
Why VCs sometimes push companies to burn too fast - craigcannon
https://blog.ycombinator.com/why-vcs-sometimes-push-companies-to-burn-too-fast/
======
hitekker
> The Worst Case:

> The company runs out of money.

Actually, the worst case is keeping a company going even though the
fundamentals of the business are imprecise, hard-to-define or just plain
wrong.

You end up wasting resources of all kinds for everyone involved. Investors,
employees, and founders, to varying degrees, will squander time, energy,
enthusiasm, money in pursuit of a mirage.

Money isn't everything, surprisingly, even in a round of funding. If you
accept a huge sum of cash with a giant valuation attached, you must have
reasonable certainty that you will at some point achieve that valuation
without more raising. Mental gymnastics aside, I don't think most startups can
guarantee outcomes, but they must be, at least, certain of their motives.

Are you raising because you're at the scaling stage? Or are you raising to buy
yourself a little bit more time to hopefully, maybe, figure things out?

The latter reason is a poor reason to raise, and most of the time, only staves
off the inevitable at the cost of unnecessary suffering and hardship.

~~~
edblarney
"Investors, employees, and founders, to varying degrees, will squander time,
energy, enthusiasm, money in pursuit of a mirage"

Most 'employees' will never see any significant upside in any of the startups
they've worked at or will work with - so their compensation is their
livelihood and not exactly a waste of time.

There is a lot of inefficiency at big companies as well, so it's arguable that
most tech workers are 'wasting at least some of their time' in the big
disorderly march to progress.

They are also gaining skills.

But I agree it's a pretty bad thing to do to raise money to 'figure things
out'. I'd loathe to think of how many of those would actually get funded.

------
lpolovets
I'm a VC. I think a lot of this boils down to the asymmetric relationship
between the upside and the downside.

If a company doesn't do well, the investor loses all/most of their investment.
It doesn't matter how ambitiously or unambitiously the startup acted, the VC's
losses are roughly fixed.

On the other hand, the difference between a company having a very good (e.g.
8x) vs. fantastic (e.g. 50x) outcome is _huge_. If increasing burn helps a
company grow faster, acquire more market share, and improves the chances that
the company will 50x instead of 8x, then that's worth a higher chance of
failure to the VC because they have some diversification. It may or may not be
worth it to the founders, who only work on one startup at a time.

So basically, if the two possible scenarios are the following..

1) 60% chance to 0x, 30% chance to 3x, 10% chance to 8x

2) 80% chance to 0x, 15% chance to 3x, 5% chance to 50x

.. then VCs strongly prefer the second scenario. There's a slightly higher
chance of a loss, but the upside is much, much greater.

~~~
didgeoridoo
Given the expected values in your example, I don't think anyone would fault a
VC (or any actor with a non-pathological marginal utility curve) for taking
option 2. Now, what about the two bets:

1) 80% 1x, 20% 5x (EV: 1.8x)

2) 99% 0x, 1% 100x (EV: 1.0x)

How many VCs do you know who would take 1 over 2, even though it's the
"obvious" money-winning bet?

I'd love your thoughts on why this is. My semi-cynical thesis is that VCs need
home-run logos on the Portfolio page of their website to keep their spot at
the dealflow table.

Let's break the VC world up into three types:

A - Brand-name VCs that funded yesterday's massive unicorns, and are regarded
as clairvoyant masters of the universe

B - Unknown VCs with a half-decent return on their last fund, but didn't back
anyone you've heard of

C - VCs that swung for the fences a few too many times and imploded

Founders want to work with "A" VCs (for both rational and irrational reasons),
so the first names they call are the ones whose past big bets paid off. "B"
VCs are much lower on the call list, and only get access to the deals that "A"
VCs all passed on. "C" VCs are obviously not available to chat.

