Springboard to Funding #8 - Too Much Too Young

 
Added Tuesday, February 6 2018

Venture Capital firms get a bad press from many sources, but rarely from amongst themselves. So it came as a bit of a shock recently when Eric Paley, Managing Partner of the Founder Collective in the USA came out and said venture capital is toxic!

His line of argument is quite fascinating. Scaled down from US figures to potential local ones it goes like this:

Imagine a young start-up company with a strong team, compelling product but limited traction ie validation of their business. Exactly the type of business a VC should be looking at. So they invest say £2m, valuing the company at £10m even though their revenue is only perhaps one or two hundred thousand Pounds. So far so good.

However the investors are not doing this for the good of their health. They are looking for a good return which will help make their fund successful and thus allow them to raise their next fund. They are on a tough treadmill. So they would like to see the company worth three times their entry valuation ideally in 3 years or so. 

Now to be worth £30m so quickly, the key is rapid growth. Not profitability, that can come (much) later, it’s all about growth. 

So the company expands the sales team and the marketing budget. Cash burn rate goes up of course, but that’s agreed to be OK as it’s all to get that growth. 

Now if the company, a young start-up remember, has got its business model right, then this investment will lead to more sales. However the model is new and relatively untested. It will need to be refined, tuned and probably changed in the light of experience. But there isn’t time to try out various routes, measure, decide and refine. Instead, and with good funding to fuel it, the company blasts on and blasts hard.

The effect is one of declining instead of improving sales efficiency. Perhaps at the start an investment of £1 returned sales of £1.50 in time. Now, driven by the need to grow rather than refine, this falls to £1 for £1 or below. Sales are still growing of course, which is the agreed aim, but at an increasing cost.

The assumption was that if the company has more capital, it will scale faster. However, if the time pressure is too much then this can be at a cost which can literally kill the company. 

Founders will often believe that the problems can be fixed as the company scales. However in practice this rarely works out, there’s just too much stuff going on and too much pressure for this to happen. The answer of course is to pause the growth, concentrate on fixing the problems and then return to growth in a more sustainable manner. But this means driving a coach and horses through the VC’s hope of backing a spectacular star in their desired timescale.

Looking at the risk finance scene in Northern Ireland, there are some interesting points to draw from this.  We often hear it said that lack of capital is the major constraint to scaling start-ups here, when too much capital too early might actually hide the key underlying constraints in the business model.  When people believe that problems within the company will be fixed at scale, they’re actually more likely to be exacerbated.

What can kill companies is VCs investing on an over ambitious growth plan to make it even more ambitious. Or more likely in NI, investing a reasonable figure but then once invested pushing for growth too early and with too much ambition

To put it another way, capital is a multiplier. This means a multiplier of both the good and the bad. To quote Eric Paley, “The faster you accelerate the engine, the more the car leaks and the greater the risk of explosion”.

Alan Watts is the Director of Capital Match at Catalyst Inc (formerly the NI Science Park).
For more information about Capital Match or to contact Alan, go to capitalmatch.catalyst-inc.org