The Future of Financing Businesses

European Straits #105

Dear all,

🇮🇹 This week I’m writing from Italy, where I’m travelling with my colleague Pietro Invernizzi to talk about my book Hedge and expand The Family’s network in a country in which we’re still in the process of discovering the local startup communities.

On Monday we were in Milan, where I discussed Hedge with Francesco Cancellato (moderator), Marta Ghiglioni of Italia Fintech and Andrea Garnero, an economist at the OECD. Yesterday was Rome, where I talked at the ClubHouse Barberini with Roberto Basso (moderator), Licia Ottavi Fabbrianesi of ANGI, and Stefano Firpo of the Italian ministry of economic development. Today we’re on our way to Naples, where I’ll be speaking about Hedge as part of the NAStartUpDay.

And all of this has been made possible thanks to the incredible support of our friends Raffaele Russo, Roberta Laudazi, and Fabrizio Pagani ❤️.

When venture capital goes mainstream

A recent New York Times article on startups shunning venture capital has caught the attention of many in the tech world. It suggests that startup founders have become addicted to raising venture funds when in fact it’s often a mistake to do so. In reaction, more founders are turning down the opportunity to raise venture capital and instead opt for bootstrapping their venture. Meanwhile, some investors, such as OATV’s Bryce Roberts, are exploring a new way of financing innovative ventures, one in which founders raise less money and thus retain the majority of the returns in case of success. The wave of ‘small is beautiful’ seems to have taken over the conversation of what startups are about.

What I don’t like in this discussion is that in Europe it enables all the toxic people who bring out their ‘I-told-you-so’ spirit and tell European founders that it’s time for them to renounce venture capital, too. This is a pattern that we at The Family know all too well. First US entrepreneurs do something (like raising a lot of VC money) and get rewarded with great successes; then they do too much of it, which triggers a backlash; then it’s “Oh no, we shouldn’t have done that, shame on us”; and finally, just as Europe is catching up (because Europe’s always late to the game), the backlash provides toxic people here with arguments and European founders are yet again deprived of the successes that their US counterparts enjoyed a few years before.

So instead of bragging about “See, even the Americans are turning against venture capital now!”, it’s time to put this discussion in perspective. Let me share three ideas to that effect.

First of all, the backlash against venture capital is only the later stage of founders gaining more power over investors. Steve Blank published a great piece in 2017, in which he explained that “21st century VCs have been relegated to passive investors/board observers”. For me, it’s all but predictable that founders having the upper hand in general has led some of them to raise too much money. And because raising too much money inevitably leads to problems, like a cat eating the entire box of treats, one seemingly logical reaction is to promote frugality.

It’s not that renouncing venture capital is right for everyone. Rather, it’s just that a new moral standard has to exist that pushes the most addicted ones away from their self-destructive behavior. In other words, the fact that some people are addicted to alcohol doesn’t mean that we should all refrain from having a glass of excellent Bordeaux. It means that moderation has to be touted as virtuous if only to make people think twice before downing the whole bottle and then chasing it with a shot of cognac.

My second idea is that relying less on venture capital is more logical as tech entrepreneurs explore more tangible industries and more regulated markets. Venture capital was the ideal tool for financing businesses when tech entrepreneurship was all about intangible assets, such as distributing music and advertising brands on lightly regulated markets (as opposed to, say, healthcare and real estate). Today, building a tech company comes with what I call the “Northern Side”—that is, everything in a business that is tangible and regulated and thus comes with diminishing returns to scale.

You’ll find a Northern Side in every tech company: think about Amazon’s world-class logistics, Google’s massive salesforce, Uber’s compliance with regulations that differ in every city. But all of them can still be called tech companies because their “Southern Side”, the one that is built with computing and networks and thus generates increasing returns to scale, accounts for a larger part of their value chain.

But as software is eating new parts of the world, tech companies are entering new territories in which the tangible Northern Side tends to weigh more and more on the business returns—degrading their capacity to grow at scale and making these new tech companies more closely resemble traditional companies.

Should it be a surprise that this kind of tech company is less prone to raise venture capital? No. Venture capital perfectly fits a company whose returns increase exponentially as it scales. It’s less relevant, however, when the company raising funds has to deal with a more prominent Northern Side and sees its capacity to generate increasing returns flounder as a result. For such companies, traditional ways of financing, starting with bank loans and, later, raising money on the bond market, are more relevant; after all, they have the tangible assets and the regulatory moats to reassure traditional investors that are far removed from the world of venture capital.

And so this is how we should interpret this revolt of the founders against venture capital. It’s not that their mindset has changed as compared with the previous generations. It’s more that this new generation of founders is tackling different entrepreneurial challenges in sectors in which the difficulty to generate increasing returns to scale makes venture capital less relevant.

Finally, let me conclude with a third idea: we in Europe didn’t wait for the Americans to relapse to realize that you need to generate revenue before you raise more capital. Let me simply quote my co-founder Oussama Ammar on that:

“Bootstrapping is absolutely difficult. But as hard as it is, it’s also very rewarding, mentally and financially. There’s no pleasure for an entrepreneur like having a satisfied customer. In terms of development, having a company that shows growing revenues makes everyone happy. It gives you leverage when the day comes to fundraise, and you’ve put the power on your side.”

Off to Barcelona, and then Menlo Park

🇪🇸The Hedge tour continues! Next week I’ll spend two days in Barcelona, by invitation of my old friend and classmate Cyril Piquemal, who’s the French Consul général there. I’ll be participating in a panel, probably in French, as part of La nuit des idées, about which you can find more details here.

My colleague Lorenzo Castro and I don’t have a full schedule yet, so if you’re in Barcelona and would like to meet, please reply to this email! Also don’t forget to buy your copy of Hedge by visiting the relevant Amazon website depending on where you are: 🇺🇸US, 🇬🇧UK, 🇫🇷FR, 🇩🇪DE, 🇮🇹IT, 🇪🇸ES.

🇺🇸 Right after that, I’ll board a plane to San Francisco to spend two days on the Facebook campus in Menlo Park as part of Tim O’Reilly’s Social Science Foo Camp. Then I’ll have a full day in San Francisco (Monday, February 4) where I still have a bit of time: so if you’re around, let’s grab a coffee!

Also have a look at those two articles:

More readings about venture capital as technology goes mainstream

Warm regards (from Rome, Italy),

Nicolas