Venture capitalists are glorified gamblers in the Ace-from-Casino sense of the word. They try their best to collect intel on the players, but ultimately still just place bets. Bets that usually fail more often than they succeed. It’s the 1-in-10 blowout payoff that makes sure the piano keeps playing for them while the tune goes mum for the rest of their bets.
Those are potentially good-enough odds for a VC to make a decent return for their investors. Lots of VC’s can’t even pass that bar, though, and end up net-negative for their backers. But let’s just take the guys who do make it. What’s their seal of approval worth?
According to Adam from Heroku, it’s much more valuable to get the peg from these gamblers than actually having sales in the shop:
When you’re doing your own thing, you have very little feedback on whether your path makes sense. You’ve got users/customers, sure. But for any random thing you might build, you’ll always be able to find some weirdos that want it, and maybe are even willing to pay for it. Whether those people represent the vanguard of a sustainable customer base, or whether they are a niche too tiny to build a real business on, is impossible to tell early on.
But convincing investors of the viability of your idea – enough to place a monetary wager on it – provides early confirmation that you’re on a viable path. It may even provide some course-corrective feedback. This is why VC-backed companies tend to get more respect than non, all other things being equal. A firm whose sole purpose is predicting technology trends believes that there is a reasonable chance that this company’s product will be the next big thing.
It’s funny, I have the exact opposite take from the same indicators.
Real customers who use their own money to pay for your products seem like a much better, much more real confirmation that you’re doing something right than getting pegged by a VC using other people’s money to fish for 1-in-10 chances of a monster trout.
To me, convincing a VC to give you money only confirms that they think your outfit is capable of having a long shot of making a big sale down the line. And that they can dilute you successfully enough that they’ll get the lion’s share of the spoils. As a confirmation of a real business? Meh.
Separate users from customers to determine success
I think the confusion comes from how callously users and customers are conflated. I absolutely agree that if you’re just giving away your shit for free, then interest is only an indirect indicator for possible success at best. Who knows if these freeloaders can actually be made to turn a profit? Better take the money upfront and run for the exit before you have to find out!
But if you stop thinking so much about users (or eyeballs if we’re talking early 2000s) and start focusing on customers, the game opens up. Real customers not only confirm directly that you have a compelling product (rather than the by-proxy way of a VC), they also help fund your operation from the get-go.
You don’t need outside bets to launch a web business
Most web startups don’t have high costs outside of labor that can’t be linked at least linearly (and preferably better than that!) to the growth in customers. If you need lots of servers, it’s presumably because lots of people like your product and if you’re treating your users as customers, that means you’ll be having plenty of dough to bake a profitable cake.
All that being said, it’s certainly possible that being on the receiving end of a VC bet can lead you to the jackpot. The wheels in Vegas wouldn’t keep turning if some people didn’t see a big bucks ringing of cha-ching sometimes. So if the idea of trusting VCs over customers appeals to you, just roll your dice and hope you don’t roll seven!
Jim Greer
on 16 Aug 08Can we have a new topic please? I think we can sum up this argument as “it depends on what kind of business you want to start”.
Christophe Maximin
on 16 Aug 08I totally agree with you David, but I still have a question though: How do you attract your first hundred customers, without the money of the VCs and the free publicity of your funding by the VCs ?
Melvin Ram
on 16 Aug 08I like this distinction between Users & Customers.
Napster had lots of users but couldn’t turn them into customers. Movie screenings will usually pack a full house but it doesn’t indicate a blockbuster flick.
I respect Adam and what his team is doing with heroku but I wish he would create the pricing plans & offer them for purchase already. I haven’t been able to use them because I don’t know how much they will charge.
The feedback of whether you are on the right track consists of two parts:
A) Am I creating something useful/valuable?
B) Will people pay for it? And am I offering it at a price that enough people will pay for it?
Both questions are critical to the success of a company.
Getting VC might confirm the first part (at least from the VC’s POV) but leaves the second question, the most important question, up in the air.
Good write-up David. Got me thinking!
PS: I wrote the above comment in a blackberry but couldn’t submit it because your blog system uses javascript to submit a comment. Just FYI.
John C.
on 16 Aug 08Related: You don’t need outside funding – the Magento interview (Video) – http://blog.mixergy.com/outside-funding-magento/
JF
on 16 Aug 08How do you attract your first hundred customers, without the money of the VCs and the free publicity of your funding by the VCs?
