Dilution · Growth

Smaller piece of a bigger pie?

Michael Barnathan

June 3rd, 2015

I keep hearing people rationalize dilution as taking "a smaller piece of a bigger pie". However, company sizes in the economy at large are power-law distributed (think 80/20 rule). Assuming the same is true of startups, this seems irrational - your odds of performing to meet a high valuation become vanishingly small, you have to waste a lot of time trying to raise rounds, AND you're getting diluted down to nothing at the same time. Even if you do succeed, it will take you a much longer amount of time to grow a company to that size, during which you might have been able to start a bunch of smaller companies and surpass your eventual (small piece of a big) exit.

This obviously works out well for investors, whose capital is usually necessary to grow to that size, but I see lots of founders getting diluted to nothing, failing to sell when they should, or getting eaten up by liquidation preferences for thinking this way.

So convince me: if you're in entrepreneurship to get rich, why aim for a single large exit instead of lots of smaller ones? Is this the equivalent of buying a lottery ticket or is there something I'm not seeing?
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Paul Paetz Startup Advisor, Consultant in Disruptive Innovation, Adjunct Professor

June 4th, 2015

"So convince me: if you're in entrepreneurship to get rich, why aim for a single large exit instead of lots of smaller ones?"

If you are in entrepreneurship to get rich, you are likely to fail at both. This is the worst possible reason to be an entrepreneur, and if your focus is always on $$$, you are likely sucking value from the product/service you create rather than adding it. In other words, you are far more likely to create an Enron than a Facebook or an Apple, or lots of under-performing smallish companies that neither you nor investors are that interested in.

You should be an entrepreneur because you are passionate about solving a problem that you believe a lot of people have, and that you believe you have the best possible answer to. If you are focused on solving that problem and believe in what you're doing, you'll be able to get over the many hurdles and pains that come with growing a company (including fund raising and dilution), and profits and company value will be a natural consequence.

If your level of greed is such that you can't bear to give up an extra percent of what you feel you're entitled to, others around you will sense this and you won't be able to keep the best and most passionate people who are necessary to building a strong company with a high valuation.

Besides all that, there are too many assumptions embedded in your thesis which are probably false. Just starting a company doesn't mean you are creating something of value that you can either sell for a lot or grow into a highly valuable colossus. Trying to grow without investment, fast enough that you capture the greatest market share, is only possible if no one else sees the same opportunity and no one else seeks investment capital to grow faster. If you don't have high growth potential, then you shouldn't be seeking outside (high risk investment) capital, and you have nothing to worry about in terms of dilution (and VCs won't be that interested anyway). If you've got enough of your own money, then keep all the shares and don't dilute.

Dilution is a cost of seeking outside capital. It's a choice you make, and it may or may not add value. That depends on you and your idea, and who you bring in as advisors, investors and your leadership team. The real issue is not whether you will eventually do it, but whether your company needs/warrants it, and when you do it. The longer you can keep going without getting additional capital while growing value, the more of it you get to keep. But keeping the most you can should never be the reason for creating a company.

Paul Paetz Startup Advisor, Consultant in Disruptive Innovation, Adjunct Professor

