Wednesday, September 30, 2009

How To Invest in Poor Decision Makers

I couldn't think of a better title that fit my "How To ..." pattern. The point is, I wanted to make a response to the 37signals post that I found a little harsh. Sure, if you were able to build your company up without investors, that's a great thing! It doesn't make it a terrible thing to get a boost in the early stages or give you a license to insult people trying to pay the bills and put children through college.

Making great products is something a lot of us aspire to. Frankly, that simply isn't all of us and there really are good developers out there who are still only in it for the money. I don't know that is the case with Mint.com, but neither does anyone over at 37signals. Belittling them for taking a quick-cash option assumes a lot that may just be completely wrong about the intentions.

Now with a chunk of change, maybe the founders are planning to jump ship in a couple years and self-fund their real dreams.

On the matter of start-up investment itself, I do want to make some comments. Full disclosure: I've never been involved in a venture backed startup and I'm completely making this up from my own opinions about the world!

Pretend I'm from your bank and call you back after a loan application. You're taking out a small business loan to build an additional room in your home for a new child. Everything looks good, and I've got a few questions to go over before approving the loan.

"I'd like to make you an offer for 10% ownership in exchange for this investment in your new venture," I begin.

"What the hell are you talking about?" you quizzically respond.

"We're talking about a significant investment in a potentially very profitable new enterprise. This child may well become a doctor or lawyer and if we're going to help with the initial costs of raising this from the ground up, we all feel it is a reasonable request to share part ownership and benefit from that share over the lifetime of its profitability."

"Umm... I thought I'd pay the loan back. Plus interest, even. I don't even think I would own the child myself, technically. This is very strange..."

"Pay us back? A guarantee of interest accumulated as profit on our contribution? We'd rather take a chance of nothing or you paying us regularly for the rest of the child's entire lifespan. Oh, and all of it's children, of course."

*click*

If we look at everything in our world from neutral eyes that aren't used to our ways, things look weird. Does our investment model make sense, in this industry or any other? Why are any initial investments not setup as high-risk, high-interest loans, most likely with some initial grace period to await profitability? Of course, we could make some comments about the predatory loans and paying a cut of income for the rest of one's life, but at least banks pretend that isn't the deal upfront.

It isn't like this isn't an unusual idea. People get small business loans all the time. The tech sector seems to have skewed expectations that lead to dangerous and strange arrangements for funding. Still, I can't help but wonder if there are independent investors who would or do take such a (relatively) altruistic route. I imagine something like a traditional investment round, mandating some grace period of 1-2 years, a repayment schedule requirement full reimbursement, and interest accumulation that tapers off after repayment of the initial investment.

The basic foundation could be extended to view all initial players as investors, be the investors of time or money. Invest your time to get a business started, helped by monetary investments from others, and after repaying yourself and those individuals the company becomes its own entity. It is not burdened with paying out profit shares to you or anyone else. Yes, you'll still make your salary and you'll still run the company, but it might be a better one for it.

3 comments:

manuelg said...

I guess the unbounded upside of a percentage ownership of a wildly successful venture is attractive, and that attracts more capital for investment, than otherwise would be available, if not for that unbounded upside.

So structuring everything as a "loan" would probably work out just fine, but it would attract a smaller pool of capital.

James Thiele said...

You wrote:
Full disclosure: I've never been involved in a venture backed startup and I'm completely making this up from my own opinions about the world!
--
Clearly you have not :-)

manuelg is correct, but there is more to it than that.

Vulture capitalists (the semantically correct form for venture capitalists) are experts at squeezing out the founders of a startup. One of their techniques is to fund a company for a certain amount and then stall negotiations for future funding until the startup is starved for cash and has to bend over and take whatever the VCs want. Been there, seen that and read other companies' accounts of the same thing.

Jamieson said...

I'm wholly against venture capital for my companies (which have low startup costs and low risk), but there are definitely examples where only an incredibly outsize upside is compensated by an incredibly outsize risk. Essentially, VC is speculation, but I don't mean to say that as if it's a bad thing. It's a huge tradeoff. VC's want to make a killing -- who doesn't -- but at the same time they do assume significant risks. Most of the time, most startups fail for whatever reasons (and those reasons are mostly irrelevant.) The important thing is that VC's invest very large sums of money in company after company and most of them fail. When one does make it big, it's gotta be big.



In my view, VC's take a huge chance and deserve to be rewarded for that chance. However, I consider myself a better risk than they might, and thus I value any company that *I* start higher than they would -- by definition. Thus, IF I have the resources to build the company on my own (say, a software firm) then I'd rather do that. However, if I'm building something that requires massive investment, then the VC is the smartest AND SAFEST way to go for any founder, not just the inexperienced (just have a good lawyer.) It protects YOUR upside as well. Would you rather have 10% of $1M or 100% of $100k? They're equal -- but if one company can't get off the ground without sufficient capital, you take what you can get.



Examples:



* almost any dot-com ten years ago

* manufacturer, esp of some high-tech large piece of hardware

* electric cars

* rockets for commercial space use

* something that requires large advertising investment in order to hit critical mass (see Joel Spolsky re: amazon vs ben & jerry's)



There are definitely many examples of companies that wouldn't exist without massive amounts of VC. Google, YouTube, etc. As I understand it, YouTube had a datacenter bill of a million dollars PER MONTH when purchased by Google.



In short, VC is perhaps distasteful to some but ultimately is a very valid approach. I'd rather have 25% of a $10B company than 100% of a $1M company, and that's just leaving out the fact that big companies tend to get bigger and small companies tend to get smaller unless they can find ways to effectively keep the big companies from consuming their hard-won market. Momentum isn't everything, but it's definitely something.


Just don't forget to have your own, really good lawyers. Even if they're about to give you $1M in investment, you still need extra money to make money -- lawyers for patents, lawyers for deal review, lawyers for everything.

I write here about programming, how to program better, things I think are neat and are related to programming. I might write other things at my personal website.

I am happily employed by the excellent Caktus Group, located in beautiful and friendly Carrboro, NC, where I work with Python, Django, and Javascript.

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