Fundraising

Why Founders Should Be Cautious About Over-Raising

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There’s a fallacy that the only way startups can fail is by running out of money. What’s less often discussed are the downsides of raising too much money.

In my work as a Partner at Bessemer Venture Partners investing in companies ranging from Twitch to Intercom, I’ve seen spectacular successes and major disappointments — many stemming from raising too much funding.

To break down this common problem, I’ll address:

  • Why and how over-raising transpires
  • How you can avoid making this mistake
  • Tips on raising the appropriate amount of money

Why Startups Over-Raise

As a founder, it’s understandably difficult to accept the following supposition: you should raise less money. It’s going to be harder and more stressful, but it will make you better.

When you decline unnecessary funding, it intentionally puts pain on a founder and the company by constraining available resources. It’s as if you are training to compete in a race, and someone advises you to not eat for a few days so that the race will seem easier by comparison: even if you agree, it’s tough to take the short-term discomfort.

It’s easy to see why founders take readily available money right now: they believe they’re de-risking their options by taking the money and putting it in the proverbial “vault.” The problem is: I’ve never seen this mythical vault. Does it even exist?

It may be true that some founders can bank that money and continue to operate in scarce resource mode; however, in my experience, that’s way more exception than the rule. More commonly, startups spend the money on expenses they wouldn’t have incurred otherwise. After all, wouldn’t you spend more money to grow faster if you believe there’s a chance this equation works out?

3 Ways Over-Raising Can Hurt – Or Kill – a Startup

Accepting too much cash can actually make it harder to build a company that endures over the long run, and often the inefficiencies that result sink a startup’s potential for a profitable exit along the way. Other side effects can include a loss of independence and decreased ownership for the founding team and employees.

1. Team never learns how to build a sustainable business

When startups over-raise, they skip over (potentially FOREVER) make-or-break moments that make companies stronger, such as needing to build the absolute best product to generate short-term sales.

Once you tap into investor money, it’s psychologically difficult to force yourself to make trade-off decisions. An environment where you have infinite capital is much more enabling than one where you have budgetary constraints — and not always in a good way.

Startups sometimes avoid nailing product/market fit because they have the capital to overspend on customer acquisition – fooling themselves into thinking the fit is there. Sometimes, product/market fit is achieved, but the team never figures out go-to-market.

Either way, the core point is that because of a belief in infinite chances, the team either never develops — or loses — the skill of how to build a business that actually works on its own merits! …without the crutch of investor money to keep things alive.

2. Waste Money

Successful startups build a profitable business model. The inherent risks when teams receive large sums of money is to overbuild the product, the team, and spend unprofitably on go-to-market activities.

Too Much Overhead

It’s far easier to manage a team of 10 than a team of 50. When a company’s coffers overflow — even temporarily — it is all too easy to pack different functions with excess staff.

There’s a law to describe this phenomenon. Published in The Economist in 1955, Cyril Parkinson wrote, “Work expands so as to fill the time available for its completion.”

It’s similar with money. When you get access to large amounts of capital, it’s easy to needlessly expand overhead with expenses such as:

  • Hiring a team when an IC will suffice
  • Getting the nicer office
  • Spending those marginal extra dollars on ads

Sometimes it’s a net-positive, as those extra expenses are what helps a business scale faster or find product/market fit more quickly. But more often than not, overcapitalization leads to waste – and the more waste inherent in a business, the weaker the company that results.

It’s not a black-and-white rule — some very successful startups have spent big and then become profitable as they got to scale. But many others got stuck in a tricky situation precisely because they never separated nice-to-haves from necessities.

Overly Expensive GTM Model

Another common mistake is building a go-to-market model that is simply too expensive for the product or service being delivered – which either masks issues in the product or hides for lack of product/market fit.

I call this bludgeoning your way to success – and at some point, the blunt instrument stops working. Your GTM model is central to the entire company’s value. In selling product, less is more and the fewer resources you can dedicate here, the more efficient and valuable your company will be. And of course, you can plow that extra savings back into R&D.

A lot of on-demand businesses, like Handy, Shift, and Homejoy emulated Uber. As a result, none of these companies ever quite got their unit economics to work.

Flawed Unit Economics

The other side of an overly expensive GTM model is never figuring out sustainable unit economics.

By continuously throwing money at acquisition or service delivery, startups push out — possibly forever — achieving a self-sustaining, profitable way to acquire and serve new customers. At some point, businesses have to be able to support themselves — or there’s often no long-term financial value created. This was a harsh reality that many of the on-demand businesses faced when investor cash dried up.

3. Fewer Exit Options

It’s important to keep your eye on the real prize, and its corresponding reality: involving venture capital will decrease your share of the company — and the windfall from any exit. It’s true that with proper investment, certain ideas can balloon 10x — however, growth takes time, and there is no guarantee spending more will be worth it.

As an example, let’s look at the following hypothetical company:

  • Raise $10M for an interesting concept valued at $30M pre-money.
  • Investors own 25% of the company, and the team retains 75%.
  • If someone wants to buy the company for $100M, the team walks away with $75M, and investors see a 2.5x return. Everyone is pretty happy!

