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Controlled burn: the perils of raising too much investment

Written by Josh Russell on Monday, 03 November 2014. Posted in Investment, Finance

Whilst it’s tempting to take funding whenever it’s available, it’s worth considering that the startup that burns twice as bright burns half as long

Controlled burn: the perils of raising too much investment

With so much attention paid to the paucity of funding available for startups, it’s more common to hear people rejoicing they’ve received investment than lamenting for raising too much too soon. When a startup is hungry for capital, it can be tempting to take any and every offer that comes its way but this isn’t necessarily going to be the best tactic for growing a healthy business. Learning to keep things lean and grow in a sustainable manner can mean the difference between an enterprise that goes the distance and one that falters all too soon. 

It’s not hard to understand why startups rarely feel able to pass up a funding round. “If you take it from the point of view of a startup, raising money takes up a huge amount of time, it’s a massive distraction to the senior management team and, if a cashflow crisis happens, it can be completely catastrophic to the business,” says George Whitehead, venture partner manager at Octopus Ventures. Inevitably, given the unpredictable nature of entrepreneurialism, one can never be sure what lies around the corner and so to some it can seem imprudent if they don’t take on funding when it’s available. “There’s a big incentive to say ‘actually if the opportunity’s there, I want to grab it’,” he says.

However, it’s not just about shoring oneself up against potential disaster; often for startups getting more investors on board helps to demonstrate the fact that others have faith in the project. “Sometimes people raise money as a kind of endorsement of what they’re doing,” says Alex Cheatle, CEO of Ten Group, the lifestyle concierge and loyalty company. “Even if they say ‘no, it’s because we’re really going for it; we’re in investment mode’, sometimes people really raise investment to meet that emotional need.” But whilst external investment appears to offer a clear validation of the direction a startup is moving in, it’s not the best marker of success and is far from a sensible motivation for giving away equity in one’s business. “It’s a really poor reason to raise money because the best endorsement of what you’re doing is getting paid by a customer, not getting investment in from a VC,” Cheatle continues.

The rewards of a successful investment round are plain for all to see. But sometimes it’s not easy to recognise the problems a startup may be letting themselves in for if they try to cram in too much investment too soon.

First off, it’s important to remember that you don’t get something for nothing. When a company is still in its infancy, trading off significant amounts of equity for a comparatively small amount of money isn’t the smartest move. “It’s important for entrepreneurs to keep enough skin in the game,” says Olga Nuryaeva, co-founder of Lenstore, the online contact lens retailer. “By giving too much away in the early investment rounds, entrepreneurs may find that their share in the future success is simply too low to motivate them to give their best.”

But there are subtler risks involved in raising investment when it isn’t needed. Sometimes being flush can prevent a startup from thinking objectively about its financial priorities and it’s easy for an enterprise’s burn rate to creep up in line with its cash reserves. “Having excess cash can lead to lazy thinking,” comments David Richards, CEO of WANdisco, the big data company. “The safety net it affords can dilute the need to think critically about where the money is going.”

Part of this is down to the fact that when an enterprise raises money there is suddenly an increased expectation for it to be putting its new funds to work. “It’s tempting to start spending as soon as you get investment,” says Nuryaeva. But whilst it can seem like any expansion is good expansion, it’s better to be more circumspect with the funding that has been raised. Gradually allocating it to the projects that will offer the most return will have much more long-term benefit than burning through it all in a 12-month splurge. “Otherwise you may find that only 10% of spend has been used effectively and the young business has wasted money which could have been very useful later on,” she says.

There’s a positive counterpoint to this however. While a glut of funds can sometimes encourage a more blasé attitude towards a company’s outgoings, running on a limited intake tends to teach good habits. “The scar tissue that you develop in a business through growing under your own steam isn’t always pretty but it’s a very effective protection against the slings and arrows of working in a normal business,” adds Cheatle.

Certainly, experience running as a lean and trim enterprise can prove to be a fantastic primer for the trials and tribulations that may come down the line. “The benefits of the discipline and the lessons it gives you do make you ruthlessly focused on bringing customers orders in because that is your lifeblood,” Whitehead says. But there is still a huge value in having funding available for judicious investments, whether that be expanding one’s salesforce or developing new tech. “What you really want is money in the bank and discipline to be able to manage that money appropriately and then you’ve got the best of both worlds,” he continues.

Whilst raising investment unnecessarily can destabilise a company long-term, an entrepreneur would still be foolish not to raise when it’s required. “Things don’t always go to plan for these kinds of fast-growth, disruptive, pivoting businesses and they need some flexibility,” says Whitehead. Protecting oneself against nasty surprises and avoiding stagnation, where a company isn’t able to fund necessary expansion due to a lack of capital, means recognising a fair way ahead of time when its the right time to raise.

“A good measure is when you are very confident that a strategy is going to create more back in terms of profit and cashflow than it’s going to cost you,” says Cheatle. An example he gives is if by raising investment one will be able to increase efficiencies or boost profit to the tune of £100,000 a month; this would be £500,000 of venture capital well spent as in the long run it will significantly boost the profitability of the business. “It’s where it’s got to a point that, instead of it being wishful thinking, you can put together a solid business case and utterly believe it yourself,” he explains.

Ultimately, a smart business will raise in line with its requirements, rather than taking on funds just because they’re available. “You can build a successful business without looking to raise finance whenever and wherever possible,” says Richards. “It’s the pressure of having to make ends meet that results in the development of better products – and with it better businesses.”

 

Money to burn

Ten Group

Ten Group is no stranger to the damage taking unnecessary funding can do. “We raised several million pounds back in the dying days of the dot com boom,” says Alex Cheatle, the company’s CEO. “Because we were young and confident and because it seemed like a good time to raise money, we took it.” Inevitably, raising a hefty amount of capital came with the expectation that the enterprise would find ways to put it to work. “We were under pressure from our investors in particular who said ‘we agree that you guys are great; let’s launch into Germany and Australia’,” he recalls.

Rushing into this kind of expansion turned out to be a costly mistake. “It was just the wrong decision,” Cheale says. “We just weren’t ready to roll out.” Ten Group lost a significant amount of capital, as well as a huge amount of management time, before having to abort the expansion. Fortunately this helped the enterprise see that organic growth would give it a more effective and sustainable route to international expansion. “Since 2004 - 2005, we only spent the money that we got in from customers,” he says. “We were able to grow from £3m to £20m turnover and that was very successful for us.”

Whilst raising at the wrong time cost Ten Group dearly, it has learnt from the experience and is in a far stronger position because of it. “First we did it wrong,” Cheatle says. “Then we did it in the old-fashioned way, the ‘eat what you kill’ kind of approach, for which I have huge amounts of respect.” The company is now raising again but with the learnings that come having to really justify how the business spends its funds. “We’re actually backing a model that is very successful,” he explains. “We know how to turn cash into more cash rather than pour cash down the sink.” 

About the Author

Josh Russell

Josh Russell

As editor, Russell is the man in charge of properly apostrophising our publication and ensuring Oxford commas are mercilessly excised. Our digital doyen, he’s also a Photoshop Pro, a dab hand with InDesign and the man to go to if you need a four-hour soliloquy about the UK's best silicon startups.

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