This myth has been known to rear its ugly head under many different disguises. The many faces of this myth include:
Lack of money is the number one fear of most entrepreneurs. There's an old saying that the #1 job of the CEO is to make sure the company NEVER runs out of cash. (Incidentally, that old saying weaves its way into a Start-Up Myth in Chapter 6, Myths for Managing the Financials of the Growing Company).
This myth, however, is not so much concerned with the logistics of running out of cash (which isn't a good thing for any company), but rather with not having enough money to do XYZ! XYZ stands for whatever it is the entrepreneur wants to do today, and that can change very quickly in today's business climate. So the natural answer for most entrepreneurs is to go and raise outside financing so that they can go do X, Y, and/or Z.
The problem with this myth is that throwing money at a company isn't always the answer; in fact, it often masks serious business issues. With enough money in the bank, the company can overlook important fundamentals like "listening to customers," "being profitable," or "having a well-defined business model".
And worse, raising a lot of money can send the company down a path that is deadly for both the enterprise and the entrepreneur: The Endless Wheel of Financing. This is a particularly pernicious myth, and there's a lot to learn from it.
A not too unusual story
WebMate was a company that was on a fast track in 1996. They had raised $5 million on the way to an IPO, and, when the IPO was pushed off, had to raise $2 million more ... in a hurry! I went to visit them to see if there was some way I could help.
When I went to visit WebMate, they were almost out of cash, and I was amazed at the lengths they had gone to spend money. They had placed ads in the Wall Street Journal (an unusual thing for a technology company, particularly a start-up company with minimal revenues; they had started very expensive marketing campaigns, and had a full management team in which everyone was making $100K or more. All of this was before they had significant revenues from their product!
Though WebMate was a little extreme in how they spent money, the overall pattern is not too uncommon when companies raise significant financing. "You have to invest money," say the advocates of this approach, "before you make any money. If you want to make it really big, you have to invest a lot of money."
I introduced them to a group of investors who did put in the $2 million more, but it didn't take too long for that money to be spent, either. The inevitable result was bankruptcy.
You see, when WebMate raised its first sum over $1 million dollars, they had stepped on the Endless Wheel of Financing ... they just didn't realize it until it was too late!
Welcome to the endless wheel of financing
I once attended a talk by a Buddhist master who spoke of the nature of
reality, life, death, and re-birth. The Buddhists have an interesting concept
called the wheel of life - the endless cycle of birth, death, and rebirth. In
their philosophy, a soul goes from one lifetime to the next, with the purpose of
evolving by learning lessons. The problem is that most people don't learn
too much from their lifetimes, and so they end up going back again and again and
reliving the same kinds of experiences. Eventually, somebody wizens up (becomes
"enlightened") and consciously steps off, and stays off, the endless
wheel. Many entrepreneurs start and run their businesses and get caught up in the
same old patterns. They keep making the same mistakes again and again.
Eventually, some of these entrepreneurs slow down amidst the pandemonium around
them, reflect on their experiences, and see clearly how to step off the wheel.
So how does one get on the wheel in the first place? <<Insert Figure 1: Graph showing standard growth path of VC financed
companies - from 0 to $50 million in 5 years>> If you have just raised at least $1 million dollars, and your company is
still small (under 25 people), then it's likely you showed the investors a
business plan that looks like Figure 1. The standard venture financed plan is to
grow to be a $50 million company in 5 years. In other words, the goal of raising
this type of money is to run like hell and "hit a home run". The cycle begins innocently enough. You invest in sales & marketing, and
in infrastructure. Then you invest in experienced management (who are very, very
costly). Next, you invest in additional advertising and marketing programs to
keep the ball rolling, and then you hire additional people so that your people
aren't overworked to the extreme. Soon it's time to move into better
office space to keep up the image of being a "company that's going
places," so yet even more people will want to work for you. If that's the case, then I think you should be aware that you have a
BIG problem that's creeping up on you very FAST! Did you know that 9 out of 10 companies that put out plans like Figure 1
don't meet their revenue projections? Deals take longer than expected to
close, product development cycles slip, resellers take longer to sign up, and on
and on. Well, that's simply a fact of startup life. Since everyone misses
his or her numbers in this game, that's not the real problem. Well then, what is the real problem, you ask? The real problem, the one that's going to take a bite out of your
flesh, is that you raised your expense structure in anticipation of meeting
those numbers! There was no realistic way to meet your aggressive projections without
spending a lot of money. This is happening at the same time that there
isn't quite as much money coming in as you expected. The result? You have
to sell more of the company in order to keep the company going, or you have to
lay off half of the employees, or you may have to do both! Principle # 3.1: Most companies that raise financing don't realize that
they're stepping on the Endless Wheel of financing until it's too
late. Welcome to the wheel of endless financing ... you are trapped in the
endless cycle of raising financing, raising expenses, and then ... raising
financing, raising expenses, and on and on and on ... This is how many
entrepreneurs end up owning less than 5% of their companies when all is said and
done. It is, of course, possible to be intelligent about raising financing, and it
is possible to stay off the endless wheel. Yet, in order to understand how to do
this, you really need to understand the differences between bootstrapped and
well-financed companies. It took me years of experience with raising and spending Venture Capital
money before I realized that he was right, because bootstrapped companies behave
differently than well financed companies ...
