Every startup needs some money to get going. Often founders start with their own funds and then turn to outside sources when they need more. Outside sources may include banks and credit cards, friends and family, angel investors, and venture capital firms. Entrepreneurs are often so enthusiastic about and confident in their startup that they believe money will solve all their problems. However, they should beware of these 4 dangers of raising money.
1. Dilution
Dilution means the founders own less of the company. For example, two founders may own 50% each until an angel investor takes 10% in return for an investment. Now the founders only own 45%. This may not seem like a big deal, but most companies need additional rounds of investment. Each round will reduce the founders’ ownership.
A venture capital firm might take 20% of the company for the next round, which means the founders own 36% each, and the angel investor owns 8%. Founders can be left with a tiny percentage of the company after several investment rounds.
Dilution isn’t necessarily a bad thing. A small piece of a huge pie may be better than a big piece of a tiny pie. The trick is to make sure the investment grows the pie and doesn’t continue to divide the small pie.
2. Loss of Control
Loss of control is related to dilution. In theory, each owner has influence over the company in proportion to their ownership stake. In practice, owners elect a board of directors to represent their interests. When founders start a company, they have complete control. Each new investment gives someone else input into company decisions.
Some investors will require more control than their ownership stake would normally allow. For example, venture capital funds that own a minority share in the company might have a guaranteed seat on the board of directors and veto power over certain decisions.
As with dilution, lack of control isn’t always a bad thing. Investors can (and should) use their influence, experience, and contacts to help the company succeed. The trick is to find “smart money,” or money from investors who can actually help the company succeed.
3. False sense of security
Some teams believe that money will solve all their problems. They celebrate the closing of an investment round as if they have made it.
The truth is that money doesn’t solve problems. An associate of mine often says, “if money will solve the problem, it’s not a real problem.” It might simply give the team more time and resources to throw at the problem, but it doesn’t solve the problem.
Instead, teams should celebrate the revenue and profit growth enabled by the investment.
4. Acceleration in the wrong direction
Investment is to companies what rocket fuel is to spaceships. Engineers and astronauts spend months or even years preparing for a visit to space. They make sure all their plans are solid, and then adding fuel is one of the last steps in the process. The fuel enables the acceleration to the destination that they have prepared for.
What if the engineers don’t know what their destination is? Or what if they know where they want to go, but they don’t know the route to get there? The rocket fuel still has the same amount of power, but it won’t send them to where they want to go.
Entrepreneurs should know what direction they want to go before taking outside money.
The Antidote - Lean Thinking
One of the antidotes to the dangers of fundraising is lean thinking, which I wrote about here. Eric Ries also writes about lean principles in his book, The Lean Startup. Companies should start small, evaluate and test as they go, make continuous improvements, and build slowly.
Outside money should come into the picture only after entrepreneurs prove their ideas and discover the tactics that work. Following lean thinking principles will prevent the founders from being diluted by outside money that is used to discover a strategy. It will prevent founders from losing control of their company before they can figure out what direction they’re going. It will prevent teams from having a false sense of security and from accelerating in the wrong direction.
Question: What are other dangers of raising money?