While most startups would struggle due to a lack of funds, the dangers of overfunding cannot be overlooked either. Companies like Katerra, a construction tech firm, and Quibi, a video streaming platform, raised billions yet failed due to strategic missteps when raising more capital.
The startup ecosystem is filled with cautionary steps of premature scaling, loss of focus, and complacency. These are challenges that teams with limited funding are naturally forced to avoid.
In this article, we shall discuss certain disadvantages and psychological challenges that accompany overfunding and can ultimately lead to a startup’s downfall.
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Five risks of raising more capital than necessary
Raising more funds than necessary can unexpectedly derail your startup in several ways, including:
Excessive dilution
In order to raise more funds, you must issue more equity, which will dilute your stake as well as the stakes of early investors. As a result, you may lose control over your startup. This can be a problem if the new investors’ priorities are different than yours.
For instance, corporate venture capital funds may wish to support the development of technologies that would boost their parent company’s offerings and cost economics. In this pursuit, such funds may exert their influence in a manner that delays commercialization, prioritizes research in an extremely narrow sense, and prevents valuation growth so that the eventual acquisition is inexpensive.
Even if such stark differences in priorities do not exist, in the long term, slight differences can impede the decision-making process.If the investors you chose do not wish to actively participate in management, these issues may not concern you. However, even then, the overall returns, for you as well as early investors, would be reduced.
Premature scaling
A Harvard study shows that premature scaling, defined as scaling operations within 12 months of founding, increases the risk of failure by 20-40%.
Founders must note that first impressions can be extremely important. So, if you hastily launch your product and the intended users have a bad experience, it is unlikely to develop traction, and in the worst-case scenario, it will develop a bad reputation through negative word of mouth.
Premature scaling is an even greater risk for tech startups offering online services. Without proper stress testing, it’s difficult to determine how much traffic their infrastructure can handle. These startups must assess how scaling impacts service quality and align their growth strategy accordingly to ensure a seamless user experience.
An interesting case to consider in this context would be Color Labs which was a photo-sharing social media app. After the app’s photo-sharing model failed to impress, it pivoted to a video streaming model. However, video streaming demands significantly higher IT infrastructure, putting Color Labs at a disadvantage. As a result, larger players like Google quickly outpaced the company in this space.
Loss of focus when raising more capital
When founders have limited funds, they will keep a close eye on objectives that are likely to connect to the next funding round. For instance, when you receive limited seed funding, instead of chasing multiple product ideas, you are likely to focus on perfecting your prototype.
At later stages, an example of loss of focus due to excess funds would be running the startup purely as a passion project. The freedom to follow one’s vision is what drives most entrepreneurs. However, you would lose this freedom, much faster than it was gained, if you forget your responsibility to shareholders.
An example of a start-up that raised substantial funds but failed due to a lack of focus would be Katerra. The startup aimed to revolutionize the construction industry through prefabrication. Numerous investors showed faith in its vision by investing $1.6 billion over 12 funding rounds.
The key issue was that Katerra aimed to be a vertically integrated one-stop shop for construction needs. However, construction involves structural and interior design, procurement, licensing, labor sourcing, machinery leasing, and project management. Rather than perfecting a core offering, Katerra spread itself too thin.
Complacency
When a startup has limited funds, innovation and creative solutions are the only way to survive. In such situations, you must be extremely deliberate about your hiring decisions. You would not have the luxury to pursue every opportunity or initiative. This constraint fosters a culture of disciplined decision-making. Your team will constantly push to develop leaner processes and optimize resource allocation.
Such a mindset can get lost if your startup raises more capital than necessary.
An example of a startup that raised too much money and failed due to becoming complacent is Quibi. The investor confidence in this video streaming service was so strong that it was able to raise $1.75 billion before launch. On this app, users could watch various shows packaged in short videos for a $5 monthly subscription fee.
However, the platform lacked shareability and user-generated content, could not be accessed on desktops, and did not have memorable, quality content. As a result, the platform never really made a mark in a space that is now dominated by Instagram Reels, YouTube Shorts, and TikTok.
With the funds at hand, the platform should have been able to solve at least some of the various issues. Unfortunately, the company shut down before realizing its vision of using quality short-form videos to capture screen time in a period wherein lifestyles are marked by dwindling attention spans and busy schedules.
Excessively high valuations
If you were able to raise more capital than needed without issuing more equity, you may not need to worry about dilution. However, in its absence, a different challenge awaits- overvaluation. When a startup achieves an excessively high valuation, two issues occur.
First, it inflates the startup’s perceived growth rate. If future funding rounds offer a lower valuation than what sustained growth would justify, current investors may see it as underperformance.
Second, overvaluation raises the baseline from which you must grow. For instance, if your previous valuation was $80 million and now it is $120 million when it should have been $100 million, any future increases would appear weaker. In the subsequent funding round, a rise to $130 million, despite reflecting an actual 30% growth, would seem like less than 10% growth to investors.
In this scenario, your startup is performing exceptionally well, with its true valuation increasing by 25% in the current funding round and 30% in the next. However, even this strong growth may fall short of investor expectations. As a result, you will need exceptionally high growth to justify the inflated valuation. This will also diminish the future value of your ESOPs, making it harder to attract and retain talent in a cash-efficient way.
Know your value to raising more capital with confidence!
Losing sight of one’s progress is one of the core issues that occurs with overfunding. This issue can manifest itself in the form of premature scaling, exuberant spending, and complacency. The solution is to avoid measuring success by valuation growth or funds raised. Instead, when raising more capital, you must focus on the milestones needed for sustainable growth and treat excess capital as a reserve for navigating potential challenges.