Where’s the evidence that selling a piece of your company to a VC will net you 1. a hundred customers, and 2. the type of public exposure that your potential customers are paying attention to? You may get a few people in the VC sphere all hot and bothered, but it’s likely your customers are paying attention to different news.
And even if this was true – and I don’t believe it is – selling a big chunk of your company so you can send out a press release and maybe get mentioned on a few blogs seems like a terrible return on that sale.
You generate media interest not through a financial transaction (usually a bad one too—you don’t have any leverage at the beginning so you are getting a bad deal anyway), but through solid products that are newsworthy. Anyone can raise money from someone. The newsworthy companies are those with something new to offer.
GeeIWonder
on 16 Aug 08Noit all VCs are gamblers. Some are ideologically driven (‘Angels’). Some are driven for other reasons.
Bets that usually fail more often than they succeed. It’s the 1-in-10 blowout payoff
Not all VC relies on big payout models.
GeeIWonder
on 16 Aug 08(I do tend to agree with the rest of the sentiment though.)
Matt
on 16 Aug 08Also worth noting the “me too” mentality of most VCs. Do they believe in your product/team or is it a knee jerk reaction to their neighbors up the road who just bet on the next new thing? Customers pay for things that make life easier and that means you’re on the right track.
Berislav Lopac
on 16 Aug 08JF, Cristophe wanted to ask “how do you attract your customers without the money”. You need to fund your development, and it’s irrelevant whether that money comes from your own pockets, your ongoing operations or VCs—it still needs to come from somewhere.
As Jim said above, it all depends on the type of a business. Some businesses can start making money from day one, while others simply need being funded for an extended period of time. One size doesn’t fit all, and you guys should simply stop seeing your situation as universal and accept that different models work for different people/companies.
LoafOfPaint
on 16 Aug 08“you guys should simply stop seeing your situation as universal and accept that different models work for different people/companies”
They’ve said that repeatedly, on the blog when folks have brought up the issue. But there’s no point in dull-as-dishwater, overly qualified, “but there are always exceptions” posts. Speak strongly or Please Just Stop Clogging The Net. You want the other opinion, they LINK TO IT.
DHH
on 16 Aug 08VC investment certainly works for some scenarios: Those where you need big up-front capital investment and where there’s a long delay in seeing a payback. That’s not what I’m really arguing about here, though.
I’m challenging the quote from Adam that getting VC money trumps paying customers as an indicator of success. He says it does, I think not.
Jeff
on 17 Aug 08Large companies tend to be good companies because customers paid them, and they got bigger. Large companies are faced with more inefficiencies, but they ultimately produce more despite their lossyness. Companies that produce more can outrun small teams in the same space, including spending more time listening to customers. Plenty of customers, especially enterprise, will not settle for minimalist feature sets, no matter how proud your team is of your self-control. So you build more of what people want faster, and all other things being equal, you win. VC is a shortcut to let companies do this. While both are business validators, VC is damn harder to get. Maybe you meant that, at some arbitrary revenue or customer growth rate, customers are a better indicator of success. Long term, nobody’s arguing that customers trump VC. For the short term startup phase, I’m agreeing with Adam. VC trumps customers.
GeeIWonder
on 17 Aug 08So you build more of what people want faster, and all other things being equal, you win.
I see examples that both support and refute your [progression of] statements to this point. But basically, that’s a big implicit if (‘all others…’)
VC isn’t free—far from it.
Brad
on 17 Aug 08Heroku plays in a completely different space than 37signals. First, when people from Heroku wake up in the morning they don’t have a definitive, “Yes, this product will work” or “No, leave Heroku and start working on something else”; rather, they have a “This might work. People might buy into it.”
Heroku is in a position where they are not entirely sure who their customers will be long term. Are they individual rails developers, enterprises, or both? Since they are not entirely sure who their customers are going to be they need at least one of the following two items to find out: time or money.
37signals would say that time is the best way to get answers from customers; which is right… assuming you have the time. Since you guys love what you do so much, you can take all the time in the world to learn that your customers want bulk import for Highrise.
Heroku wants to speed up the process of finding these customers by taking on investment. Its not a question of “investors know more than customers”; what investors do provide, in terms of information, is more money to answer the question, “who exactly are my customers?” Its a classic “time is money” problem.
VC money is all about arriving at a definitive “yes” or “no” about the viability of a particular approach to a business and/or problem.
Throw market forces into the mix and you’ve got an even more interesting situation on your hands. Heroku needs to answer the question, “who exactly are my customers”, before their competitors Google, Amazon (I know, they’re built on EC2, but AMZN is probably salivating at Heroku), and Microsoft do. This is a bleeding-edge, high-stakes technology game of who will dominate an app hosting industry worth billions of dollars; not a race to see who can build a better address book and make a couple million bucks doing it (not that there is anything wrong with that).
