Why Tech Startups Can't Seem to Stop Flushing Cash Down the Toilet
Investors are pumping more cash into tech startups than ever before. CoinDesk reported that initial coin offerings raised more money through March 2018 than such offerings did in all of 2017. And, according to Crunchbase, angel and seed rounds in Q1 of 2018 nearly doubled from the first quarter last year.
Clearly, the money is flowing into tech, and new startups are eager to secure their share.
Two factors are driving this investment frenzy. First, exponential technology trends show that it’s easier than ever for startups to become billion-dollar companies. Jet, for instance, took less than a year after its founding to achieve unicorn status. And, overall, today's investors see $1 billion as less of an unrealistic goal than as a near-term achievable target.
In addition to this trend of rapid growth, dry powder (meaning reserves or lliquidity) in private equity is at an all-time high. Thanks to macroeconomic trends, private equity holders have massive amounts of capital, and they’re eager to invest that money in yield-generating assets such as tech startups.
Unfortunately, this excess of capital is creating some bad habits in the startup and venture capital worlds. Limited partners may push VCs to invest their existing capital quickly, which then incentivizes those VCs to be less picky about their chosen investments. But too much early money can force premature growth and encourage negative behaviors.
This same trend was rampant in the 1990s, and if something doesn’t change, the market will take matters into its own unforgiving hands.
More seed money, more startup problems
When tech entrepreneurs get too much capital, they typically fall prey to three common mistakes.
First, excessive money enables entrepreneurs to build solutions first and look for problems later. They raise enough to build the solution as they envision it -- unshaped by testing and refinement, as they incrementally bring on customers.
In other words, getting too much too soon can cause entrepreneurs to skip this invaluable step of learning to sell and shape their products around the rejections they'll inevitably receive.
Second, an overabundance of cash leads tech startups to over-engineer their first product releases. Limited capital forces companies to use their resources judiciously. Without a lean startup mindset, founders skip the fundamentals of smart product development; they add bells and whistles to their products instead of revenue to their businesses.
Finally, backed by too much cash, founders go to market before they establish product-market fit. They market their products before they know whether people even want them. They rack up big bills for paid ad campaigns, then discover that their money has gone to waste on something that nobody actually wants.
Success with or without funding
Too much fund-raising too soon in the process often causes problems for the next round of raising capital by forcing a down round. It's a death trap for a young company to raise a lot, then run out of money before hitting the revenue threshold necessary to get to the next round of funding.
So, the message here is: Founders don’t need boatloads of cash to turn their visions into high-growth companies. If you're in this position, follow these tips to prevent cash from turning your promising young company into a bloated disaster:
1. Follow the lean startup philosophy.
Plenty of companies have gone from garage projects to global sensations by working with what’s available and letting the market dictate the next move.
Look at Classpass, the fitness membership company, which initially struggled to find its product-market fit but then exquisitely employed lean startup tricks to nail down its model. Rather than assume its service would catch on with bigger marketing spends, ClassPass overhauled its model (numerous times) based on customer feedback and usage data. The company has now raised more money to expand its operations overseas.
2. Expect a market correction.
Venture and private equity valuations will not remain as high as they are today. Founders who build their companies based on that assumption will quickly find themselves in trouble.
Sometimes, banking on limitless market growth forces a down round. Other times, founders have to sell their companies just to break even. Not even unicorns are exempt from this rule: Apple purchased former $1 billion-valued unicorn Shazam for $400 million.
If you've done something similar and the market dips, you as founder will be hurt more more than your investors due to preferred stock waterfalls.
3. Find a faster path to revenue.
The days of raising money based on monthly active user numbers are over. Investors and their investments cannot survive on activity alone --- that activity must be accompanied by revenue.
For startups, revenue goes hand in hand with business-model scalability. A company needs to make some money now with the potential -- and capability -- to make much more money later, or it will eventually cave in on itself.
4. Ditch the launch party and marketing push.
This seems pretty obvious, but too many founders dump cash on sales and marketing for a product that nobody wants. In the early stages, use your capital to validate assumptions, establish unit-economic models for customer acquisition, experiment and engage with customers.
Don't throw parties just to drive buzz. Build the right product, sell it a few times yourself and then think about more extensive marketing and sales later.
5. Ignore the peer pressures of funding.
Don't compare your seed money to the next startup's. Instead, look at how quickly you can grow the value of your and your investors' equity. No one needs to raise boatloads of money or hire tons of people to lead a successful startup. MailChimp’s CEO is a big believer in bootstrapping, which isn’t surprising: He and his co-founders started the company using their severance checks.
Don’t fall into the trap of gluttony with your startup, either. When you do the equivalent with your startup of slamming down 14 McDonald's cheeseburgers (fresh beef or not) in an hour, things will end poorly for everyone. Companies with more money than sense might survive for a time, but only those with a good business model and good business-building habits -- habits that companies usually form through their struggle to run lean -- will succeed in the long run.