I happen to have a distinct perspective on this. I spent ten years of my career as a growth stage venture capitalist working with a well regarded investment fund. Conversely, I also spent the last number of years building a company that never raised institutional capital nor will it ever need a venture capital financing. I have a decent network in the venture business, and understand exactly how to raise venture dollars. Oddly, I chose not to.

To start off with, let’s discuss how founders capitalize a company. There are three basic options: debt, equity, and revenues from customers. Debt typically comes from banks. Despite their missteps running up to the mortgage crisis, banks are some of the most conservative institutions in America. They try to eliminate as much risk as possible. As an early stage, pre-$20M company, banks will only lend on positive cash flow, or by collateralizing the loan with assets the company has [or by asking you to collateralize the loan with your own bank account].

You can see why this doesn’t work: most start-ups don’t have assets or positive cash flow. That leaves you with issuing equity — which is selling a piece of the business that doesn’t have the downside protection that debt has and you can give up considerable ownership in your business. Otherwise you’re left with using the revenues from your customers.

Sources for equity tend to be your friends and family, angel investors, or venture capitalists. Friends and family and angel investors can take you some of the distance, and they can play a role in the company that is or is not venture funded (as they have in our case here at Kipsu). Beyond a few million dollars though, you are likely looking to VCs unless you can feed the beast with cash from customers.

The venture capital business exists because banks don’t lend to start-ups, which leaves most entrepreneurs with two options: raising equity, oftentimes at onerous terms, and using the cash they generate from their customers.

For context, let’s discuss what venture capitalists are seeking. VCs are funded by large institutions such as insurance companies, foundations, pension plans and endowments. The managers overseeing those large pools of capital diversify their holdings across many different investment categories, with a small amount of it going into private, high risk investment funds. The investments in these funds are expected to produce outsized returns — in areas such as venture capital, private equity and real estate. These institutions expect these high risk investments to produce a 10% premium above what they can get from the the publicly traded equity markets — that’s roughly 20% per year returns.

VCs are factoring in significant “mortality rates” into their investments so they want to see that each investment can individually produce 60% annual rates of return to make up for the half to two thirds of the portfolio that will make little or no contribution. The expectations here are huge. Most companies either 1) don’t play in markets that can deliver 60% per year growth, on average, for ten years; or 2) aren’t executed flawlessly in such a way as to deliver that same return profile.

The math is this simple: [$2M initial market size] x [60% CAGR] ^ [10 years] = $220M within 10 years.

Not many markets achieve that kind of scale in 10 years, but many companies build large businesses over longer windows of time. Starbucks, for example, took 20 years to get to 100 stores. Between 20 and 40 years, it ramped to 17,000 stores. There’s nothing wrong with taking time to build a large company. There is however something wrong with swallowing lots of capital to build a small business.

I believe the fundamental question you need to answer is: how fast will the market move for what we do?

So… when does venture capital work?

When you are in a business where the fuse is lit and all the right conditions exist for it to scale rapidly. What are those conditions?

a) You have product-market fit dialed in and now it’s go-time. Customers are sticking with you and actively recommending it to others. If you are a subscription business, churn is low. You’ve tested your marketing and have the formula down. You know that investing X dollars in sales and marketing will repeatedly produce Y dollars in new revenue. The ratio of X to Y is an acceptable sales ROI for your market.

-and-

b) You have competitors that have product market-fit dialed in and are ramping sales and marketing spend. You risk losing the race to capture customers and being left behind.

2. When your business is natively capital intensive and requires significant upfront funding. This would include things like having to invest a few hundred million to build a new fab to crank out semiconductors or build another type of unique manufacturing capability. This is rare these days because most information technology companies have much lower capital intensity due to open source software, cloud computing resources, internet based distribution and lower cost sales models than in the past.

When are you better off not seeking venture capital investors?

The problem you are solving is very difficult to solve and may take years for you or anyone to pull it off. For example, it requires substantial behavioral change or the time to build a complete offering relies on substantial observation of how the customer operates. You believe the market development timeline may be longer than the 60% per year hurdle in the first ten years of the business. There is very little competition in your market or your market is highly fragmented with little potential for rapid consolidation. The market you operate in is small and you are betting on a series of successful adaptations of your product to scale the business.

What else should I know?

If you take venture dollars, know what you have signed up for and commit to the potential ramifications. Many complaints have come from founders that take a venture round and find themselves out of a job when the business isn’t tracking as it should. When you accept a venture round, you go from being your own boss to having a boss — the investors. And the VCs have a job to do: make money for their investors. If they don’t produce their expected returns then you will find themselves out of a job. So changes to who runs the company if performance isn’t being met should not be a surprise.

This isn’t a question about dilution or control. You need to match the approach for capitalizing the business with the speed of market growth. If you do that right, you won’t care that you gave up ownership as your slice will be much bigger than the pie you used to own. And control mechanisms will never need to be exercised because everyone will be happy with the execution.

There’s no blanket right answer here. There are only companies, markets and circumstances that are a good fit for venture and those that are not. The key message here is to match the capitalization strategy with the market opportunity.

Christopher Smith is a Co-Founder and the CEO of Kipsu, which helps hoteliers, retailers and other high touch service providers build amazing relationships with their customers using text messaging and other digital conversation channels. Chris is also a Co-Founder and the Co-Chair of Minnesota Comeback, an education reform network tackling the opportunity gap in Minneapolis. You can reach him at chris@kipsu.com.