Startup is full of these chicken-and-egg paradoxes. A couple of years ago, I wrote a post titled You Need $250,000 To Start a Company. The clever twist (debatable) was that I didn’t peg outside investment as the only source of that $250K.
I’ve been building startups and helping build startups for over 20 years. And while I work for startups that have raised outside money, and I advise startups that have raised outside money, these days I don’t even go after an investment on my own unless I can prove, with revenue, that the idea doesn’t need investment to be viable. Chicken and egg.
But I also understand why I’m the outlier here. All I need to do is look at Clubhouse, and its recent private-money raise at a $4 billion valuation — Who wouldn’t want that?
Very few early-stage ventures get funded, and when they do, it’s usually due to an underlying factor, like a previously successful management team or, in the Clubhouse case, some viral phenomenon that investors are trying to exploit to capitalize on a reward with (seemingly) less risk than usual.
Is that a good reason to invest in a company? Maybe. Is it the right catalyst for a startup to seek an investment? Definitely not. Here are four more misguided reasons to seek outside investment and better alternatives for each.
Investment as idea validation
I did this a lot in my early days as an entrepreneur. Then I realized that seeking investment to validate an idea is like a dog chasing a car and not knowing what to do with it when they catch it.
Entrepreneurs are always looking for validation. It could be from peers and advisors as an initial validation of their idea. It could be from early adopters as the acceptance of their product within a specific market. We’re always seeking validation from customers in the form of revenue.
There’s a big difference between customers purchasing the product — and thereby putting in a small amount of money for an immediate return — and investors funding a company and thereby putting in a large amount of money for a later return. That said, both are validation, but only when there’s something tangible to transact.
Customers don’t buy ideas, they buy products. Investors don’t invest in ideas, they invest in execution.
So instead, chase investment as validation of the the execution plan, and to prove that the plan can scale, providing the same or more value at the same or lower cost, whether it’s one customer or a million customers.
Investment as activity
Raising money is hard work. It feels like work. But it also sneakily looks like progress.
This mistake happens innocently enough. I know, because I’ve been there. The entrepreneur will flesh out their awesome idea, cobbling together just enough evidence to prove that the product can exist, should exist, and will sell. Maybe they scrape together an MVP solution that works, maybe they even land a couple of early adopters as customers. None of that is easy to do.
But then they give up an all that hard work and choose another equally, if not more difficult, path. They think, “If I can just raise a seed round, I can afford the talent and resources to make a real run at this.”
Like I said, this is an easy trap to fall into, and most of the time, it happens by process of elimination. Nothing in this world is free, including time from talented people and resources necessary to land customers. Unless the entrepreneur in independently wealthy or can get quick access to cash, this is usually where the dream dies.
No good entrepreneur will give up on their dream that easily, so what they end up doing is taking a few months to physically or digitally knock on every VC door they can find.
Here’s why it’s a slippery slope. For one thing, there are enough doors to knock on to keep a person busy for an entire lifetime. But the real killer is that while the entrepreneur will hear a lot of “no” and “maybe,” they’ll also be told that hearing “no” and “maybe” is OK.
Sure, I agree, but hearing “no” and “maybe” a thousand times doesn’t ever mean you’ll get a “yes.”
Instead, use the same concepts of minimalism that got you to an MVP to trim down the idea and the execution to something that can sustain itself. A startup doesn’t need to care about going from 0 miles per hour to 60 mph. The story gets written between 0mph and 10mph and 20mph and so on.
Think about all that hard work you were going to spend to launch into the stratosphere and use it to just get to the next level.
Investment as market awareness
Here’s an easy assumption to make:
- Startup comes out of nowhere, let’s call it a dorm room or an incubator or even some kind of contest.
- Startup raises a couple million dollars and gets a story in TechCrunch.
- Startup immediately sells tens or hundreds of millions of dollars worth of product.
This is mostly a fable. It absolutely happens, but at a low enough frequency that it’s almost identical to winning the lottery. One would never describe waking up each morning and buying scratch-off lottery tickets as “their job,” but somewhere the stretch from lottery win to press win gets made.
I’ve been there. I’ve even gotten tons of press for some of my startups. Didn’t do much of anything to the top or bottom line. The number of people who read TechCrunch and other stories about companies landing investment is incredibly small. The number of customer prospects you need to reach is incredibly large. The math just doesn’t work.
Furthermore, you don’t want to reach people who want to invest in companies, you want to reach people who want to buy what you’re selling.
Instead of chasing initial investment as the springboard to future sales, chase initial sales as the springboard to future investment. Again, the chicken-and-egg nature of startup also dictates that the companies most likely to land investment are the ones least likely to need it to remain sustainable.
Investment to accelerate when there’s nothing to accelerate
Another common trap entrepreneurs fall into is something I call the magical multiplier.
When a startup is able to close a number of one-off sales to build a modest customer base, it’s easy to think, “If I can land these customers on my own with my limited time and resources, think of how many I can land with some capital?”
This is actually a pretty good assumption. Where it goes off the rails is when the entrepreneur turns a linear multiplier into an exponential multiplier for no good reason.
The resources-to-revenue equation usually works like this: You take the profits and the projections from current sales and hire an additional resource. That resource provides a bump to sales, hopefully more than double, because they should be dedicated to selling. But eventually, as you add more resources, you start to see diminishing returns for each new resource until you level out.
If you’re starting from a really low or even modest revenue number before you add resources, you’ll wind up in a death spiral pretty quickly, where costs start outweigh sales. It doesn’t matter how much “dry powder” you raise in an investment, eventually that runway disappears.
Instead, once you independently find the formula to ensure a 10x or more revenue return for each new resource you bring on, start chasing investment to fund longer sales cycles to seek larger partnerships instead of additional individual sales. That way when the linear growth hits a ceiling, you have a plan for exponential growth already in execution.
As you might imagine, all the wrong reasons to seek investment are rooted in starting the fundraising process before the business is ready to capitalize on the use of funds. These are strategic decisions that can move any startup from the non-investable category to the investable category.
The great thing about this strategy is that the longer you can wait to raise capital, the better chance you have to scale, and the more of your company you’ll end up keeping.
Joe Procopio is a multi-exit, multi-failure entrepreneur. In 2015, he sold Automated Insights to Vista Equity Partners. In 2013, he sold ExitEvent to Capitol Broadcasting. Before that, he built Intrepid Media, the first social network for writers. You can read more and sign up for his newsletter at www.joeprocopio.com
If you want more direct advice and answers, look into Teaching Startup.