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Saturday, January 24, 2009

Should a startup take outside investor money?

Dewitt asked several questions over at friendfeed which I thought were interesting, and worth writing about. The big one is when should a venture take on outside investors?

My feeling is that if you can fund a startup all by yourself, bring it to profitability, and own the business free and clear, there's no reason to bring in venture or outside investors. Once you take in that money you now have an obligation to grow fast and reward the investors with capital gains. If you own the business free and clear you can grow organically, and go for long term profitability. Gary Erickson's Raising the Bar covers this approach very well. Other examples are Perforce Software, a profitable company that's done very well over the years --- it will never be a Google, but you don't have to build a Google in order to make yourself very wealthy, and a low risk approach like Perforce's is very profitable for its owners.

The reason to take outside investors is that you need a ton of capital so you can move quickly. Why would you need to move quickly? The first reason is that the market has low technical barriers to entry. That means that as soon as you launch, your competitors will realize what you're doing and you'd better be growing fast in order to dominate the market before they can enter. This fits in very well with the VC model, since they want you to grow as quickly as you can as well (that ten year horizon on the VC fund is relentless!). Let me illustrate with two well-known examples.

When Reed Hastings started Pure Software, he worked in his basement for two years on the first product, Purify. He only hired an employee after he had something working on Sun workstations (he hired someone to port it to the MIPS processor). He then took out a second mortgage on his home, hired salespeople, and launched the company. The company was profitable within 3 months. He could take 2 years to build product because at that time, purify was such an off-the-wall idea that he could rely on nobody else building it with a bigger team. Pure Software eventually took VC money because Reed wanted to grow it fast, but the whole thing ended badly for the company, because Pure really fell into the Perforce model --- development tools are inherently an organic growth market and can't be forced.

When it came to Netflix, there was no way Reed could have funded it all himself without taking a lot of risk. Building a huge video library is expensive, and building the website for Netflix is not a significant technical barrier --- Blockbuster and Hollywood Video could have done it if they had realized what Netflix was doing. This was a natural fit with the VC model, and Hollywood and Blockbuster dithered enough entering the market that Netflix was dominant by the time they entered, and hence put both established companies in trouble.

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