swombat.com

daily articles for founders

Investment as a cushion or a springboard

I believe new entrepreneurs should not take investment. Here's why.

There are two primary types of investment that I've observed being taken: investment as a cushion, to protect the company from having to focus on short-term revenue generation right away, and investment as a springboard, to help the company grow faster or enable a cash-intensive business model. These can be loosely matched with the Seed and Series A stages of funding, though some Series A are cushion funding, and some Seed funding is used as a springboard.

One might expect me to launch into a tirade about how one is better than the other, but that's not really the case. Both uses are valid. However, cushion funding is dangerous for inexperienced founders.

A cushion from reality

Starting a business with zero revenues and zero funds, you have to do what's called "bootstrapping". As UK entrepreneur Iqbal Gandham (who contributed this swombat.com article) argued on TechCrunch, bootstrapping from zero funds is impossible:

The harsh reality for startups is that you need someone somewhere to pick up a tab for around £50k, which of course could be split over two people, i.e £25k a piece, but still that is just £300 or so pounds less than the average salary in the UK.

However, many people commonly raise this initial £50k (though it's often much less) from their own savings (saving £50k is hard, but hardly impossible, when you're an IT contractor earning £50-100k/year). Bootstrapping, then, is creating a business without taking external investment. When it's your own savings dripping through the hourglass, when every expense matters, you end up, hopefully, being very focused on reaching revenues as soon as possible. Lack of funds creates an extreme awareness of the need for more funds.

However, if you have a nice £100-200k cushion provided by someone else, you don't feel the bite quite so much. Sure, you still have a runway, and it is diminishing, and it is something you need to "think about", but it is far more theoretical than seeing the biggest number in your bank account steadily approaching zero.

One of the biggest things that new entrepreneurs (at least in most of the world outside of Silicon Valley) need to learn is not how to build a product or deliver technical work, but how to run a business profitably. It's all these ancillary tasks, from sales to accounting, finance, legal, marketing, and general business management, that take three years to learn (give or take). That learning is one of the most important forms of progress for the new entrepreneur.

In that context, any cushion which slows down the learning, which delays it, makes it more distant and theoretical, is potentially harmful. Most successful entrepreneurs are the kind of people who thrive in sink-or-swim situations, and investment-as-a-cushion can turn this into a delayed sink-or-swim, and even set things up for a sink: having funds makes you more likely to take on fixed expenses start relying on your ability to spend, which you shouldn't - not until you have a functioning business and/or know what you're doing.

So, my advice to new entrepreneurs is: don't take funding, and if you do, take a minimal amount and spend as little of it as humanly possible.

A cushion from short-term focus

The proposition is considerably different for experienced entrepreneurs. Managing your cash flow, your runway, your fixed expenses, etc, is a very hard lesson to forget. Once you learn how to sell a product that doesn't exist based on a reputation that's only in your head, that's a skill acquired for life.

Many experienced entrepreneurs who could fund themselves take seed funding anyway. However, they don't take it "because they couldn't afford to do a startup otherwise", they take the seed funding because it enables them to put aside the short-term revenue focus for a little while and aim for something bigger and riskier. Once you've learned how much the short-term focus matters to your survival, it's very hard to ignore it. The cushion of external investment enables an experienced entrepreneur to temporarily ignore that pressure.

In this situation, I think it makes a lot of sense to take external investment as a cushion.

A springboard to greatness

Finally, the third case almost exclusively applies to experienced entrepreneurs, since, at least in the sane world outside of the Valley, VCs will pretty much never invest in a business that doesn't have either a proven founder or proven revenues (both of which add up to an experienced entrepreneur).

In this case, funding is required to enable the business to grow much faster than by organic growth alone. This is particularly important in winner-takes-all and first-mover-advantage types of markets. Paypal and eBay are great examples of the first: most people will have only one online payment account, and they'll pick whoever has the most popular platform. This winner-takes-all advantage paradigm is so strong that even with all their misbehaviours, both of those players are still firmly lodged at the top of their respective markets. Worth taking investment to get there first? You bet.

For the second case, looking in the enterprise market, many pieces of software like SAP have huge installation costs. A large SAP installation might cost $200m: $20m in software licences, and $180m in consulting fees to set it up. In a market like this, being the first to make the sale is pretty important, because customers are very rarely going to change platform if it costs that much.

In these contexts, taking growth investment makes sense, because otherwise a competitor who does take that investment will beat you to the post. This type of investment is not at all a cushion - in fact, it makes the fall much harder if you miss, turning a moderate success into a complete failure - it is a springboard, an amplifier of your efforts.

If you know what you're doing and are willing to take the risk, springboard investment does of course make sense.

Conclusion

So, in summary, taking investment can be seen as either a cushion from reality (often the case with new entrepreneurs), a cushion from short-term focus, or a springboard to greatness.

Only the latter two are good uses for investment. If you don't yet know what you're doing, if you feel you need the cushion just to survive, then you probably should not take it.

To conclude, it's worth noting that these arguments apply mostly to the 99% of the world outside of Silicon Valley, where spending tens of millions to build a company with zero revenues for years is not an option.


More from the library:
The copywriting difference
Hot markets and flying turkeys
Fit your product to the right market
Google Analytics Alternative