Why raise venture capital?

Venture capital is a niche financial product. I can think of only 3 reasons to raise it. These are also the patterns I try to match a company to when I’m evaluating whether or not to invest.

1. “We have a coin-operated time machine.” This is probably the best case for raising venture capital. For a company that has identified its constraints on growth and can solve for those constraints with money, venture capital is a great product. A good example is a SaaS company that can use venture capital to hire additional sales reps. Assuming a sufficient number of qualified leads and high customer retention, the company grows faster by having more sales reps work in parallel, and can therefore use venture capital to hire more of them up front without waiting for revenue to come in. The key is that in this case, the only change is in time to outcome and not the outcome itself. The same company would likely have gotten to $XM in ARR in Y years, but by raising capital, can get there in some fraction of Y years instead. Said another way, the company is trading away equity for time, hence the coin-operated time machine metaphor. So long as the value of shifting the outcome forward in time exceeds the dilution taken in getting there, it’s a profitable trade for the business.

2. “We can create a fixed cost base that will serve a large number of customers at near-zero marginal cost.” Consider CoffeeCo, your local coffee shop. Coffee is basically hot water, so CoffeeCo makes a 95% gross profit margin on each cup of coffee. Whenever CoffeeCo gets a flood of customers, the line goes out the door. To serve more customers, CoffeeCo hires more baristas and buys more equipment, until eventually so many customers visit that there is literally nowhere else to sit or queue in the store. CoffeeCo has marginal costs to serve each additional customer (baristas, equipment, coffee) and its fixed cost base (the store) can only serve a limited number of customers.

Now consider PayCo, the payments company that supplies CoffeeCo’s point of sale system. PayCo makes money by taking a 0.1% fee on each of its customer’s sales. Like CoffeeCo, PayCo has both marginal and fixed costs. PayCo incurs marginal costs when it sells a new customer, because it needs to pay its sales people a commission on the sale, ship a payments terminal to the new customer, and help install it. However, these costs are one-time only. Once the payments system is installed, PayCo earns its 0.1% fee with zero marginal cost to PayCo. At its headquarters, PayCo employs hundreds of engineers who build and maintain financial software that processes payments not just for CoffeeCo, but tens of thousands of other businesses too. These engineers have built PayCo’s systems such that PayCo can support a virtually unlimited number of businesses and payments transactions without any changes or customization. As a result, as PayCo serves more and more customers, its R&D spend stays largely constant, representing a fixed cost base that can serve an unlimited number of customers.

PayCo is a venture-backable company, and CoffeeCo is not. CoffeeCo’s model is inherently constrained, and the addition of venture capital will not change it. Regardless of how many baristas it hires or stores it opens, it will always incur marginal costs to serve incremental customers, and be constrained by the physical limits of each store. By contrast, most venture investors would be happy to subsidize many years of losses at PayCo as it builds its payments systems and acquires its initial customers, because at scale these costs will fade as a proportion of revenue. These dynamics explain most successful venture-backed SaaS companies (marginal costs of sales & marketing and implementation are one-time; a single multi-tenant SaaS applications can support an unlimited number of customers), marketplaces (marginal costs of each sale are borne by the users, not the company; single platform supports both sides), and even drug companies (research and commercialization costs are fixed; marginal cost to manufacture drugs is trivial relative to price). These dynamics also explain why venture capitalists are willing to subsidize large losses on a net income basis for many years – so long as the market is large enough, it makes sense to invest heavily to build a fixed cost base that can serve a large portion of the market at zero marginal cost.

The thing to remember here is that high gross margins are not a proxy for low marginal costs. Remember that CoffeeCo had extremely high gross margins (higher than Salesforce!) but also high marginal costs. I consider sales and marketing to be a marginal cost, which is why the ultimate venture-scale outcomes are companies that have not only the lowest marginal cost to serve a customer, but also the lowest marginal cost to acquire a customer relative to the unit price of each product and the size of the market. Consider that both PayCo and CoffeeCo use Microsoft Office for email, word processing, and presentations; Google for search; Facebook for networking and advertising; and Amazon for occasional supplies. Nobody at PayCo or CoffeeCo has ever spoken with a sales person or customer support agent from any of these companies.

3. “We would be silly not to take it.” This is when capital is being offered to you on terms that are so favorable that it would be irresponsible not to take it, or the capital capital comes bundled with some other feature that makes it worthwhile to take regardless of whether or not the business needs it – e.g., an extremely valuable board member, a deal with a critical customer or strategic partner, etc. In the latter case, you’re arguably not raising venture capital at all; rather you are bringing on board a partner who seeks to capture economic value by investing capital in the business. The challenge is that it’s generally impossible to fire an investor or remove someone from a cap table without their consent, meaning there is often a big mismatch between expectations around investor/partner support and reality of delivery.