VCs Don’t Like Small Investments

When we were first starting NetApp, back in 1992, we thought that we could create a product and a company on an unusually small amount of money. We also thought our low cost would give us an advantage in trying to raise Venture Capital (VC) money. We were half right.

It took us just over a year from when we incorporated to ship product, and we had raised only $1.6 million dollars. To put that in context, some start-ups have raised over $100 million to enter the storage market and still not gone public. We shipped our first product with just eight full time employees and only three full time development engineers. The eight were a CEO, head of sales (the only sales person), head of marketing (the only marketing person), head of customer support (the only support person), an office manager, and three engineers including both James and me. We also had three part-time consultants—one on manufacturing and two more engineers.

We were right about building a product with surprisingly little cash, but we were wrong in thinking that VCs would find this attractive. VCs don’t particularly like small investments. In fact, we had to raise that first $1.6 million entirely through “angel investors”—rich individuals who invest their own money. The VCs wouldn’t invest until after we’d shipped product. It took another $10 million or so for us to go public.

In business, it’s always helpful to understand the other person’s perspective, so let me describe how the world appears if you are a VC. A VC fund is a lot like a mutual fund, except that instead of getting money from regular people, you get it from university endowments, pension funds, really rich people, and so on. And instead of buying stock in public companies, you invest in start-ups. Your job, as a VC, is to invest all that money you’ve raised, and the funds are sometimes very large. Some funds are a few hundred million dollars, some multi-billion dollars.

The problem is, it’s just not easy to invest that much money, and it’s almost impossible to invest that much money in small chunks. I recently had lunch with the CEO of a small start-up, and he told me that he was looking to raise $7 million, but one investor said, “Couldn’t you take $13 million?”

It boggles most people’s minds to imagine investing a hundred million dollars, much less a billion, so let’s imagine that you have $100 to invest, and you are trying to figure out what stocks to buy. (Me personally—I recommend index funds, but let’s just assume that you have your heart set on stocks.) It wouldn’t make sense to invest $1 each in a hundred different companies. That would take way too much research and would be a pain to manage. You’d probably be completely uninterested in a fifty-cent investment, no matter how good it sounded.

That’s exactly how a VC feels when a start-up comes in and says, “We’ve got this great idea, and best of all, we’ll only need a million or two.” VCs typically go on the boards of all the companies they invest in, and the last thing they want is to be on a hundred boards, or even fifty. After all, that might distract from the summer in Europe and the winter in the Caribbean. It’s much, much easier to invest larger chunks of money in a smaller number of companies.

Comments

[Pete]

Sounds like the settlement in "The Mouse that Roared". Grand Fenwick asks for $1 million in foreign aid and the US ambassador counters with "I don't know if I can do that -- I might have to make it $1 billion instead."

[DR Shaw]

This is a very interesting article. I often wonder why this philosophy is so hard to grasp. Yes, you’ve simplified the concept for the masses, but the message is the same - pay for what you believe in. I wonder when this philosophy will apply to employees as well. Attracting and retaining great talent is not that difficult with this philosophy. However, this never seems to materialize for the true talent in a company, the employees.

It is amazing to see the turnover rate soar because of the false impression a company may give like, “Financial hard times.” Same story since 2000. One might say, “We need to ensure we maintain our levels for our shareholders.” Here’s a thought, make the employees more of shareholder base. I would expect a company that promoted such beliefs be a major holder higher then 20% of their own company stock. Only then are you getting paid for results, retaining the best employees, and being more productive.

Very good article though.

Thank you for the insight!

I sent this to a friend who I know has a keen interest in VCs and is getting his MBA at Darden b/c I thought he would enjoy your post. His response was:

"That's really cool. It's actually one of the things we're learning about in my VC class. We've spent a lot of time looking at how VC funds have grown and it's made it much harder to raise the early startup money in the $500k-$2M range. We actually had a guy named ** come down from DC to talk to us. * is a great guy who actually helped me negotiate my original contract with * and is considered the godfather of Angle Investing.

The crazy thing to me is how rich those original 8 employees must be. It's absolutely amazing that they were able to start NetApp with $1.6M and get to the market in less then a year. I'm sure by the time they took the $10M it was at a very good valuation and to be able to take a company like that public for less then $12M is incredible!"

[Carlos A. Arredondo]

How can the stock of a company doing a buy-back of over 40 million shares drop so dramatically? I own 880,000 shares and have owned much since 1999. Please obtain an answer for me as I find it difficult to believe that Dan Warmenhoven would be a passive observer to the damage being done to him and the company's reputation.
I live in Greenwich,CT and Madrid, Spain (where I am here at 4:05am)
Thank you.

It's pretty impressive, however, that people with no legal claim to anything on the property have been able to make GC bend over backwards. I guess it's also impressive that GC has shown such restraint with plans-- perhaps Ed's point about the funding maybe not being there for GC to build the complex is on- target.