Are VCs Toxic? Not in the Midwest

Eric Paley of Founder Collective recently argued in TechCrunch that “VC kills more startups than slow customer adoption, technical debt and co-founder infighting—combined.”

His argument is essentially that VCs, lured by the sirens’ song of hyper-growth, back numerous companies with business models that aren’t ready to scale. VCs bet that, with new venture dollars, these companies will solve their business model issues while they’re scaling. In fact, the reverse is usually true: When VCs pour dollars into companies with mediocre unit economics, the numbers almost always get worse, not better. Why? Because the best sales and marketing ideas have typically already been executed—the marginal idea tends to yield fewer benefits.

Paley suggests that many companies would survive, if not thrive, if VCs had less of a “go big or go home” mentality. VCs shouldn’t throw money at fast-growing companies and hope growth continues or even accelerates. Rather, Paley contends, they should invest enough venture dollars to fund a tight set of growth experiments, carefully monitor how those experiments affect the underlying economics of the business, and double down when experiments show great promise. In Paley’s words: “Money has no insights on how to fix a broken business. Great businesses solve these problems first and then use capital to intelligently scale models that are clearly working.”

It is difficult to take issue with Paley’s reasoning. A lot of VCs do swing for the fences on every pitch. And a lot of venture-backed businesses do implode because they take on too much capital too early, before they’ve dialed in their business model for scale. Take a look at PitchBook’s recent startup graveyard, prepared for Halloween – 11 companies that soared to 9-figure valuations, only to go down in flames.

But are VCs toxic? Not in the Midwest. The “go big or go home” mentality has never taken hold here. The reason why, I think, is twofold. The first concerns fundamentals. In the Midwest, VCs love hyper-growth companies, but only when those companies also have solid unit economics and a path to profitability. To be fair, plenty of VCs on the coasts care about solid fundamentals as well. Indeed, we work with a number of highly sophisticated coastal investors on the boards of our portfolio companies who fit this mold. The difference is that in the Midwest, investing in companies with solid fundamentals is a deep-rooted value. Maybe we’re a little more conservative, or a bit more cautious. But every Midwest VC with whom I’ve worked looks as carefully at things like burn rate, margins, and CAC payback as they do at top-line growth.

Midwest VCs also reject “go big or go home” because of its tendency to jeopardize relationships. When VCs throw excessive capital at a business, they don’t have a lot of reasons to work closely with entrepreneurs to intelligently steer the business. The company is loaded up with cash. The leadership team doesn’t need to think particularly carefully about the best experiments to run. They just need to go run, and as fast as possible. The VC’s mentality is: “Here’s $100 million. Deliver me 250 percent year-over- year growth. Become a unicorn. Otherwise I’ll move on to the companies in my portfolio that can.”

This mentality is not only inconsistent with the kind of relationships Midwest VCs want to have with their entrepreneurs; it is also problematic on a deeper level. It cuts against Midwestern values. Perhaps no value is more central to Midwesterners than sincerity: the ability to look your colleagues, friends, and neighbors directly in the eyes and speak frankly with them. But as a VC, how do you deal with the leadership team that you’ve written off? I suppose some investors – much steelier than I – might be able to simply tell entrepreneurs that they’re done providing them with time and attention: “Since you’re not performing, I’ve got no time for you.” But that would violate another value we Midwesterners hold dear: keeping our promises. When we persuade companies to take our dollars, rather than dollars from other funds, we don’t say money is all we’re giving you. We talk, among many other things, about the connections we’ll make and the experience we’ll bring to the boardroom, and most importantly the counsel we’ll provide when things go sideways, as they almost inevitably will at some point in the life of a company. In short, we promise to be partners in good times and bad.

At this point you might be skeptical. Are Midwestern investors really so different? The data suggests that we are. According to PitchBook, among companies founded in 2013, those on the West Coast have raised nearly $32m on average, compared to just $17m on the East Coast and $11m between the coasts. The numbers for the 2014 and 2015 cohorts look very similar. West Coast companies take more than 3 times the capital, on average, than companies in the middle of the country. ¹

Of course, you might look at the graphs and say that the problem isn’t that coastal companies are getting too much capital, but that Midwest companies aren’t getting enough. I agree, and I’ve made that argument before myself. But it can both be true that the Midwest is undercapitalized and that Midwest VCs reject “go big or go home”—and I believe that this is the case.

You might also argue that the reason many coastal VCs adopt “go big or go home” and Midwestern investors reject it has nothing to do with values. Many coastal investors have monstrously large funds, and deploying that capital forces them to swing for the fences. I’m sympathetic to this line of reasoning, and I believe the full explanation is probably a nuanced one that includes a story about fund-size incentives and one about values. Frankly, I look forward to the day, not so far in the future, when the Midwest has a few monster funds of its own, and we can watch the natural experiment play out. My hunch is that we’ll see some bigger swings from Midwestern VCs, but that we’ll also continue to see commitments to fundamentals and the deep relationships that endure when times get tough.

¹ I’m looking here at companies rather than investors because I think the data is more meaningful. But it is important to note that investors tend to focus on what’s in their backyards. According to PitchBook, nearly 60% of the deals done by West Coast investors are done on the West Coast, for example.