Raising capital is a funny thing. It used to be that venture dollars supported very ambitious ideas that had a wild chance at totally revolutionizing the way the world works. Now, you can’t raise money unless you don’t need the money. The ambitious endeavors are being undertaken with corporate and government backing: the rise in corporate (i.e. strategic) funds, Google X, DARPA, NASA. etc.. Which makes any logical person wonder: why raise venture capital at all?

Taking immense risk at a startup to be financially rewarded should not be looked down upon. There is no shame in wanting financial security so you can provide for your friends and family and spend more of your time doing what you want, not slaving away for someone else. How great that America has a free (but dwindling) market system to reward producers for their risks and efforts. If John Rockefeller had to make billions of dollars so that I could have access to low-cost polymers, fuel, power and medicine, I’ll gladly accept the system that provides it.

But taking the risk, spending countless years of your life toiling long hours, and then handing over the fruits of your labor to someone who’s already making millions a year by taking no risk is borderline insanity. Yet founders continue to make these decisions, despite very clear math that leaves sane people inquiring why.

I’d first like to examine OpenTable. Founded by Chuck Templeton in 1998, OpenTable was able to capitalize on the investor enthusiasm of the late 90′s, raising $48M with only a few hundred restaurant customers… you can’t do that today. But brick and mortar – especially the restaurant vertical – turned out to be more stubborn than everyone anticipated.

After nearly 12 years of work, OpenTable IPO’d in 2009. Despite debuting at a market cap of $700M, you’ll notice that the founders of OpenTable have such little ownership that they’re not even mentioned in the S-1. From personal relationships I will anecdotally mention that the founding team has less than a few million dollars in collective ownership. Fair trade for years of 15-hour days with little pay? You can decide.

More recently, Box IPO’d in 2015. After the S-1 was published, many intrigued readers took publicly to Quora to ask why Aaron Levie, Box’s CEO and founder since 2005, owned so little of a $3B company he created. Journalists inquired too, and Forbes even published a list of the investors who made more than Box’s hapless CEO. Like a stud, Aaron shrugged it off. But what about the founders who don’t make it to IPO… if Aaron’s ownership is paltry, think how bad is it for other founders who took “venture” money.

Lastly, I went ahead and searched for startups on Angelist. I wanted to see what sorts of solvency “angel” investors are looking for in “startups”. Conveniently Angelist has started a portion of the site showing completed financings; some of these “startups” will list their performance metrics, valuation and money raised.

I took some screenshots of one that I wanted to explore further. Here’s a screenshot showing the revenue growth from a “startup” founded a year ago. In the span of a year they’ve reached $1M in revenue and are projecting $4M in sales by the end of this year. I looked on Crunchbase to see if this startup had raised any previous money and it looks like they’ve reached this revenue milestone organically. In other words, they’re profitable.

For some reason this startup decided to raise money. They raised $775K for, presumably, 25% of their company, valuing the company at ~3x trailing annual revenue. Are you f*cking kidding? What investor wouldn’t take this deal with a $4M ARR pipeline? This is instant arbitrage. As little as a few years ago the average trailing revenue multiple was 10x.

It’s no wonder that founders end up with little to no ownership if they take “venture” money. Each round eats 25% of their stake, and the terms are getting such that unless you grow revenue from $1M to $100M in 3 years, investors will swoop in for non-performance and seize any vestiges of ownership you may have left.

How might this have ended up differently for Chuck at OpenTable if he didn’t take “venture” dollars? Chuck starts OpenTable. He grows it hard for three years and reaches $1M in annual revenue. He takes 20% of the company and sets it aside for employees, leaving himself 80%. In year four, Chuck is on pace to hit $3M in annual revenue.

A large company is interested in acquiring OpenTable. Chuck demonstrates his growth rate and shows the opportunity to earn tens of millions in revenue from potential customers, so he really needs to be persuaded to sell. The company gives Chuck credit for earning $3M annually. They then decide it’s worth doubling that for a control premium. Using market comparables, they’re willing to pay 10x revenue. Chuck looks at the numbers and agrees to sell for $60M. $12M goes to his employees, netting Chuck $48M (not including the government’s take).

Founders everywhere need to get smarter about finance. Unless you’re a fast growing consumer company, where “venture” dollars are essential to supporting server costs, you’re almost always better off not taking external money. If you know you can grow revenue from $0 to $100M 3 years, go raise money. But remember: “venture” investors prey on founder optimism.

If you’ve ever had the opportunity to pitch investors you must paint a massive, billion-dollar opportunity. Usually this level of success cannot be delivered via one core product itself. Instead, it’s typically delivered by creating customer relationships with a simple product and expanding out from there. You can look at Facebook’s conquest for messaging and picture sharing, or the entirety of Google X.

