Stop Using Funding as Market Validation

It drives me mad when I hear startups use the fact that one of their competitors received €X Million in funding as market validation. Customers are a measure of success, so is revenue, so is profit. Funding is not.

Investors put money in high growth companies because they expect a high return but they also accept a high degree of risk. A typical Series A VC is hoping that 10% of their investment will be a huge success and a further 20-30% will return their money. The remainder are going to fail. So on an investment basis they expect that only 1 in 10 companies will achieve their ambitions.  

If you use funding as a measure of success you will be wrong 90% of the time. Being wrong 90% of the time isn’t good.

No one should set up their company for the purposes of attracting funding. You take on funding as a means to achieve a much larger ambition. Funding is a vanity metric. It is a metric that people use to make themselves feel important, to boast about and to intimidate others. But funding is nothing to be proud of, it is what you do with the funding that matters.

You Can’t Spend All The Money you Raise (or at least you shouldn’t)

Everything takes longer and costs more than you think it will. However, everyone should know this already and most companies allow for this to degree (not nearly as much as they should do) and I’ll write an article about this at a later stage. However, this post talks about the fact that you can’t spend all of the money that you raise and therefore you need to raise more money – confused yet?

When you raise funds you do it to invest in your company. As you invest you increase the company’s cost base (salaries increase, you move offices, etc.).  As your cost base increase so does the buffer of cash you need to ensure you can meet those cost without interruption (failing to meet payroll is a very bad thing).

Let’s say you raise €2 million to grow your software company. A few programers here and a sales team there and before you know it you have a payroll of €150K and a total monthly cost base of €200K. Now cast you mind forward to when you’ve scaled the company and your total cost base is €200K a month. Just how low would you be willing to let your cash balance go or are you willing to run it all the way to zero and risk bankruptcy? 1 month? 2 months? 3 months?

If it’s 3 months then you only have €1.4M to invest in your company not the €2M that you actually raised. The remaining €600K is going hopefully sit in your bank account to protect you from the possibility of not making payroll. You can’t spend all the money you raised.

There are loads of reasons why you need to raise more than you think but working capital requirements is one of the easiest to quantify and inexcusable to ignore.

Investor & Founder Alignment is a Myth – Maintaining the Fantasy is Important to Both

It’s a common refrain among professional investors that founder and investor interests need to be aligned. The theory is sound – as long as the investor’s interests are also in the founder’s interests then the investor is protected by the self-interest of the founder. The problem is that this theory ignores reality. An investor’s success is only partly dependant on the success of the company whereas the founder’s success is solely dependant on it.

An investor’s success depends on the blended return of a number of investments. While they are generally over exposed to a market segment, they have their risk diversified within that segment. The founder’s return, on the other hand, can be thought of as binary. They either lose or they win, and there isn’t much of a middle ground.

I’ve seen this innate misalignment between investor and founder cause problems several times. Generally it only happens at the extremes – when the company is going very well or very badly. These are the moments where alignment matters most, as misalignment can come at a huge cost to the founder or investor.

Where the company is doing very well it often makes sense for an investor to increase the company’s chances of failure but also increase the potential returns. For an investor managing a portfolio this is a sensible action. As long as they increase the potential return by more than the chance of failure then the value of their portfolio improves. For the founder, with a binary outcome, this makes little sense – they should be more focused on minimising the chance of failure.

Example: Company ABC is worth €20M and the investor and founder own 50% each. The founder has no other notable assets whereas the investor has 30 identical investments (obviously a very contrived example). It is in the investor’s interest to try and 10X the company’s value even if there is an 80% chance of failure. Ideally the investor would do the same with every company in their portfolio.  However, for the founders, introducing an 80% risk of failure into their only asset of value is clearly a foolish thing to do.

This is a real problem. Investors have blocked the sale of companies that would have made their founders very happy because they thought a better sale was possible, and founders have pushed through sales that aren’t in investors’ best interests. Investors have encouraged and promoted courses of action to ‘pour fuel on the fire’ of promising companies even when doing so increased the chances of bankruptcy.  

When companies are doing extremely poorly and the only way forward is for the founder to continue spend more of their time in the venture, it’s in the investor’s interest for the founder to continue. The investor doesn’t suffer the cost of the founder’s ongoing investment, but gets to keep their investment ‘live’. Meanwhile the founder suffers the full brunt of the cost of continuing to work at the enterprise. From the founder’s perspective, a dispassionate analysis frequently suggests that shuttering the company would be the best course of action. Once again, different investment exposure results in misaligned interests.

It’s nice to think we stand together and together we fall/succeed but both investors and founders should be working on a different set of calculations and assumptions and recognising that they have different interests.  

Even though investor and founder interests aren’t aligned, it is still in everyone’s interest to pretend that they are. Founders want potential investors to think their interests are aligned so that the investor will put money in the company. Investors want founders to think they’re aligned so they can convince founders to take a course of action that is not in the founder interest.  Normally everyone maintains this fantasy for as long as possible but when things go very well or when the shit hits the fan, make sure you know what your interests are and don’t rely on the other party.   

Your Company isn’t ‘Alive’ and it can’t ‘Die’ – But You Can

I recently advised a young entrepreneur to shut down his two year old business. This was despite being able to raise enough money to ‘survive’.  His company was generating revenue but was in a very small sector and the available financing wasn’t going to be enough to pivot his way out of it. It was only going to lead the entrepreneur back to the same situation in 6 – 9 months, except this time he’d be that much older.  It was the very essence of surviving for survival’s sake.

What struck me the most about our conversation was our use of language and how it didn’t serve us well. We talked about the company as if it were a living, breathing entity. We used words like ‘alive’, ‘survive’, ‘keep alive’, ‘time to live’ and ‘die’. This use of emotional language automatically put us in place where talking dispassionately about the business was difficult and if ever there was a time where dispassionate analysis was needed it was then.

I particularly remember the entrepreneur’s response to me telling him that the small amount of money he could raise wouldn’t get him anywhere except back to the same place he was. “Well it’s better than being dead” was his response.  

This anthropomorphizing of his company was automatically leading him to the wrong conclusion and if we continued to use language that suggested his company was ‘alive’ it was going to be close to impossible for him to accept that his company should be shut down. As humans, we find the ‘death’ of something to be tragic. However shutting a company that’s not going anywhere isn’t tragic – the founder continuing to expend more of his limited human capacity on it is.   

A business isn’t alive – it’s not even a natural thing, like rock or stone. It’s an artificial construct and it can’t be alive, dead, surviving or any of the other things that are the primacy of living things.  The only thing that’s alive about a company is the entrepreneur and the people working there. Use of language that suggests otherwise doesn’t serve founders.

It may serve investors but more on that later.