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Equating funding with success in entrepreneurship

During the past decade massive injections of capital from venture capital firms have created the Unicorn, a term used to describe privately-held companies valued at over $1 billion. Uber, Lyft, Peloton, WeWork are some examples. Interestingly, many Unicorns of the past decade had yet to turn a profit when VC firms poured money into them and bumped up their valuations into the tens of billions. Before Uber’s IPO in May 2019, it was valued at around $80 billion and was still making losses. Thanks to Adam Neumann’s talent at wooing investors, he bumped WeWork’s valuation to an enormous $47 billion. The company was growing at breakneck speed. But it wasn’t making any money. Investing in companies that aren’t profitable is actually the norm in the VC world. Injections of capital are meant to help the high potential startup to grow until it achieves profitability, and is either sold or goes public (IPO). But what impact does the provision of immense capital have on these fledgling startups? Once struggling to survive, they now have more money than they ever could have dreamed of.

The obsession with valuations, to be in the elite Unicorn club, can become a startup’s highest priority. This, of course, makes sense since money is needed for the company to survive, but it makes less sense when a startup chases an arbitrary valuation amount for prestige. Being upset about a $50 million valuation instead of a $100 million valuation seems silly when the company is yet to make any money. Has the flow of ‘easy’ capital from Silicon Valley created a culture that prioritizes valuations over profitability? Are startups becoming too reliant on funding as a measure of success?

Let’s consider a scenario. You’re a CEO of a start-up. You’re getting good press and the company is growing. But there’s one problem. You’re running out of money, fast! In a few months, you won’t have enough money to pay your team. You stay up at night wondering what to do. Will everything you worked for collapse like a house of cards? Then one afternoon you receive a call. It’s from a VC firm. And it’s good news. In an instant you have a commitment for millions of dollars. This changes everything, you think. It even changes something imperceptible to you. Your psychology.

You’re on top of the world. You look in the mirror and think, “Wow! Look what I’ve achieved. Look at how much my start-up is worth!” You go from thinking you’re not good enough to thinking you’re the best in the world. You have the Midas touch. Every decision you make from now on cannot be wrong. Soon the company upgrades its offices from a former abandoned warehouse to a plush skyscraper office. You need to be up there with the other happening start-ups, so you decorate your office walls with expensive art. The team that was once constrained quintuples in size, attracted by high salaries and perks of the job, including free food and coffee.

You’re a CEO of a company valued at hundreds of millions of dollars, so you need to act the part. Only the most expensive suits. You can’t fly commercial either. That’s beneath you. Private aviation only. Some party-poopers warn you to be careful with your spending, but what do they know? You’re the CEO, b*tch! Things can’t go wrong… until they do. The strategic decisions you made weren’t practical or based on data. Instead they were driven by ego and a hubristic belief that you couldn’t be wrong. Investors are banging at your door asking for reports on business progress. You’ve met your targets, right? Your projections said you’d have doubled revenue by this stage. This can’t be happening. No, it isn’t happening. It’s just a minor blip. We’ll fake the numbers, just for now, until we get back on track!

Male and female workers discussing data on computer screens at night.
Serveral high profile Silicon Valley startup scandals have involved falsification of data.

The scenario above has been repeated over and over. But why? The business was sound, the CEO was talented. It turns out that VC funding is a double-edged sword. It isn’t just an injection of money but also a stamp of approval. It’s a sign telling the world that the VC firm believes in the startup; they’ll go on to do great things. It’s also stamp of approval for the CEO. We believe in your leadership and vision. You have what it takes to get the job done. However, upon receipt of the first round of funding, it’s easy to fall prey to the ‘prestige trap’.

Following an announcement of funding is a flurry of press activity for the startup, providing far more exposure than a high-budget marketing campaign ever could. The prestige associated with receiving funding, especially high amounts of it, encourages startups to chase valuations, not profits. One can absolutely happen without the other. Some of the world’s most valuable startups such as Amazon and Spotify failed to make profits until many years after their founding.

The VC funding in and of itself builds reputation and buzz, opening up the door to successive funding rounds. After a Series A round, more investors will want to get in on the action of a multi-million dollar company yet to reach its full potential – importantly, to get that money in before an IPO or acquisition. When a startup strapped for cash suddenly finds itself with millions of dollars, decisions can go awry. The dot-com boom and bust of the late 90s and early 2000s has many examples of profligate spending. Pixelon, the video streaming start-up launched in 1998, spent $16 million on their launch party iBash ’99. This came out of a financing round of $20 million; probably not the best idea to spend 80% of VC funding on a launch party. As it happens, the management decisions to reach ever higher valuations can be in conflict with the decisions required to reach profitability. The startup’s leadership will do anything to meet its goals even if they have to go down the unethical route.

The prestige trap also arises because of shift in the balance of power once funding has been approved. Funding is often equated with success because a VC investment is much more than financial in nature. Once a company receives VC investment, it gains bargaining power. The dynamic of the conversation changes. The company is no longer frantically scurrying for money. Instead it adopts a new position:

You invested in our company. Good decision, but remember this. You, the VC company, are lucky. If you hadn’t invested, someone else would have.

Some companies are self-assured of their growth and don’t let the initial bargaining power in favour of VC firms dictate the rules. These companies don’t accept the first investor to hand them money. They get to pick and choose who they want money from. If the investment amount, and consequently the company’s valuation, isn’t enough, the investor is rejected. Also VC firms compete with each other to discover and invest in the next unicorn. If one VC firm feels it will lose out to its competitor, the start-up has even more bargaining power. At face value the VC firm appears as this all-powerful entity that gives life to the weak start-up. However much like in any other industry, VC firms lose out to other firms, make mistakes and get rejected by startups.

And ultimately, while entrepreneurial success is often associated with successful VC funding, it’s worth remembering that funding is little more than a business decision. When Instagram was growing rapidly at the beginning of the 2010s, competitors tried to take away some of IG’s shine, most notably PicPlz. Tech history shows us that companies can serve the same purpose but have very different trajectories. Examples include Reddit and Digg, or YouTube and Dailymotion. Venture capital company Andreesen Horowitz invested more money into PicPlz after it had already invested in Instagram. History would prove that VC funding and success don’t always go hand in hand. PicPlz shut down in 2012 and Instagram is one of the most downloaded apps of all time.

And so, while VC funding continues to be a cause for celebration among cash-strapped startups, equating it with long-term success isn’t always wise. In fact, rejecting investors even if they have deep pockets, can be seen as a practical move if their values don’t align with those of the startup. Bootstrapping, which refers to entrepreneurship with limited external funding, is a popular mode of operation among a segment of the entrepreneurial community. Part of the rationale to bootstrap is that the company remains committed to its goals and values over time, perhaps a more important determinant for long-term success, instead of having to give up ownership and control to an investment firm.

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