The difference between a bootstrapped start-up and a well-financed
start-up
The first and major difference between a bootstrapped start-up and a financed
startup is that the bootstrapped startup is profitable because it has to be. It
has no choice. More money must come in the door than can go out the door,
because there is only so much money to go around. If a customer complains, the problem has to be fixed ... because if
it's not ... the customer may not pay! If the customer doesn't
pay ... then ... you get the idea. In a well financed company, when a
customer doesn't pay, it doesn't affect day to day operations and it
takes longer for the problem to be fixed. Do you remember the Saturday morning edu-commercials that taught kids about
history, grammar, etc? In one about inventions, Thomas Edison is shown with his
mother, who is trying to sew something, but it has gotten too dark for her to
see. She represents "Mother Necessity," a force that drove Edison to
his famous discovery. Well, "Mother Necessity" also drives bootstrapped startup
companies. Now the bootstrapped entrepreneur bemoans the scarcity of funds because
he/she wants to do XYZ. When the financing is raised, the entrepreneur starts to
do X, Y, and Z by hiring a large number of additional employees. Soon, as the
number of employees grows, they begin to leave earlier and earlier. Salaries go
up. When one person is overworked, another person is hired to help them. Vice
Presidents for each major department are hired ... Why? Because if
it's going to be a $50 million company in five years, you need to have
seasoned management laying the right groundwork to build the infrastructure in
each department. This brings us back to a principle that was first mentioned in myth #1. In
engineering circles, there's an old saying that a task will expand to fill
all of the time that's available for its completion. The start-up
corollary is an important principle to remember whenever you raise money: Principle #3.2: Unchecked, a company will expand to spend all of the money
that it has raised. I know a startup company in Cambridge that spent $30 million and only brought
in several million dollars of revenue in 2 years! They would have been better
off spending the $30 million to buy their own products! At least then they
would've had $30 million in revenues to match their $30 million in
expenses. But, in a bootstrapped company, the entrepreneur can only do X or Y or Z.
This forces the company to prioritize and to only engage in those activities
which have the highest payback and are most important to the company's
success. Ancillary activities are pushed aside. The bottom line is that bootstrapped companies are almost always profitable
or breakeven, while financed companies can afford to unprofitable for an
extended period of time. When you're profitable, you don't need a lot of money and there
will be no shortage of people who are willing to give it to you. As soon as you
spend that money and become unprofitable, suddenly there aren't as many
people willing to give you money anymore. You've painted yourself in a
corner and will accept whatever financing deals are on the table. Well, by now you're probably thinking, This is a grim picture.
Surely all companies that raise financing don't end up that way... Is
there an answer? There is, of course, an answer: Avoid unprofitability like the plague,
even when you've raised financing. This seems like a non-sequitor
at first glance, because if you're going to stay profitable then you
don't need financing in the first place. And if you need to raise
financing, it's because you want to spend more than you bring in, which is
the definition of unprofitability. The appropriate question is, how can you
raise financing to make important long term investments, and still stay
profitable so you don't step on the Endless
Wheel?
How to avoid the "Unprofitability Plague" by staging
growth...