DHH
on 17 Aug 08How is money going to tell Heroku whether their customers are individuals or enterprises? That doesn’t make any sense.
Besides, this is a different debate than the point discussed in this post. Which, again, is whether a peg from a VC is better than paying customers in determining whether an idea is worth pursuing.
I do love the small-potatoes jab, though. That’s always a classic. Keep ‘em coming, but at least thrown in a shrimp cocktail and some belly dancers.
Isaac Garcia
on 17 Aug 08Sure, most VCs are essentially gamblers – as are most entrepreneurs.
Reward is usually proportional to the risk taken. Whether that risk was to “consult your way” to success or to “fund your way” to success is mostly irrelevant. Either way – there is risk – and either way there can be a pay out.
Sure, customers and revenue trumps the “need for VC” in the early stages of a company…...
...but customers and revenue with VC can also be a trump card and can often be the fuel required to grow a company from “successful” to “largely successful” or “more impactful” or ___.
Berislav Lopac
on 17 Aug 08Robert Einspruch
on 17 Aug 08I think David is 100% right. My company solves a real world, offline need – not one created by the internet itself – and we have customers that open their wallets and pay to use our service. I naively thought that this fact alone would be enough for VCs. Instead, the universal question posed to me was “How do you make ziizoo a $100MM revenue company?” (how do you answer that with a straight face?).
David makes the important point that, for better or for worse, this is what VCs are looking for. Thus it pushes you and your company down a very unnatural path, often with a binary outcome. On the other hand, if you build a solid business you will always have the flexibility to raise raise external capital (and if you are really lucky, in the debt markets rather than the equity markets).
As a challenge to the Paul Graham / Adam Wiggins camp, I would love to see some examples of companies that focused on profitability too early. Did they go out of business because of a failed model (e.g., selling pet food online) or failed strategy (growth vs. profitability)?
Dylan
on 17 Aug 08eBay’s story is similar to what David is describing. They focused on creating a great product that people loved to use…started charging fees because the product “worked”...users turned into customers and immediately turned a profit. The rest is history.
Tom G
on 17 Aug 08Gee I thought my customers were my VCs…
Mike
on 17 Aug 08So does Jeff Bezos think that you’re just capable of a big sale down the line? Is he just waiting for the 37s spoils? OR Does “a minority private equity investment in 37signals” not qualify as VC?
condor
on 17 Aug 08@brad
I think that’s the problem, Heroku is just playing right now, they aren’t actually allowing people to back their use of heroku with money, and place a hard vote on the service. Once Heroku allows that, those questions will begin to be answered in a tangible way. The only way to know if “People might buy into it” is by giving people a chance to actually buy into it.
Which business does? Once heroku goes from being a company to being a business (by offering a product/service for sale) they will have a much better idea.
I think you nailed it right here, the goal of a lot of new software companies (without a lot of CAPX needs) in taking Investor money is to speed the process up. They want to skip from first to fifth grade and expect to know how to read, do math, and write. They want to skip all the steps of trial and error in figuring out who will pay for their product, what functions customers will value, etc. That may give them a faster start in making the product they envision people will buy, but skipping over these early indicators also allows them to miss some important early guidance. On the flipside, it allows them to comfortably develop (with guaranteed salaries, an office maybe, enough resources), on a path they aren’t 100% sure customers will be willing to follow them down.
VC money is about arriving at a definitive “yes” or “no” about the INVESTMENT viability of a particular approach to a business and/or problem. An investment from a VC doesn’t provide you a definitive yes or no about the viability of the actual business, the only way that happens is by the business being out in the customer marketplace and operating at a profit.
Exactly, lets do that and actually find out, versus having to guess by proxy that it will be a success because an investor, who is most likely not a customer, thinks other people will eventually be customers.
How is it a game? Why does it need to be a race to see who dominates, is that the only way a business can succeed?
Tony Wright
on 17 Aug 08Interesting post—I think that you might be talking about different types of validation.
Users/customers validate whether you’ve built something that people want.
VCs (theoretically) validate that you’re pursuing an big opportunity and have a better than average chance at liquidity. So if Adam’s hope is to build a big business that someone will eventually buy, VC is a MUCH better indicator than the first 100 (or 1,000) users.
