Fundraising is critical for startups since they are rarely in a position to cover expenses from Day One. Oversimplifying immensely, the startup accepts funds and, in return, gives slices of company ownership–or equity–to investors. With many opportunities for funding available, startups could be tempted to continue collecting funds and granting equity after meeting their target. This can be dangerous.
What drives overfunding
For a business to receive funding, its idea, team, and total addressable market (TAM) have to be compelling enough to make investors reach for their wire transfer info. Ideas with high growth potential, or “painkillers,”–because they address consumers’ pain points–are more appealing to investors and more likely to get them interested in investing. Ideas that are good, but may not really solve a need–“vitamins”–will have less potential for growth. The problem starts when founders continue funding efforts as an attempt to camouflage a vitamin as a painkiller. Here’s why this is not a good idea.
How it hurts
In the early days of a startup, expenses are usually low. With investor funding, though, the business can now grow and expand. This means that expenses will increase. However, if the idea that the fundraising is based upon doesn’t fill a critical need, the company will not be able to make enough money to cover the increased expenses. The company will now be spending even more than it makes.
To keep from going under, the company could either:
(1) Cut costs by selling off some of the company’s assets or firing employees, which could make the business look unstable.
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(2) Try to find more investors willing to fund it. However, since the startup is declining, it could find itself without any bargaining power and at the mercy of unscrupulous investors. The company may have no choice but to give in to stay afloat.
Having too many investors
Even when your idea is a painkiller, caution is needed when considering how many investors you accept. Having to answer to many investors can leave the CEO pulled in too many directions. Also, each added investor means more equity being released; the startup’s founders could lose their controlling interest and no longer have the deciding vote in what happens to it.
To avoid this, decide in advance of fundraising how much money your business really needs, and stick with it. Next, find investors who will allow you to work unhindered.
Less urgency, complacency steps in
Overfunding can present another, more subtle, danger to startups. With money no longer a problem, complacency could begin creeping in. The sense of urgency that comes with tight budgets evaporates when investors pump money into the business. Therefore, innovation could paradoxically dry up.
Additionally, with overfunding, valuable learning opportunities are taken away. Living within a budget is no longer necessary, so developing the management skill of handling limited resources carefully is no longer a priority.
So even though having investors pounding down the door is an enviable position for startups, founders would be wise to set limits in advance in order to preserve their ability to determine their own path.