“Money kills startups”
Money kills startups is what has become a blunt saying among our angel investors. In a nutshell, it means that funding under the wrong circumstances does more harm than good to a company, and can even get a company ‘killed’.
How funding is supposed to work
Before startups get funding, expenses are usually low (not much money there that could be spent anyways). Ideally, some revenue is generated, and the bottom line is about breakeven, with slight losses or slight profits.
If a startup grows organically, entrepreneurs take money from revenue to invest into expenses, which will then grow the revenue, which will then generate more money for more expenses, which will then grow the revenue further, and so forth. This will usually take quite some time.
With external funding, a company can grow much faster. The logic is that instead of money generated from revenue, investors’ money is used to invest into expenses. Unlike with organic growth, the money available is usually more, so revenue is supposed to increase more and faster too. A company can grow to a big size within years, and not decades, as it might take with organic growth.
So far, so good.
How funding turns into a ‘death trap’ where money kills startups
Why do we say money kills startups? For a company to be viable, revenue must be at least as high as expenses (= breakeven). With funding, expenses are increased upfront, so the company slides into having operational losses. This is supposed to be temporary, because, with the expenses (mostly spent on growth such as marketing), the revenue is supposed to increase too. By the time the funding is used up, revenue should have at least ‘caught up’ with the expenses, or be even higher. Then, the scaling of the company went well.
Throughout this article, I will continue using revenue as the key to measure performance (vs. expenses). However, this article applies equivalently to companies that don’t have revenue, but where founders and investors agreed to use e.g. user base or no. of transactions as key KPIs to measure performance. To scale, the same rules apply: if monthly expenses are being increased 10x with the funding received, e.g. no of users are expected to increase 10x too, or hit a certain milestone which makes sense. At the end of the day, expenses vs. performance must make sense.
The dangerous part lies in expenses shooting up,
but the performance failing to follow through!
In reality, the scenario observed often looks a bit like this:
- Funding comes into startup
- Monthly expenses are increased to a higher level
- Money from funding is used up
- Revenue didn’t catch up enough to match the expenses
- Operational Cash flow is negative/losses
This scenario is what we call a ‘death trap’ where money kills startups. With the first round of funding used up and revenue that did not increase enough to cover expenses, the company cannot sustain itself. Immediate actions are needed, or the company will run out of cash.
Once trapped, it is hard to get out
In this situation, there are two options not to go bankrupt/run out of cash.
First, you could decrease your expenses back to a lower level, so your revenue can cover. This might work in theory, but in practice, it is not that simple. It means that you, for example, have to fire staff or move from your new and big office back to a smaller office. The effect on your reputation in the market will be devastating, and worse, it will affect the confidence of your team & staff. It signals that the company is on the way down. Even if you only fire one employee, you can probably expect that another few will start looking for a new job too. Panic on a sinking ship.
Second, you could raise more money to cover the negative cash flow and give the revenue more time to grow. Possible, but you are in a bad situation to do that:
- You are under time-pressure. Funding used up and still negative monthly results mean you need cash flow immediately. This reduces your bargaining power.
- The confidence of investors will be low. Your revenue couldn’t catch up to match the expenses – does this mean more funding will again increase the expenses, and the performance won’t follow through again? This would worsen the problem. Investors will see a real risk there.
If you are able to raise money despite the difficult situation, the valuation is likely to be lower than planned. Your revenue didn’t increase as planned, so your valuation will also not increase as planned. Additionally, the two above points (a. and b.) will affect your valuation. And a down round in valuation can have as bad effects as downsizing your business, which is described above.
Again, if you are working on a business model without revenue, this article applies to you as well. Certain KPIs must be met to be able to get the next round of funding. If they are not met by the time the previous funding is used up, the company is stuck in a similar death trap where money kills startups (usually worse, because without revenue, you fully rely on your next round of funding).
So how to prevent being caught in this funding trap?
Validation, validation, validation!
Raising money for growth means you have tested your business model, and you have validated your product, your market, and your growth strategy! It means you have already found out which marketing or sales strategy is effective for your company! It means you know exactly how you will do your marketing, through which channels, how much it will cost – and you know how much revenue it will generate – based on your validation results. (Make sure you have completed the 3 validation steps: http://www.nexeaangels.com/startup-idea-validation-before-scaling/)
Monthly Cash Flow Planning
Most entrepreneurs are naturally more driven towards visionary ideas and execution, and they typically hate (detailed figure) planning. That’s what makes them great entrepreneurs (and not so great accountants). So it’s ok if planning time is limited, but no matter how limited, make sure you have worked out one single file: Your monthly cash flow plan! It will help you to see the big picture and enable you to spot potential ‘death traps’ where money kills startups from far ahead, giving you more time to find solutions to such problems.
Raise the correct amount at the correct valuation
To be able to do that, you must look ahead – to the point where your funding will be used up. What is the revenue you need/plan to achieve once funding is used up? Subsequently: What valuation will you be able to demand with that revenue next round? Make sure there is a good upside to your current valuation, to prevent down rounds. This way you will be able to receive more funding next round, by giving out less equity.
Make sure you have done your homework on the above three points before raising funds! You can show to and discuss with potential investors too! Good investors will be able to help you by sharing their strategies and experiences. As a bonus: It will surely also increase their confidence in you, as it proves that you work on the big picture plan of your company.