Two different types validation. I don’t think anyone (including Adam or Paul Graham) would argue that the validation you get from happy users/customers is the more important milestone…
If you look at Adam’s post through the lens of his goals (which I’m guessing at), his post makes perfect sense.
Dylan
on 17 Aug 08@Mike. Why the negativity? I think you’ll find that 37signals invited Bezos on board not for his capital, but for his experience growing companies and his access to networks and contacts. 37signals is already profitable and as they’ve explained many before…their overheads are low and they don’t believe in scaling up for the sake of it…
The Bezos investment is entirely different from the scenario outlined by David in this post and suggesting otherwise just makes you look argumentative.
Jesus A. Domingo
on 18 Aug 08For start-ups, getting VC money may get things moving faster – you get more skilled heads, setup the necessary infrastructure, etc. But depending on how your target users and customers receive your app, you could instead be heading nowhere fast, instead.
Don Schenck
on 18 Aug 08I never heard of Heroku before reading this. So it wasn’t a VC that clued me.
Something to think about…
Matt Radel
on 18 Aug 08I think there are plenty of simple and cheap ways to promote your app or service (blogging, Twitter, Facebook..etc.), without selling your soul to a VC. I’ve found commenting on blogs that are relative to your market to be the most effective.
Certainly I’m not advocating that you place an ad in the comments of a post, but if you can add something insightful to a conversation on a regular basis (and link back to your product / service site of course), you’ll start to raise awareness – and you’ll probably learn a few things about your audience in the process. :)
Richard B.
on 18 Aug 08Having experienced a VC’s minority shareholder squeeze-out first hand, I completely agree with David’s article. In addition to all the points made already, consider these:
- Customers typically don’t engage in minority shareholder squeeze-out (oppression) tactics that take all or most of the ownership away from the entrepreneur (beware the cash call). VC’s have an entire handbook of minority shareholder oppression tactics that can make your life miserable.
- VC’s want to exrtact everything they can from the business; customers typically want you to succeed.
- Customers aren’t typically motivated to bankrupt you so they can buy whatever little company ownership you may have (and any claims you may have had as an owner) after after the squeeze-out via the courts for pennies on the dollar
- Customers can’t fire you from your job at the company. VC’s will fire you as part of their squeeze-out effort.
If you value your happiness and you love your company (the way I did) then you should avoid Venture Capitalists. Follow the words of Ben Franklin:
“the Borrower is the slave to the Lender, be frugal and be free.”
Damon Cali
on 18 Aug 08I’m with David. The idea that investment means your idea is good (i.e. that it will be accepted by loads of customers that will pay you for it) is just crazy. While VC backing from a great VC (top 25%ish) is undoubtedly a hopeful sign, that’s all it is.
Likewise, if you think that financing source has an impact on the respect a company gets from it’s customers (who else matters?), I think you are a little too entrenched in the echo chamber. Other investors might perk up, but that’s not really the point, is it?
This all has nothing to do with the value or appropriateness of VC financing. Sometimes it’d good, sometimes not. But VC money does not equal market validation.
My thoughts on why VC isn’t for everyone are on my blog here:
Why VC Probably isn’t for You
Mike
on 18 Aug 08@Dylan – There is no negativity. David made a statement and I’m curious how that statement should be applied to 37s, if at all. It can be read as pointed, but I’m just posing the question.
Yes, the post has a specific point. My question opens another point that VCs aren’t always in it to make the quick sale. When you give up some part of your business for money you’re doing to for something in return. Whether it’s validation, access to resources or cash to enable you to fund something – staff, assets and the like.
The post brings up the question about VC and how it can affect your business – so I ask how VC, mentoring, access to resources, whatever you want to call it, has effected 37s?
Dylan
on 19 Aug 08@Mike. “So I ask how VC, mentoring, access to resources, whatever you want to call it, has effected 37s?” that is a much more sensible question and (in my opinion) entirely different from your first comment which read as a sarcastic insult. I’m sure you’re not the only one who would like to learn about what 37signals has learned through the Bezos investment. Maybe it will come out in a future post?
Dan
on 19 Aug 08There’s another reason not to take outside funding, except your customers.
It makes you lazy. You’ll not work as hard as before taking that unearned money.
Your business should be fast, agile and make you money, not need money from you.
Mike
on 19 Aug 08@Dylan – I simply copied what David wrote and inserted 37s and Jeff Bezos into his statement and stuck a question mark on the end. If it sounds sarcastic – I can’t take blame(?) for that. When you read something you can emphasize whatever you want and spin that emphasis to match your feeling. There was no sarcasm intended.
This discussion is closed.