Do You Really Need VC Financing?

A high percentage of startups that we rejected at Speedinvest fell into the category “not a VC case”. While the definition of this term varies across funds since the size of a fund defines the returns it has to make (read more on fund economics here if you didn’t know this), the following holds true unilaterally: many businesses that are looking for money from Venture Capital funds don’t actually need it. This blog post covers the key characteristics of startups which should in fact be looking for money from VCs.

High Risk/Uncertainty

Venture Capital already implies riskiness in its name: the word “venture” originated back in the early 15th century meaning “to risk the loss” (of something). VC money is there to fund businesses that create new products without clear business models — where it’s unclear how, where and maybe even to who they will sell to — as well as companies that are trying to create completely new markets. A great example for this is Facebook: who knew people wanted a social network to connect with friends online? And even once this need was recognized because of the millions of user sign-ups, it would be years before the platform understood how it could make money and started monetizing the data it collected. Some of the more risky start-ups Speedinvest has invested in include WeFox (building an online-only insurance experience), Tier Mobility (bringing a new form of mobility to cities) and Dronamics (developing cargo-shipping drones).

A counter example for this is a hair dresser, a century old business with a clear business model — people pay to get their hair cut — and market need: if you’ve gone a few months without having your hair cut or tried cutting your hair yourself, you probably understand the need. The only uncertainty is choosing the right location and then making sure you acquire (recurring) customers. If you have a good credit score, you can probably get a bank loan to cover any upfront costs for this type of business.

High Upfront & Low Marginal Costs

A typical VC case is moreover defined by (very) high upfront costs but lower marginal costs at the tail: a profit J-curve or the VCs’ favorite “hockey stick growth”. SaaS solutions are a perfect example for this: it’s very costly to build the technology and product, but once that’s done and you have your first customers, there is (relatively) little cost for handling additional customers except for maintenance and hosting. This is why VC funds love “deeptech” topics and founders with strong technical background, because these have the potential of creating the next Palantir.

Another way of achieving hockey stick growth is via network effects. Take AirBnB as an example: getting the first apartment owners and renters on the platform was difficult and expensive, but once they had reached a critical mass of users on the platform, the costs of acquiring new users decreased significantly because of brand visibility and word-of-mouth. No need for founder Chesky to go around and take pictures of the apartments himself anymore, as he did in the beginning days.

As you might be able to imagine, this characteristic is why consulting businesses don’t need VC funding. When I set up my own business, I literally had zero upfront costs: I used my personal laptop, worked from home, didn’t have to employ anyone and payments come in monthly. There is really no need for VC money or a bank loan here.

Easy Scalability/Replicability

One way of achieving lower marginal costs at the tail as described above is by fulfilling the following condition: can your product be easily replicated to several other areas (industries, customers, countries,…)? For network effects businesses this requires indirect, data or transregional network effects, e.g. camper van sharing platform PaulCamper has transregional network effects across countries because their renters travel the whole world (note that the camper van owners are not mobile though).

Another example are appointment management solutions (e.g. Shore) which started out catering only to hairdressers but were able to use their technology to cater to other customers such as doctors, fitness professionals and restaurants.

The extreme opposite of such a business is a tax advisory: not only are tax laws different across countries, for every new office you will need to start from scratch by hiring new people and acquiring new customers. So, there is little replicability that could be leveraged by venture capital.

Competitive Market Dynamics

Being active in a “hot” market can require a company to spend a lot of capital upfront. Some markets exhibit winner-takes-all dynamics and there are clear advantages to being a first mover (not all markets do, though). What this means for companies in these kinds of markets is that they need to move as fast as possible and at minimum faster than their competitors. And of course, the best way to move faster is by having more resources — both human and financial — to launch in new markets, acquire new partners, get brand visibility. This is where Venture Capital is especially helpful for a business.

The best-known example right now is the micro mobility market and here especially the e-scooters. Because the most successful companies will be the ones whose app users have already downloaded and whose e-scooters are readily available, start-ups benefit from a lot of (venture) capital to scale to as many cities with as many e-scooters as possible and especially from being first in partnering with cities — and that’s where the e-scooter funding “war” began.

On the other hand, businesses with low switching costs don’t have strong first mover advantages, e.g. people will instantly switch to the ice cream parlor next door if the ice cream is better or the price is lower. This results in lower importance of quick scaling and the capital needed for this.

For some businesses, it’s very clear they won’t benefit from VC money: you don’t see a lot of hairdressers, tax advisors or strategy consultants raising a Seed round. But then there are companies where it’s not as definitive and it’s up to the founders whether they want to take money from a VC fund. I hope this blog post has given you some background as to whether your company could be a “VC case”.