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Goldilocks Capital Raises
Typically, I think of cash in the bank as a means to reduce the risk of a startup. Makes sense – more cash means more runway, more flexibility, and less sensitivity to the near-term capital markets.
When markets are good, the conventional advice has been to take that advantage to raise as much capital as you can. Get what the getting is good, because you never know when you might need it.
This isn’t even just for startups. VC’s do the same thing. They raise bigger funds when times are good, and they raise funds more frequently as well while there is access to capital.
The problem is that the risk of capital is not only in having too little. It’s also in having too much too quickly. It’s not an all-you-can-eat buffet, it’s more of a goldilocks situations.
This means that raising too much capital creates a lot of risk. In a world where founders raised 20-50% more than they needed as cushion, the extra capital probably did reduce risk. But in the last few years, companies have raised 3-10X more than they needed to hit tangible milestones, and we are going to see that this is a big problem for a few reasons.
First, it locks companies into a financing or exit path that is unrealistic for the vast majority of companies. The public markets are pretty unforgiving for weak businesses, but the M&A market doesn’t usually support more than a handful of acquisitions of $500M+ scale. Raising huge amounts of capital creates significant risk for these exits, or for future financing with investors that are thinking more more about short term liquidity.
Second, when a company has money, they tend to spend it. Burn goes way up, and discipline around prioritization of initiatives and resources goes down. Next thing you know, a nimble speedboat becomes an aircraft carrier, and it’s very hard to course correct, much more than you ever expected. You also have a bunch of employees at this point that joined because they liked the idea of joining a company that was flush with cash and paid out great cash compensation. When things go sideways, it will be unclear how much staying power these folks might have.
In the venture capital world, a similar thing happens too. Larger funds creates a higher bar for great returns. More frequent funds concentrate portfolios in companies formed around tighter time band, creating more concentrated macro risk for that portfolio. Even though in the long term, VC’s can do great investing in good times and bad, time diversification helps, and it’s tough when a huge portion of your portfolio is going to need additional financing when investors are fearful.
Personally, I like to think about capital raised in terms of what other companies have raised to get to the outcomes or milestones you are shooting for. One does this by keeping in mind that all companies are different, and that the larger the outcome, the fewer the companies that actually achieve this. It’s interesting to think that companies like HubSpot and Marketo got to be good public software companies with ~$100M in paid in capital. It’s interesting to think that the last public e-commerce company took in about $350M, but half of that coming within a year from the IPO.
Again, no two companies are the same. Sometimes, raising lots of money more quickly helps for companies to achieve wonderful things. And sometimes, it does behoove you to raise capital when it’s available to create a war-chest. But there is greater risk associated with more capital that is under-appreciated. But I think it will be appreciated a lot more over the next 12 months.