't care if the companies are profitable, they just want them to grow as quickly as possible. VCs provide startups with capital in exchange for equity, and they expect a return on their investment when the company either sells or goes public.

Despite the perception that raising venture capital is a sign of success, the reality is that most startups fail. 

Your chances of being the next Slack, Zoom, or Figma are slim, and even the chances of raising VC capital at all, let alone at favorable terms, are small. Even if a startup manages to raise a round, if it's not growing quickly, it won't be able to raise a second or third round. 

Once a startup is on the VC train, it's hard to get off because expectations are so high, and the company is required to burn cash to grow. If a startup decides to get lean and profitable, its investors may turn on the founders, demanding to be bought out, exercising their shareholder rights, or even suing for "shareholder oppression."

VCs are looking for unicorns, and if a startup doesn't look perfect on paper, they just won’t invest, especially in today’s market. 

A tale of two SaaS companies.

The first company is the classic startup dream we’ve all had since we watched The Social Network:

A founder builds a minimum viable product, gets insane traction, and raises significant venture capital. 

Being pre-revenue, the founder manages to raise $2 million at a $10 million valuation post-money and hires 20 people to scale up the company, pouring everything into growth; product features, sales, sponsorships, ads, you name it.

Within 12 months, the startup hits $1 million in annual recurring revenue (ARR). The headcount alone costs nearly $3 million per year, which means that the company is burning through cash quickly. 

The board of directors then encourages the founder to start raising more money to ensure that the growth continues and that the company doesn't run out of cash.

The next raise is more difficult because VCs aren’t just looking at pure traction, they now care about retention metrics, CAC to LTV, burn multiples, and capital efficiency. The fact that the founder put so much of the capital into expensive hires with no concern for profitability or unit economics makes raising money even harder. 

The new VCs give the founder a term sheet valuing the company at 6x ARR, which is 40% less than the original valuation. This means that the founder is raising at a down round, where the valuation is lower than the last round. Everyone's shares have lost 40% of their value, which means that the founders and original shareholders will all own much less of the company after the next raise. 

The founder now faces a few options: don't raise and risk losing everything, raise at a reasonable price and lose a lot of their ownership stake and control, or raise at a high valuation and put even more pressure on the company to grow in the future. 

If the founder chooses to raise at a high valuation, say 10-20x multiples, they are still expected to eventually grow into that valuation. This means that they are kicking the can down the road, and eventually, it will catch up to them. 

After 5-8 years of mediocre growth, high burn, and constant raising, the founder burns out and tries to sell the business at $30M ARR - a far cry from where the VCs thought the business could get to. They manage to sell for 5x ARR but have diluted their ownership stake so much that they only own 10-20% of their own company.

Moreover, the investors, who have all but given up on this company and not participated in subsequent rounds, have separate classes of shares that give them 2x liquidation preferences, which means that in the event of a fire sale, they get at least all their money back times two before anyone gets anything. As a result, there is a high likelihood that the founders walk away with nothing.

This scenario is a lot more common than you might think.

Scenario Two: Bootstrapping to Success

Now let's look at a different scenario. A founder creates a SaaS company, and instead of raising venture capital, they decide to bootstrap the company. They focus on building a product that solves a real problem for their customers and is profitable from day one.

The founder doesn't hire a lot of people right away; instead, they focus on being efficient and making every hire count. They keep expenses low and reinvest profits into the business. They focus on creating a great customer experience, which leads to strong word-of-mouth marketing and organic growth.

Over time, the company continues to grow and becomes profitable enough to hire a small team. The founder is able to pay themselves a decent salary and still reinvest profits into the business.

Because the company is profitable, the founder doesn't have to worry about raising venture capital or answering to investors. They have the freedom to make decisions that are in the best interest of the business and its customers.

As the company grows, the founder decides to take on a small amount of debt to fuel growth. They use the money to hire a few more people and invest in marketing. The debt is manageable because the company is profitable and has a clear path to growth.

After ten years of slow, steady growth, the company is now at $30M ARR with 20% margins and growing at 20% annually. The founder takes a few million dollars each year in dividends, shares profit with staff, donates to worthy causes, and reinvests the rest back into growth.

Now private equity firms come knocking, as this company is attractive because a) it follows the rule of 40, and b) it would fit strategically if combined with another company in their portfolio. They offer 6x on ARR, or $180,000,000. The founder, who owns 100% cashes out with generational wealth they can use to build a legacy.

This scenario is also more likely than you’d think.

Each scenario involves a similar degree of risk, time, and effort. Both take about ten years and the company lands at $30M in revenue. But it’s obvious which one you would take if you had to choose between the two.

So now that we’re in a world of 5-6x multiples, why are so many startup founders still obsessed with raising venture capital?