Startup FInance

What This Startup’s Failure to Become a Billion Dollar Company Can Teach Us About Venture Funding

In February 2019, startup founder Sahil Lavingia published a post on the publishing platform Medium with an attention-grabbing headline: “Reflecting on My Failure to Build a Billion-Dollar Company.”

In the post, Lavingia told the story of his startup, Gumroad — an ecommerce platform for makers and entrepreneurs — and his journey from a 19-year-old CEO of a venture-backed company with $8 million in venture capital in the bank to laying off 75% of his company in a desperate bid to save it from certain death.

The post struck a nerve, racking up more than 100,000 claps on the publishing site. (For reference, a post that nets 2,000 claps falls within the top 1% of content published on Medium.)

Lavingia isn’t the only person grappling with the pitfalls of the venture capital model. His post is part of a broader reckoning that has been going on within the tech world about the role of venture capital and whether taking on VC funding is really the road to success that popular imagination has made it out to be.

Founders of prominent startups like Buffer and Wistia have spoken openly about their decision to stop taking on venture capital and buy out their existing investors. A movement called Zebras Unite has emerged to urge entrepreneurs to consider alternatives to venture capital, arguing in their manifesto that the current VC pathway “rewards quantity over quality, consumption over creation, quick exits over sustainable growth, and shareholder profit over shared prosperity.”

There are those who defend the VC model. In January 2019—the month before Lavingia published his Medium post—angel investor and vocal VC proponent Jason Calacanis published a blog post titled WARNING: Venture capital is for founders who want to grow fast (duh). “Everyone in Silicon Valley, the founders most of all, understand the deal: VCs give you the money to take a shot at changing the world. Most of the time it doesn’t work out and that’s OK because when it does work out the world’s greatest companies are built.

Clearly, there’s a Civil War brewing in Startupland. And the story of Gumroad provides a glimpse into what that war looks like for the founders on the ground: how a promising startup can go from $8M in VC funding to startup life support — and what happens after.

Billion-dollar businesses are the exception, not the rule

The first thing to know about building a billion-dollar company is that it’s rare. So rare, in fact, that businesses that achieve a $1B valuation as privately held companies as often called “unicorns.”

According to research firm CB Insights, a U.S. tech company that raises an initial seed round of funding has about a 1% chance of ending as a unicorn.

The CB Insights data has more to say about the fate of venture-funded companies as well. The firm tracked the trajectories of over 1,000 U.S. tech companies that raised seed funding between 2008 and 2010. Of the 1,119 companies they followed, just 12 reached the billion-dollar mark. Over half of the companies tracked never raised a second round of funding, and more than two-thirds never reached an exit event (merger/acquisition or initial public offering), ultimately winding up either dead or self-sustaining.

Source: CB Insights

In other words, not building a billion-dollar company is a failure in the same way that becoming a scientist and not winning the Nobel Prize is a failure. There’s a broad spectrum of possible outcomes between unicorn status and total defeat.

But founders—Lavingia included—aren’t conditioned to give much thought to those other outcomes.

“I thought Gumroad would become a billion-dollar company, with hundreds of employees. It would IPO, and I would work on it until I died. Something like that,” Lavingia writes in his post.

With business media reporting on $1B startups on such a frequent basis, it’s easy to forget the rarity of the achievement.

And the way that venture capitalists advise the founders they fund also contributes to these unrealistic expectations. To understand that, it’s important to get a clear picture of the underlying business model of venture capital, and how the incentives of VC firms set the tone for the companies they invest in.

Investors want a 10X return

People loosely familiar with the world of VC may have heard of the “10X return” that VCs look for in their investments — but they often don’t understand why that benchmark exists.

VC firms raise the money they invest in startups from limited partners, typically institutions such as pension funds and insurance companies. Before the VC firm can realize any profits from investments, it has to return these initial investments to the limited partners, along with 80% of the returns after the initial investment. A limited partner will typically want to see a 12% return on their investment; anything less than that, and they are better off investing their money someplace other than the high-risk realm of startups.

A general rule of thumb in venture capital is that a VC fund needs to achieve a 3X rate of return to be considered a success. At that level, the firm can fulfill its obligations to its limited partners and still see a healthy profit itself.

A 2017 post on the popular tech blog TechCrunch models out what it takes to reach that 3X return. Say a venture capital firm raises $100 million and invests that money equally across 10 startups. In order for the fund to be successful, those investments need to return 3X, or $300 million.

Suppose all 10 investments perform “average” and achieve exits of $50 million:

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Source: TechCrunch

The VC fund nets $12.5 million in returns from each investment, or $125 million total — less than half of what it needs to hit its 3X goal.