For some businesses this is totally doable. For others, the idea of a platform is less realistic. They’re either missing the cultural requirements to attract and empower innovators, or they’re limited by their own business model, sometimes by no fault of their own.

In the POS and payments spaces, we’ve seen a remarkable increase in activity over the past few years. Investors are catching on that 90% of commerce is still transacted in brick and mortar. This is a world starved of data, insights, and transparency. The size of the market and dearth of solutions has all flavors of opportunists licking their chomps.

But I’m have a hard time understanding the financings as of late. Many cloud POS companies are raising large amounts of money and I cannot determine if the financing is predicated on a large, future merchant base, or if there’s a “platform” play.

The “large merchant base” thesis is worrying. Brick and mortar is very nuanced. Take restaurants, for instance. The POS solution that works for a small pizza shop won’t work for a fine dining chain. And the staying power of solutions is a continual battle. The market sees an inherent 25% annual churn, meaning every year a quarter of your clients drop dead. Without successful sales it’s hard to imagine market share staying flat, let alone avoiding a fatal decline.

We can look at a company that succeeded under the merchant base thesis to learn a little more. Micros POS sold to Oracle for over $5B. Their market share? ~ 60K restaurants in a domestic universe of 600K (note: I do not adhere to the NRA’s counting method, which includes your daughter’s lemonade stand). Expanding further, Micros boasts 300,000 retail customers in 140 countries - including the 60K restaurants. There are 3.8 million retail locations in the US alone according to the National Retail Federation.

Micros, then, was a 35-year old POS company that had penetrated single digit percentages of the physical world. They also had a drastically different business model that earned substantially more revenue: tens of thousands for the POS software and hardware, $200/hour for support and ancillary services. In fact two thirds of their revenues were from services, which cloud POS companies do not charge for. Here’s a link to Micros’ entire 2013 10K; relevant screenshot below.

In the spirit of the “large merchant base” thesis, let’s dissect Toast’s recent fundraise. Toast publicly announced that it has grown to 1,000 merchants over two years, spending $7M along the way. They’ve raised a Series B of $30M for growth. For a typical $30M financing, you’re looking at a post-money valuation of ~$100M. So each of Toast’s merchants is “worth” $100K today. Let’s assume a continued aggressive growth rate where Toast adds another 2,000 merchants per year. In two years, they’ll be at 5,000 merchants. I have many issues with growth potential in a very crowded cloud POS market using an expensive direct sales model, but we will ignore this for now.

In two year’s time, each of Toast’s merchants is valued at $20,000 assuming the $100M valuation doesn’t change. This merchant economic still feels outrageously high considering Heartland bought Dinerware and PCAmerica at a value of $500/merchant, nor is it considering the more mature POS feature IP of Dinerware and PCAmerica.

Well, if the “large merchant base” thesis isn’t about the value of each merchant, maybe it’s about the POS revenue generated. Toast charges $100/mo for the core POS with free support and updates. Toast does offer some additional bolt-ons for increased fees, but I don’t want to get ahead of myself here: let’s assume the merchants don’t buy any of them.

If we can agree that merchants churn 25% annually, the average life span of a merchant is generously 2.5 years. At Toast’s current billing rate of $100/mo, they can expect $3,000 in lifetime value per merchant at a rate of $1,200 per year. At 5,000 merchants, Toast earns $6M a year. So even if Toast’s valuation in two years remains unchanged at $100M, that’s still ~17x revenue multiple on 5,000 merchants.

Okay well neither of these comparisons seem to hold any financial logic under the “large merchant base” thesis. So what the hell is going on?

It’s my belief that Toast, along with other cloud POS companies, sees the POS as a platform play. With open access to data, there are a myriad of solutions that can quickly plug and play with the POS, and the POS company can take a cut of each one. If a merchant previously paid $20K for a POS system and is now only forking over $1,500, there seems to be a pretty large delta of available funds. At face value this is logical, and correct. But the model will fall apart under the current approach.

I’m unconvinced any POS provider successfully builds their own bolt-on offerings or platforms alongside their core POS. Unlike the online worlds of search and social, POS is not inherently a high margin business. There’s the dirty work of sales, feature improvements, and support that limit margins. This keeps available funds for bolt-on product development to a minimum.

It’s also hard to compete with companies that do one or two things really well who aren’t in the business of selling POS, too. Is Revel going to build a better CRM than Salesforce? Shopkeep a better loyalty tool than FiveStars?

