To Burn or Not to Burn

Lots has been written about the abundant capital available to high growth, venture-backed companies and the ramifications on round sizes and valuations.  Bill Gurley has adeptly pointed out the rise of a risk bubble, Tomasz Tunguz has reminded us that there are far fewer IPOs than there are large private rounds, and Josh Kopelman has talked about the lack of market-priced equity in “Private IPO” companies.

Less has been written regarding what an entrepreneur should do about this surge in available capital.  Nowadays, companies showing strong growth and promise, even if nascent, have the opportunity to raise ever larger rounds of capital at high prices.  If you’re a founder of one of these companies, should you do it?  Should you raise gargantuan sums and set valuation benchmarks extraordinarily high?  I think the answer really depends on your unique situation.  Here’s a framework I’ve been developing.

Why Companies Should Raise (and Burn) Aggressively

  • Overwhelm your competition. In markets where competition is intense and barriers to entry are low, you risk falling too far behind a competitor who has deeper pockets.  Conversely, if you’re able to raise more than your competitors, you can beat them by locking down key marketing channels, developing distribution and hiring the best execs to help you keep scaling and widen your lead.
  • Leader takes most. Related to the point above, in most tech markets, it really pays to be the market leader.  Valuation tends to accrue in non-linear fashion, favoring the leader.  In a famous example, is now worth over $40Bn while once worthy, but slightly smaller, adversary UpShot sold to Oracle for under $100M.  In some B2C areas, this phenomenon can be even more pronounced given network effects (eg, Facebook versus MySpace).
  • Benefits of scale. In some businesses, the economic benefits of scale seem so pronounced that the faster once can get there, the better.  This is particularly true if the economics of a business are lousy when you’re small and, while you believe strongly in the benefits of scale, you’re not sure the market will always buy into this vision of the future.  If that’s the case, raise the required capital while you can get it, and then prove out the model.  Groupon executed this play flawlessly, but then turned out to have challenges with its model at scale anyway.
  • Build out your TAM. As I’ve mentioned before, one of the keys to a successful IPO and long term value creation is a very large market, so you can grow at a rapid rate for a long period of time.  If you have concerns that your market isn’t large enough to support many years of strong growth, it makes good sense to take heaps of capital while its available to fund both acquisitions that give you new TAM to pursue and internal development to resource “side bets” that may emerge into meaningful new growth areas.
  • War chest for rainy day. The above points all assume that you’ll burn more aggressively with more capital on your balance sheet.  I’ve seen some founders raise more than they’ll need, even assuming a more aggressive spend pattern, and escrow a bunch of the capital for a “rainy day.”  I think this discipline is difficult, but if you can pull it off, an inexpensive insurance policy makes good sense.

Why Companies Should NOT Raise (and Burn) Aggressively

  • Importance of momentum. As a founder, there is no variable more important to manage adeptly than momentum.  The perception of strong momentum is critical when you’re trying to recruit great people, raise funds and convince prospects to become customers.  Similarly, the loss of momentum can have starkly negative effects on each of these dimensions.  When you raise a big round at a very high price, the momentum bar gaps upward.  If you reset the bar too high, you risk the next step not being up, but actually flat or down, causing momentum to erode.  Sometimes more realistic and steadier step-ups in key metrics, including fundraising and burn rate, makes momentum easier to hold for longer, ultimately enabling you to arrive at a better destination. Etsy’s (ETSY) IPO last week is a good example.  The company raised under $100M over the 9+ years it grew prior to its public debut, including a $40M Series F in mid 2012, it’s last private round, at a sub $400M valuation.  The company left plenty of headway to continue its valuation march upwards.
  • Necessity is the mother of invention. Some of the very strongest companies develop strength, resolve and focus early on when resources are scarce.  These qualities can become part of the culture and serve as powerful enablers down the road as competition heats up and stakes get higher. Tableau (DATA) and Splunk (SPLK), both worth over $6Bn as public companies today, each raised far less than $100M before going public as examples.
  • Reduce optionality. The higher you price your company and the more money you take, the fewer good exit options become available.  Price too high and the most likely acquirers may get priced out of buying your company and look elsewhere.  In the absence of potential acquirers, an IPO becomes the only plausible positive exit, but the public market can be fickle and unpredictable.
  • Capital market reliance can be deadly. An aggressive burn rate can become addictive, making it difficult to reduce spend.  Relying on new rounds of capital at ever higher valuations to finance your high burn works great in up markets.  But, when the market turns down (which it eventually always does), you will face a very difficult situation if you need cash to support growth (upon which your high valuation is predicated).

In the absence of a simple recipe, I typically advise founders to raise cash when you can get it, but always have a plan to live off your current round that you can implement if the market turns downward.  If you risk losing leadership in your market, raise and spend enough to protect your position, but not much more.  Finally, make sure your investors are in alignment with your strategy.  If you face unexpected challenges, you’ll need their support more than ever.

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