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4 problems venture capital can’t solve

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Collin Wallace

Contributor

Collin Wallace is a Techstars managing director leading the Silicon Valley-based accelerator program. He is also a lecturer at Stanford University’s Graduate School of Business’ Startup Garage class.

As the technology industry retrenches and venture capital firms tighten their standards, savvy founders should consider this counterintuitive question: Even if my vision is compelling enough to secure funding, should I take it?

Today’s marketplace is teeming with companies that simply grew too quickly, aided and abetted by their VC partners, and now find themselves managing the pain of down rounds, expense reductions, layoffs and a retreat from their boldest strategic gambles.

Would it have been better for many of them to have not taken excessive levels of venture capital in the first place?

This might seem like a strange question coming from me. As an investor, my job is to put capital to work. But the truth is, I see founders every day looking for money for the wrong reasons. They — and to some extent we, as investors — have lost sight of when venture capital can be an accelerant and when it can hasten the demise of what might have been a viable business.

In recent years, increasing pressure to invest ready capital meant that investors were not as discerning as they otherwise might have been. In 2021, VCs poured a record-breaking $329.1 billion into startups. Some of that capital was clearly not put to its best use. This reckoning underpins the 63% drop in funding in the fourth quarter of 2022 over the same period in 2021.

Add inflation, corporate cost-cutting and market volatility, and it’s understandable why many investors and founders are skittish.

For an entrepreneur looking to raise money, the current landscape could prove difficult. But even for founders who can still attract capital, it’s a time to be wary: It’s quite possible that you could destroy your business deploying that cash.

Consider some of the wrong reasons to raise money:

To accelerate a business with negative unit economics

Imagine a founder looking to grow a same-day delivery service in a niche market with negative unit economics. They seek venture funding to increase sales and marketing. But the business isn’t making money on a contribution margin basis, only the variable costs of a good or service.

Their assumption — likely incorrect — might be that new money for sales and marketing will solve the company’s problems. In reality, what is needed is a deep dive into the company’s fundamentals. Most of the time, what stands between a company and its ability to achieve scale is not a lack of money.

It’s better to ask: Do we have hustle problems? Product problems? Process problems? People problems? Is my business model fundamentally flawed?

More money won’t solve these issues. Without a clear picture of what is fueling losses, venture capital will only accelerate your demise.

Ask yourself this vital question: Are you raising capital so that you can lose money even faster? Consider your business model’s unit economics first and foremost.

Raising money to patent “weak” IP

Another founder has a great idea that stands a real chance of resonating in the marketplace: in this case, the cybersecurity space. The founder believes the time is right to consider protecting their idea. They’ve come up with what they believes is a novel approach in a market where many large incumbents and startups are innovating fast to keep up. Spending money to obtain a patent seems like a logical step, a powerful strategy, especially because the market is so big and the field so crowded.

The problem is that a patent is only as good as your company’s ability to enforce it.

Let’s say the company’s cyberprotection software is pulling in a couple of hundred thousand dollars annually, but then the founder sees another product in the market that may be infringing. The base costs in legal fees to simply write an email that says the patent is being infringed could go up to $20,000. If there isn’t money in reserve to cover the cost of litigation, the consequences could be significant.

Meanwhile, many patents don’t hold up under scrutiny, calling into question the founder’s initial decision to put time, money and energy into winning the patent in the first place. An adverse decision from the USPTO or Appeals Board could result in a declaration that the patent shouldn’t have been granted in the first place.

Washington-based inventor advocacy group US Inventor’s analysis of patents that were challenged and fully reviewed found that 84% of patents do not stand up to legal scrutiny.

The key question to ask: Are you raising money to dig a moat you cannot defend? Consider instead focusing on your speed to market.

Seeking capital to fight large incumbents on their own turf

For sheer inspiration, what could be better than a David and Goliath story? Who doesn’t love the little startup knocking out the arrogant giant with nothing but a slingshot and a rock? In real life, however, Goliath clobbers David pretty much every time.

Large incumbents already have in place the brand clout, deep resources and expert teams that founders are just setting up. Outspending them is not a viable strategy. A founder who wants capital just to build a brand to rival large incumbents is being set up to lose.

David only triumphed because he was playing a game in which Goliath couldn’t compete, taking a big risk for a big return. Goliaths are good at safe and slow things like branding. Instead of challenging incumbents at their own game, look for ways to force them to make hard decisions that distract their team or diverge from their existing business model.

David did not win because of the slingshot; he won because he made the fight about something other than brute strength. Venture capital can be your slingshot, but you will only succeed if it’s combined with wit and the right strategy.

Consider Airbnb when they first started. Marriott could easily have crushed them with millions in marketing spend but didn’t until it was too late. Instead, Airbnb made the competition about community, uniqueness and inclusion, not marketing spend. Marriott was unable or unwilling to pursue Airbnb down a path that might compromise its existing business model. In the end, Airbnb surpassed Marriott and today is valued almost 50% more than the one-time hospitality Goliath.

When it comes to venture capital, knowing how to use it is critical. When Doordash was growing, the incumbent teams at Grubhub saw them coming from a mile away. However, Doordash grew by making large investments in customer and driver acquisition, listing restaurants without explicit permission and operating in the gray area around worker classification.

As a public company, Grubhub was not willing to risk burning capital, listing restaurants without permission or the lawsuits that might arise if accused of misclassifying workers. Instead, it continued with its existing strategy until it was too late and Doordash was able to use venture capital to take over the market.

The question: Are you raising money to challenge incumbents to a battle of strength on their home turf? Consider instead changing the rules of the game before engaging.

Raising money to avoid pain

For some, an ideal business story is one where everything runs smoothly from day one. I always caution against this type of thinking because, like it or not, pain is necessary. It fosters discovery and growth. A founder who is afraid to fail, to take the hits, is missing out on valuable information and lessons that will ultimately inform and shape their business.

It’s like an inexperienced and fearful sailor prematurely tarring an entire boat to ensure its seaworthiness, but, in the process, overweighting it to the point of sinking. In the same way, founders seek to prematurely “tar” their companies with venture capital in order to cover up problems and challenges.

In business, I encourage sailors (founders) to get out into the water — well over their head, in fact. As leaks spring all around, stay calm and evaluate the situation, because while the boat may be sinking, it’s also revealing where the leaks are. By leaning into the discomfort of uncertainty, a founder gains critical insights and knowledge about the risks and vulnerabilities that threaten the business, which can only help to strengthen and improve it.

Consider a fourth founder: Their company sought to sell marketing software to small- and medium-sized businesses. Based on positive early feedback, they were convinced their product would get overloaded with demand the moment they opened it up and didn’t want to make a bad first impression. So they raised millions in venture capital to bolster servers and hire engineers, designers and sales reps.

It wasn’t until it was too late that they realized they were selling to the wrong customer and burning too much capital to turn the company around. If they had deployed capital in response to, rather than anticipation of, problems, they probably would have been successful.

Are you raising capital in anticipation of pain that may never materialize? You might do better to embrace the pain and strengthen your business.

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