Founders Take Note: You Lose Options With Every Dollar You Raise

As early-stage investors, we take our fair share of risks. In fact, that’s what our LPs have backed us to do.

We take many different kinds of risks too, team, product, market, and execution. We also deal with the risks that develop as more capital comes into the business, we call this optionality risk.

It might seem as though a company becomes less risky as capital pours in. In reality, as more capital flows into a company, something very important is lost: exit optionality.

Our companies are probably sick of hearing us talk about the importance of keeping their options open. But it’s true: You reduce the successful exit options available with each dollar of funding raised.

What Money Does to Startups

As venture capital is invested in a company, several things generally happen:

• Expenses increase: Investors didn’t give you $10 million to sit on $10 million. They invested so that you could continue to grow, expand, and iterate on your product. All of a sudden, the money leaves as quickly as it came in.
• Valuation goes up: When money comes in, the company’s valuation typically rises. In some instances it grows to a value that can’t be justified by fundamentals and/or metrics. Instead, the valuation is driven by market dynamics. Many acquirers will use fundamentals in modeling a purchase price which produces a gap between the venture valuation and the exit valuation.

What Happens When Expenses Go Up

Unfortunately, companies usually can’t grow revenues as quickly as anticipated. Their burn rate becomes unsustainable to the point where even more capital is needed, which further reduces exit optionality.

The other option, of course, is cutting expenses, which usually comes in the form of layoffs. Startups often struggle to rebound after a round of layoffs.

Unfortunately, there have been too many great companies that go from raising a small amount of capital and building a profitable, nimble and attractive company to being wooed by venture capital and high valuations. Many time those companies end up failing.

They had the option to stay on their initial trajectory. They could have turned down a round, pushed it back, or settled for a smaller round and ultimately had a higher chance of success for everyone involved.

To help reduce this reduce risk, we advise our profitable companies that they should never increase burn by an amount that would take them more than 120 days to become profitable again if they freeze the spend (usually hiring). Cash is king.

What Happens When Valuation Goes Up

An increased valuation results in a reduction in the number of potential buyers. When companies are valued under $100 million, there are many buyers.

At the $100 million — $500 million range, there is a smaller set of buyers. There are even fewer buyers at the $500 million — $2.5 billion range. With each subsequent round of funding, your pool of potential acquirers shrinks.

Keep in mind that this concept also applies to raising a round of capital. As the valuation increases, the number of venture funds capable of participating decreases.

In any case, raising more capital won’t necessarily net a better return. The data speaks for itself: Founders get the best returns when they sell for less than $100 million.

It bears repeating: We tell our companies to keep their options open.

We would rather see a higher probability of success even if it means a lower-multiple exit. We believe that over time, this approach benefits founders, employees, and our investors.