Why External Funding Can Be A Distraction
US Venture Capital Investment Surpasses $130 Billion in 2019 for Second Consecutive Year
You can’t be an entrepreneur without encountering numerous ways and opportunities for external funding. This is especially true for Tech startups where there is an entire ecosystem around VC funding. While all forms of funding have their place, there is an unintended impact of the buzz and ease of funding. It is distracting a lot of great concepts.
Say what? Wouldn’t funding help me gain traction?
Funding yes. The chase for funding? Not necessarily.
The problem is many CEOs dedicate a significant amount of their limited time, talent and resources chasing funding. These are precious cycles, often early in the life of a business, spent on investor decks, pitches and travel. All too often this has been undertaken in place of customer growth and interaction, operational assessments, sound financial plans or focus on being profitable.
What becomes particularly concerning about the investor chase is the vanity of it and how that impacts businesses. CEOs may wind up focusing on metrics they think investors want, or hiring roles that will inspire investor confidence, all at the expense of their own bottom lines. These same bottom lines could be fueling growth. That growth and revenue that might actually help you more easily attract investors – certainly a lot more efficient than the time spent on developing investor decks.
In addition to the effort it takes to raise capital, you’ve now entered a place where investors are focused on their returns. Don’t take my word for it, Mark Cuban who literally has a TV show on investing, says it very pointedly.
“I think the biggest mistake people make is once they have an idea and the goal of starting a business, they think they have to raise money,” Cuban said on Thursday’s episode of Seacrest’s podcast “On Air.”
“And once you raise money, that’s not an accomplishment, that’s an obligation, because now, you’re reporting to whoever you raised money from”– Mark Cuban via Inc.com
The Financial and Energy Drain
Recently a CEO made a pitch for external funding. Their pitch and metrics were fantastic. They claimed 80% Gross Margin on their products, and that they had more customers than they could support. They asked for a 6 figure pre-seed round of funding. This was a red flag. Their figures claimed to generate enough operational cash flow in 3 months to fund their entire round. If the business is that cash positive, why did they need external funding?
THE #1 JOB OF THE CEO: CAPITAL ALLOCATION– Fortis Capital
Experience tells us that there are a handful of ways an entrepreneur misallocates funds:
- The CEO is spending the money it all on non business related expenses
- The cost of time and overhead (unneeded employees, marketing expenses, travel, etc) of the pitches is so much of a drain on the bottom line they cannot self fund
- The books are not accurate or their external cost factors (loan repayments, etc)
In this specific case, #2 seemed to be the issue.
Even when the financial drain isn’t a blind spot to the CEO, there are a number of CEOs who have addressed investor push back with new hires and leadership. While having the right leadership is critical to both funding and operating companies, it is too easy to get drawn into paying employees (both in cash and in shares, diluting ownership) solely in an effort try to appease investors. It’s also easy to get caught up in what many consider the “opinion cycle”. This is where every VC who doesn’t invest also has an opinion about the business. This can easily become a distraction for CEOs. Rather than sticking to a solid business plan and reacting to the market and the health of the business, they begin to chase ideas for funding or out of fear of “getting it wrong”.
So What Should I Do? When Should I Seek Funding?
How long does it take to raise capital for a startup? Plan at least six months to open and close a round.– Forbes Jan 3, 2019
Before taking on the mission to seek funding, consider the following exercise.
First, take a look at your books and see what your operating and net cash flow numbers are. If these are positive, calculate the number of months you need to get you to your needed investment.
Second, add in the cost of your time to build investor pitches and decks. Even if you don’t pay yourself a significant salary, how much less revenue is the company generating when you are focused on something other than the business? The time to raise funds is typically 6 months. However, if you’ve never raised funds this could take longer. It is much easier to raise funds if you have a proven track record so first time CEOs are going to have a much harder time. This is the opportunity cost of your fund raising.
You should also look at things from the other perspective so as a third step, calculate the opportunity cost of not raising funds. You should consider that this is only relevant if the time to self fund is actually longer than the 6-12 months typically needed to raise funds. The point here is to be realistic so you don’t undervalue your own ability to find, nor undersell the opportunities for your business if you are able to successfully raise funds.
Next, you’ll want to calculate the impact to your short term and long term financial projections of any costs (travel, pitch decks, other team members, new hires) that you’d need to raise funds and/or satisfy investors.
Now consider the ways you could fund the business growth. While VC funding is one approach, it comes with a few considerations. In an upcoming blog post I’ll highlight a number of ways you can fund business growth, including but not limited to traditional VC funding.
If you don’t know your cash flow, don’t yet have financial projects or otherwise are not comfortable with this exercise, chances are you are exactly the kind of business that should spend more time focusing on itself than worrying about investors.
Do I Even Need External Funding?
The answer may be no. This is the best place to be. For one, 82% of companies self fund. So you are actually in the majority if you don’t. Also, you may be able to maintain more control and ownership of your business if you don’t take on external investing.
When Do I Need External Funding?
If you do calculate that it is faster and with a lower opportunity cost to raise funds OR you have a compelling market condition where you should seek funds, then your business is a great candidate to pursue external funding. However, you should still consider the pros and cons of the different funding approaches.
Some examples of compelling market conditions:
- You have or could have competitors where there is a race for market share that would be difficult to win later
- The business model is likely successful, but has a high upfront capital cost. Examples could be the need for costly specialized equipment or deferred revenue recovery like a subscription service
- Bottom line and operating margins would greatly expand through scale
Compelling market conditions should be truly compelling, not driven by impatience.
Ultimately each business individually must determine whether the best use of their leaderships time is in fund raising. At least I’ve laid out a formula to help you determine whether it is truly worth the effort for your company. Despite the fact that I, myself an an investor, I personally believe most CEOs are better served when they are focused on the bottom line to drive growth.