The answer is not so much in the raising of the money, but in how you
spend the money. Entrepreneurs are optimists by nature. They usually only
plan for the best case scenario. The next two principles are critical to
reducing the risk you put yourself and your company at every time you raise
financing. They boil down to planning for situations where things don't go
according to plan. If you follow them, you will be able to survive the
inevitable surprises of the start-up world without losing control of your
company! Principle #3.3: Start with a profitable base and use financing as a staged
investment from this profitable base. Always measure and keep the profitable
base separate from the unprofitable investment. If you are starting with a profitable company, then you can simply view the
financing as establishing an "unprofitable part of the company". The
money that you raise is to be used to get this new, unprofitable part of the
company profitable. You need to monitor how long it stays unprofitable and ask yourself tough
questions about what to do if it doesn't become profitable in a given
period of time. This is extremely hard to do unless you have a strong budgeting
process to monitor the progress of each part of the company separately. You can
instill this culture of profitability within the company by measuring how long
it takes any project to produce a positive impact on your cash flow and
rewarding your employees based on this impact. It is important to make investments, but you need to do it in such a way that
a bad investment will not bring the whole company down with it. By approaching
the financing and the company in this way, you will have an understanding of the
profitability of different parts of your company at all times. When you have a
keen handle on that, you can easily pare down expenses when they get too high in
the appropriate parts of the company rather than take the whole company down the
road of endless rounds of financing. This brings us to the final principle in this myth. Principle #3.2 tells us
that Unchecked, a company will expand to spend all of the money that it has
raised. Your goal should be to become profitable again without spending all
of the money that was raised. This can be done by staying in bootstrapped mode
in all parts of the company, but most particularly, in the unprofitable
part! Principle #3.4: Don't lose the bootstrapped mode of operation, even
with money in the bank. Spend less than your plan calls for. In a bootstrapped startup, every dollar counts. Every dollar spent has to be
vigorously justified along with the trade-offs for spending each dollar.
Continuing this habit is the key to using financing effectively. This will allow
you to build a cushion into your financing, so you don't end up spending
as much as you thought you would. There are those who will tell you that you should invest (i.e. spend) all of
the money if you took the trouble to raise it. But why do you have to spend it
all? It just puts your company at risk unnecessarily and causes you to go out
and raise more financing. When you build your plan for financing, you should build the plan like most
financed companies do, but you should do so with the understanding that you will
still spend money like a bootstrapped company. Measure the progress of the money and challenge yourself to stay profitable,
even with $x million in the bank. Some "wise" people will tell you
that if you have that money in the bank, YOU HAVE TO USE IT, otherwise
you're doing your investors some sort of an injustice. When you hear this advice, you should remind them of the "endless wheel
of financing". Remember that Venture Capital firms invest money in multiple
companies; they want each company to "go for it" big, and some will
make it while others will not. . But you don't have multiple companies,
you only have one, and you have to make sure you don't do anything
that's going to possibly jeopardize your largest
asset!
In Brief ...
This myth should really be restated as follows: Truth: "If only I had more money, I could spend more money" This statement is the one thing that all financing events have in common!
Too often, entrepreneurs who are cash strapped wish for more cash to do the
things they want to do. But when the money comes, they begin to lose the
critical behavior patterns that made them a successful profitable company in the
first place. And slowly, the company starts spending the money in unwise ways.
Little things start to add up, and then suddenly the expense structure seems to
have ballooned out of control with sales taking longer than expected to ramp
up... If, however, you start with a profitable base and add to it in a controlled
manner, you will be prepared for the inevitable things that can go wrong, ready
to return to your profitable base if you need to. So go ahead and raise money - just be sure you spend it intelligently, insure
that every dollar spent brings benefits to the company. The principles resulting from this myth are: Principle # 3.1: Most companies that raise financing don't realize that
they're stepping on the Endless Wheel of financing until it's too
late. Principle #3.2: Unchecked, a company will expand to spend all of the money
that it has raised. Principle #3.3: Start with a profitable base and use financing as a staged
investment from this profitable base. Always measure and keep the profitable
base separate from the unprofitable investment. Principle #3.4: Don't lose the bootstrapped mode of operation, even
with money in the bank. Spend less than your plan calls
for.