Why you should avoid overcapitalization (and how to get fundraising right)

If you take too much capital and accept a valuation that drifts too far from reality, you can find your business someplace you never wanted to be.

Unicorns — privately held startups valued at over $1 billion — were once rare and remarkable. Today, there are now nearly 900 unicorns stampeding all over the world, collectively valued at close to $3 trillion. Unicorns are no longer the magical, elusive entities they once were, and many of them are, quite frankly, a common quarter horse with an investor-adorned horn attached.

According to CB Insights’ most recent State of Venture report, venture capital financing more than doubled in 2021, to $621 billion, and there was a record 1,556 rounds of funding valued at $100 million or more. In 2021, that number was 620. There is a lot of money flowing into private markets as investors look to balance out their portfolios.

As an entrepreneur, this bonanza of free-flowing capital might sound pretty great. So what if an investor thinks your business is worth more than it is? You’ve struggled to get your business to this point, why struggle more? Why not take as much money as you can while it’s easy? But if you’ve been through it before, you learn the risks of overcapitalization firsthand.

As CEO of my previous company, Appirio, I raised $111.7 million. Today, that sounds like pocket change, but in the mid-to-late 2000s this was a huge amount of money — especially for a professional services business. But we were growing like crazy and wanted the cushion to support that growth. Big competitors were coming into our market and we needed more people, marketing, and offerings to compete. We also had big plans to shake up our category.

Sound familiar?

But looking back, it was more money than we needed, and it became more of a distraction than an accelerator. The pressure to put this money to work drove us to make some “OK, why not?” moves that really didn’t help the business. In the end, we had a great exit, acquired by Wipro, but I learned some important lessons along the way.

If you take too much capital and accept a valuation that drifts too far from reality, you can find your business someplace you never wanted to be. To achieve some of the valuations we’re seeing, execution needs to be near-perfect, and that rarely happens in a growing business. Investors will also expect a return on that inflated valuation. And if you need to raise more capital for an important strategic reason later, valuations in future rounds will need to keep increasing, further inflating the bubble.

This is why, when my team and I founded Tercera, a growth investor for cloud and digital services businesses, we built it around former operators. We are very focused on helping our founders understand the “right size” for capital raises, working with them throughout the funding process to understand how they’re going to use the capital. What’s the right amount to support realistic growth plans and the bumps that inevitably come along in a high-growth business, but also not so much that it distracts or demotivates people with unrealistic expectations?

Here are a few practical guidelines for founders looking to raise capital based on some of the lessons my team and I have learned over the past 20 years.

Have a plan going in

Know how you’re going to use the money before you take the money. If you’re offered money and investors don’t ask about your plan for where and how you’re going to use it, that’s a red flag. Your plan should consider what’s really needed for the next 24-36 months. For most companies, having capital that takes you out five years does not make sense, especially if you’re in a fast-moving business. You simply can’t see that far over the horizon.

At the same time, don’t starve success. If you have a plan that requires a minimum of $20 million to work, it’s fine to raise double that for cushion. If the past few years have taught us anything, it’s that things don’t always go according to plan and that you can’t plan for every eventuality.

Don’t take “f*** you” money

First-time founders may be tempted to pay themselves back for years of sacrifice, but if the plan is to keep building, beware of the lure of the giant payout. Taking a little off the table to make yourself comfortable and make some worthwhile investments is one thing, buying a fleet of sports cars and a mega-mansion to park them in is another. Staying hungry keeps you sharp and focused and enables future opportunities.

Investors and employees will remember who delivered on their promises and who was focused only on helping themselves.

Stop focusing on valuation

Consider the tragic case of WeWork CEO Adam Neumann. In 2019, he was toying with an IPO. WeWork’s valuation was a stratospheric $47 billion dollars, but in the headiness of the moment, Neumann forgot that it was only “pretend” money. Worse, he also forgot that the company’s wild valuation was based on unrealistic growth promises. At one point, they counted literally any American desk worker living in a city with a WeWork space as a potential member. Yet despite the cautionary tale of WeWork, founders get pushed to be the next Adam Neumann by their investors every day.

Your value is your value, not your multiple or your valuation: It’s all about what you bring to market, what you bring to your customers, and what you bring to your employees. It’s about building a business that can thrive over the long term. Remember, valuation only really matters once — when you exit.

The post Why You Should Avoid Overcapitalization (and How to Get Fundraising Right) appeared first on Inc.

Original source: Inc.

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