Optionality for Founders: Becoming Profitable Can Do a Funny Thing

A few weeks ago, Bhavin Parikh, cofounder and CEO of Magooshpenned a great note that cautioned Founders about what they should know before they raise money from a VC.   Bhavin is in a unique position to opine on the subject, as his company raised a small Seed round and hasn’t since raised another dime from outside investors.  In a nutshell, he warned founders to be sure of alignment of interests with their capital sources.  I thought it would be interesting to share our perspective on the subject as well.

In 2011, Bee Partners co-led the Seed Round in Magoosh, and at the time, we had an expectation that the Company would require additional capital. Later, they did ‘top up’ their financing a bit, but it turned out that they started generating cash-flow! Becoming profitable can do a funny thing…. It can create ‘optionality’ for founders, which is exactly what Bhavin has achieved.  If he wanted to, he could easily raise more outside money, but at the same time, he can just as well grow using cash flow from operations.  This optionality is something we talk frequently about with founders inside the offices of Bee Partners, and we’re extremely supportive of this potential path for founders. Here’s why we are so supportive, from the context of the multiple hats we wear inside of the firm:

As a VC, we will generate a meaningful return
1/ Unlike most VC firms, our fund size is small, and intentionally so, which is a topic worthy of a separate blog post. Because of our appropriate size, were Bhavin to generate the 10x return that he’s aiming for, it would meaningfully contribute to our returns! In baseball parlance, it’d be a stand-up triple and we’re more than happy to hit those as well as doubles all day long (with a home run every now and again too :-).

But… if we had a $75 million fund, Magoosh exiting for a 10x return wouldn’t do enough for Fund returns for us to crack open a celebratory PBR. We’d certainly be happy, particularly for Bhavin (see below) and his team, but on a purely financial basis, with a $75 million fund, it would be a ‘meh’ outcome.

As an Individual, I’ll see a check myself
2/ Bhavin is right to suggest that VCs invest OPM, or other people’s money; but for us, we’re also ‘all in’ at Bee Partners. As a result, we care…. a lot! … about companies generating return. So for us, a Magoosh 10xer would send a check home as well. Were we larger, the proceeds generated from a Magoosh exit like this would instead get recycled or ‘held back’ to get reinvested into more companies. The VC partner may not even get paid a bonus/carry in this case. And so… they’d be disappointed from the optionality whereas we’re thrilled.

As a long-time Partner & Friend, we’ll be proud of their achievement
3/ Such an exit would likely be a life-changing event for Bhavin and his team and we clearly want to support that. I’ve had the great opportunity to witness these events on a few occasions, and expect more in the future. It’s wonderful to see your friends succeed and have the optionality to do as they wish. Some party, some share, some buy and some invest, most do a little of it all – it doesn’t matter. I wonder whether Bhavin would head to culinary school….

So what, you may ask?   Well, if you’re thinking that this ‘optionality’ sounds appealing, how then should you solve for fit when finding your pre-Seed and Seed capital partner? Well first:

  • If you want to build an indie business and specifically don’t want to pursue a $billion+ outcome, then seek alternative capital sources outside of Seed and institutional VC. Doing so will save you a ton of time & headache. For every one investor that may take you on because they think that your indie business could become a unicorn, there are 100 who will decline simply because you’re not aiming high enough. Instead, consider capital that takes the form of consulting revenue, angels, friends & family, crowdfunding, etc. Regardless of your approach, always remember to be clear in your intentions with your capital partners.

  • If you aim to become a unicorn, when pitching to VCs and Seed investors, don’t pitch to the optionality! By all means, pitch the big hairy audacious goal (BHAG), and include your financial partners into your thought process about the optionality route, but don’t lead with optionality.   Then, as you reach indie status and rethink your approach due to the market not unfolding as you expected, or due to your personal desire to pursue an organic growth model instead, just be forthright with your investors. Honesty is so important here.

Second, as you choose your investors, I’d ask them a series of questions:

  • If we become an indie, how does your involvement in my company change?

  • Please share examples of when you’ve advised your founders to not pursue VC funding.

  • Would a 10x return drive meaningful returns to your firm?

  • How much of your fund do you own?

Responses to these questions will offer you a great deal of information about your potential capital partner, so that when that difficult decision is made to pursue an alternate route, that you know they still have your best intentions in mind. It’s true that we’re searching for ‘unicorn’-potential founders. But if that’s just not how things work out, and instead we see a $25 – 100mm exit, I’ll still buy you a steak dinner and sing your praises as a successful Founder.