The Harsh Reality of Start-ups: Why They Won't Make You Rich
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Chapter 1: The Myth of Wealth from Start-ups
Many people dream of entrepreneurship, envisioning a future where they control their own destiny. However, the inspiration for starting a company should come from a genuine desire to improve the world with innovative products or services. Unfortunately, for many, the allure of entrepreneurship is simply a quest for riches.
I must clarify: start-ups do not lead to wealth. This is particularly true for early-stage founders and team members. This observation holds true across both the traditional web2 landscape and the burgeoning web3 space.
Recently, I assisted a founder preparing for his first seed round. His enthusiasm was commendable, reflecting his perseverance during challenging economic times. However, this excitement was tempered with confusion upon reviewing the venture capital (VC) term sheet. Key issues included:
- Significant dilution of ownership for him and his team
- The VC's insistence on preferred shares
- A pre-money valuation contingent on a post-money option pool
We will delve into these points in detail. It's crucial to consider some statistics: 90% of start-ups fail, 75% of venture-backed firms do not survive, and only 1% achieve a valuation exceeding $1 billion.
This isn't meant to discourage aspiring entrepreneurs. The ideals of self-determination and being your own savior are invaluable. If you possess a groundbreaking idea, pursue it relentlessly. But if your primary goal in launching or joining a start-up is financial gain, reconsider.
Section 1.1: The Impact of Dilution
Most aspiring founders understand that dilution will occur as they raise capital. They often accept this trade-off, believing that while their percentage ownership diminishes, the overall value of their shares will increase.
It sounds appealing: by the time you reach Series G, you might own just 17% of the company, but its valuation could soar to $1 billion.
"16% of a billion is more valuable than 80% of nothing," a typical VC might argue as a founder signs away their stake.
Indeed, if a founder sells their company for $1 billion after raising $7 million, they could walk away with around $571 million. But this scenario is exceptionally optimistic and rare.
Statistics reveal that only 48% of start-ups that secure a seed round can raise a second round, and a mere 15% proceed beyond a third. According to CBInsights, only 13 of 1,119 companies exited for over $500 million, with just five surpassing $1 billion: Uber, Airbnb, Stripe, Slack, and Docker.
Founders must realistically assess their total addressable market and potential market share. I advise focusing on exit values of less than $100 million, as this is where most transactions happen.
The Founder's Collective's two-year review found a median exit value of $44 million. Notably, nearly 60% of companies that exited in 2020 did so for amounts lower than the average Series A pre-money valuation.
Subsection 1.1.1: The Need for Caution
Venture capitalists typically focus on $1 billion exits, while founders should concentrate on sub-$1 billion outcomes. Unlike VCs, founders do not have a portfolio of start-ups to mitigate risks. The reality is stark: the majority of start-ups will fail, with many fading into obscurity.
As of late 2022, valuations for pre-IPO start-ups had dropped significantly. ForgeGlobal reported a 41% decrease in the trading prices of companies on their platform compared to their last funding round.
The broader economic landscape suggests that investors will continue to seek safer options, leading to an ongoing rise in the cost of capital.
Section 1.2: Managing Expectations
What does this mean for our founder? Managing expectations is crucial. During the era of easy money, fewer than 1% of VC-backed companies achieved a billion-dollar exit. Moving forward, founders should prepare for best-case scenarios of under $100 million.
If we assume a fortunate exit of $50 million, a founder might net around $11 million. However, remember that the chance of a successful exit after multiple funding rounds is less than 15%, and it typically takes 11 years to achieve this.
Founders must weigh the opportunity cost of their choice to pursue a start-up versus a stable career in finance, consulting, or big tech.
Chapter 2: The True Cost of Entrepreneurship
The first video titled "Want To Get Rich, Don't Start A Business (Do This Instead)" discusses alternative pathways to wealth that may be more viable than starting a company.
Founders often sacrifice stable incomes for the uncertainty of entrepreneurship. Consider an experienced professional with over a decade in big tech. They might command a salary of $300,000 to $400,000, earning between $3.5 million and $4.5 million over 11 years.
If they shift to a start-up and achieve an exit of $11 million, they may gain only $8 million compared to staying in their stable job, but if the start-up fails, they could lose out on $2.5 million in potential earnings.
The question remains: would you prefer $4 million over 11 years or a 15% chance of $12 million with an 85% chance of $1.3 million? Only the founder can answer.
Section 2.1: The Dangers for Early Team Members
Founding teams often consist of one or two full-time founders with early team members who juggle day jobs while working on the start-up. These initial contributors typically receive 5% to 10% of shares.
In a scenario where the founder holds 80% of the company, the early team members' share can diminish significantly through dilution, leading to disappointing outcomes even in the event of a successful exit.