Why you should be cautious about overfunding your startup

There’s a fallacy that the only way startups can fail is by running out of money. What’s less often discussed are the downsides of overcapitalization—raising too much money.

In my work as a Partner at Bessemer Venture Partners investing in companies ranging from Twitch to Intercom, I’ve seen spectacular successes and major disappointments — many stemming from raising too much funding.

‍

Overcapitalization and undercapitalization

What is overcapitalization?

It’s easy to see why founders take readily available money. They believe they’re de-risking their options by taking the money and putting it in the proverbial vault—but the effect of overcapitalization is that the money gets spent on expenses that wouldn't have been incurred otherwise. Long-term, it can make it harder to build a company that endures and can decrease ownership for the founding team and employees.

Even though it runs counter to popular narratives, founders should internalize this lesson: Raise less money. When you decline unnecessary funding, it intentionally adds a constraint on available resources. It’s going to be harder and more stressful, but it will make you better.

‍

What is undercapitalization?

Undercapitalization is when a business has insufficient funding to operate and expand. An undercapitalized business can arise from various factors, including inadequate initial investment, poor financial management, unexpected economic downturns, or rapid expansion without proper funding.

To avoid undercapitalization, startups need to 

• carefully assess their financial needs, 
• secure adequate funding, 

and implement sound financial strategies, such as a cap table, to ensure long-term sustainability and growth.

‍

How to build a sustainable business

When startups are overcapitalized, they skip over make-or-break moments that make them stronger, such as needing to build the absolute best product to generate short-term sales.

Once you tap into investor money, it’s psychologically difficult to force yourself to make trade-off decisions. An environment where you have a big capital investment is much more enabling than one where you have budgetary constraints—and not always in a good way.

Startups sometimes avoid nailing product/market fit because they have the capital to overspend on customer acquisition, fooling themselves into thinking the fit is there. Sometimes, product/market fit is achieved, but the team never figures out the go-to-market. Having a constraint helps teams develop the skill for building a business that works on its own merits, without the crutch of investor money to keep things alive.

‍

1. Waste less

Successful startups build a profitable business model. By keeping a focus on the business, you also avoid the temptation to overbuild the product, the team, and spend unprofitably on go-to-market activities.

‍

2. Keep overhead light

It’s far easier to manage a team of 10 than a team of 50. When a company’s coffers overflow—even temporarily—it is all too easy to pack different functions with excess staff. There’s a law to describe this phenomenon. Published in The Economist in 1955, Cyril Parkinson wrote: “Work expands so as to fill the time available for its completion.”

It’s similar to money. When you get access to a big capital investment, it’s easy to needlessly expand overhead with expenses such as hiring a team when contractors will suffice, upgrading the office, or spending those marginal extra dollars on ads.

Sometimes it’s a net-positive, as those extra expenses are what help a business scale faster or find product/market fit more quickly. But more often than not, overfunding leads to waste, and the more waste inherent in a startup, the weaker the company that results.

It’s not a hard and fast rule—some very successful startups have spent big and then become profitable as they got to scale. But many others got stuck in a tricky situation precisely because they never separated nice-to-haves from necessities.

‍

3. Avoid costly go-to-market models

When cash is easily available, a common mistake is building a go-to-market model that is simply too expensive for the product or service being delivered. It can mask issues in the product or hides a lack of product/market fit.

That amounts to bludgeoning your way to success, and at some point, the blunt instrument stops working. Your go-to-market model is central to the entire company’s value. In selling products, less is more and the fewer resources you can dedicate here, the more efficient and valuable your company will be. And of course, you can put that extra savings back into research and development.

‍

4. Nail the unit economics

In addition to figuring out GTM models, startups need to figure out sustainable unit economics in order for the business to support itself. Without throwing cash at the problem and pushing out this reality, a business is forced to search harder for a self-sustaining, profitable way to acquire and serve new customers.