Let’s look at the same $100M deal, but you raised and spent $100M to build the company:

  • Raise $100m over three rounds of funding (a $10m Series A, a $25m Series B, and a $65m Series C).
  • As a result of three successive rounds of dilution, the team owns 25%, while investors collectively own 75%. The team is somewhat demoralized to see their stakes so diminished.
  • Now that same $100m offer comes into play, and all of it goes to repaying investors (who yield a 1x return on their investment), while the team walks away with nothing.

In both cases, you built a $100M company! For the first founder, they’ve built a company worth 10x the amount of capital raised and made $75m in the process. Quite a payday!

On the other hand, the second founder is looking at a soft landing that wipes out any potential returns. The perception of the two is hugely different as well: one is a mediocre sale for all parties, the other a home run success.

The caveat: Let’s say you have grand plans, and you really think you can build a billion-dollar business. Then take the extra $90M! You’re going to own less, but you have a potential shot of building a much bigger company. But, only go for it if you have strong reason to believe the opportunity is there. Don’t go for it just because the money is available.

Said another way: don’t let anyone else make this decision but you.

How to Raise the Right Amount

There are two distinct stages of growth, each with a different recommended approach for calculating how much capital you need.

Pre-Product/Market Fit

While in the initial pre-product/market fit stage, activities that don’t scale can help identify exactly what your customers want. Expenses are small at this time because the team is lean and you can hold things together while still iterating to figure out what works.

In this phase, most companies do not possess a predictable model. You don’t know exactly how much to spend on each aspect of the business, and it’s tough to figure out how much to raise.

I generally advise startups at this point to estimate what you think it will take to reach product/market fit, plus a buffer of three mistakes. A mistake could take a month to recover, or be more devastating: you might have to re-tool or re-architect a core assumption you had at the outset of starting your business.

Usually, the money required in this phase is less than you think, because you’re mostly focused on engineering and product work. I wouldn’t raise funds to scale a big sales team or do a lot of marketing activities until you have a good sense of exactly what you’re selling, how, and why someone is buying it. Raise just enough to get the product out there and nail product/market fit. With demonstrable success there, you should have no trouble raising more in any kind of environment.

Post-Product/Market Fit

After you achieve product/market fit, the calculations around what you need become a lot more clear. If the math works, it is time to go for it, and you can make more informed estimates on how much it costs to scale your business.

Whether you are focused on scaling the sales learning curve, or ramping marketing, you can forecast your needs based on the historical go-to market expenses (sales/marketing) and conversion rates. Here again you want to give yourself some buffer. There will always be a lot of experimentation required to scale a business. Figure out how many experiments you need to do before you’re confident one of them will work, and give yourself room for 3 mistakes along the way.

How to Prevent Over-Raising

Far too often, I see otherwise well-intentioned founders upsizing their rounds, then hiring faster and doing more than they are ready for — all because more people are showing up ready to write a check, not because of a preexisting plan.

While unintentional, there’s a psychological tendency to accept money when offered: the mere opportunity to take more often skews a founder’s psychology into believing greater success will come faster. But this is clearly the wrong causality and a clear case of the tail wagging the dog.

So who’s to blame for this state of affairs?

The Role of the Venture Capitalist

All too often, VCs are the problem. Too many times for me to count, I’ve witnessed VCs convince founders to go big with more money — when the founder would have otherwise kept the company lean and capital efficient.

As VCs, we should hold ourselves to strict standards regarding which companies are going after big market opportunities and have  evidence of the enabling ingredients, such as:

  • Product/market fit
  • Scalable GTM
  • A strong executive and founding team excited to go the distance.

Sinking the requisite amount of money into these “lightning strikes moments” makes sense all day long… but, we often get it very wrong by assigning the wrong expectations to the wrong companies.

Founders are the Decision Makers

Ultimately, even in cases where VCs encourage ill-advised fundraising, responsibility lies with the founders and key executives to make the right decisions for the business — including how to capitalize it appropriately.

Founders need to perform a dispassionate, neutral analysis — outside of the presence of imminent funding offers — to avoid the pitfalls of overfunding.

Founders must make this decision for themselves. Whatever your process for making big decisions as a founding team, execute it on your own time in your way. Don’t let someone else make such an important decision — especially someone with a vested interest in the result (like a potential source of funds).

Once you make a decision, stick with it and don’t let anyone shake you off of it!

Conclusion

Even when capital is flowing from the peaks and valleys of San Francisco, don’t equate fundraising success with ultimate success. As obvious as it sounds, companies are valuable because they create value in the world. And as the great Justin Kan recently wrote, “A round of financing isn’t a destination: it’s a means to continue to grow and deliver better service.”

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Ethan Kurzweil is a Partner at Bessemer Venture Partners who joined the firm in 2008, where he focuses on consumer technologies and developer platforms. Ethan’s investments include consumer companies such as Twitch, Periscope, Dropcam, and Playdom, and developer platforms such as PagerDuty, Intercom, Twilio, SendGrid and many others.

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