Overfunding Companies

The biggest problem facing the venture capital business these days is that we can't seem to stop overfunding businesses. The prevailing sentiment seems to be if its a good deal, let's put in as much money as we can. Well I think that's crazy and I wish we'd stop doing this.

I've got an investment in a really solid company. The management is smart. They've built a business that has a bunch of happy customers and revenues are doubling every year. They've done all this on less than $3 million in total investment. They probably need to do one more round of financing before they've got the business to the point where it can finance itself with profits. We were thinking that we'd raise maybe $4 million just to be sure we had enough money.

Well along comes a competitor who knocks off our business plan. That's allright with me. This is capitalism. May the best company win. But today I heard that this knockoff competitor is in the market raising $20 million. For what purpose, I've got no idea. Maybe they can't figure out how to build a business with less than that. Or maybe the VCs just want to pour a lot of money into this "big winner" they've got on their hands. Who knows why they want to do this, but I think its crazy.

I sure hope our management team doesn't get spooked by all this money their competitor is going to raise. Because my experience tells me that more money doesn't usually translate into a better business. In fact, most of the time more money has translated into a worse business. Sure you need enough to do what matters, but too much money leads to all kinds of mistakes that I expect our competitor will end up making.

Less is more in my mind. I am in the return on investment business. It's always easier to make a good return when you have less money at work. And I think if you look back at the way the venture business operated in 70s and 80s, you'll see that most of the really huge successes were built on relatively small amounts of capital invested. I think we need to return to that model. But its going to be hard if this overfunding craze doesn't stop.

Comments

[Bill G]

I agree. Less is more in this game. Companies with fewer resources learn how to be more resourceful...which often translates into superior execution.

The Oct. issue of Darwin Magaazine published an article titled "What Makes Some Startups Succeed?

The authors write about a study initiated by Crescendo Ventures on the same subject. One of the first findings -- "Companies raising the most capital don't have the strongest chance to succeed."

The article continues "In fact, the research report states, "there is a negative trend in the number of (successful) exits as funding exceeds the average range." Over-funding actually allows companies to follow a flawed strategy for too long, the report points out."

[MattS]

Overfunding often kills companies because it lets them not deal with mistakes. Volatile revenue streams can often to this as well by presenting a mirage of high income.

[John L]

I also agree. One odd thing about many VCs is that they will pour tons of money into a single deal, simply because they have a large fund and need to put their capital to work. I once saw a presentation by a partner at Highland capital that had a really interesting chart showing the average first round investment by major VC firms over the course of the nineties. The number increased from something like $1-2 million to about $8 million! Crazy.

What I find even more peculiar is the flip side of this phenomenon. Institutional investors often will not invest at all in a company unless they can put in at least a few million bucks. This is nuts. VCs, in my opinion, should be more willing to make small ($200-300k) seed investments to get ideas and teams off the ground. By making many small investments they can diversify risk by seeing how budding management teams perform with only a modest amount of capital. In other words, they can seed and weed -- put more money into those companies that make the most of their initial investment. In fact, the VC could demand the right to lead the second round in return for its small seed investment.

Yes, this happens more informally with angel rounds, etc. But I am surprised we don't see it more often as an institutionalized strategy.

I guess what I am saying is:
* Too much money = wasted cash
* No money = wasted opportunities
Like Aristotle used to say back in the (way) old days, the truth is somewhere in the middle.

[MattS]

You might be interested that this applies with political campaigns as well. If you're overfunded at the start this impacts your attitude towards resource utilization in general.

[JayR]

Overfunding was a big problem during the bubble and it is unfortunate that people haven't learned from that experience. There were a lot of investors in the late '90s that put freight cars of capital into companies to try to create a barrier to entry into a particular market segment. Typically, the trajectory for the growth of these companies was not a function of the development of the company's business but of positioning for an exit. It became more of an arbitrage play - time the market rather than grow the business. And even though the IPO market hasn't really come back yet (and will likely never come back to the point where you can really come to rely upon it for an exit strategy), there are still investors who still try to use cash to create a barrier to entry.

You also still see founders out there who have no problem with that approach. Some still believe that their success is measured by how much money they can raise, no matter what their business model may be. It is often very difficult to talk a founder out of looking for institutional or accepting more money than he/she needs when another financing strategy would be more appropriate for his/her particular business. It takes discipline and a clear head to think about dilution and the liquidation preferences that sit on top of the company's capital structure, which can present real issues regarding management incentive when the prospects for the big exit dwindle.

The bottom line is that investors and founders should try to remain disciplined and think long-term in devising a financing strategy for their particular situation.

[henrycopeland]

Two great books illustrating the point that, when it comes to innovation and starting-up, smaller is smarter: Moneyball by Michael Lewis and E-Bay, The Perfect Store by Adam Cohen.

[hugh macleod]

Overfunding i.e. create the "image" and hope that the substance will catch up before the money runs out.

Fred, have you ever been in a situation where the guy asking you for VC has a great idea, but you declined to invest because you just somehow knew that he was more in love with the trappings of success than the actual business itself? I imagine it happens quite a lot.

[JayR]

Hugh, I can give you the lawyer's perspective on your question. There is nothing wrong with a founder who enjoys the trappings of success - it's great motivation. The problem is when the founder doesn't really enjoy doing the hard work in building a business. The telltale sign is when the founder spends more time talking about the ROI and exit strategy than about the business itself. After 15 years of doing this, I have learned to turn down engagements in that situation (although I'm certainly not perfect in that regard).

[Coty Rosenblath]

Nothing substantive to add to the comments above, but I do have to offer what I thought was an amusing comment from a serial entrepreneur I know:

Too much venture capital is like too many vitamins, you just end up p*ssing all the extra away.