Posted on December 8, 2007
Filed Under VC Insanity |
A cardinal sin for any startup when raising a round of funding is to not raise enough money. There are few things an investor hates to hear more than “We’ve run out of money” before the milestones that were to be achieved with that money have been accomplished. As such, it is crucial that entrepreneurs try to accurately project how much money their startups need and to raise an amount at least somewhat greater than that since any experienced entrepreneur knows that expenses are almost always underestimated and revenues are almost always overestimated.
Additionally, because conditions can change quickly, both with a startup itself and the economy at large, entrepreneurs are often advised to take as much money as they can while they can. At times, this pays off. Take for instance, PayPal, which right before Bubble 1.0 burst raised an amount of funding that, at the time, seemed excessive. That extra capital helped it survive the downturn.
Now that we’re in Bubble 2.0 and the spigot of VC money is flowing again, it’s worth looking at the negative impact significant overfunding can have on a startup. While there is no doubt that overfunding can wind up saving a company as it did PayPal, investors should be weary of overfunding startups because too much money can just as easily destroy a startup’s chances.
Money Reduces Hunger
In one of my favorite movies, Wall Street, Gordon Gecko states “give me guys that are poor, smart, hungry.” The rationale is quite simple: guys that are poor, smart and hungry have a lot more motivation to make things happen than guys who are rich, can afford to not be smart and that are well-fed. When a startup raises too much money, the management team is unlikely to feel nearly as poor and hungry as they did before. A certain comfort level is achieved and the urgency that may have existed when the company was unsure of its survival is taken away. Things that can be done today get put off until tomorrow. In the worst cases, the management team feels like it’s already hit the jackpot and spends accordingly.
Successful Silicon Valley serial entrepreneur Glenn Kelman himself suggested that one of the reasons that second-time founders rarely achieve the same level of success after their first is often probably due in some part to the fact that they don’t need to. As he stated, “few second-timers operate at the same level of savagery that drove the early, destitute years of their first startup. Most don’t even try. A friend of mine had a great idea, raised money from his old investors, then took a three-week yachting trip.” I would argue that it’s very easy for any entrepreneur to fall into trap when his company is overfunded, even if his personal bank account isn’t nearly as large as the company’s.
Investor Money Isn’t Real Money
When we look at the psychology behind the massive consumer debt that Americans have and continue to rack up, it’s clear that one of the reasons that it’s so easy to go into debt is that debt money isn’t “real” money. Even though you can watch as your credit card balance increases, the “money” you’ve spent isn’t coming out of your checking account. The result is a warped perception of your finances.
Investor money is a lot like a credit card except for the fact that it doesn’t carry an interest rate and if you don’t “pay” the investor back, there’s no legal or financial consequence to you (unless of course you spent more than 1.25% of it on cocaine and escorts, in which case you might have a problem if you didn’t raise money from firms I won’t name here). While investor money is “free” money regardless of how much of it an entrepreneur has raised, giving an entrepreneur too much is like giving him an American Express Black Card and instructing American Express to remove any limit.
It doesn’t take a rocket scientist to figure out what is often likely to happen when a person is given too much money with essentially no strings attached. There’s a reason quite a few lottery winners die broke. At the end of the day, it is in an investor’s best interest to make sure that a startup has enough capital to realistically achieve specific goals but not so much capital that it encourages waste and hampers the efforts to achieve those goals. As Gordon Gecko pointed out, “The Carnegies, the Mellons, the men who built this great industrial empire, made sure of it because it was their money at stake.” Investors should remember that when they write an entrepreneur a check, the entrepreneur knows it’s not his money at stake.
Money Taken is Money to Be Spent
VCs understand this very well. When a firm on Sand Hill Road raises its new $500 million fund, there’s only one thing worse than not using it to generate great returns: not being able to invest it all and having to give money back to limited partners. Of course, this is flawed, but it’s the way things work. When a VC firm raises a fund, there’s an expectation that it will be able to put that fund to use.
The same is thus true for entrepreneurs. Just as a VC firm that raised $500 million and only invested $50 million of it would look like it was not capable of putting its money to work, an entrepreneur who raised $20 million would look almost foolish if he could spend only $1 million of it. Regardless of the capital needs of a company, there’s an expectation that capital raised will be capital used and the result for overfunded startups is that capital is wasted.
Money Reduces Creativity
Having an abundance of capital often reduces the amount of creativity that a company and its management team will exercise to build the business. When a company has limited resources, decisions related to finances and resource utilization more frequently result in creative solutions. A bootstrap company is much more likely to come up with clever ways to acquire what it needs whereas an overcapitalized company is more likely to make far less effort negotiating the acquisition of what it needs, potentially resulting in unnecessary waste. The end result: when compared side by side, the bootstrap company uses its capital much more effectively and efficiently than the overcapitalized company. Eventually, an accumulation of ineffectiveness and inefficiency in how capital is used adds up. One of the common traits of most successful companies is that they use their capital effectively and reduce waste as much as possible. If necessity is the mother of invention, a company with less capital is forced to be much more creative in finding ways to use its capital effectively and efficiently.
Overfunding is as detrimental to a startup as underfunding can be and investors would be wise to pay more attention to this. This is probably unlikely and today many investors are overfunding like money is going out of fashion. In an upcoming post, I’ll name the Internet startups that I think are the most overfunded and the investors that have victimized them.Print This Post