Why Raising Too Much Funding Is Often Fatal

As the bifurcation of the venture market deepens, founders are faced with an important decision: to raise from traditional boutique VCs or from the platform giants?

On the surface, there’s status associated with the big platforms. Their deep pockets means they can pay over the odds, and bigger rounds at higher prices make for more impressive headlines. To founders, who are staring into a void of uncertainty, it might feel like winning the lottery.

Unfortunately, but unsurprisingly, it’s not quite that simple. Consider this quote from veteran investor, Fred Wilson:

“The fact is that the amount of money start-ups raise in their seed and Series A rounds is inversely correlated with success. Yes, I mean that. Less money raised leads to more success. That is the data I stare at all the time.”

Being on the boutique side of this argument, perhaps Wilson just doesn’t want to compete on price against the big platforms? As usual, data can point to the truth of this question, for those who care to look.

Premature scaling

In 2011, Startup Genome released a report on “premature scaling.” In its effort to understand the major drivers of startup failure, one factor kept coming up: Startups that raised large amounts of capital early would try to build their way to success without properly testing assumptions. By sinking money into untested product development or team expansion, they removed the optionality and flexibility that is vital to innovation.

This mirrors advice given to founders by Y Combinator co-founder Paul Graham:

“The more you raise, the more you spend, and spending a lot of money can be disastrous for an early stage startup. Spending a lot makes it harder to become profitable, and perhaps even worse, it makes you more rigid, because the main way to spend money is people, and the more people you have, the harder it is to change directions.”

Today, as the bar for traction in subsequent rounds has risen so steeply, this is an even greater concern for founders. Coming to the conclusion that you need to pivot (which many successful startups will) after you’ve already burned millions of venture dollars may be too late, as the runway to hit the metrics for your next round grows shorter.

Re-risking

The more you spend, the more fragile your vision becomes. This is a process that venture capitalist Rob Go has described as “re-risking.”

“At each funding round, there is a significant re-risking of the startup, to the point that you are not moving meaningfully down the risk curve for a long long time. And even at a late stage, a mega funding round can bring you right back up to the point of maximum risk.”

The lingering question is why the big platform firms would pursue a strategy that amplifies failure. The key is to understand their priority: to be in the leader in any major category, at almost any cost.

This strategy justifies putting options on as many startups as possible in the areas of consensus, and then winnowing that down to a handful of winners. If you crank the “power law” of venture capital up to 11 by injecting ever-larger sums of capital, owning these monstrous outcomes is worth hundreds of small failures. This strategy, while zero-sum in effect, is effective as long as enough of the remaining value accrues to these winners.

So, be careful about the motivation attached to any capital you may raise. Some investors are out there to support you through a journey of exploration, while others just want to pump you with rocket fuel and see what happens.

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Dan Gray, a frequent guest author for Crunchbase News, is the head of insights at Equidam, a platform for startup valuation.

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Illustration: Dom Guzman