There is a common misconception that failure to raise funding is the only way in which startups can fail (or that it's the predominant cause of startup death). But the downsides of raising too much money are seldom discussed.
While it’s true that there has been some discussion on the subject:
Even so, this discussion has not yet entered the mainstream startup world. Indeed, it seems at times that the discourse on "over-raising" or overfunding is treated as almost a taboo topic in startup circles.
As a result, more ventures than ever are opening their doors to overfunding. This is not a prudent thing to do.
To break down this concerning problem, this post will answer crucial questions like:
- What does overfunding mean?
- Why do startups get overfunded?
- Why to avoid the mistake of overfunding?
- 3 ways overfunding can hurt (or even kill) a startup
- How to raise the right amount?
- How to prevent overfunding?
What does overfunding mean?
Overfunding occurs after the point that a startup or business secures the target funding that it set out to raise and chooses to receive further funding in return for releasing more equity. It is not mandatory for startups to accept being overfunded by investors. An investor who invests after 100% of the startup’s funding target has been achieved receives the same rights as someone who invested before 100% of the funding target was reached.
Why do Startups get overfunded?
There is a simple logic behind why founders pounce upon readily available money. They believe that they are de-risking their options by taking the money and putting it in the proverbial ‘vault’.
So, what's the problem?
Well, it lies in the fact that this mythical vault does not actually exist in most cases. While there come a few founders every now and then who bank the extra money, prioritise being lean and efficient, and continue to operate in "scarce resource" mode - that is far more of the exception than the norm.
In fact, the more common occurrence is of startups that spend the extra money on expenses that they wouldn’t have incurred otherwise.
In other words:
The more money you raise, the more money you will spend.
After all, wouldn’t you readily spend more money to grow faster if you believed that there was a positive correlation between expenditure and growth? If you believed that there was a chance that this equation could work out in your favour?
Why you should avoid the mistake of overfunding?
Here’s an expert hypothesis:
You should raise less money.
It is understandably difficult for a founder to accept that supposition. Although it will be harder and stressful for you initially, the benefits that this decision (of rejecting extra funds) will offer to your company in the long run will almost certainly outweigh the initial difficulty.
Declining unnecessary funding intentionally puts pain on the company and the founder(s), by constraining available resources. With these constraints, startups usually develop creative ways to achieve their targets while being lean. However, the thought of having additional funding seems like an opportunity and cushion that founders feel they will regret rejecting.
This is why most startups choose not to bear it. They circumvent the advice to stay financially lean, indulging in gluttonous overfunding - only to suffer the terrible fate that (most) gluttons do.
Let’s find out what this fate is.
3 ways Overfunding can Hurt (or Kill) a Startup
Accepting more cash than necessary can actually make it harder for founders to build a company that endures in the long run.
Quite frequently, overfunding results in inefficiencies that sink a startup’s potential for a profitable exit strategy along the way. Other side-effects include decreased ownership and a loss of independence for the founding team and employees.
What are the 3 ways in which overfunding can hurt (or kill) a startup?
- The team never learns sustainable business-building
- Money is wasted
- Exit options are limited
1. The team never learns sustainable business-building
Founders that get overfunded bypass key opportunities for learning and development that occur in the startup's natural journey. These opportunities are challenges in disguise that make companies stronger and knit team members closer together. Such challenges include key moments like the need to build the absolute best product to generate short-term sales with optimal retention.
In overfunding cases, however, founders skip over these make-or-break moments.
Why is this the case?
This happens because it is psychologically difficult to compel oneself to make trade-off decisions after one taps into an abundant pool of investor money.
Why does this matter?
It matters because it’s precisely this exposure to constraint along with the decisions that we make within severe limitations that prove to be the most instructive. What we learn under pressure, we carry forward and apply productively at other crucial junctures in the startup’s journey.
It is for this reason that Inc. has a great piece about how “scarcity is a blessing for innovators”.
When compared to a setup where you have budgetary constraints, an environment where you have access to copious capital is much more enabling - but not always in a good way.
What happens when capital is readily available?
It’s overspent on customer acquisition. Like clockwork. This is oftentimes the beginning of the end, because when this happens, startups aren’t left with enough incentive to focus on fine-tuning the product/market fit - thereby committing the deadly sin of fooling themselves into thinking that the fit is achieved (when it’s actually not).
At other times, while the product/market fit has been achieved, the team ends up never figuring out the go-to-market.
Either way, the fact remains that it is because of a belief in having too many chances to succeed that the team never develops (and simultaneously loses the greatest opportunity to develop) the invaluable expertise of how to build a business that actually works on its own merits. The “merits”, of course - as this post excellently outlines - should include:
- Repeatable traction
Instead of any of the above four qualities, it’s the excess money that becomes a crutch for keeping things alive and moving at startups that get overfunded.
As a result, the team never learns sustainable business-building.
2. Money is wasted
One of the primary hallmarks of successful businesses is their ability to build (and then depend on) a profitable business model. There are grave risks that inherently manifest in teams that receive large sums of money from investors.
These risks include overbuilding the team, over-engineering the product, and unprofitably spending on go-to-market activities.
Below are 3 of the most common ways in which money is wasted in a startup that has been overfunded:
- Too much overhead
- Overly expensive GTM model
- Flawed unit economics
Too much overhead
It is far simpler to manage a team of 10 as compared to managing a team of 50.
Despite that, it becomes all too easy to pack different functions with excess staff when a company’s coffers overflow (even temporarily).
Apparently, there’s also a law to describe this phenomenon. Cyril Parkinson wrote in The Economist, 1955: “Work expands so as to fill the time available for its completion”.