It is arguably rational for a VC to seek to become an "A" and end up as a "C",
rather than to muddle along as a "B" until she's getting pitched every week by
hair salon and gym owners with A Great App Idea and her LPs wonder what she's
doing with their money.

~~~
lpolovets
Lots of great points in your comment.

First, I don't think any rational VC would take #2 over #1 in your example,
but the caveats are: a) people aren't good at estimating small probabilities,
so they might think that #2 should be 97%/3% instead of 99%/1%, and then #2 is
"better". And b) They overestimate how much of a "sure thing" something is, so
maybe what seems like 80%/20% in scenario #1 is really 50% 0x, 30% 1x, and 20%
5x. I can't remember the origin of the quote, but I've repeatedly heard that
"trying to build a $100m company is not that much riskier than trying to build
a $10b company, so you may as well shoot for $10b."

Also, generally VCs won't take bets where the EV is <3x or so. A good fund
will have a net return of 3x+, and you can't get there by making a lot of 2x
bets.

Furthermore, 99% 0x vs. 1% 100x is _very_ lopsided. Probably too lopsided for
most investors with portfolios of 20-40 companies per fund. If someone made
that bet for all 30 companies in their fund, the fund would be 0x almost 3/4
of the time. But if the bet was more like 95% 0x and 5% 100x, then that's kind
of interesting. Making 30 investments like that would produce a terrible
return 21% of the time (0 wins), a good return 34% of the time (1 win), and a
terrific return the rest of the time (2+ wins).

That said, prestige is (unfortunately) a factor. So I could imagine someone
making an investment with an EV of 4x that is likely to be a unicorn over an
investment with an EV of 5x that is unlikely to be a unicorn.

The last thing I'll add is that A/B/C grades for investors are context-
specific. An 'A' like Sequoia or Accel might be generally pretty great for
everyone, and you won't go wrong taking money from those firms. But in certain
areas, lesser-known funds might be very strong company-building partners. For
example, there are specialty funds that are focused on SaaS companies or
frontier tech, and if you operate in one of those spaces then those funds
might be just as good as taking money from Sequoia.

Finally, below is an interesting set of tweets from an LP who has been
investing in VC funds for several decades. TLDR: it's basically impossible to
build a great fund return on top of lots of small wins; you need a few huge
wins instead.

[https://twitter.com/HorsleyBridge/status/657287940456886272](https://twitter.com/HorsleyBridge/status/657287940456886272)

[https://twitter.com/HorsleyBridge/status/657288063329013760](https://twitter.com/HorsleyBridge/status/657288063329013760)

[https://twitter.com/HorsleyBridge/status/657288245105917952](https://twitter.com/HorsleyBridge/status/657288245105917952)

[https://twitter.com/HorsleyBridge/status/657288489331855360](https://twitter.com/HorsleyBridge/status/657288489331855360)

~~~
akiselev
I wonder if this financial reality is really the way it has to be or if it's a
natural consequence of competition in the VC industry getting out of control.
When the intangible value-add a firm can provide is low, all they can really
compete on is the financials and how favorable the terms are to the founders.
This causes a spiral where the valuations go up (dragging up even the
valuations of 'A' firm deals) but the dilution each round does not keep pace.
Founders with unicorn ambitions benefit by growing faster and keeping more of
the future fortune so they keep the inflation train going. Everyone else who
wants to build a solid company or reward investors with a steadily growing
stream of dividends and a good but not great ROI suffers from the pressure to
grow faster than they or their business model are capable of handling. Of
course there's a second pressure from the other direction as companies compete
to acquire more nimble competitors in lieu of hiring slowly and risking
internal R&D. Since M&A has become a more and more common exit strategy over
the last few decades, there's more opportunity for those unicorn returns with
less risk, further souring VCs' opinion of other deals.

In other industries like biotech it's not that rare to see early rounds where
founders give up 40-50% of the company so even though investments are bigger
and riskier, the financials work out to returns as good or better than tech in
general. The pharmaceutical industry has outsourced large amounts of R&D risk
to biotech investors for a long time though, so the risk is usually scientific
and not product-market fit or sales/distribution. If you're working on a drug
for a certain disease or condition, it's pretty easy to calculate how much you
can make or how much you'd be worth to a pharmaceutical giant at various
stages of risk (seed, animal studies, efficacy studies, clinical trials, post
approval, etc.).

------
carsongross
A more succinct, cynical take: anyone who sells money for equity is always
going to be happy to see you need more money.

(The author dances around this, for understandable reasons.)

~~~
akharris
I understand the cynical take, but having worked with a lot of investors, I
don't think it's the dominant reason. If at all possible, investors would
rather own a smaller piece of something huge than an ever increasing share of
something small.

This is actually something you can use when negotiating if someone tells you
"I need 20%." Really, they need a big return on their invested dollars. The
exact % is just a rule of thumb based on the overall returns they expect from
their investments in the context of the entire portfolio.

~~~
rhizome
So maybe the higher the ask%, the lower their faith in the company?

------
payne92
A much simpler and cleaner analysis: risk-return divergence.

Investors manage portfolios and fund returns are dominated by the home runs.

Therefore, investors generally want to maximize risk (and potential return),
which is usually at odds with a founding team with most of their net worth
tied up in the company.

~~~
greglindahl
Plenty of people on founding teams like home runs, too.

~~~
aetherson
Well, of course they do. But what they "like" is a pretty trivial level of
analysis.