Now, suppose half of the investments do the average exit of $50 million, while the other half do better and manage $100 million exits:

1-fmt-vbyutrdxxfrltmqhqw.png

Source: TechCrunch

That’s (5*$12.5 million) + (5*$25 million) = $187.5 million — still well short of the $300 million mark.

The TechCrunch author runs through a few other scenarios, showing how his hypothetical venture fund’s fortunes improve as larger and larger successes get added to the pot.

Finally, he models what the outcome of this fund would be with five failures, three modest exits, one medium exit, and one billion-dollar unicorn success.

1-ifljpx3ehzaqhpjofpndra.png

Source: TechCrunch

The return in this case: (5 * $0) + (3 * $6 million) + (1 * $50 million) + (1 * $250 million) = $318 million. The fund is home free. But the overwhelming majority of the returns — 78% — come from that single billion-dollar exit.

The scenarios the TechCrunch post models are, of course, simplifications — the numbers are never as neat in practice. But the exercise serves as a useful illustration of the fundamental principle that rules the VC universe: the vast majority of VC returns are generated by a small handful of oversized successes. If a VC fund is going to be successful, it needs a unicorn in its stable.

The real-world data bears this out as well. In a 2019 newsletter post, Andreessen Horowitz partner Andrew Chen shared a visualization of the “VC power law curve,” showing how 60% of the returns from U.S. venture investments between 1985 and 2014 came from just 6% of deals—the ones that netted a return of greater than 10X.

vc-power-curve-768x433.png

Source: Andrew Chen

Even knowing the rarity of billion-dollar exits, venture capitalists push for them because that’s how they stay in business. VCs are businesses in their own right, with their own stakeholders and their own incentives, goals, and priorities.

What this means for startups and their founders is that, however much venture capital they take on, they need to plan on achieving an exit—either by IPO or strategic acquisition—of at least 10X that amount.

Sahil Lavingia raised $8 million in funding for Gumroad, including investments from notable angel investors Max Levchin and Chris Sacca and VC firms Accel Partners, First Round Capital, and lead investor Kleiner Perkins Caufield & Byers (KPCB). In order for everybody to be happy with Gumroad’s outcome, the company would need an exit of at least $80 million. Had they gone on to raise more money in subsequent rounds, the expected exit would have been higher.

As Lavingia puts it in his Medium post, raising venture capital is“like playing a game of double-or-nothing. It’s euphoric when things are going your way — and suffocating when they’re not.”

Before long, it became clear that things were not going Gumroad’s way.

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The gospel of growth at all costs

VCs are chasing their $1 billion success story, but they don’t know which of the 10 horses they’ve bet on will be the billion-dollar winner, if any. Because of this, they treat all of their portfolio companies as though they are going to be the ones that clear the hurdle and push a program that they believe will get them there.

In the current moment of VC thinking, the program of choice has been something called blitzscaling.

Originally coined by VC and LinkedIn founder Reid Hoffman and investor Chris Yeh, the term “blitzscaling” refers to “both a general framework and the specific techniques that allow companies to achieve massive scale at incredible speed.” Startups that pursue a blitzscaling model prioritize speed over efficiency and embrace big, risky moves with the goal of growing so big so fast that they box out the competition and sweep the table in a winner-take-all market.

The big venture capital success stories of the past several decades—companies like Amazon, Facebook, Uber, Airbnb—have all followed some version of the blitzscaling model. But not all markets are winner-take-all markets, and not all markets can support that kind of massive growth, as Sahil Lavingia experienced firsthand.

Gumroad was growing, but not fast enough to satisfy the demands of the blitzscaling model and justify the $15 million Series B round that was the next step down the VC trail.

Source: Medium

“For the type of business we were trying to build, every month of less than 20% growth should have been a red flag,” Lavingia noted in his post.

Ultimately, what hobbled Gumroad in its quest for the billion-dollar exit was the size of its market: there simply weren’t enough makers looking for a way to sell products online to propel Gumroad into the startup stratosphere.

“Product-market fit is great,” Lavingia wrote. “But we needed to find a new, larger fit to justify raising more money (and then do it again and again, until acquisition or IPO).”

Pivoting into a new market is a massive endeavor, calling for huge investments of time and money.

Unfortunately, Gumroad was running out of both.

The hidden costs of “grow now, profit later”

The blitzscaling startup motto is “Growth at all costs.” One of the things that typically gets sacrificed in the pursuit of growth is profits.

