We all love the feeling. When you close that big round of funding, and it gets announced in a major publication, it's an amazing experience. Your family and friends congratulate you. More investors start calling you, and all of a sudden your team has more energy than ever before.
While raising funds is a great accomplishment for entrepreneurs, it also can be taken too far. Like all elements of life, too much of a good thing is a bad thing.
From my experience, there are certain downsides to raising too much money too early at high valuations. This is what I like to refer to as a "Silicon Valley" round of funding. Below I share some of the consequences you'll face if you raise a too much capital early on. Keep this in mind before you go over that next term sheet.
1. High valuations hurt acquisition opportunities
This seems a bit ironic at first. As entrepreneurs, shouldn't we always push for the highest valuation possible? In reality, the answer is no. When you raise capital at a high valuation early on, your investors are most likely going to take a board seat for your company. Down the line, when you get an offer to get acquired, you may be sitting on a great exit opportunity. The problem will arise when your investor says no because they won't get the return they're looking for.
Raising money at a high valuation too early can end up coming back to haunt you. This is because it raises expectations for what your company needs to achieve to have a successful exit. The companies you see on Techcrunch that get acquired for $100 million are few and far between. You never hear about the founders who walk away with a $20 million to $30 million exit. That's because small exits aren't as exciting as hearing about the founders who swung for the fences and hit a home run. You also don't hear about the companies that could have had a nice exit but raised huge rounds and failed.
So before you rush to close a deal for a high valuation early on, just bear in mind what you'd be comfortable walking away with. There are plenty of entrepreneurs who keep more of their company and are successful with several small exits. They may not be all over the press, but they have a much higher chance of succeeding than someone who only will sell for $100 million.
2. Too much money can stop you from running lean
When you're starting out, you have to be extremely creative to get your company off the ground. This is especially true for tech, where development talent can cost you hundreds of thousands of dollars. I remember when we started Alumnify, we would trade pizza in exchange for development hours. Over time, as we started raising more money, I noticed it became much harder for me to keep that lean mindset I started out with. It's hard to be frugal when you go from keeping your company going month to month to all a sudden raising huge sums of money.
You need capital to speed up the growth of your business, but raising too much money can also increase the funds you start wasting. This happens to many startup founders who get caught in what they see in The Social Network or Silicon Valley. The problem with this state of mind is that most entrepreneurs don't realize how far their money is really going to take them. With expenses like legal and accounting, your funding probably won't take you as far as you think. When that happens, you're going to be forced to raise more money at a worse valuation, and that could lead you to a downward spiral.
Instead, raise capital but force yourself to still be just as stingy as when you started. Be creative with your option pool. Try not to spend money on an office too early. Let team members have other jobs until you know you have more than enough money to bring them on full-time. A great example of this is 37Signals. Basecamp was a side project that ended up becoming a huge revenue source for them. It didn't need 40 hours a week to get it off the ground. Until you've proven your model and are ready to scale, you'll be surprised at how far you can go with part-time employees. The more money you save, the more company you can keep, and the less time you'll have to spend chasing down investors.