Know the size of your opportunity before you ramp expenditure

Only a small subset of companies should think about raising venture capital – those that genuinely have potential to exit for say $100m and can substantially increase their chances of getting there by accelerating investment.  This is an important point as many companies that don’t meet these criteria waste time trying to raise venture.  If you are a regular reader you will know I have made it several times before.

I’m returning to it today after reading Roger Ehrenberg’s post on his excellent Information Arbitrage blog about how some companies make the mistake of committing themselves to having to raise venture capital when they think and believe they have the potential to get the big exit, but when in reality it is too early to be sure:

I think one of the hardest parts of being an entrepreneur is trying to honestly assess the magnitude of the opportunity being addressed and to finance the opportunity properly. For instance, there is absolutely nothing wrong with building a business that in all likelihood is a “small” outcome (let’s say an exit in the low tens of millions of dollars). …  But to be clear, the investment math of these kinds of businesses generally don’t work for venture firms and as such, should be capitalized and operated in such a way that they don’t require venture backing. …..

I frequently see disconnects between founders (“This business is going to change the world”) and venture investors (“Really? You are super smart and I love your enthusiasm but I respectfully disagree”) after a business has already been angel financed. The company has financed itself and calibrated its burn rate on the assumption that venture investment will invariably follow, and when it appears that this assumption was incorrect – doh! Unless you’ve got the right angels, it may be very hard to get additional financing out of your original syndicate. And if you’ve set up the business such that your structural burn rate leaves you between a rock and a hard place, there is generally only one answer left: fire sale/acqui-hire. And this is not what anyone was looking for going into this exciting, “world-changing” investment. This could have been prevented by spending less aggressively, getting to revenues earlier and selecting investors who have the mind-set and resources to support the company during its ugly teenage years (read: Years 2-3). And if, by chance, it really does appear that the company has the chance to be truly disruptive, smart and patient venture capital is always there to support a scale opportunity.

That’s a long quote from Roger’s post, and it’s pretty dense reading (not least because I cut some bits out) but to repeat/summarise his point is that

  • it is hard to know how big your opportunity is until you get into it
  • if you build a cost base that assumes the opportunity is big and you turn out to be wrong you will be in trouble
  • whereas if you keep your cost base down you retain the ability to generate a good outcome for everyone with a relatively small exit and you will always be able to raise venture later
  • therefore you should wait until you *know* your opportunity is big before you scale expenditure

This raises the question of when do you *know*? or more accurately how sure is sure enough?  As Roger says this is one of the hardest things an entrepreneur has to assess. 

One good test is when VCs start believing you.  Another good test is when you have talked to enough people that you know all the counter arguments and have good answers for them.  One pitfall to avoid is not trying hard enough to seek out counter arguments.  Another is to acknowledge a potential powerful counter argument, but not consider it properly, usually with a variant of “yes that might be a problem, but if it is we will fix it down the line, and if you worry about it now then you are focusing on the wrong thing, or simply don’t get what we are about”.

  • Giles Palmer

    i agree that knowing when is right to raise is very difficult. One issue you don’t mention though is the ability of the entrepreneur or core team. There are plenty of examples of companies facing the same or similar opportunity from a data point of view, which subsequently have wildly different success rates. And sometimes the successful ones have not with the original business model – self-belief, conviction, persistence and determination CAN count just as much as the objective data points imho, but i guess these are even tougher to measure and evaluate up front.

  • Hi Giles – yes, I was taking good team as a given. You hit on an interesting point though – getting the right balance between blind belief/determination and being open to feedback is tough. Not least because the point of equilibrium moves as the company matures.
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