Let's say you invest 5-10 years into a startup. Which would you rather have? A
30% chance at a $10M payday, or a 5% chance at a $100M payday? The answer is
not "Well, I'll just repeat until the 5% chance materializes."

~~~
greglindahl
I'll take the 5%. Makes it easier to raise money. I've done this twice, so you
can take my answer as actual and not theoretical.

------
Animats
The zombie problem - same issue I brought up at [1]. Not successful enough to
pay back investors, but they _won 't die._

[1]
[https://news.ycombinator.com/item?id=12981392](https://news.ycombinator.com/item?id=12981392)

~~~
danieltillett
I am surprised that VCs don't sell their zombies to specialized turn-around
firms or to other investors looking for slower, but more steady growth.

~~~
dilemma
Private Equity

~~~
mbesto
This. I've advised on 30+ PE deals involving software companies this past
year. Definitely worth looking into if you're a profitable mid market SaaS
company.

------
huangc10
I actually gave this quite some thought after talking with a friend about the
up-and-coming startup he was working for. Recently they just received a 20 mil
series A funding and yeh...they're burning cash (mass hirings, searching for a
new location, etc.).

The thing is, the CEO has started his own company twice and sold both (this
was his third company) so we both assume he knows what he's doing.

In the scenario of the CEO, I feel like his plan is this, and only this:

"high risk, high reward"

"live fast, die young"

Are these the correct thoughts for a serial entrepreneur (who is also sorta
like an investor)?

*edit, funding was actually for series A not B

~~~
mattthebaker
Yeah, these are correct thoughts for a serial entrepreneur. With two,
assumingly successful, exits he now likely has a net worth somewhere between
2-100M. He could live off his investments/net worth. If his next exit is not a
very big one, he will not really gain much. i.e. If he exits for 10M, which
could be good for the early employees, he has only made a small fractional
increase in net worth, for presumably a ton of work -- he wasted his time. So
of course he will want to take big risks. This is probably a big part of why
VCs prefer serial entrepreneurs, besides other obvious benefits like
experience, they are prepared to shoot for the stars which is how VCs get
paid.

~~~
huangc10
agreed.

------
akharris
Author here - curious if you've seen this happen.

~~~
jaf12duke
You have the dynamic mostly correct, but the motivations reside more at the
partner level than the VC firm level. Individual partner IRRs are determined
by the mark up they can report for the specific deals on which they have
attribution.

When a VC pushes for a faster burn which then necessitates a new VC firm to
fund the next round (perhaps prematurely relative to the founder's
perspective), it's so that that individual VC can mark up their personal IRR.

Which may be relevant to their firm and the firm's fundraising plans to LPs.
But could also be even more relevant if that partner is thinking about
changing firms or starting his/her fund own. Individual IRR, based on deals
with attribution, is the resume of a VC.

The effect of this is, junior partners push for this type of behavior more
than senior partners that are already set with an impressive personal IRR.

~~~
akharris
Agree that much of this is partner dependent, but I've seen the dynamic play
out happen with senior partners who have great track records and with younger
partners out to prove themselves. In each case, I think the motivations differ
slightly, but the same theme is at work.

------
graycat
Main theme: The VCs again are not looking carefully at the plans of the
company and, instead, are focused just on current _traction_ and maybe the
growth rate of that traction. So, the VCs are looking at essentially just
accounting measures. That's like betting on race cars without looking at the
car engineering.

Problem: Using just traction and its rate of growth is a poor way to evaluate
the real future of the company.

Here's some of how: That approach ignores (A) the size of the market and its
growth rate, (B) the core technology and is it defensible or, instead, easy to
duplicate or equal, (C) the status of would be competition, (D) the
scalability of the technology, (E) the margins once have reached some
significant scale, etc.

The VCs look like they would really like a drag race car that from a standing
start just went 0-100 MPH in 2.5 seconds but 500 feet ahead is headed off a
cliff, in another 1/2 second will have the rear tires explode, the
supercharger belt fail, or already has the engine at 8000 RPM and in 1/2
second at 10,000 RPM the engine will explode.

Why Do VCs Do This: As the OP explains, the VCs have to report back to their
LPs quite frequently, and the LPs are looking only for simplistic measures,
e.g., from something close to traditional accounting, e.g., would ignore
anything about the engineering of a race car.

Apparently the VCs and LPs would prefer a lemonade stand that opened just
before July 4th and on July 5th can show good traction and fantastic rate of
growth in traction.

For a safe, effective, cheap one pill that taken once can cure any cancer now
in Phase III trials, the information technology VCs would say "No traction"
and f'get about it.

So, the VCs want an early _pop_ easy to see and measure in simplistic terms.
Okay, that can become a game. So, delay all reports of progress. When have
accumulated some nice progress in traction, in January say that will have
rapid growth starting in March and will have a report on April 1st. Do that,
and have the April 1st report look really good on traction and its rate of
growth. Then let the VCs report this fantastic _exploding success_ back to the
LPs.

