I can’t believe you’re back
Hi friends! Thank you so much for taking the time to read last week's essay, to send me feedback, and to subscribe to this newsletter. The overwhelming feedback I received was that I should include more memes, so this time around I hope I don't disappoint.
Many of you know me for working at a string of venture-backed, high growth tech startups, and I often get this sense from people that venture-backed firms are held in higher regard than ones that aren't. Writes Moiz Ali who founded direct to consumer deodorant brand Native: "In Silicon Valley, it’s often embarrassing when you haven’t raised money". Venture capitalists know they pull their startups into public markets on the backs of the public’s reverance for them, so they've carefully crafted this narrative of their ultimate superiority. However, in today's piece I want to give you an understanding of how you should deploy venture capital (hint: It's not so you can do whatever you want, like pop culture suggests), and the perils of seeking their capital if you're not prepared. Here's what I'm going to cover:
The definition of a successful company
How venture capital works
The perils of deploying venture capital
Sit tight and watch me burn all my venture capital bridges.
The definition of success
How would you define a successful startup? For many, it's probably when a private company reaches the illustrious $1B valuation (unicorn status). For venture capitalists, it's the maximum return you can get for an investment at exit.
Here's a fun little fact for you: Did you know that Canada has the worst production of unicorns among countries with over $250 million in venture capital funding?
You can also use this as a proxy for the average size of company you're going to build with x dollars invested in our companies. Either way, this makes a pretty bad case for the ROI of venture capital in Canada.
Why might this be the case? Research institutes like the Narwhal Project presume it could be that funding is spread too thinly across Canadian firms which doesn't allow the best to blossom. Alex Danco, who writes a popular newsletter about venture funding, argues that the Canadian tech ecosystem is set up to "stifle" startups. The average person is going to tell you the main issue is that we lose our best talent right off the bat- 84% of Waterloo's software engineering 2020 grad class is going to the States.
These reasons make sense, but I dispute that we can't pump out unicorns because we are bottom-of-the-barrel talent or because filling out government grants turns our companies into "work programs". I think many Canadians don't want to just build unicorns for the sake of building unicorns because, honestly, it's not that fun. We’re a relatively chill group of folks who want to have a good time because we’re not so status oriented.
Silicon Valley has long cultivated an image of this sexy city upon a hill that is the purveyor of all things innovative, fun, and exciting, because of rich capital, young people, and an absence of rules. However, enter a number of unspoken negative externalities: Clout chasing, overwork, and a lack of diversity. Building for the sake of a valuation isn't good for people, and in the long term, economies will suffer the consequences.
A sustainable company
If I had to name my 3 top priorities for a company to build, I'd want to employ a diverse workforce, make a positive impact long after I'm gone, and for it to be a great time where I met cool people along the way. I'm not building with the intention of exiting within my lifetime because being a multi-billionaire sounds kinda boring. Companies are meant to be mechanisms for people to do good and live balanced lives.
If I said that to a venture capitalist they would laugh me out of the room. Here’s what Jordan Kong, Principal at Atomic (can someone smart tell me what a principal at a fund does) who is a true simulation, has to say:
See, the status quo definition of success for a venture fund is designed to build the antithesis of a sustainable company. Deploying their capital often fosters work environments that are suitable for only a small slice of the population. They are laser-focused on maximizing an exit valuation, not long term value for the economy. The venture funding model is set up to make companies go viral and reap those rewards, but in reality, lots of companies will fizzle after their 15 minutes of fame. That's why Uber, Juicero, Theranos, WeWork, and other questionable unicorns were perfect.
It all boils down to how venture capital operates and the impact it has on the companies that take their capital.
Venture capital 101
Venture capital isn't looking to fund tech businesses with good profits that promote good health and solve a pressing problem- They are looking for firms that are expressly going to double their revenue every year in the early stages. They are also not looking for slow, sustained growth, but for growth to be as explosive as possible while the company is still private. A crazy growth rate is what gives tech company their laughably high IPO valuations that are upwards of 20 times their profit. It's been said that venture firms aren't interested in a company early on unless they are doubling their revenue every year.
