We Need a Third Way

“We’re not going to sell out. We’re going all the way to IPO.”

You’ve heard that line, right? It’s what all the cool startups say, even when they’re a couple of guys in some apartment running on the $10k investment from the CEO’s uncle. Since pretty much forever, IPO has been the endgame for the entire startup lifecycle. You start up, raise seed money, raise a Series A, then a Series B, then maybe C, then maybe a few more oddly shapred rounds, then you IPO for beaucoup bucks and everybody gets rich.

Even so, far more startups get acquired than go IPO, and recently we’ve seen a lot of smaller acquisitions as companies like Facebook and Google snap up startups that are barely into the prototype phase as talent acquisitions. Heck, we’re even making jokes about starting companies just to get “acqhired” without even intending to build for the long haul. Even companies that are trying to build for the long term end up selling out because, man, the money is so good. I hope we can learn to appreciate acquisition as a legitimate outcome for startups, but I can’t help but wonder: is there a third way?

IPO, acquisition, or bust. Those are the three outcomes for a startup today. Historically, that’s really been the only way we could do it: proving out ideas took millions of dollars and our ability to pick winners has been terrible, so the returns from the successes have to be massive to turn a profit for the investors. This forces investors at every stage to seek 10x (or more) returns on their investments to cover the duds. If you’re looking for that kind of return, there’s no way you’re going to make it on dividends. You have no choice but to sell it on to the next investor, and so on until the IPO. Finally, at that point, all the speculators can cash in and real investors can step in. But wait, do recently IPOed companies pay dividends? No way! Apple has been around for over 30 years and just finally announced a dividend program this year. So really, those of us buying IPO stocks are yet more speculators, expecting the price to go up even further before the company starts paying dividends. It takes decades before a company actually starts throwing off enough revenue to make its stock cash-flow competitive with bonds.

Think about this for a minute. Most companies bring in revenue. Many could be profitable on that revenue. They aren’t, though, because they must grow further to satisfy the investors, who are pressured by their economics to demand crazy returns. Instead, they keep growing, often collapsing under their own weight before ever paying a dime in dividends.

Why can’t a company start up, get some traction, pass breakeven, and start throwing off cash for its investors? Small business do this all the time, but how about startups?

Historically, the immense capital required to prove out ideas combined with poor metrics for success forced us into this model. What about today? Proving out web applications can cost under $1 million, sometimes even less than $100k. Some crazy percentage of Y Combinator-backed startups are still doing well, far beyond the “1 in 10” number we so often throw around. On top of that, many startups “fail” because they were pushed too hard by their investors, and with a different structure could have done just fine. How many revenue-generating, successful companies have had to pull the plug because they didn’t hit the jackpot?

What if VC funds, instead of returning the principal to their investors, held onto their portfolio and paid out dividends from the portfolio’s profits? Could a sufficiently large angel fund spread risk well enough to get a positive ROI out of small startups that climb quickly to profitability but can’t make it to $1 billion in revenue? Could companies avoid going public completely and focus instead on building a sustainable organization, free from short-term earnings-oriented investors?

I believe that to truly enable the greatest amount of innovation and progress in our industry, we need to develop alternative paths for the immense variety of startups that we have today.