Gorging on capital can be the worst thing for your start-up's health. Here's why.
Which do you think is a better predictor of your company’s future? To have such a great concept that investors throw $400 million at you to bring it to life? Or to face enough skepticism that you can squeeze out just $9 million over multiple rounds of funding?
Okay, you knew it was a trick question, but the facts are pretty surprising. History shows that capital efficiency—raising no more than you need—has been a better indicator of success than capital access. Apple raised just $9 million in venture money, Cisco just $3 million. YouTube raised just $15 million in total and was acquired for $1.7 billion. WebVan, on the other hand, was the company that raised over $400 million. It was out of business within four years.
Obviously, how much capital you need depends on the type of company you are building and the stage of your company’s lifecycle. My venture capital firm focuses on high-growth companies that plan to complete globally and need outside funding to maximize growth in their early years. But it pays to be capital efficient no matter what kind of company you run, for a couple reasons:
1. It keeps things real.
Raising smaller amounts tends to keep your options open and your investors’ expectations reasonable. With less money in the bank, you won't be under pressure to ramp up hiring or shoot for a pedal-to-the-medal growth rate. Your investors won’t be pushing for a possibly premature exit.
Research from the Startup Genome Project shows, in fact, that 74% of tech startups fail because they try to scale too soon—essentially, they apply large amounts of capital to grow their businesses before they really know if the business makes sense. The pressure from excess capital can tempt entrepreneurs to shortchange research on customer demand or market requirements and leap on a single false positive signal. Once a large influx of capital comes into company, it’s hard to take the time to develop a deep understanding of customer or user needs.
2. You need far less money than you once did, anyway.
New technologies, such as pay-as-you-go cloud computing and open source software, make it much cheaper to start a high-growth business with small amounts of capital. Today it may take as little as as $50,000 - $250,000 to build an initial cloud-based product, though it will certainly require much more over time to scale globally.
3. Less capital means you need only small wins to keep everyone happy. And small wins are easier.
If you can make progress with a small amount of capital, you are more likely to a) not need more capital, which preserves more ownership for you; or b) if you do need future rounds, investors are more likely to give you a higher valuation. Your initial milestones might include product development goals, such as the beta release or a public launch, or business development goals, such as gaining initial customers or a critical distribution partner. These can be compelling proof points for future investors.
Within my own portfolio, for example, the Hoopla Software founding team gained over three dozen paying customers from their angel financed efforts before seeking the first institutional round of investment. An ability to execute well against a plan is exactly what our firm looks for in a founding team.
4. That said, give yourself a cushion
Yes, you should be as capital-efficient as possible, but you also need enough money to ensure your survival if everything doesn’t go as planned – because it never does. At a minimum, you should seek enough to cover an extra quarter of expenses beyond your budget. There are just too many things that you don’t control.
Back in the late 1990s, when I was a founder/CEO myself, I learned this the hard way. I had accepted a term sheet that was due to close in 30 days. In the interim, I realized that my VP of Engineering just wasn’t the right person for the job. Talented engineers were hard to come by at that time, and this decision scared by investors, who delayed the financing while I looked for a replacement. The search took 60 days; Had I not been able to temporarily finance the company from existing capital, my company might have had a very short story to tell.
My experience as a founder, CEO, and VC has taught me the wisdom of running lean. Raise just enough to get yourself to attainable milestones and to cover the unexpected. Raising more won’t help. It might even hurt.
CINDY PADNOS is founder and managing partner of Illuminate Ventures, an early-stage micro VC firm focused on cloud computing. Padnos has deployed more than $100 million in venture funding to help dozens of start-ups reach successful outcomes. @illuminateVC