Information technology VCs just flatly refuse to evaluate projects based on
the real internals and, instead, pay attention only to simplistic, visible,
external measures. That's foolish.

Entrepreneurs beware: Reporting to a BoD of fools is no fun.

~~~
CalChris
I agree with a lot of what you said but would biotech VCs evaluate IT any
better? Biotech has really long expensive cycle times from discovery through
trials. It's like correspondence chess vs bullet. Not the same, not similar.

On biotech, I had a sailing buddy, Cambridge PhD, and I could not understand
the motivation of principle engineer level researchers in that field. Maybe
it's a job job; I couldn't see any parallel.

~~~
shostack
Is that a viable path to becoming a biotech VC?

------
neom
The only VC firm I know who doesn't put loads of pressure onto the
foundry/exec to deploy capital is a16z, or at least the partners I know of
and/or founders I know who have worked with them seem to have not felt that
pressure. I always thought this was both annoying and pretty useful. On one
hand, if you're building a sustainable business and you're in the growth
stage, you're simply going to market, and so that can take as long as it takes
(if the market is nascent, maybe you're waiting for it to mature etc), and
that's nice. On the other hand, I've seen founders get so wrapped up in
building the company they forget to build the business, or so wrapped up in
building the business they forget to build the company, if you're under the
gun of investing capital, you have to stay pretty focused on your real
revenue. Forgetting to focusing on real revenue can be pretty easy when you're
well funded and know you have big pro-ratas/names behind you who won't tank an
investment. If you're in the MVP stage, founders who don't burn and burn
quickly are probably doing it wrong, as an MVP may not be a business yet, and
if it is, it's almost certainly not geared to operate at scale. IMO seed/mvp
should burn consistently and quite quickly, growth stage should burn very
planned and systematically.

------
fanzhang
Can a lot of this be distilled into differing risk aversions between the
investors and the founders?

Two major reasons here seem to be 1) VCs not wanting to sink time into a
failing startup (force downside) and 2) markups in valuation are preferred by
VCs (force upside).

But directionally these incentives are the same for founders. Founders
probably want to work less if their startup is failing (per person*years they
put in). Founders also prefer the case where they're valued a lot and worth a
lot.

Magnitude-wise these motivations are very different between founders and
investors. For founders, a failure means lost years of their lives -- forcing
a downside is a lot more painful. Founders also celebrate the home-run as much
as the VCs (in fact probably for the biggest home runs, the founders get out
more than an individual VC right?).

This could create an asymmetry whereby founders are in no hurry if hurry could
mean failure, and the model above is classical risk aversion. Conversely, VCs
don't mind that much if your chance of failure goes up by a few percentage
points.

Aaron also tacks on some new ingredients: VCs like to see markups for it's own
sake (to solve the monitoring problem between LPs and VCs).

I have no doubt with his experience the mechanisms are absolutely correct,
just wondering if the majority of the underlying generator of these symptoms
is underlying risk aversion.

------
djyaz1200
VC's want your company to quickly "Blow up" one way or another.

------
danieltillett
I wonder how much of this dynamic is caused by the 10 year fund life? Would
VCs respond the same way if the LPs gave them 15 years? Would VCs change the
sort of company they invest in?

~~~
greglindahl
In order to raise Fund N+1, a VC firm needs successful exits from Fund N. I
had a startup whose exit timing was driven by our investors needing a
successful exit so they could raise. A longer-lived fund would not have
changed the timing.

~~~
mason55
Theoretically you could try to shift it so that fund N was based on the exits
from fund N-2. That way you don't have to the cohort in N-1 to exit so fast.

The only difficulty would be the first couple funds where you'd have to push
group 1 to exit so you could raise fund 2, then try to raise fund 3 on the
exits of fund 1 plus the growth (but not exits) of fund 2.

~~~
greglindahl
The investors in question had raised many funds. I suspect their LPs were more
interested in "what have you done for me lately" than anything about Fund N-2.

------
paulsutter
> Conversely, companies that fail remove themselves as a time commitment for a
> partner

If you look at the portfolio of a VC fund you'll see why. If they're in 45
companies, essentially all the return will come from 3-5 companies. The other
40 board seats are a hassle. Whether they return 0x or 2x, they're just not
material to the success of the fund.

------
kriro
Are there really no small ball (in the Moneyball sense) VCs?

It seems like there could even be a market for taking the ok but never great
companies off the hands of boom/bust mentality funds at fairly good
conditions.

~~~
anandkulkarni
Dave McClure laid out a model for playing Moneyball on startups – investing
well before product/market fit, when other VCs didn't see value. Today, that's
500 Startups. [http://500hats.typepad.com/500blogs/2010/07/moneyball-for-
st...](http://500hats.typepad.com/500blogs/2010/07/moneyball-for-
startups.html)

