Less money = better companies

Less money = better companies

Entrepreneurs who act like banks by raising huge sums of money opportunistically, or worse, out of pride or false validation, often face unfavorable outcomes.

Growth capital, when used properly, has energized many of the best companies, and handled incorrectly, it has created toxic dependencies and poor outcomes.

The conventional wisdom is that when building a company, more capital means higher growth. But this "go big or go home" approach rarely stand up to scrutiny. Looking at IPOs, well-capitalized companies do not outperform their efficient (lightly-capitalized) peers up to the IPO event and underperform after the IPO.

Raising a massive sum of money is a requirement to join the unicorn herd, but a look at the best outcomes suggests that a well-stocked war chest doesn't correlate with success. In the case of only a couple of outliers (e.g., Facebook and Twitter), heavily funding the best companies is a winning strategy.

For entrepreneurs, though, companies like Facebook and Twitter are not a good model for startups. Unless the entrepreneur is very confident that they are building the next Facebook, they should focus on creating higher multiples instead of higher exit value.

Investors can afford to risk overfunding companies to be a part of the epoch-defining winners, but entrepreneurs only have one shot. The financial math for entrepreneurs is often also worse than it appears. Incremental funding comes with extra dilution, and pre-IPO preferences will favor the investors if the startup's hot streak falls off and it doesn't go public.

Beyond risk, more capital limits the number of possible exit paths. Entrepreneurs leading efficient companies can sell their companies at any point for a healthy return. Heavily funded companies get locked into billion-dollar IPO exits with diminishing returns on capital.

For successful companies, capital is rarely the biggest constraint or the most significant opportunity. Entrepreneurs don't need to raise huge sums to be successful, and it seems that even in the highest upside cases, raising less money leads to better companies. Yet, most entrepreneurs are convincing themselves to take the opposite approach.

Conversely, entrepreneurs at efficient startups (with less funding) often have the same ambition and hunger to build businesses as their enriched counterparts (those with more funding). The efficient ones, however, tend to do a better job. More efficient entrepreneurs are building real businesses with far less risk and likely own much more of their companies. Being capital-constrained to some degree is helpful, not harmful.

Too much raised capital also creates a culture that substitutes cash for creativity and operational discipline. Lots of money allow companies to grow inefficiently, to paper over problems with headcount and spend, rather than confronting value creation.

Having less money forces a management team to make hard decisions early on and to cut off potentially wasteful problems that otherwise could linger indefinitely.

Growth capital is an essential ingredient in the success of many startups, but there are rare times when adding huge amounts of capital is justified.  As an entrepreneur, think about how you would run your company differently if the money in the bank were the last you'd ever get? The answer to that question could make you very happy.

Inspired by: TechCrunch - Overdosing on VC: Lessons from 71 IPOs by Eric Paley and Joseph Flaherty