There are exceptions to this rule (the video conferencing startup Zoom, for example, achieved both a billion-dollar valuation and profitability before going public in 2019), but for the most part, blitzscaling companies put profits on the back burner to prioritize growth. The idea behind this is that they can “flip the switch” on profitability once they reach a critical mass of customers.

. High-profile disappointments like the underwhelming IPO of mega-unicorn Uber have further fueled a suspicion that the “burn cash for growth” model is not quite right.

But there are consequences to this “grow now, profit later” approach: once a startup takes on capital and commits to this model, it’s hooked. It needs to keep taking on capital in order to stay alive. If funding dries up, founders are left having to make some extremely painful decisions, as Sahil Lavingia learned firsthand.

Gumroad did what a good VC-backed company is supposed to do: ramp up the spending in the hopes that more spending would translate into more growth. In his Medium post, Lavingia shares a snapshot of what Gumroad’s financials looked like in June 2015, three years after it closed funding:

  • Revenue: $89,000 for the month
  • Gross profit: $17,000
  • Operating expenses: $364,000
  • Net profit: -$351,000

A blitzscaling startup would simply subsidize those losses with additional rounds of funding. But with no additional funding in sight, Lavingia was left with a business that was hemorrhaging cash and no obvious way to stem the tide—and a countdown clock ticking in the background.

Gumroad was now among the 67% of businesses from the CB Insights survey that stalled along the VC path and ended either as self-sustaining businesses or dead in the water.

The only question left was which of those Gumroad would be.

Gumroad after venture funding

Lavingia knew that if he wanted the company to survive, they had to “become profitable at any cost.”

Getting there meant making some tough choices, like getting out of their $25,000/month office and laying off 75% of the Gumroad team. Lavingia calls they layoffs his “lowest point.”

But it worked. A year after the layoffs, Gumroad had turned the corner into being a profitable company.

  • Revenue: $176,000
  • Gross profit: $42,000
  • Operating expenses: $32,000
  • Net profit: $10,000

“It hurt, but it meant creators would keep getting paid,” Lavingia wrote. “It also meant that we were in control of our own destiny.”

Then, another game changer: Gumroad’s lead investor, KPCB, offered to sell their ownership stake in the company back to Gumroad for $1.

Why did that matter? Gumroad may have been retired from the fundraising game, but it still had its existing investors, and those investors had liquidation preferences. That meant that if the company were to sell, the investors would need to see their return on investment before Lavingia or the other Gumroad team members would be able to see any return on what they had built.

With KPCB bowing out, Gumroad’s liquidation preferences went from $16.5 million to $2.5M. Lavingia went on to buy out several more investors as well.

“All of a sudden, there was a light at the end of the tunnel,” Lavingia wrote. “Small, dim, and far away, but present. There was a path to an independent business, not beholden to the go-big-or-go-home mentality I signed up for when I raised money.”

Reframing startup success beyond a billion-dollar valuation

Six years after taking on venture capital, Gumroad is not a billion-dollar company and likely never will be. Instead, “a profitable, growing, low-maintenance software business serving adoring customers,” in Lavingia’s words.

Since jumping off the VC track, Gumroad has achieved a number of different milestones. The company is now profitable. Lavingia shares top-line numbers each month on Twitter, and as of this writing, the company’s most recent numbers were $133,000 in profit on $361,000 in revenue. And with no investors needing their share of the profits, Gumroad is free to put that money elsewhere. In 2018, the company donated 8% of its profits to charitable causes, including hurricane relief. In 2019, Lavingia introduced the Gumroad Creators Fund, which would see the company invest 10% of its profits into creative projects.

Lavingia also highlights another metric: the value that Gumroad has provided for its audience of makers and creators. “We turned $10 million of investor capital into $178 million for creators,” Lavingia wrote on Medium. “And without a fundraising goal coming up, we are just focused on building the best product we can for them.”

Taking on venture capital is one road to building a successful company, but it’s not the only road, and it’s not the right road for many startups.

First Round Capital principal Josh Kopelman offers a useful analogy: Some companies are motorcycles. Others are jet planes. “VCs sell jet fuel, which doesn’t work in motorcycles,” he wrote on Twitter. “Bad stuff happens if VCs push jet fuel on a bike owner. Or if a bike owner thinks they can fly.”

Founders who are contemplating the VC path need to think carefully about whether they really want to build a jet plane, or if perhaps a motorcycle will suit their purposes better.

As for Sahil Lavingia, he took a shot at launching a jet, and it didn’t take off. But in the wreckage, he found something just as valuable: the freedom to define success on his own terms.