I’m really not trying to pick on Toast, but if we look at their add-ons page I see their online ordering and delivery product staring me right in the face.  Is Toast going to build a better ordering product than OLO, who has raised over $60M to do one thing really, really well? And what about consumer eyeballs: is Toast going to bring as much marketing value to ordering as a Grubhub? Grubhub is an antiquated technology platform requiring fax machines, but it works because they offer consumer exposure. How can Toast generate the same consumer platform value as a Grubhub? Do I want a separate ordering app for Toast’s 1,000 restaurants? Methinks not.

Previous POS companies that have tried their hand at building non-core products have suffered: when was the last time you downloaded a POS app to transact with its merchants? Micros and NCR have offered plenty of bolt-on solutions but few customers use them because they’re expensive relative to 3rd party options; POS companies have large expenses to simply run their core POS business and they pass those costs onto their merchants in their bolt-on products. Realizing this, Micros and NCR went so far as to build walled gardens to ensure that their solutions were the only approved choices available to their merchants*, but in a twist of irony this has helped spur the rapid growth of cloud POS.

Success has come when companies recognize their core strengths and play to them. FirstData, in an effort to do more with its data, hired Palantir to build Insightics. It then used its distribution muscle to deliver value to tens of thousands of merchants. Similarly, TSYS partnered with Womply. Womply built and sold a product directly to TSYS merchants, and TSYS provided the data it had from hundreds of thousands of merchants to make the product possible. If POS companies took this approach they could focus on their core product while earning revenue share from best-of-breed third party bolt-ons and platforms, all without burning crucial, limited funds on R&D.

Unfortunately I’ve seen very little in this line of thinking from cloud POS providers. It’s possible that cloud POS is taking a short-term layover, and they’re establishing business processes until they must focus hard on their future. But it gives me pause when POS providers are branding themselves as the “all-in-one” solution. I understand that you need to tell investors that you’ll do everything. In the low-margin POS industry, it’s scary if you actually believe it.

* Micros and NCR require their merchants to pay laughable prices for integration modules, like AlohaConnect, in order to use many third party applications. AlohaConnect was last priced at a meager $1,500… or the cost of an entirely new cloud POS system.

Square was an innovator. They saw a great opportunity to combine a small piece of hardware with a mobile device to enable commerce for tens of millions of small businesses. And by small I mean the guy at the farmers’ market who sells 100 heads of cabbage a year.

The farmer’s market seller was Square’s bread-and-butter client. He was never going to buy a POS. Conventional payments companies didn’t want his business because he was too small. And in an increasingly cashless world, he wanted to accept card payments.

These sorts of clients would have netted Square a nice, profitable business. As soon as one seller at the farmers’ market starts accepting cards, everyone wants to accept cards. The hardware to make it happen is sleek, cheap (likely free), and it works. This is the perfect recipe for word of mouth adoption: solve a real problem in a small enough market that you become the market leader.

But Square got greedy. Or investors got greedy. Or maybe it was the inevitable result of investor money. As soon as Square took the first drop of Venture Capital, they had to become a billion-dollar company. In under 5 years. Or else (cue dooming music).

This means that the economics of the farmers’ market customer would not suffice. If Square had focused on the lady who hocks 8 ugly cat sweaters a year, it would have built a solid, profitable business.  Not a billion-dollar enterprise, but a consistent $20M revenue stream with EBITDA.

Instead, Square needed to burn through hundreds of millions of investor dollars to build a company that has no path to profit in sight. Square’s only real shot at profitability lies in the data it collects. The merging of SKU and PII could be useful, but I don’t know if it has enough of either.

Maybe it was fear of competition. Maybe it was hubris. Or ignorance. Regardless, there are hundreds of people who are now worse off. Square employees had stock options – that they likely purchased – at a share price much higher than the public market deems them to be worth today.

But celebrity founders always seem to do alright. Jack Dorsey retains hefty ownership in Square, even with share price reconciliation and his divided focus as Twitter’s boss. And let’s not forget the investors. If anyone loses money, they’re the last to do so.

PS I’m not kidding about the size of merchants who use Square. See this chart produced by the Strawheker group.

When “venture”* capitalists raise larger and larger funds, they write larger and larger checks. At its simplest, “venture” firms have a limited number of partners and cannot possibly deploy large funds with $5M checks. Thus “venture” firms keep the number of deals flat but increase check size… lest they take on more partners.

This has created a swelling of private market valuations in the later stages of “startup”* lifecycles. Larger investor checks = larger valuations = larger desire for growth = subsidized products and services for market share = miserable/unsustainable unit economics. And nothing demonstrates this better than the last-mile, on-demand delivery market.

Few of today’s founders will remember – perhaps by choice – Webvan, a last-mile delivery service from the late 90′s. Similar to today’s last-mile players, Webvan set out to deliver groceries to customers within a 30-minute window. Numbers vary, but Webvan reportedly earned $400,000 in cumulative revenue prior to its 1999 IPO, where it raised $375M.

