The other day Foursquare announced a successful series B round of funding that raised the company $20 million – a huge amount of money given the size of the company. This really got me to thinking about whether such funding is really a good healthy thing for a company – especially for companies that are not profitable.
I fully understand needing money to become profitable, or being willing to invest in a company hoping for future profits – what I don’t understand is throwing your cash into a black hole.
In the article linked to above Erick Schonfeld says:
As far as making Foursquare a great company that makes a lot of money, Horowitz says the “monetization” opportunities are “very obvious and straightforward.” There are many ways Foursquare can start charging businesses once it reaches a larger scale. “Would you pay to know your most frequent customer?,” Horowitz asks rhetorically. “Probably.” The bigger issue is how to take Foursquare from nearly 2 million users to tens of millions of users and beyond.
I think they should have bought a Lotto ticket if that is the way they invest, having huge potential is great, but having it contingent on a “tens of millions of users” is just damn risky. Facebook and Google could swing into the fold and decide to make a competitor that easily crushes Foursquare. Gowalla could easy add users faster and crush them as well. I see Foursquare as MySpace in the early days – a ton of potential if ran right, but a huge downside if mis-managed. Could Gowalla be the Facebook to Foursquare’s MySpace?
Taking Venture Funding is Like Playing Monopoly
Everyone knows that the key to winning in Monopoly is to build hotels and lots of them – those hotels also cost a ton of money. Many start-ups seem to think this same way, they need to hold the Boardwalk monopoly and build a hotel fast before the other players in the industry can build their own. In pursuing this path many start-ups decide to take on venture capital funding to help build the company fast.
The problem – as often pointed out by Jason Fried of 37Signals – is that this leads you down the wrong path more often than not. Let’s go back to the Monopoly analogy, say you have bought everything you landed on for the past 2 turns, including Park Place, making you just one property away from the coveted Boardwalk monopoly. Now, on your 3rd turn, you land on Boardwalk and you want to buy it, but you can’t afford it. Your choice is to let it go to auction against the other players, or mortgage what you need in order to buy it.
Most people mortgage their properties (venture funding in this case) and now they are stuck not collecting rent on those properties, unable to build the hotel and in debt. This is not a good spot to be in. Same goes for people that would rather mortgage everything then sell it to another player. When I play I let things go to auction, and sell off assets only keeping the core monopoly that I own debt free.
I have won entire games with a monopoly on the light blue row – a cheap monopoly to hold – by choosing a plan of attack and sticking to it. When companies take on venture funding to pursue new growth avenues without making their current product profitable first – I start to get pretty worried. A company needs to focus on their core product and making it the best it can be – in doing so they will attract customers and profits. Adding more and more in hopes of exponential growth is often a fools game.
Now of course Monopoly is not real life – I know this and so do you – but the strategy involved plays out. Foursquare is not in debt – they owe those investors a return – a return that can only come from two things: profit or a sale/acquisition.
Profit is not Revenue or Cash Flow
Here is where things get tricky, when people talk about how well a company is doing they like to talk about Profit and Revenue. These are not the same thing, profits are a factor of revenue, but revenue alone will not give you a profit. If you have $100 in revenue for a year and costs of $100 then you have no profit. Likewise if you have $10 in revenue for a year and $1 in costs then you have a $9 profit. Thus the $10 a year company is more profitable than the larger $100 a year company.
The more debt you take on from loans or people demanding a return on investment, the less profit your company will have for you to take pay yourself (not withstanding salaries). Stop looking at revenue numbers and start looking at profits. A good company is profitable and leverage company has large revenue and no profits.
+ to Cash Flow or + To M&A
This is the real debate that entrepreneurs are making right now. One camp is saying that you should build a business that cash flows and pays you a nice check each month. The other camp is trying to get big (really big) and fast (really fast) in hopes of a cash out in some form or another that will make them set for life. To clarify both models make you set for life, one model does it without you having to work anymore.
I am clearly in the cash flow camp – getting a sale that will make you set for life is a gamble and doesn’t happen that often. It is however easy to setup a nice company that cash flows each month and can pay you for quite sometime. This is exactly what I have done with the company I run – we cash flow each month and I get paid. This is not to say that my company will be around forever – we must adapt like any other company – but our underlying philosophy is not one that pushes to make risky moves and to take on debt, ignoring profits in hope of a sale.
There is one thing I have not touched on: what happens when you get venture funding and can’t find a buyer or profitability? Most people assume that when a company like Twitter or Foursquare take on funding that it is because they are close to making money – they usually aren’t, after all if you are making money then you don’t need funding.
Once you have that funding in your bank account you have investors that want returns, they often hope to push you into a fast sale long before you are profitable. They push you into this because they know one thing: profits are never a guaranteed.
So what if a year later you are out of money and have no interested buyers and no profits to show for it? Often you are S.O.L. ((shit out of luck)) and on rare occasions you can raise another round of funding to keep you on life support. This life support though will only put more pressure on your company.
My point is not that venture capital is bad or good, just that it is not the only way to make money. Most importantly though: just because someone gives you $20 million dollars does not guarantee:
All venture capital insures is that you now owe money to more people than just you and your co-founders.