The game that VCs are playing is to guess the exact snapshot in time that your revenue and growth rate convene to maximize the valuation of your company, at which point they plan to exit. Why is this is a fixed point in time? Because no company is going to double their revenue every year for the rest of time. Your products are going to reach market saturation once you sell to all the biggest banks or when pretty much everyone who's gonna buy an iPhone has already purchased an iPhone. In a study looking at 20 firms that had gone public between 2016 and 2018, 14 of them had declined in annual growth rate an average of 7%. Here's a chart showing the average growth rate versus the revenue generated for the 58 companies in that paper:
The equation used to determine valuation for startups is driven by revenue growth. The growth rate increases the revenue multiple which drives the valuation.
Revenue x Revenue Multiple = Valuation
When your growth slows, it has the dual effect of decreasing revenue potential and makes for a lower revenue multiple.1
What does this tell us about some companies that are able to get VC backing and go public?
The point in time a company IPOs is meant to be either the highest a company is worth before the growth is predicted to decline. If your company was doubling but theoretically you were going to be obselete/no longer be able to grow in few years, the venture firm is going to let the public pay your bills.
Profitability isn't really a factor in this valuation equation, and in fact, it's discouraged in favour of using all your money to market your product and sell even more.
Once you start getting venture funding you're almost locked on a path to grow as fast as possible because they have a say in what your company does. On average, IPO companies went back to get more funding every 1.5 years, raised about $2.30 for every $1 they made, and lost 76% of that capital they raised before they went public. This funding is all used in the name of increasing the revenue growth rate.
Venture capital isn't like this because VCs are simply out of touch and want to drown in even more money than they already have (minor dig because yes they are out of touch, cmv). The median venture fund actually makes a return around 11%, which is probably what you could do on the stock market as an individual in a good year. There are just so many risks with companies that size that growth is the best way to guarantee a return.
To win, venture firms are looking for new category definers that have the potential to monopolize a market to a point where there is no competition. That's not usually going to be a physical DTC product or a dating app, it should be new (though anything could go public with enough money). To better self select for venture capital, just ask yourself the following:
Would I be happy if my company comfortably generates millions in revenue or do I want to go public? If you're happy with a couple millions, that's sounds cool and fun, but avoid VC.
Am I prepared to double in growth every year for a decade? Buckle in boys, we're going for a ride.
High growth perils
Achieving more growth just means that you build more stuff and you get more people to use your stuff or pay you more. You can have an amazing product that makes getting people to use your stuff easier, but ultimately you just need as many people as you can afford to make things and repeatedly sell them. Day in, day out.
Growth that isn't offset by the need to create any positive value is just a race to the bottom in terms of effort. I'll scratch the surface by covering 3 negative externalities of making explosive, short term growth your main priority: Burnout, culture erosion, and long term consequences.
Burnout
In recent years, China has produced some of the most admirable and innovative tech companies in the world, bar none. Their strategies and growth trajectories are studied under a microscope by tech leaders in the US. Among my favourite coverage is this fascinating read about Shein, a fast fashion retailer that has won the hearts and wallets of American teens while they quietly verticalized their manufacturing and ecommerce presence to make new SKUs the instant they become trendy online.
Lesser known is the work culture that propels these companies to success. Employees are pressured into working at tech firms from 9AM to 9PM, 6 days a week. This phenomena is so pervasive that people refer to this working pattern with a formalized name: 996. It has been endorsed by the highest Chinese tech executives, like Jack Ma.
This is prevalent for high growth firms everywhere in the world, but it's just not as egregiously endorsed by leadership- Mostly just the top venture capitalists, as demonstrated in the tweets above. The most sinister problem that this raises is that it pushes out the majority of the population from being able to participate, thus making the tech workforce younger and less diverse. If you're not in your prime, younger than 40, and single with few responsibilities other than your career, this is not an environment in which you can safely work.
