Too Much / Too Little Money

This is the first entry in my Scylla and Charybdis Series of blog posts.  In case you missed the introduction, the idea is that startups are hard because you can always err both by doing too little of something but also by doing too much of it.  Since I don’t have a lot of time to write this morning, I am picking a particularly easy one: raising money.

If you raise too little money the bad consequences are fairly obvious.  In the worst case you run out of money altogether and have to shut down.  But even when it’s not a fatal outcome, you may wind up spending too much time fundraising again soon and more importantly you may be underspending relative to the opportunity.  That might create an opening for a competitor to come in and you wind up building a smaller company than you otherwise could have.

But what are the failure modes when you raise too much money?  Money has a funny way of “spending itself.” Initially you wind up hiring just a bit too fast and those hires then hire a bit too fast themselves and pretty sure the organization as a whole is growing too fast. And you will be undisciplined in other areas as well from excessive marketing spend to feature creep (or delaying launch).  Put differently, there is a declining marginal benefit of money raised — eg $10 million doesn’t get you twice as far as $5 million.  Often it will get you barely any further and sometimes the bad consequences will be so sever that you never ship or ship an awful product that falls completely flat because it is hyped but fails to deliver (can you spell Color?).

There are to other important failure modes that come from raising too much money: turning down what would have been a good exit and having to endure a down round.  Generally entrepreneurs get seduced into raising too much money because they see pre-money valuations going up with the size of the raise and so each dollar raised seems less dilutive.  But that doesn’t properly capture the opportunity cost of carrying a higher valuation.  The higher the post-money valuation the less optionality exists with regard to exits and future financing.  If you are familiar with option pricing you know that it essentially amounts to adding up values across many future paths.  By having a high post money you more or less eliminate the paths that have an exit or a financing at lower valuations.  That doesn’t show up anywhere on paper but if you were calculating optionality, cutting out paths reduces the value of an option.

So the challenge for the entrepreneur is to for each financing to find the Goldilocks amount to raise.  How do you do that?  There is a lot of detail to be filled in but the basic principle is simple: be realistic about your revenue/usage and expense growth and raise for give or take 18 months.

Posted: 4th October 2012Comments
Tags:  startups scylla charybdis

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