June 4th, 2015

Several things:
  • It’s usually a false assumption to “follow the money”, even when explaining large scale social behavior. This works for sales people and criminals and Wall Streeters - one could argue these are a special case on a spectrum of sociopathy, and that a Venn diagram of these types would have a lot of overlap. Most people, despite traditional assumptions of economic theory, do not act in their own economic interest, especially in the long term. Many recent studies have demonstrated that we are much more driven by emotions than by money, and that the notion of rational markets is a false idea.
  • It is certainly a false assumption if you are interested in successful entrepreneurs. There are some obvious exceptions, but by and large, the most successful have had a primary driver which was not money. Money is a byproduct of success.
  • If your primary goal was maximum return, then you would probably not choose the entrepreneurial path, because you’d be more interested in protecting a sure thing than in pursuing high risk ventures (risk aversion theory). Entrepreneurs tend to not believe in or acknowledge risks because they have an (irrational) belief in their ability to overcome them. They also believe that what they are doing is important and necessary (emotional drivers, not financial ones). Their endeavor is compelling and has an element of heroism.
  • As a “for the sake of argument” discussion, I don’t believe that your hypothesis works or that either proposition can be proven, however it is very difficult to grow fast enough that having 100% control of a small company will provide you with greater value than a heavily diluted fraction of a large company. You have to make the assumption that if you don’t capture the available market, someone else who invests more in product development, marketing and reach will. If you decide to stay small, the best economic outcome is going to be by serving a niche market that is willing to pay more for a custom-fit product that a larger mainstream company can’t offer, but that necessarily limits your growth to the size of that niche. You will have many of the same risks (including the possibility of being outflanked by a larger and better resourced competitor who targets a generalized mainstream offering), but lower maximum reward.
  • You are correct that not all opportunities are large ones, but it is the potentially large and disruptive ones that VCs are interested in funding, so those are the ones where it makes sense to talk about the dilution effect. In those special cases, it is precisely because disruptive innovations grow the size of the pie that it makes sense to take on the investment you need to deliver the right solutions and grow as fast as possible, capturing market share before someone else takes it. So, your choice is really between retaining control of a niche product in a smallish market that doesn’t grow, or having a much smaller piece of a much bigger pie. If you believe that your solution has general applicability to a large market, then it would seem to me to be foolish not to target the high growth option that takes on outside investment and dilutes your share. You are also more likely to succeed given the push that the right investors will offer you in reaching your target markets. (If their contribution is strictly money, then you are not attracting the right investors.)

I believe that when people choose to not take on outside investment in a high growth market, the reasoning has more to do with control than with maximizing return. I just don't see anyone thinking "I'll make more if the company stays small".

Logan Kleier

June 3rd, 2015

In software startups, conventional wisdom tilts towards the idea that VC money is the holy grail and that you're nothing if you don't seek hockey stick like growth (which a variety of VCs want). This means that reality bends towards a single large exit once you've got a push from VCs for hockey stick like growth.

With that said, I think there's another issue with pushing for lots of smaller exits. Good executable ideas are hard to come by and most people can't string together multiple small exits. Looks at Elon Musk, he's hailed as a visionary. I admire a lot of things about him, but I don't think his strength is in idea creation. It's in finding and running with other people's ideas. Elon's got it right, he's sniffing out ideas, because he knows that they're hard to come by. He just looks for really big ideas. 

Karl Schulmeisters CTO ClearRoadmap

June 5th, 2015

Andrea - the reason VCs are looking for the 1000x payout is because startups are extremely risky. The NASDAQ Composite Index (very little effort) averages about 13% ROI year on year.

now 90% of all startups fail. So if you were going to invest in startups blindly you would need each startup you invest in have a business planthat returns 126% year on year JUST TO MEET the NASDAQ. and of course VC investing is much harder than the NASDAQ and riskier so you necessarily increase the cost.

The realty is that 70% of the companies the VCs invest in basically disappear in a puff of smoke. No meaningful assets left behind

An addition 20% perform below NASDAQ market ROI.

And additional 5% perform basically at NASDAQ ROI

So you have (0.05 x 13%) + (0.2 x 7%) + (0.7 x 0) ==> 95% of your portfolio will contribute a weighted ROI of 2.05% to your overall ROI. Now using hedging and options and other strategems - that take about as much work as running a VC probably gets you to 20%. So that means your REAL target ROI has to be 20%.

so that means your remaining 5% have to provide aweighted contribution of 17.95% ROI.

That means they have to on average produce an ROI of 360%.!!

Now if we dive into this remaining 5%, about 1/2 of them make their 10x in 3 years growth targets which gives you a weighted ROI of 8.325%. added to the above 2.05% and we are now at 10.33%

So the remaining 2.5% by itself has to generate some 10%-15% of your total ROI. That means they have to have roughly 500%-600% ROI year on year.

