Unit 53 of 63
In Progress

When Raising Too Much Money Makes Exits Difficult

👉 Watch the video AFTER reading the lesson.

 

Contrary to what most Founders and even VCs tend to think, the investment discipline is not a dependent variable of the state of the market. 

In other terms, some basic principles remain valid both in bull and bear markets.

How much you should invest in startups is one such principle.

The temptation exists to pour vast amounts of cash into startups when the economic environment is bullish, and you’ve raised a large VC fund. 

During economic crises, the reverse is equally tempting: shutting the door to new deal opportunities or being too prudent at a time when risk-taking may lead to better rewards.

Investing Too Much May Backfire

Raising too much money, or pumping too much cash in a startup – if you take the VC’s standpoint – may have two undesired consequences.

1/ You burn too much cash, too fast

As Mark Suster reminds us in this video edited from a 2013 TechCrunch interview, having a pile of VC money in the bank account often pushes Founders to spend more cash than necessary. By increasing their burn rates, the incremental value creation diminishes.

2/ The threshold of the exit price is higher

Investing too much compared to the startup’s needs or growth potential often results in disappointing returns for investors. 

As you will learn in the next section of this course, VC returns follow a power-law pattern. Given the average outcomes on their investments, VCs need to score 10x to 100x multiples on the startups that survive to generate good returns for their investors.  

If you want to understand this fundamental issue in VC better, you can start reading the articles posted below. 

Don’t panic: we will cover this topic at length on this track.

3/ Founders lose motivation due to severe dilution

A long-term impact of investing too much money when the startup has not yet found it’s product/market fit, for example, is that Founders are diluted too early. As the Suster illustration proves, motivation often decreases, and Founders tend to want to exit faster.

What are the unintended consequences of investing too much in startups? How do you define “too much”? Why do you believe VCs keep making this mistake?

💬 Let us know in the Comments section below.

👀 Sources & Additional Material

  • Is there a way to spot when a firm raises too much money verses when it raises money at too high of a valuation? They are not mutually exclusive but it is quite hard from an outsider perspective to understand if the company is currently raising way more than it needs, yet it could help one find a potentially bad investment.

  • To me this seems like a difficult trade off for founderes. When they have the chance to raise more money than they potentially need (like today…), they might want to consider that if the bullish market turns bearish, this will not be the case any more. So they could make use of very favorable financing conditions with the cost of raising more money than needed…

    • Besides the economic cycles, there is another point that makes the balance even more delicate for founders, in my point of view. We previously saw that “Running out of cash and failing to raise new capital” was the leading factor for start-up failure (see the infographic on the section “The Most Common Exit For Startups”), at a whopping 38%. I would imagine this creates incentives for founders to raise more cash than needed, as the risk of dilution is not as evident and dangerous in the short-run as the risk of going bankrupt.

  • I think this has something to do with the Theranos case. In the past, the global economy was in an era of incremental growth. As long as there was enough capital as a subsidy, a company could occupy the market demand. As a result, Chinese food delivery platforms and online car-hailing platforms have appeared in the subsidy war, and that’s why Theranos can get a steady stream of financing. However, as the economy moves towards the game of stock, various industries are faced with competition from giants. For start-ups, especially high-tech companies, burning money cannot guarantee to win the market competition, but many companies still have this idea. Also for early investors, after investing too much money, they may not be willing to admit their losses, and even continue to endorse the company, which will also lead to the further expansion of the scam.

  • I think VCs might make the mistake of investing too much because they want to win the deal. Moreover, some founders do not understand the dilution point until it is too late and accept too much money from VCs.

  • In regards to the first section about timing/economic environment, I’d be curious to know if there are any firms that take a contrarian approach to investment; aka they try to take advantage of bear cycles by investing when there is less competition and they can perhaps get more favorable terms. Additionally, the start-ups would potentially be well-positioned to grow as economic conditions improve (assuming they can survive in the first place).

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