The same goes for overhead and capital. It’s easy (and surprisingly natural behaviour) to expand overhead with needless expenses when you have large amounts of capital at your disposal. This includes:
- Hiring a team member when an independent contractor would have sufficed
- Getting that nicer, more expensive office
- Spending those extra dollars on advertisements
Sometimes, this kind of spending does result in a net-positive. This is because paying those extra bills could help a business scale faster or find product/market fit more quickly.
However, overcapitalization leads to waste more often than not. This refers to a wastage of time, energy, and resources (capital) on fruitless endeavours.
And the more waste of this sort that there is in a business, the more vulnerable, more inefficient and weaker the company becomes over time.
Overly expensive GTM model
Building a go-to-market model that is simply too expensive for the product or service being delivered is another common mistake that is responsible for the wastage of money.
Even this authoritative post by Hubspot (“The Proven Process for Developing a Go-To-Market Strategy”) emphasises the importance of being economical with GTM spending at the early stage: “For startups, it’s healthy to scale over time rather than investing in an expensive sales team too early.”
An unreasonably expensive GTM model typically disguises at least one of two problems. These are:
- The lack of product/market fit
- Issues or inadequacies in the product
That’s not all...
Your GTM model is central to the entire company’s value. Less is more - while selling a product or service - and the fewer resources you can dedicate here, the more efficient and valuable your company will be.
You can, of course, invest what you save in this manner back into R&D (or even into G&A, though the best ROI on investment in that regard will always be outsourcing all G&A functions to folks like AbstractOps).
Flawed Unit Economics
Not figuring out sustainable unit economics is the other side of an overly expensive GTM model.
As mentioned in #1 (“Teams never learn sustainable business-building”), startups that get overfunded get lured into the vicious cycle of continuously throwing money at acquisition or service delivery.
The most concerning consequence of this kind of overindulgence is that startups end up pushing out the possibility of achieving a profitable and self-sustaining pipeline to acquire (and serve) new customers. All because of their own flawed understanding of unit economics.
Why does this matter?
This matters because businesses should be able to support themselves at some point or there’s no long-term financial value created. This is a harsh reality that many of the on-demand businesses face when the investor cash dries up.
This post about unit economics and why they are important in early stage startups is a great place to start if you’re interested to learn more about the subject.
3. Exit options are limited
It’s vital to keep your eye on not just the monetary prize but also the reality that it corresponds to.
Here’s the fact of the matter:
With that said, real growth takes time - and there is no guarantee that investing more will be worth it.
Let us look at this hypothetical company as an example:
- Raises $10M for an interesting concept valued at $30M pre-money.
- Investors own 25% of the company, and the team retains 75%.
- If an acquirer comes along and wants to buy the company for $100M, the team walks away with $75M, while investors see a 2.5x return. Everyone is pretty happy!
Let’s look at the same $100M deal, but the team raised (and spent) $100M to build the company:
- Raises $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%.
- Now that same $100M offer comes into play (assuming the company doesn't optimize use of funds for the best ROI), all of it goes into repaying investors (who yield a 1x return on their investment), while the team walks away with nothing.
The first founder built a company worth 10x the amount of funding raised and earned capital gains of $75M in the process. The second founder, on the other hand, is looking at a soft landing that wipes out any potential returns.
Which brings us to the next question.
How to raise the right amount?
There are two distinct stages of growth:
- Pre-product/market fit
- Post-product/market fit
Each stage comes with a different recommended approach for calculating how much capital is needed (or, in other words, for calculating the right amount to be raised).
Activities that don’t scale can help identify exactly what your customers want in the initial stage, i.e., the pre-product/market fit stage. 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.
Most companies do not possess a predictable model in this phase. You don’t know exactly how much to spend on each aspect of the business, which makes it tough to figure out how much to raise.
Therefore, startups are advised to estimate the amount that they think it will take to reach product/market fit - plus keep a buffer of three mistakes.
A mistake could take a month to recover, or be more devastating: you might have to re-architect a core assumption that 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 product work and engineering.
We can’t emphasise this enough:
Do not raise funds in order to scale a big sales team or to do a lot of marketing activities until you have a good sense of:
- What you’re selling
- How you’re selling it
- Why people are buying what you’re selling
Raise just enough money to nail product/market fit and get the product out there properly. Once you achieve demonstrable success, you should have minimal trouble in raising more funds in any kind of environment.
The calculations surrounding how much you need become far clearer after you achieve product/market fit. This is because you can make much more informed estimates of how much it costs to scale your business.
Whether you are focused on scaling the sales learning curve, or ramping up marketing, you can forecast your monetary needs based on historical go-to market expenses (sales/marketing) and conversion rates.
How to prevent overfunding?
While (somewhat and sometimes) unintentional, there’s a reflexive psychological tendency to accept money when offered.
Why is this important?
Because in almost all cases, it is the mere opportunity (read: temptation) to take more that skews the mindset of even the most prudent founder into believing that greater success will come faster with more funding.
The question is:
Who’s to blame for this state of affairs?
The Role of the Venture Capitalist
VCs should hold themselves 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 (and repeatable traction)
- A strong team that’s excited to grind in the long-term
Ultimately, the responsibility of making the right decisions for the business lies with the founders and key executives, even in cases where VCs encourage ill-advised fundraising. This responsibility includes the decision of how the business should be capitalized appropriately.
It is for this very reason that founders need to perform a dispassionate, neutral analysis — outside of the seductive influence of imminent funding offers — in order to avoid the pitfalls of overfunding.
Don’t equate fundraising success with ultimate business success. Over raising capital can lead you to unintentionally deprioritize your business' GTM, unit economics, and ability to sustain independently without constant cash influx.