The irony is that these firms claim to be the giants of the future because they've defined a new market and they've grown to a huge critical mass in just a few short years. However, their innovation often revolves around automating away a lot of labour for older folks while replacing their jobs with dangerous, underpaid, or overworked roles suitable only for skilled and young people. We see a pretty bleak future if the workforces of these futuristic firms don't reflect or provide for the population.
Culture erosion
Establishing a strong culture directs staff how to respond to new contexts. It doesn’t provide a set of scripted, procedural instructions, but it informs staff of your underlying mission. This enables them to interpret and respond to different situations. A strong company culture can infuse your team with motivation and focus, helping minimize the ambiguity and chaos that infuses a scaling startup. — Mudassir Sheikha, founder of Careem, Uber/Postmates for the Middle East
Most people have been in a situation where they didn't like their role but they stayed because they really enjoyed the people they worked with or they believed in the company's mission. One day, you suddenly wake up and realize that your department has doubled in size with most people having been at the company for less than 2 months. Your talented coworker who was the cornerstone of your team has gotten tired of the new beaucracy and decides to go elsewhere. You start classifying new employees as "them" and old employees as "us". A rift starts to form.
When you grow at the pace it takes to double your revenue, you're probably close to doubling your workforce every year as well. There are scientific studies to indicate that changes such as these cause immense stress, but you don't need me to tell you that. Not only is it not easy to grow an org quickly, it's not fun. It's a straight grind. You interview people with most of your time, hound your poor headhunters, and try to indoctrinate new people all at once.
Long term consequences
Venture capital money kills more businesses than it helps. — Jason Fried, founder of Basecamp, owns the domain “Hey.com”, famous for giving the finger to venture capital
Technically these firms are trying to make the best business decisions they can, except they have to do it impossibly fast and thus are going to cut corners. Innovating to produce your product at lower margins upfront, taking care to build a quality product, using capital to drive fundamental value of the product, investing in staff- All the fundamentals of a good business go out the window. Instead, firms will race to make as much as possible and sell half built garbage to as many customers as possible. It's going to come back and bite these companies.
It's no fault of the employees themselves that they start making decisions in a shorter term mindset- They are racing against the arbitrary constraint of time to deliver growth results. Less time means less hiring means less time spent on individual products which leads to more fires and chaos to fix. Your understaffed team gets burdened by problems and doesn't get to sell new stuff, which will be compounded into a bigger problem later on.
These reasons contribute to the reason that turnover is so high in Silicon Valley- Working at these companies isn't exactly a walk in the park. Rather, they're likened to being "digital sweatshops".
One Valley is enough
What is Silicon Valley's secret sauce? It’s the number of sub-25 year olds who came right out of college making top tax bracket salaries. They're hungry for clout, willing to judge others who don't put in long hours, and understandly feel superior to the average person. When I landed in California 2 years ago, I was struck by how everyone had designs to change the world with their startup idea. It was intoxicating. Having smart young people build and lead billion dollar companies that IPO in 12 years is really neat, but experienced leaders should note that they don't have all the answers. They're just trying new shit and getting help from celebrities to blow it up, which isn’t as fun or rational as it sounds. That's the reason that we in Canada don’t produce as many extremes - successes and failures - as the Valley.
In Canada, VC money isn't as effective because our people aren't empowered by clout in the same way. If we're going to work for a third of the wages, we want to build a company without burning out. Can we support founders better with higher overall wages and less intrusive funding? Always. However, I'd argue not being motivated by status is for the better: Venture capital creates firms that sprint for success instead of developing endurance to run the marathon that building a better future is. And when we build something that does become a smashing success like Shopify, it really is a rare, magical, and awe-inspiring company with a meaningful skyhigh valuation.
It's what a unicorn is meant to be, no?
You made it to the end! In the future, I plan to showcase some of the diamond-in-the-rough startups that are being built in Canada because they make great stories, but I’d love to know what you’d like to read about as well.
If you have any response to what I’ve written, please let me know in the comments or tweet me @pizzaking41.
As always, thanks for reading and consider sharing this piece or subscribing to give me that much appreciated dopamine hit. See you next week!