The risks of scaling too fast, too soon

By boris, April 11, 2018

While preparing for some recent LP presentations, we took a close look at all of the companies that we exited in Fund I. There were ten exits out of a total of 20 investments. These were all “early exits” with mostly unsatisfactory outcomes for everybody involved, especially the dedicated and talented founders who had poured their hearts into these companies.

We wanted a better understanding as to why these outcomes didn’t turn out as well as we had hoped. These were all good companies… good ideas, good founders, good teams. So, what happened?

After analyzing the early exits, we realized we could put them into two buckets: the ones that never got product-market fit and the ones that raised too much money and scaled prematurely.

The first bucket is to be expected in an early-stage portfolio. One of the major risks of investing as early as we do, is that the company never really finds product-market fit, and hence can never raise follow-on financing.

But the second bucket surprised us. How is it that a company could have product-market fit, raise very good A and B rounds, have tens of millions of dollars, and yet end up with a sub-par outcome? And, this wasn’t just one outlier – we saw several start-ups exhibit the same pattern.

It all comes down to scaling prematurely. Many of these companies not only raised a lot of venture capital, but also put it to work quickly. And this is understandable. Closing a Series A or B, and that sudden influx of cash, places a lot of stress on a young company. There’s considerable pressure to show results and hence, move fast.

We found that these companies spent quickly in two areas:

  1. Dialing up user acquisition when customer acquisition costs and unit economics were not 100% understood. There’s a risk of aggressively building a marketing and sales organization before really understanding the ideal customer profile, how to acquire leads for these customers and then convert those leads to sales.
  2. Aggressively building up the rest of the organization. And again, this is only natural. When you begin ramping up the user acquisition efforts, you expect higher revenue – and you also feel the pressure to build up the rest of the company in order to support all those marketing and sales initiatives.

There’s nothing wrong with scaling up user acquisition and creating an infrastructure to support those efforts. But the problem arises when you have spent millions on sales and marketing, only to realize that you have acquired the wrong customers (too much churn) or too many customers at the wrong acquisition costs. Then, revenue doesn’t come in the way you expect and the burn is higher than planned.

Most founders then decide that they need to step on the brake, dial down their marketing and sales and make cuts to the rest of the organization to take down the burn rate. Few organizations can recover from that kind of shock to the system and future financing rounds will also be harder as new investors will look at the disconnect between previous capital raised and the current revenue.

What’s the lesson for us all? VC markets are full of “easy cash”, but be aware of the downside of raising a lot of capital. All of that money comes with heightened pressure to put it to work. This leads start-ups to scale prematurely and the outcome isn’t what anyone wants.

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