Funding Foundations
A house built on sand is unstable, indeed. A house built on a solid foundation can support itself even when the winds howl, the rain comes, and the floodwaters rise. In business, cash is the lifeblood, and the source of that cash reveals the nature of your foundation.
Building a Rocket Can Be a Sandy Foundation
Fundamentally, venture funding is an accelerant. The intent is to enable a startup to reach a much faster business development and growth trajectory by infusing capital, justified by the idea that the venture-backed business will be able to generate bigger, faster investor returns. However, in addition to the challenges of building a fast-growing business, this approach creates a dependence on continuing infusions of cash until the company becomes self-sustaining – and that comes with certain risks.
For high-potential ventures, using the rocket fuel of venture capital can be exciting and, if all goes well, potentially quite lucrative. In addition to fueling hyper-growth tech companies, venture capital is also used to create businesses that require a hefty investment in product development or regulatory approval to get to the point where you have something to sell. Regulated medical devices, pharmaceuticals, hardware plays, and requirements for specialized manufacturing investments all come to mind. These startups need to demonstrate outsize intellectual property protection, massive market potential, rapid growth, sustainable business models, and other characteristics that justify using venture capital to potentially achieve 10x returns on investment. These businesses justify venture investment because they have the potential to become scalable product enterprises with massive moats. For this approach to succeed, you must find investors ready to bet that what you can build with their money will work out well. This is not easy to accomplish.
Venture capital is like leverage in real estate investing because the venture-backed startup team uses money from investors to accelerate progress rather than be limited to the growth rate the business can fund from its operations or its founders’ own generally more limited resources to accomplish its objectives. The founding team is shooting for the moon at breakneck speed and leveraging the power of freely flowing venture capital to fuel that rapid growth. This creates a heady mix as long as the capital keeps flowing as the startup needs it for the next stage of rocket fuel, often in hopes of building a $1B+ unicorn valuation.
However, the foundation of such a fast developing/growing startup is utterly dependent on its ability to hit aggressive milestones to continue to secure each successive stage of rocket fuel until it achieves the escape velocity of profitability. Because venture capital markets are highly competitive, venture-backed companies are expected to continuously translate that expensive venture capital into valuable milestones at an aggressive rate. Often, the risk profile of such companies is very high as large amounts of capital are deployed in big bets, and many of the critical success factors involved are outside the startup’s direct control.
One of the biggest bets of all is assuming that you can raise that next round. For companies whose growth and existence depend on regular infusions of investor capital, one of those challenges is that the fundraising markets ebb and flow, often in response to unseen “weather systems” far away. What was once a “hot” investment theme fades as newly minted startups proliferate to soak up whatever capital is available, some startups flameout causing investors to focus on the risks they are taking, and even minor stumbles get magnified.
For the startup, this dependence on outside capital lasts until they achieve cash flow breakeven. In other words, until the cash that the business generates exceeds the expenses it incurs to deliver its products and services as it grows. That makes the startup vulnerable to any factors that might make fundraising difficult. Flameouts occur when needed capital infusions are not available, even to promising businesses.
Profit-led Business Building Provides a Firmer Foundation
Real profit-led businesses create their own source of funding through cash generated by their business operations and don’t have to ask anyone for permission to exist. This is the profit advantage.
While unlikely to grow as fast without the fuel of outside capital infusions, businesses that prioritize slower growth in favor of achieving profitability more quickly are much less dependent on the vagaries of the capital markets. A more capital-efficient profit-led approach provides a certain freedom to build the business at a more measured pace without the risk and pressure for hyper-growth or competing with other venture-funded businesses to hit aggressive milestones faster to justify additional investment. Often, this allows profit-led businesses to focus intently on their customers because the way to achieve profitable growth is solely through delighting their customers, without the distractions of hitting milestones that investors focus on, which may not align particularly well with what customers want.
By taking a more capital-efficient approach and prioritizing achieving profitability faster, profit-led businesses tend to make smaller, more measured bets like hiring more gradually, expanding product lines more cautiously, and focusing on efficiency and productivity. This approach to business building can still result in very big, very profitable businesses being created; however, by establishing business models and target markets that can generate cash steadily, the amount of outside capital becomes much more manageable and expands the types of capital available to lower cost options like loans.
Most importantly, as soon as profit-led businesses achieve cash-flow breakeven and then profitability, they reduce risks and the pressure to do sometimes crazy things to secure that next round of lifeblood capital. This provides the powerful negotiating leverage of the ability to say “no” when faced with less than attractive investment or loan terms. For those leading profitable companies, the focus can be on building a strong, steady cash-generating business foundation, which yields more managerial freedom to pursue the business’s strategic interests and serve customers well.
The great profitable businesses that populate the public markets demonstrate that it is possible to grow to a massive scale with prodigious cash generation capabilities over time. These businesses deliver value to their customers, their teams, and their investors. They grow into the scale and resources to make strategic bets based on what serves their business the best, without regard to venture capital market fads.
The Venture Funding Pendulum
One reason I have been reflecting on the tension between profit-led growth and venture-capital-fueled growth lately is because the recent past has demonstrated one of the vagaries of the venture capital market. This pattern is connected to the relative tightness or looseness of the venture capital markets, and results in periodic pendulum swings between investors pushing aggressive growth at practically any cost to focusing on startups that are more capital efficient and seeking profitability earlier. When venture capital markets are flush, there can be a mad scramble to “put money to work” on the latest hot startups with rocket ship stories. Then, when venture capital markets inevitably tighten as some of those rocket ships crash, and economic winds shift, investors may start encouraging their portfolio companies to cut costs and become more capital efficient (a.k.a seek to become somewhat more profit-led). The back and forth can leave startups that are of the currently “out of favor type” to be left out in the cold. If that happens, hopefully, those startups have the ability to adjust to a more profit-led, less dependent on raising capital approach before they fly off a cliff.
The challenge is that these swings in venture capital availability often ebb and flow more quickly than the businesses that are being funded progress through their life cycle. To startup leaders, it can feel like being whipsawed and can really emphasize that there are sometimes differing incentives for investors and founders. The point of this blog is to remind us all of the funding choices we face in building businesses.