So what the VCs look for is a 10x growth in 3 years as a viable business plan. The assume 95% of their investments will not return this. The assume 2%-3% will and they assume 2% will exceed this

If they are very good, they exceed this by a significant amount. But if you want OTHER PEOPLE'S MONEY to take the risk in your company, you need to compensate that risk above and beyond what they can get simply by buying an index fund

And the reason many entrepreneurs want to sell is.. well they are ideas people.  The notion of slogging it out day in and day out doing incremental growth in sales - sure making good money - is exactly what they sought to avoid by not taking that corporate gig and instead taking the riskier path of startup world

Chris Carruth VP/Director. Strategy | Business Development | Operations | Product | Solutions

June 4th, 2015

Great points. I would add one more. If you look at sales funnels a lot of times the largest opportunities are given the most resources in terms of pre-sales headcount and mgmt. support. This is true even if there are 10x the opportunity in a bunch of smaller accounts. The reason?  The effort to close a small opportunity (aka a small size startup being successful) is the same effort to close a large scale opportunity (aka a unicorn startup). Given the success rates of startups, even fully capitalized and staffed with the best minds, is still 1 in 10 in most VCs playbooks, it just doesn't make sense to go after small opportunities. You would have to dramatically close many more small ones  to have the same ROI, in the end, as one large one. 

The smaller ones are more suitable for ff&f financing, where Uncle Bob is thrilled to get $10k back on his $5k investment...and if not, still gives you a hug at the family reunion :)

Karl Schulmeisters CTO ClearRoadmap

June 4th, 2015

As Paul points out, not all human behavior is rational   Many startups are plain stupid  but their founders truly believe in the value of the product.  So they don't believe their idea will fail.  This sort of unrealistic optimism has been studied and is well documented throughout behavioural economics.   Even Garrison Keeler of The Prairie Home Companion show alludes to this with his closing tag line

"Well, that's the news from Lake Wobegon, where all the women are strong, all the men are good looking, and all the children are above average."

Karl Schulmeisters CTO ClearRoadmap

June 5th, 2015

>>The real problem, in my opinion, is that most founders and VCs think that they will go viral sooner rather than later and that is a total delusion. <<

I think you misunderstand the process.  VCs KNOW that 90% of the companies will NOT go viral.  OTOH 100% of the founders do.   That's the mismatch.  So VCs base their assumptions on the data they have of industry success rates.  And again the track record of failure is what it is.  And if you want VCs to invest in your company in the face of that, you have to offer a payoff to the VC that will beat the market.

And no I'm not saying that from day 1 you "need the whole structure in place" . Frankly I didn't address structure at all.  So please don't put words into my mouth.  All I am saying is that if you restrict VC investment to less than $1 million, you restrict the sorts of projects that can be accomplished.  Developing something like a Tesla requires quite a bit more than $1 million, or a DNS address and a website.

The market force are what drive VC behavior... and if you don't understand why, then I suggest look to understanding the market forces

Vijay MD Founder Chefalytics, Co-owner Bite Catering Couture, Independent consultant (ex-McKinsey)

June 3rd, 2015

Opportunity cost -- much harder to get started on your own vs someone else's money.  

Plus funding allows you to attract talent, etc much easier than figuring out how to do it from cash flow while a potential competitor is taking your market.

Those that have grown slowly (SAS is a good example) take a lot longer but tend to be more steady and stable (and of course the founder keeps equity).

You don't hear about them as much, as founders don't need to put out same level of PR and they tend to be older by the time they're big.  But going from zero to something on your own dime is not an option for many.

Rey Tamayo Founder and CEO at ReyNovation, Tech Startup Strategy and Product Development Mentor and Coach.. Author. @phatinnovator

June 4th, 2015

You are right in principle, however in practice it is very much more difficult to create many companies because of time and funding constraints.  Not only will it consume all if not more time than you have but also because you are not entirely focused you cannot care for each as much as they need and you must split all funding around so not one of them gets just enough.

Also please remember that dilution is really a point of view, you still have the same amount of shares as when you got started, your vote may be diminished, but your wealth is increased as those shares are worth much more already. If keeping control is what you seek, then dilution can be a very bad thing but as per your question, it is about the value of the stocks, they are not affected by dilution except that supposedly they increase in value with each round if it is not a down round.

Michael Barnathan

June 4th, 2015

But let's assume you are for the sake of argument, because I'm interested in the economics of the decision, and because it's usually a safe bet to follow the money when explaining large scale social behavior ("why most people do it"). There are obviously lots of other reasons to start a company. Certainly no one goes into it to spend 4+ years of their lives making nothing - there is an expectation of a personal return through the company's equity, or else everyone would be starting a nonprofit.