And Why Do They Leave Venture Investors in a Pickle?
The first time an investor asked if I was building a lifestyle business, I felt insulted. With images of working from the beach or spending my days golfing with clients, their question seemed to belittle the insane hours I was working.
I eventually learned “lifestyle business” is a specific term that isn’t what the name implies. And now as an angel investor myself now, I’ve learned the hard way why lifestyle businesses are deadly for investors, and now ask entrepreneurs the same question when deciding whether to invest.
What Is a Lifestyle Business?
The term itself seems to imply a company run for work-life balance. Ignore that. Nothing could be further from the truth. Basically, it’s a company run to maximize profitability instead of aiming for a quick exit. And since more work by fewer employees means higher profitability, the only businesses with a worse work-life balance than venture startups are so-called lifestyle businesses.
Profitability is great so what’s the problem? Basically, focusing on profitability doesn’t fit the venture model of growing revenues as fast as possible to achieve a quick exit. A venture business has no profits since any extra cash is invested back into increasing revenues.
If I wanted to build a lifestyle business, it would have to be funded myself, or from family, or business partners, or bootstrapped from sales. Which is why most lifestyle businesses don’t start off intended to be lifestyle businesses. With angels and VCs funds lining up to throw money at me so long as I promise to focus on growth instead of profits, in the short-term, venture funding seems like an easier path to build a business. But longer-term, it can be a problem as our interests diverge.
Imagine I’m building a specialized product, a revolutionary network test tool for example. How big is the market? I have no idea—there’s nothing like it on the market. Trillions of dollars are spent building networks every year; surely there’s at least a $1B market for a device to test them. If I can reach 10% of the people I think need the product, that’s $100M.
My team puts together an MVP and we sign up early customers who love it. I pitch the VCs on our new product and they write us a check for a few million dollars. Nice! We get busy expanding the features and building the marketing. Sales jump, metrics zoom up, and we’re already picking out the fancy cars we’ll buy with our billions when we’re acquired by Cisco.
And then, after a year or two, reality hits: the hockey stick turns into a strand of overcooked spaghetti. Sales plateau at $10M. Cisco isn’t going to buy a business that only generates $10M in revenue.
We throw more money at marketing. The VCs bring in a gold-plated head of sales who’s friends with every CIO on the planet. We hire more engineers to add yet more features. Revenues increase again, but only to $15M. And now we have a payroll of $20M, so we’re running out of cash.
The Choice: Pivot or Rightsize
At this point I have two choices:
- Pivot to find a bigger market
- Downsize to operate profitably with revenues of $15M
If there was an easy way to find a bigger market, I would have done so already. At this point it means developing a completely new product or finding a way to sell to a different customer base. In other words, starting over. Go big or go home gives up on that $15M of revenue in a renewed quest to get to $100M.
The second option is to face reality and recognize that the market is $15M. If I stop wasting money chasing every possible opportunity for growth, I’m sure I can operate the business profitably and generate $2M a year in profits. In other words, turn the company into a lifestyle business. It would mean the end of my dreams as a billionaire, but millionaire is not so bad, is it?
Which option to choose depends on the details of the product and market. And whether the investors have sufficient ownership to force the company to focus on finding a bigger market or die trying (and replace me as CEO if I don’t agree.)
What’s Wrong With Profits?
Profitability ought to be good, right? Isn’t that the whole point of building a business?
Yes, but while big companies are valued for their profits, startups are valued for their potential. And potential is as measured by revenues and revenue growth. Profits don’t matter in valuing a startup, so they’re invested back in increasing revenues and growth.
Looking at the numbers helps understand the conflict of why dividends are good for me, but not for my investors.
At $15M in revenues, a healthy business can generate $2M in profits. For the 60% of shares I still own, I get to take home $1.2M in dividends every year. Not bad for me.
Let’s assume the remaining 40% of the shares are split between two VC firms for which they each paid $3M. Each year they get a dividend check of $400K. It’s 7.5 years before they even make their investment back. That does little to help to hit the 20% IRR they promised their investors. The VC model assumes we’ll grow quickly and get acquired for hundreds of millions. Once it’s clear that won’t happen, we’re dead weight.
It would be best for the VCs to sell off their investment for whatever they can get, even if it means taking a loss. They can’t wrap up the fund until all the investments are liquidated, and unlike public stocks, they can’t sell their shares to anyone else until the entire business is acquired.
Meanwhile, instead of sharing my profits with investors, I can start paying myself and the team attractive salaries. Or we move into a fancy building, improve employee benefits, and start flying first class. Profits go down to zero. Since I own a majority of the shares and control the board, I get to decide what to do with that $2M. A bit of a pickle they’re in.
Why Can’t We Sell the Business?
It’s not actually true that the business can’t be sold. Millions of small businesses are bought and sold every year to individuals, other businesses, or private equity. But valuations are far, far lower than when Cisco or Google or Apple buys a rapidly growing company they can’t live without.
Though it depends on many factors including market potential, industry, stage, and growth rates, as a simple rule of thumb, a strategic acquisition is typically at 5x revenues. This is what venture investors want. But we’d need to have higher revenues and a high growth rate before the giants would consider acquiring the business.
In contrast, private equity acquires profitable businesses to generate cash flow. But to guarantee a quick return from operating the existing business, PE values businesses at a low multiple of profitability. A typical PE valuation is 4x EBITDA. At that valuation, the $8M acquisition would be great for me and the other founders, but a loss for the VC fund. Venture investors are interested in an acquisition by private equity only as a last resort to close out a losing position.
(I’ve ignored the typical minimum of $20M in revenue for small private equity firms. At under $20M, acquisitions are usually limited to private parties or opportunistic acquisitions by medium-sized businesses at firesale prices where most of the value is locked up in earnouts.)
Is it a Lifestyle Business?
Successful lifestyle businesses are great for the founders, but disastrous for investors. And even if the founders don’t intend to build a lifestyle business, that’s frequently how they end up when the initial beachhead market for which the product was developed turns out to be the only market for the product.
For an investor, especially in early rounds, this is one of the biggest risks. So one of the most important questions to consider during the diligence process is whether the company is likely to evolve into a lifestyle business.
Looking over my own investments, around 1/3 have died completely, 1/3 generated some sort of return, and 1/3 chug along year after year as lifestyle businesses. None of them intended to become lifestyle businesses when they started, but that doesn’t help me now.
A significant fraction of my investment capital is now tied up in companies that are surviving or doing well at small scale, but it’s unclear if and when I will ever get any return at all. In other words, at this point, I have an entire jar full of pickles. In my head, I’ve had to write them off as total losses even though for the founders, employees, and customers, they’re great businesses.
If you’re building a niche product and you want my investment, don’t be surprised if I ask you if it’s likely to become a lifestyle business. And don’t be insulted either. Though the term seems to disrespect the insane amount of work you’re putting in, it’s the term everyone uses.
Instead, look me in the eye and tell me that building a fantastic business with no exit is absolutely not your plan. That our goals are aligned in shooting for the moon or dying in the attempt. Explain yet again how you’re absolutely confident there’s at least a $100M opportunity. But before you make these promises, make sure you really believe them.
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