Mentor Moment: Over-Capitalization and What it Means For Startups
One mistake that many founders sometimes make is over-capitalizing their startups and taking away future options to exit profitably for themselves and early investors.
It’s important to understand that once you take outside money as an investment, that clock starts ticking on the time frame for a return on that investment.
The goal is to raise just the right amount of money at each funding round as your company grows, which can be easier said than done. If you don’t raise enough capital, the lack of resources can artificially decrease your growth potential, or worse, you run out of cash as you go through multiple pivots. But raising too much capital too early can be just as bad as founders can overly dilute themselves while significantly increasing their burn rate to reach the higher growth metrics needed to achieve lofty valuations that are now expected by their VC investors.
This is what’s called the “go big or go home” growth funding mentality. Now if everything goes as planned, then this works out, but if things don’t go as planned, you could be faced with having to raise more money on unfriendly terms where founders are diluted even more. Or worse, raising a down-round, where your large VC decides to not follow-on but instead reallocates capital to other portfolio companies they have, which are pacing to be billion dollar companies.
In this scenario, even though a company might not ever be a billion dollar company, the sad but common reality is that if the company raised less money earlier on, they could’ve possibly grown to be valued at $50 to $100 million dollars with options to potentially sell and exit profitably for the founders and early investors.
That’s why it’s important to match the stage of funding that your company is raising with VC firms that have the appropriate fund stage focus. For example, the economics of a VC firm with a $400 million dollar fund is such that they have to allocate more capital to each portfolio company, and each company needs to have a growth trajectory to be a billion dollar company for their fund economics to workout and get the returns they promised to their LP’s. Fund size can help determine their funding stage and allocation of capital needs.
That’s why we recommend our startups raise funding based on what THEIR expected growth needs are. Then as the company progresses, re-evaluate the company’s growth potential and raise the next round accordingly. Maybe your company can be a billion dollar company OR maybe it will be a $50 or $100 million dollar company. In either case, raising the right amount of money at each funding round will give you more options, including more lucrative exit potential for you as founders, your employees, and early investors.
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