Is the Venture Funding Model Broken?

Jerry Yang’s ignominious resignation as CEO of Yahoo this week further underlined for me what’s broken about the venture capital model.

I’m not referring to the slidedeck presented by Adeo Ressi to Harvard Business School faculty earlier this month, i.e. I don’t really care to cover what’s wrong with the investments made by VCs or the reasons they were made.

I’m talking about using the equity model for startups. By now, everyone has a working knowledge of the usual financial path a startup takes, assuming it successfully stays in business:

1. Incubate an idea and stay self-funded as long as possible.
2. Take small infusions from family and friends to keep the equity spread across people you trust and who trust you and have faith in you and your idea.
3. Seek angel investment, further diluting the equity.
4. Close a round of venture capital with probably a single firm, further shrinking equity.
5. Retain employees by offering equity options in the event of a liquidity event.
6. Close x number of additional venture capital rounds, adding more firms, possibly reupping an existing investor, all the while spreading equity to more parties.
7. Contemplate a liquidity event, which requires the addition of an investment bank to the equity pool.
8. Add more stakeholders when you close the liquidity event, typically in the form of publicly traded shares of your own company or of another company, i.e. in the event of a merger or acquisition.

What you end up with at the end of this path is a whole mess of people who, rightfully, demand to have a voice in your precious company’s affairs.

Frequently, the founders of a successful company step aside during this journey, but if they remain, how much voice can they really be afforded?

Yang’s stewardship of Yahoo since Terry Semel was forced out in June 2007 includes several instances of his problem balancing his vision for and love of the company he built with what was clearly best for the company’s many stakeholders. I’m talking about the failed Microsoft acquisition.

Google co-founders Sergey Brin and Larry Page may soon face similar problems; of course, Steve Jobs has faced this in the past with Apple.

The equity model creates this issue because on the one hand, you need money to run and grow a company. On the other, how comfortable are you relinquishing control of your beloved company to outsiders whose goals are not the same as your own?

I think this is a huge problem with the equity model. Maybe serial entrepreneurs don’t mind because they start companies at the outset with the goal of maturing the idea to a certain point, divesting and moving on to another project. But what about those of us who want to stay with an idea through its full lifecycle?

Maybe you don’t agree, but I know some of you do.

Back at WhereCamp PDX, Wm Lehler discussed applying the residual model, used by movies and TV, as a new structure for compensating startup employees, instead of the prevailing model of salaries funded by venture money.

Labor is typically the largest cost for tech startups, more now than during the Bubble, since Open Source and cloud-based infrastructure services (like Amazon Web Services) have removed the sunk costs that used to be associated.

Obviously the problem is how to compensate your people when you’re not able to pay them at market rates. The equity solution is a fair way to do this, and at an early stage, it’s likely that your few employees will be inline with your vision. Why else would they take on the risk of an early stage startup over a more mature company?

I like equity for employees, especially if you can balance salary with something like residuals. This still leaves the problem of how to grow the company.

Beyond bootstrapping and staying as small and meager as possible and taking traditional loans to infuse the company, are there any other models that exist to fund and grow a company without giving up equity to investors?

I’m curious to hear thoughts on this because it’s an interesting dilemma for tech startups. Innovation and competition don’t allow the average tech startup to mature slowly, which is why the VC model has worked for so long.

Sound off in the comments.