‍

More exit options and how to calculate option profit

It’s important to keep your eye on the real prize, and its corresponding reality: involving venture capital will decrease your share of the company—and the windfall from any exit. It’s true that with proper investment, certain ideas can balloon 10x, however, growth takes time, and there is no guarantee spending more will be worth it.

As an example of calculating capital expenditures for business exit options, consider the following hypothetical startup:

• Raises $10 million for an interesting concept valued at $30 million pre-money
• Investors own 25% of the company, and the team retains 75%
• If someone wants to buy the company for $100 million, the team walks away with $75 million and investors see a 2.5X return. Everyone is pretty happy

Let’s look at the same $100 million deal, but you raised and spent $100 million to build the company:

• Raise $100 million over three rounds of funding (a $10 million Series A, a $25 million Series B, and a $65 million Series C)
• After three successive rounds of dilution, the team owns 25%, while investors collectively own 75%
• If someone wants to buy the company for $100 million, all of that goes to repaying investors (who yield a 1X ROI), while the team walks away with nothing

In both cases, you built a $100 million business. For the first founder, they’ve built a company worth 10x the amount of capital raised and made $75 million in the process. A great outcome.

For the second founder, this acquisition is a soft landing that wipes out any potential returns. The perception of the two is hugely different as well: One is a mediocre sale for all parties, the other a home run success.

The caveat: Let’s say you have grand plans, and you really think you can build a billion-dollar business. Then take the extra $90 million. You’re going to own less, but you have a potential shot of building a much bigger company. But go for it only if you have strong reason to believe the opportunity is there. Don’t go for it just because the quick capital fundingis available.

‍

What are your company’s options for raising money at different stages of product/market fit?

There are two distinct stages of growth, each with a different recommended approach for calculating capital expenditures.

1. Pre-product/market fit

‍In this stage, activities that don’t scale can help identify exactly what your customers want. Expenses are small because the team is lean and you can hold things together while still iterating to figure out what works. In this phase, most companies do not possess a predictable model. You don’t know exactly how much to spend on each aspect of the business, and it’s tough to figure out how much to raise. Estimate what you think it will take to reach product/market fit, plus a buffer of three mistakes. A mistake could take a month to recover, or be more devastating. You might have to retool or rethink a main assumption you had at the outset. Usually, the money required in this phase is less than you think, because you’re mostly focused on engineering and product work. Funds may not be needed until you need to scale a big sales team or do a lot of marketing activities. These activities should come once you have a good sense of exactly what you’re selling, how, and why someone is buying it. Raise just enough to get the product out there and nail product/market fit. With demonstrable success there, you should have no trouble raising more in any kind of environment.

‍

2. Post-product/market fit

At this stage, the calculations around what you need become a lot more clear. If the math works, it is time to go for it, and you can make more informed estimates on how much it costs to scale your startup. Whether you are focused on scaling the sales learning curve, or ramping marketing, you can forecast your needs based on the historical go-to-market expenses (sales/marketing) and conversion rates. Here again, you want to give yourself some buffer. There will always be a lot of experimentation required to scale a startup. Figure out how many experiments you need to do before you’re confident one of them will work, and give yourself room for three mistakes along the way.

‍

What is a down round and should you avoid it?

A down round is a financing round in which a company raises funds at a lower valuation compared to previous rounds. Startup down rounds are generally seen as a negative sign, but there can be strategic reasons behind them.

Sometimes, businesses intentionally raise funds at a lower valuation because down-round financing ensures their financial stability, buys time for strategic adjustments, or helps them gain support from investors who believe in their long-term potential.

‍

Founders are the decision-makers

Ultimately, the responsibility and decision lies with the founders and key executives to make the right decisions for the business, including how to capitalize.

Founders need to perform a dispassionate, neutral analysis—outside of the presence of imminent funding offers—to avoid the pitfalls of over-funding.

Whatever your process for making big decisions as a founding team, execute it on your own time, in your way. Don’t let someone else make such an important decision, especially someone with a vested interest in the result (like a potential source of funds).

Even when capital is flowing, don’t equate fundraising success with ultimate success. As obvious as it sounds, companies are valuable because they create value in the world.