This Is How Overfunding Can Kill Your Startup It's actually more detrimental to startups than underfunding.
By Hamid Ganji Edited by Joseph Shults
Opinions expressed by Entrepreneur contributors are their own.
Accepting funds from investors is inevitable for all most startups unless the founder(s) generate enough money to make up for expenses and spend on future developments, which happens rarely. Every startup needs funds to grow and expand its scope.
In normal circumstances, a startup accepts funds and releases equities in return. Compared to 15 or 20 years ago, startups find it easier to raise funds. Investors are more likely to invest their money in innovative ideas, and the number of venture capitalists has increased. Bigger companies pay billions of dollars to buy related startups, and numerous platforms for fundraising are available.
It may seem felicitous that everyone can collect funds for their ideas and start a business. But this is just a part of the issue. In today's business world, with many opportunities for collecting funds, startups are often killed by excessive fundraising, not merely underfunding.
When the funding target is met, some startups may stop fundraising and return to normal. But the danger is that some recipients may continue to collect funds and release more equities to investors. The influx of large amounts of money into the business tempts many founders to continue the process as long as possible.
Overfunding kills startups more than underfunding
When a business can receive massive sums of money, it proves that the idea behind it has been fascinating enough to make investors write the check - we don't want to talk about the operational part and other stuff involved in a business. The idea is what matters here.
Investors use "vitamins" and "painkillers" tags to identify ideas with high growth potential. Vitamins are those generic ideas that don't seem to be addictive. In contrast, painkillers are ideas that can become part of users' daily routine. Social media apps like Twitter, Facebook, Instagram and Snapchat are prominent examples of Painkillers.
The more a business can collect funds, the more promising it appears to the general public and other investors. Because of this, many founders continue fundraising in order to disguise their vitamins as painkillers. While they may think they are sly as a fox, this tactic may become a death trap for their startup. Here is how.
Related: Think You Need Venture Capital Backing to Start Your Business? Think Again.
The imbalance between expenses and revenue
The first red flag is when expenses exceed the income or total revenue, and the business has to deal with net operating loss (NOL). During the initial phases of development, expenses are not so high, so a part of the total revenue can be allocated to make up for expenses. In this case, the startup can survive, although the founders do not make much profit.
While accepting funds, the business can accelerate development and expand at double speed. This is absolutely fantastic, but it amounts to more expenses, such as hiring more people and investing more money in marketing. The first warning bell rings when there is no reasonable balance between expenses and revenues in financial statements.
In other words, the business is dealing with negative operating cash flow (OCF). The funds came to the company, skyrocketed development, and caused higher expenses. But revenues couldn't catch up with fees. A negative OCF is not something that investors like to see, and can mean that you are in a death trap.
To get out of this death trap, founders usually have two options. The first is decreasing costs by doing things like firing employees or selling part of the company's assets. This can make your business look unstable to investors, and you may lose public trust.
The second option is to find investors who trust you and are ready to inject more money into your business. However, since your company is declining, some malignant investors may take advantage of this opportunity to seize your achievements. In such a situation, you do not have much bargaining power, and you may have to give in to the demands of investors to keep your business alive.
Related: 4 Steps To Help You Manage Your Operating Cash Flow Statement
The danger of adding too many investors
When your idea is innovative enough to convince investors, you will probably be dealing with a lot of these people. Many of them are ready to give you their money to contribute to your business. This is a fixed investment rule all over the world. But it can signal a second red flag if the founder(s) accept too many investors in the business.
When a business has a large number of investors, it becomes challenging to manage them. Sometimes a CEO has to spend all his time keeping investors happy rather than focusing on the company's development and strategies. Some investors expect the CEO to be available at all times of the day.
Involving more investors is equal to releasing more equities. Due to the excessive releasing of equities, the founders may lose decision-making and bargaining power because investors have a significant share of the business. Remember when Steve Jobs was fired from Apple, the company he founded?
Before going to the fundraising stage, you need to decide on the amount of money your business needs to stay competitive. Never go too far in collecting funds. Next, you must find flexible and sophisticated investors. These investors must know your niche, and they should trust you so much that they do not interfere in your work. Boundaries and red lines must be clear so that investors do not disrupt management.
Related: How Startups Can Attract the Right Type of Investors
Less chance for innovation and risk-taking
When massive sums of money are pumped into the business, the founders will have more courage to expand their market and further development. But having an inexhaustible source of cash may hinder innovation. Sometimes the best innovations happen when founders are in financial trouble, and they have to drive the business forward with limited resources.
Another danger of having unlimited resources is that it doesn't challenge management skills. The art of driving forward with a specific budget is an essential management skill that few people have. When resources are limited, managers have to be more careful in their decisions and spend every penny for a specific reason.
