Our economy has changed. I see three significant trends.
- A significant number of youngsters, freshly out of school, want to become entrepreneurs. Corporate is not attractive, and the best talents no longer dream of corporate life. That is creating a long-term issue for corporations, but that’s another topic.
- Likewise, the startup dream is also appealing to older, more experienced folks looking for a new adventure.
- Finally, we have a growing trend toward the knowledge economy and learning marketplaces. People are sharing and selling what they know and love, we call it “Passion Economy”. Think Udemy, Patreon, and the likes.
We have an influx of entrepreneurs wannabees, building startups, hoping to join the entrepreneur movement, like never before.
However, the “startup financing model” has not changed much and is not adapted to this new trend.
The old startup ecosystem works based upon three core elements: talented entrepreneurs, smart venture capitalists, and large exit marketplaces (M&A and IPOs). It is to be noted that being part of a well-balanced ecosystem makes all the difference. Starting in Silicon Valley or Athens is not the same.
What’s the current financing model?
Let’s look into how a venture firm will think about investing in a startup.
Let’s say the VC firm has a $500M fund. That means that the VC firm has found investors (Limited Partners) for up to $500M; they have convinced investors that their investment thesis could yield at least a 3x return, meaning $1.5B in 10 years.
Now let’s say they will invest in 45 startups. So for the sake of simplicity, they invest $10M per startup, which is $450M, the rest is management fees. To keep it simple, let’s pretend that each investment gives the VC firm a 20% equity stake. Of course, it does not work exactly that way; the VC will follow-on on certain startups and not others.
The VC knows that 15% of the startups will become liquid (if part of a good ecosystem), the rest will be a loss. That’s roughly 7 startups that could return more money than what was initially invested. They also know that 3 out of 7 could be big wins. A regular win is when the return is between 3 to 10 times the investment. Let’s say our 4 wins yield a 5 times return. So 4 startups will return 5x4x$10M=$200M. Not bad, but we are far from $1.5B.
That means that the 3 startups left need to return $1.3B, $434M each! If the equity stake is 20%, the startup value needs to be in excess of $2.17B. That’s the model! The VC has no choice but to finance a startup that can become a multi-billion dollar startup.
Now, let’s say you show up and convince the VC that you could sell your startup for $200M in 5 years. That would be quite an accomplishment to start with; selling for $200M is a rare thing. However, that is not what the VC is looking for. If you sell for $200M, the VC gets $40M (20%), a drop in the bucket to reach $1.5B.
Can we match the VC model and an influx of entrepreneurs?
Only 1% of the startups get actual VC financing. Indeed very few startups have the potential to reach a multi-billion-dollar valuation. So does that means that 99% of the entrepreneurs are doomed?
Yes, if they hope to raise VC money, no if they play it differently.
We have brainwashed entrepreneurs that raising VC money is the only way. A lot of entrepreneurs are convinced that they are fundable. Most are far from it. Entrepreneurs need to understand the startup potential. If the prospect is to become a multi-billion dollar startup, VCs are the right play. Only a large influx of money can create such values.
Now, most entrepreneurs need to realize that they are not designed to appeal to VCs investment. That is not shameful. Our economy relies on small companies. There is nothing wrong with building a $20M/year company that feeds 15 families and brings joy and passion to the one involved. However, that is where the financing model is failing, and without the proper fix, we are sending cohorts of entrepreneurs into a brick wall.
How to finance a non-multi-billion dollar project?
- The best option is to generate revenues from day one. That is clearly a daunting task; every project needs time to build itself to a sustainable level.
- Ask for a bank loan. Banks are not capable of loaning money to a startup. That is not their business model, and it won’t change.
- Raise love money. That is what everyone does. Raising money comes with responsibilities. The entrepreneur needs a clear path towards creating value so that early investors can have an upside.
- Bootstrap and with sweat equity build something sustainable. It is common practice, but it cannot get the startup far enough most of the time.
- Get a grant. That’s nice. However, it is often a difficult road, and not everyone can justify it. Finally, it’s not much, just a boost.
Is there another way?
I am convinced that we need to create another funding system that enables a real project to thrive even though it will never be a multi-billion-dollar company.
Banks and Venture Capital are not the answer.
One solution is to enable stakeholders to invest.
Stakeholders are the community that supports the project, such as customers, mentors, partners, fans, or even employees. Most of the time, the funding required is not much, at least not millions of dollars. A few hundred thousand dollars could propel the project a long way, almost to sustainability.
It needs to be
- Flexible, small amount is acceptable, and hundreds of investors could join the project.
- Easy, creating equity paperwork is too complicated and costly.
- Liquid, investors, do not want to be locked in for 10 years, there needs to be a 2nd market to sell shares, and with time the company could guarantee it once profitable.
- Continuous, fundraising is time-consuming; founders want to spend time on building a business.
We are starting to see solutions, take Fairmint (www.fairmint.co). Fairmint is a modern answer to funding startups. It enables financing the new economy by potentially funding the next Google, and giving a chance to a local startup that could become a local success.
Another option is to become a minimalist entrepreneur.
Starting something has never been so easy. The capital required is not much, and there is a lot to leverage to save costs.
- Sell online and avoid distribution and warehousing costs.
- Do not hire people; pay resources with what you earn.
- Do not rent a fancy office space.
- Subcontract everything
- Define what makes you happy; it is not necessarily making tons of money.
- Build something with a short path to monetization.
The strengths of local economies depend on creating a lot of startups with local or global impact. The opportunity is very significant. If 1% are venture fundable, then at least 20% of the 99% left are legit non-multi-billion dollar projects. These entrepreneurs are building the real economy, creating millions of jobs. The irony is that financing is almost impossible. We need to see more financing initiatives. The World Economic Forum mentioned that, “65% of children entering primary school today will ultimately end up working in completely new job types that don’t yet exist.”