Entrepreneur

How raising too much capital can cost you a lucrative exit

What else can you do with all that money but bathe in it?

Above: What else can you do with all that money but bathe in it?

Image Credit: Mattysflicks

In a startup culture that glorifies funding, it’s not often that entrepreneurs hear that too much funding can actually harm their company.

For the rare bootstrapped tech startup, there are dozens of seed-stage companies that dream of getting showered in venture capital. I would argue, however, that raising too much capital too early can set unrealistic expectations, sabotage sustainable growth and create an inevitable conflict of interest between the entrepreneurs and investors.

To prevent this scenario, early-stage startups and investors need to focus on capital efficiency and raise the right amount of money.

Too much money can hurt your exit options

When a startup raises too much capital too early, the entrepreneurs lock themselves into a set of expectations and a specific exit strategy — and often they are unaware of having done so.

For example, $10 million in Series A funding raised at a $20 million pre-money valuation will lead to a post-money valuation of $30 million. Early stage VCs would want to see at least a 10-fold increase in value. So, they’re expecting an exit valuation of $300 million, and that does not take into account additional investors who join in later rounds. In this case, an exit under $100 million would be completely out of the question. Most professional VCs will have strong veto rights to legally prevent an acquisition, and they’ll exercise that right if the offer price is too low.

Overfunding can also send a tech startup into expansion mode too early, before it achieves product-market fit. When an early-stage startup with proprietary technology raises lots of money, the team will often spend the money even if it’s against their better judgment. Under heavy pressure to accelerate the business units of the company, they will hire expensive marketing and sales personnel.

However, they have not reached the stage where they know what they’re selling, to whom, and at what price point. Their marketers and salespeople begin scaling, even though it usually takes multiple product iterations to reach the stage where expansion makes sense. The new hires cost millions, and they struggle to sell the product. The premature expansion causes the company value to flatten or depreciate. In short time, the startup has gorged itself on unwarranted capital and it can’t raise more.

Now, the tech startup might fail, given what I’ve described. Or, let’s say it beats the odds and becomes a $100 million valuation company. By most standards, this looks like success, but given the $10 million raised in Series A, the investors want to sell for $300 million. When strategic acquirers come along to buy the startup, they offer $60 or $70 million.

The founders would love to sell — at that price, it would put $10 million in the founders’ pockets, which would be life-changing. Their investors, on other hand, won’t go for it. Their $20 million return is chump change in a half-billion-dollar fund. The investors and entrepreneurs are now locked in a conflict of interest. They have a product that is valuable, but a company that can’t gain value without heavy injections of capital.

How much funding is the right amount

At some stage, a startup may need to raise a lot of money and stop being capital efficient in order to scale. The trick is to recognize the right timing, which is often later than entrepreneurs or investors expect.

The antidote to overfunding is to raise the right amount of money from the beginning. In our opinion, a seed-stage startup should raise no more than $1 million to $3 million.

A double-digit B round is only appropriate when the company is selling the right product to the right customer at the right price point through the right distribution channel. If buyers make an offer before Series B, a startup that has raised only a few million can sell for $60 to $70 million and satisfy both the entrepreneurs and investors.

Yoav Leitersdorf

Yoav Andrew Leitersdorf has been a successful tech entrepreneur and investor for the past two decades. YL Ventures, which he founded, invests early in cyber security, cloud computing, big data and Software-as-a-Service software companies, and accelerates their evolution via strategic advice and Silicon Valley-based operational execution. YL Ventures is currently investing out of its $27.5 million second fund.

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