A pair of thought-provoking posts in recent days has taken opposite sides of the issue of whether start-ups should run “lean” — as a strategy, not simply a function of a tough fundraising environment — or continue to invest heavily in the business before key milestones and points of validation are achieved.
It helps that both posts (here and here) are well-researched and come from respected voices in the venture community, notably Union Square Ventures’ Fred Wilson and former entrepreneur and recent addition to the VC community, Ben Horowitz of Andreesen Horowitz. Not surprisingly, I found much to agree with in both pieces, but I’m more persuaded by Fred Wilson’s arguments that ‘Thin is in’ – both as a path to market leadership and as a strategy to retain sufficient equity in the company to fuel growth later on in the company’s evolution when capital is cheaper and more productive.
Ben Horowitz’ “Case For The Fat Startup” points out convincingly that some entrepreneurs may be overplaying their hand in VC meetings about how lean they can run, as if running lean is the panacea for all that ails the startup community. Many who have been around the start-up community long enough remember the “Get Big Fast” mantra of a decade ago and how rampant spending by companies whose business models were far from well-sorted led to a lot of carnage that took years to unwind. The scar tissue is still very much there. To this day, many limited partners remain leery of returning to the venture capital asset class because of the concern that few truly learned the lessons of the tech bust years.
For this and for a variety of other reasons, it behooves a start-up team to demonstrate to investors its ability and its willingness to be very capital efficient — particularly during the early days when key market validation points have yet to be achieved. Venture investors, particularly in the current environment, have little appetite for investing capital just so a new team can throw things at the wall and see what sticks. Angel investors may be a little more willing to accept that kind of super early stage risk, but even angels are now demonstrating less willingness to back companies at the concept stage.
That said, running “lean” needs to be seen more as a tactic, not as a long-term strategy. As the corporate world learned with the Reengineering fad of the early 1990s (yet another recessionary period), a company cannot cut its way to growth. At some point, companies need to fuel growth to solidify market position, acquire smaller companies with specific assets, add talent, and to do a host of other things critical to achieve market leadership and to remain a market leader. This typically takes capital. Lots of it.
My perspective comes from the software and services world, so much of what I say next would not reasonably apply to very capital-intensive businesses in the clean tech or hardware manufacturing realm where large capital infusions early on would be a requirement. With that caveat, I maintain that most early stage companies founded upon software/services-based business models should eschew raising and spending large amounts of capital until most early stage risk factors have been controlled for, or at least well-understood. For many first-time entrepreneurs, this is hardly a choice as few would reasonably be able to raise large amounts of capital without those factors being addressed, but it is still important to point this out. Messrs Horowitz and Andreesen were able to raise large amounts of capital due in no small part to their successful pedigree. This is clearly the exception and not the rule. That said, there are still examples of companies today viewed by venture investors as extremely attractive and those same investors will try aggressively to fund — even over-fund — those companies just in order to participate in the deal.
The pressure for certain “hot” companies to take more money and deploy that capital is very intense. While this might be seen by some entrepreneurs chastened by the current fundraising environment, quite cynically, as a “nice problem to have” it is still a problem, in my view. There are very few success stories involving companies that burned through tremendous sums of cash while they were still working out their business models, service offerings, and the like. Instead, the reverse is much more common — Pets.com, Webvan, Kozmo.com, to name but a few. Once a company is supporting hundreds of staff and millions in monthly burn, it becomes extremely difficult to remain nimble and to quickly adapt to fast-evolving markets. Even if a company, once it realizes it needs to downsize and adapt, is successful in reducing staff and the attendant burn of those resources, often the shock to the system that such a right-sizing has on the organization is too much to overcome. Morale can plummet and the “blood in the water” image of the company in the talent pool can jeopardize its ability to secure key partnerships or to hire again once better times return.
A final reason as to why most young companies should hold off on executing large financings and ramping up spend in the early days is due to valuation and equity dilution issues. Staying lean typically means less dilution because a company that has yet to sort through key early stage risk factors will simply not command the valuation it will likely command some months later when those issues are clearer for investors. As such, raising large sums when there still exists significant early stage risk will bring with it signficant dilution. From my experience, it is much better to secure large amounts of capital at a later “inflection” point when that capital is seen as fueling specific growth initiatives and not to extend runway while the company still deliberates on whether its business is viable.
In summary, there are clear reasons and opportunities for start-ups to fuel their growth with cash, but those exceptions are, to my mind, swamped by the more compelling reasons for young companies to sort out product/market fit and other points of validation before raising and deploying large amounts of capital. One of the ironies of the tech bust was that the overspending during the frothy years — particularly around communications – radically lowered the cost of launching a business, building a product, and getting that product into the marketplace. Companies that have pitched me in recent years often have a product, customers, revenue, and are sometimes at cash flow breakeven — all before raising a dime of institutional capital. A decade ago it might have cost $10mm to get a company to that point; today, often a company has done that with $300,000 from a few friends and family angels.