Why taxi drivers don’t take venture capital

Photo credit: Tommy / Unsplash

The following is an edited excerpt from Hot Seat: The Startup CEO Guidebook by Dan Shapiro. The excerpt was provided by O’Reilly Media. You can buy a copy here.

Mike Carter owns Revere Taxi, a thriving cab company in Boston, Massachusetts. He emailed me a few years ago to ask for advice on how to raise venture capital to expand his business. Mike had picked up on an intriguing opportunity: a change to local ordinances meant that massive casino development was underway in the state.

It turns out that the world at large does not understand what exactly VCs intend to do with their stockpiles of billions. Experience has shown me that, as a result, scores of good companies (but bad VC investments) waste precious time and energy chasing after a category of investor that is simply not going to be able to help them. VCs look for a set of very odd, unusual things when they invest. To find them, they rule out a lot of great companies.

As a side note, VCs have investors (called limited partners, or LPs). Those investors have very particular tax requirements. One common requirement is that VCs should pass along capital gains only. As a result, many VCs are actually forbidden from accepting dividends. specialized business. That’s because any one of the following factors can disqualify a company from venture capital consideration.

You want to build a profitable company

The funny thing about this is that VCs don’t actually like their companies to be profitable. Someday, sure, but not on their watch. You see, profitability means that the company has decided not to invest some of its money in growth. This seems odd, but think about it for a minute. At the early stages, a company may be making money, but it’s almost certainly investing every penny it makes back into the business. If it has access to outside capital (e.g., if it’s being bankrolled by a VC), it’s spending more on growth than it makes – the very definition of not being profitable. And that’s exactly what VCs like: companies that can grow at amazing speed, turning every free dollar into further growth. They want epic revenue growth. They do not want companies to slow this down so that they can reduce their burn rate and amass cash.

This benefits the VCs twice. First, it means they are owners of companies that are growing explosively. That means huge markets, executives who can scale up a business fast, and a willingness on the part of management to double down on a winning bet – over, and over, and over again. Second, it means the company keeps coming back to the VC for more money on positive terms. That means the VC keeps having the opportunity to buy more and more of the growing concern. Of course, this is something of an overly broad generalization.

Your business has reasonable margins

As a general rule, VCs don’t like reasonable margins. They are exclusively interested in outrageous margins. Ludicrous margins. We’re talking about sneering at 50 percent, and hoping for 80 percent, 90 percent, crazy astronomical stuff. Venture capital is all about investing a little bit of money to create a business with massive scale and huge multiples – investing tens of millions to build software that then can be duplicated or served up for virtually nothing extra per person, with a total market size of billions. In particular, VCs don’t like people-powered businesses.

Software businesses are awesome, but their evil twins – software consultancies – are anathema to VCs. If adding revenue means adding bodies, they don’t like it. In fact, enterprise software companies, which can tread a fine line between software consulting and software development, sometimes get really creative to come down on the right side of the line. So, the rule of thumb is that VCs like product companies: software, drugs, cleantech, and so on. And they don’t like the traditional manufacturing, service industry, and consulting businesses that often are just a tiny shift of business model away. Every new taxi requires a… well, a new taxi. And a new taxi driver. Not the right business for VCs. The reason VCs love Uber is they get the revenue of taxis without owning any taxis.

You’re going to double your investors’ money

Doubling money sounds great, right? Not so. Investors need you to make them 10 times their money. Why? Because they want to earn 9 percent per year. You see, most VCs operate with three peculiar rules. Rule number one is that the fund is ten years long and they’re graded over the full duration. They need to provide 9 percent returns over the course of a decade, not next year. Rule number two is that there’s no recycling. Once they cash out of a deal, the money gets stashed away or returned to the limited partners – never to be invested again, for the rest of the decade. So your 100 percent return gets divided by 10 years, not by two years. And rule number three is that those returns have to take into account the compounding interest they would have received on both the principal and the management fees.

A little math: to get 9 percent per year, a hypothetical $100 million investment must increase to $246 million in 10 years. That is: $100,000,000e109% = $246,000,000 But $20 million of the principal (2 percent per year) goes to management fees and can’t be invested. And the VCs get to keep 20% of the profits (the carry). So they only get to invest $80 million, and they will actually need to get a return of $290 million (a 3.6x return). Suddenly you can see that a double-your-money deal actually sets them back from their goals. When you hear that VCs aim for a 10x return, it’s not greed – it’s because if a third of their companies fail and a third just barely get them their money back, a 10x return on the winners barely makes them competitive.

You’re not their type

Here are the people VCs love to invest in: Entrepreneurs who’ve already made them lots of money. Their closest friends.

Here are the people who VCs are easily convinced to invest in: People who have been wildly successful at high-profile past jobs that are related to their new business (e.g., a former executive VP at a Fortune 500 company, the inventor of a thingamajig that everyone knows). New graduates from top-of-the-top-tier schools who have built something amazingly cool already. Extremely charismatic Type A personalities.

One of the frustrating facts about the technology industry is that investors fund women and many minorities at a lower rate than average. Or, as VC Dave McClure of 500 Startups put it dryly, “There’s a soft bias toward doing things that are familiar. That’s white male nerds. But I think we are making progress. Now brown and yellow nerds get funding too.”

You have better things to do with nine months

You will have a new boss