The rest, you could say, is history. Webvan struggled with user growth, the infrastructure required to successfully deliver groceries – even though it was only in a handful of metro areas, and, above all, the economics to ever get rightside-up.

Investors in today’s last-mile services will argue that today’s market is different. Internet users have increased 10-fold. Commerce is no longer limited to desktop computers but ubiquitous in consumers’ pockets. The cost of running  a startup has dropped precipitously with services like AWS and open development frameworks.

All of these are good points, and without specifics, true. What they neglect to mention is the relative accretive value with on-demand delivery. Most of today’s delivery startups are focused on low value purchases from low margin producers. Grocers average a margin of 2%. Restaurants average a margin of 4%. Thus consumers are conditioned to pay close to true cost for these products.

When a company like Instacart or DoorDash charges me $3 for a $15 purchase, it’s reasonable. I figure how long it would take me to drive to the retailer in traffic, park, go inside, transact, and head back to work. Add up the value of my time (which isn’t much!) and the gas/wear-and-tear on my Subaru (you can use a DOT chart to determine current reimbursement rate) and it’s usually a sound economic decision. But that’s not the true cost to these “startups”. At least in today’s market. Here’s a quick hack to prove it.

Go to TaxiFareFinder to estimate how much it would cost to have a taxi deliver food to you. I took a screenshot of the estimated fare for some pizza to be delivered to a Houston resident 3.5 miles from the pizza shop (note: this is not my address because it’s probably nicer than I can afford).

Now we have to think about margin. The best report I’ve ever seen was a five-year compilation of taxi costs published by the city of San Francisco in 2005. For those taxi operating companies that were profitable, the average margin was 20%; 36% of the operators were unprofitable. If an average transport service charged $15 for delivery, it really wouldn’t be making that much.

So how does a startup like Instacart look at these economics and think, “Awesome”? Using the fare calculator above, if I want my $15 pizza delivered, delivery just doubled the price! Since I’ve been conditioned to pay true cost for these kinds of items, for $30 I’m making an entirely different purchase decision. Just forget about sub-$15 purchases: the notion that I’ll spend $5 on a hamburger and shell out THREE TIMES the meal’s intrinsic value to have it delivered is ludicrous.

One way around this is to focus on high-dollar activities. PayonDelivery focuses on transaction sizes worth more than $100. Their strategy is logical: consumers are not going to pay double what the underlying good is worth to have it delivered. If I’m buying a broken iPhone for $20, I’m not going to pay $40 to have it delivered; for $60 I’m buying a used phone on eBay.

Another solution might be to focus exclusively on dense metro areas where positive economics can be achieved with a smaller number of deliveries. Webvan focused on the San Francisco Bay Area, San Diego, LA, Dallas, and a few other cities… but that did not work out for them.  Further, I’m not sure you can sell investors on a trillion-dollar business admitting you will be limited to dense metro areas with reasonable infrastructure (i.e. > third world) and high average sales prices (i.e. > second world).

“Sure Jordan, anyone can throw stones. Do something useful!”

Fine. Here’s how last-mile makes sense:

1. Very high supply/demand. When a 200-seat airplane flies from LAX to LAS with one passenger on board, the cost to service that passenger is the entire cost of the trip. When another passenger buys a ticket, the cost to serve each customer slices in half. Assuming passengers are buying tickets at the same price, at some number of passengers the price of a ticket covers that passenger’s cost and earns the airline a profit. To achieve positive economics, the last-mile delivery services will need an on-demand driver to have many packages in his truck at the same time. Whether the food can remain fresh, temperature-appropriate and and be served in a reasonable period of time are certainly debatable.
2. Massive changes in delivery technology. Moving away from cars and using bike couriers or rickshaw drivers would work… but only in dense metro areas in places like India where you can pay delivery drivers a few cents per day (this is how Zomato scaled their menu-curation business). The elephant in the room is the driverless car, but who knows when this will be a reality for your average American city.

I have a tough time seeing where these last-mile providers get to positive unit economics. 2016 should be the year of transparency, however, as many of the late stage companies in San Francisco run out of funds to fuel their excessive burn; we saw companies like Sidecar go belly up even before 2016. It should get interesting soon enough.

UPDATE: Foodpanda, after raising $300M for food delivery, appears to be shutting down its India operations, despite having 500 employees weeks ago.

*I use quotations around nominal terms which are, in fact, something different. A company earning tens of millions in revenue with 500 employees is not a startup, regardless of EBITDA. An investor who takes little risk likewise does not deserve an association with the word venture.