Founder-compensated startups are default dead

Paul Graham’s concept of default alive or default dead categorizes startups based on the company’s ability to make it to profitability before running out of runway. It assumes expenses are constant, predictable revenue growth, and steers founders away from relying on fundraising to “save” the business. The default alive or default dead dichotomy makes sense in a traditional startup setting where monthly costs are low (primarily consisting of hosting, food, and lodging), but startups that pay founders a salary from the start (like OCV companies) have much higher initial operating costs. 

Based on Graham’s concept, startups that compensate founders are default dead. Accounting for the salary of the founders and initial hires, operating costs are much higher. Reaching profitability with the existing runway would require either extremely fast revenue growth (not impossible but unlikely) and extremely conservative spending. Even a startup with a product that taps into a massive need and starts to have viral growth will struggle to have extremely fast revenue growth without spending much. 

Instead of focusing on absolute annual recurring revenue (ARR) and striving to be default alive, founder-compensated companies should focus on achieving a high growth rate to secure financing to stay alive. If founders know this from day one, they can optimize for the right things: high growth and fundraising. 

Grow fast and get funding

Default alive startups focus on growing ARR because operating costs are relatively low. While Graham’s original article talks about default dead companies needing to be saved, founder-compensated default dead startups operate under the mindset that they will need to fundraise from the beginning. This mindset shifts the focus away from absolute ARR as the key metric to growth rate. 

“It would be safe to be default dead if you could count on investors saving you. As a rule their interest is a function of growth. If you have steep revenue growth, say over 5x a year, you can start to count on investors being interested even if you’re not profitable.” –Paul Graham, Default Alive or Default Dead

The multiple is the most important metric when fundraising and it’s based on the company’s growth rate. You can have a relatively low ARR but achieve the minimum valuation needed to raise a seed round if you have a high growth rate. As a generic framework, a startup’s valuation is calculated as ARR times a multiple, and the multiple is based on your growth rate. A high growth rate has a high impact on the revenue multiplier, which leads to a higher valuation. 

Focusing on growth rate over absolute ARR means that speed matters more than anything. High growth is derived from quick progress. When planning activities and spending, founders should think in terms of, “How quickly will this payoff? Days, weeks, months, or years?” Activities with a quicker payoff are prioritized over longer-term investments at this stage.

Optimize for doing the most with the money you have and the chance of fundraising. If spending a lot on one activity has a high probability of generating a lot of usage and/or revenue, take the risk. Measure the speed and potential payoff of actions and go after the things with the quickest payoff.

Preserving your runway seems risk-averse, but it’s the opposite

It’s normal for new founders to stress over runway, especially when ARR is low or not growing at the rate needed to sustain the business. The most common reaction I see is from founders in this scenario wanting to pull back on spending to expand their runway.

The conversation usually starts, “I’m struggling right now so what I’m going to do is reduce spend so we have a longer runway.” This would work if there was a hurdle of a certain height to pass. For example, if a startup simply needed 1,000 users in order to raise money it would make total sense to not grow, not to hire people, and not invest much in marketing. Just reduce the growth and spend until you pass that hurdle. The problem with this mentality is that startups aren’t working toward a static goal. What founder-compensated startups have to pass is being valued enough to raise a fundraising round.

If the goal was just to grow ARR to the most, it makes sense to not grow spend as much. But the problem is you also have this multiplier based on your growth rate. If you take longer to grow because you’ve increased your runway, your growth rate is going to be lower. This lowers the multiple and makes it harder to get to the minimum valuation needed to raise a seed round.

So when you reduce your growth and spend to extend your runway, you’re not just achieving more thanks for having more time, you’re also slowing the growth rate. When you extend your runway you can jump higher but the height you have to jump goes up even more, making it harder to succeed. Preserving your runway intuitively seems risk-averse, but it’s the opposite.

For companies optimizing for fundraising, the growth rate matters a lot more than the absolute ARR. The way to influence the multiple, and thus the company’s valuation, is the growth rate. The risk-averse approach in this scenario is to grow faster. The money you have in the bank is rocket fuel to propel you to orbit. Extending runway is how you lose the momentum to skyrocket.

Why compensate founders

“Why would you start a business that is default dead?” is a reasonable question. On the surface, it could seem like setting a company up for failure but it’s actually just a reframing of how to achieve success. Paying founders a market-rate salary from day one makes it harder to achieve profitability but it greatly widens the talent pool. There’s a huge barrier to entry to becoming a founder in the traditional environment. It’s limited to people who already have access to capital or can afford to not receive a salary or employer-provided health benefits.

Compensating founders allows us to find and hire the right people, regardless of their personal financial circumstances. For a venture capital firm focused on starting companies around open source projects, it’s really important we’re able to work with people within the project’s existing community as much as possible. Eliminating some of the financial burden and risk allows us to work with founders who are already passionate about the project.

Photo by George Becker: https://www.pexels.com/photo/kick-chess-piece-standing-131616/