Myth buster - Less VC capital makes it harder

No, it's not harder when VCs investments shrink

You don’t need more capital

Welcome to the third edition of our Mythbusters off-series, where we aim to debunk some common myths about entrepreneurship.

The past decade, like many before it, has been characterized by unique macro-economic conditions. The massive quantitative easing following the 2008 subprime crisis was initially intended to alleviate the liquidity crunch. However, it inadvertently led to an environment of easy money and significant leverage across various sectors. As a result, a new generation of entrepreneurs and investors have grown accustomed to operating with seemingly unlimited funds, often without immediate concern for profitability.

It's important to note that investing and spending capital is often a necessary part of building a company. The issue arises when the rate of increase in costs and losses outpaces growth, and profit margins begin to shrink due to emerging competition.

To illustrate this, let's consider a micro-bakery operating like a tech startup from the 2020s, known for its aggressive cash burn strategies. Initially, this bakery loses one dollar on every loaf of bread it sells. After receiving a substantial investment, it decides to scale up operations, which increases its loss to $1.25 per loaf. Despite this, due to heavily subsidized growth strategies, it becomes the top seller in the market. However, when a competitor emerges, they are forced to reduce their prices to maintain market share, further increasing their loss to $1.50 per loaf. After a few years, they are left with two options: either raise more funds from venture capitalists or significantly hike their prices to quickly cover their losses, especially if their competitors have gone out of business.      

Rethink external funding

You certainly don't want to end up like that bakery. Watch your f*****g costs. A fundamental rule, echoed by successful entrepreneurs for centuries, is to vigilantly manage your costs and ensure that your growth is sustainable.

I often hear entrepreneurs lamenting their need for more cash and liquidity to achieve grand success. However, these are typically companies that exhibit some common pitfalls:

1. Lack of a defined offer or even localized product-market-fit: Many companies increase their marketing expenses without having a clear offer or achieving localized product-market fit. This approach can lead to inefficiency and wasted resources. It's a temptation I've experienced myself, wanting to boost marketing spend in the hope of gaining traction. Find your best paying user, then raise the marketing costs, in that order.

2. Subsidized growth: Some companies often reduce their margins to the extent that they essentially pay customers to use their product, resulting in negative returns on margin growth¹. This strategy is unsustainable in the long term, and need constant external capital to - temporarily - continue.

3. USSR Bureaucracy: Some companies develop a bloated, bureaucratic team structure, akin to a USSR central state apparatus, with excessive management layers. For instance, having one product manager for every minor feature of an application.

4. Dependence on external capital: Companies that are VC-backed, or operating in markets dominated by VC-backed competitors, often fall into the trap of prioritizing growth over sustainability. This reliance can create a fragile business model that's vulnerable when funding dries up.

If you have skin-in-the-game, meaning your own equity is invested in the business, operating on a model that constantly requires more cash to survive is unsustainable. External capital², especially after a few years of the company's existence, should be utilized to foster innovation, explore new market segments, or invest in highly-qualified human resources. It should not be used to sustain a failing business model³. It's better to let a small, unsustainable venture fail early on, rather than propping it up until it becomes a larger organization with potentially hundreds of employees to lay off. Allowing a minor loss early can prevent a much larger catastrophe later, akin to letting small dry wood burn to avoid a massive forest fire.

Investment shrinking can be a bless … if it does not shrink too much

The shrinking of investments can actually bring several benefits to the entrepreneurial ecosystem:

1. Fewer competitors: With less available capital, the market becomes less saturated, particularly with high-spending competitors who often distort market dynamics.

2. Better organic growth: Companies are encouraged to focus on more sustainable, organic growth strategies. This often leads to a slower, but healthier, customer acquisition cost (CAC). Marketing costs return to normal, you achieve more with less.

3. Easier hiring process: With a less frenetic startup environment, it becomes easier to hire quality talent, as the competition for skilled workers decreases. No more silly job offers with useless thousand dollars goodies.

4. Selective investment opportunities: While overall investment might decrease, this doesn't equate to zero investment. Investors may become more discerning, valuing sustainable businesses that have proven their resilience over several years. These companies might find it surprisingly easier to raise funds, as some investors shift their focus from unrealistic 1000% annual growth expectations to more grounded, sustainable growth⁴.

5. Natural, lean cost structure: Operating with limited resources in uncertain times compels businesses to adopt a lean cost structure. Your business is made to meet unpredictable events, and unavoidable crisis that will surge.

6. Prime time for innovation: As many companies struggle just to survive, those that take risks can reap significant rewards. In times of scarcity, innovative approaches stand out more and can lead to substantial outcomes.

And to conclude : Watch your fucking costs.

Love.

1. High acquisition costs are fine, if the lifetime value of your customers is largely compensated

2. Not just venture capital, but also excessive leverage and debt are to blame. Banks should avoid lending to founders who don't have skin in the game. I fear we'll soon see catastrophic bankruptcies in the tech sector. Some founders, knowing they're not personally liable, have even used borrowed funds to repay the high-interest loans they made to their own companies. It's like being on a ship where the captain has both a life jacket and an insurance policy that pays out ten times their salary in case of a shipwreck. And yet, some investors still invest !

3. I remember when an investor from in Mexico told me that “it was a very bad news” my company was breaking even

4. Well, a lot of investors still believe the last decade was normal. They should read “Booms and Busts” or “This time is Different”.