Toxic VC and the marginal-dollar problem

Eric Paley
Toxic VC and the marginal-dollar problem

Venture capital should come with a warning label. In our experience, VC kills more startups than slow customer adoption, technical debt and co-founder infighting -- combined. VC should be a catalyst for growing companies, but, more commonly, it's a toxic substance that destroys them. VC often compels companies to prematurely scale, which is typically a death sentence for startups.

Venture-backed startups face great pressures to perform. The more money raised, the more pressure. One of the challenges well-funded startups face is defining performance. For mostly good reasons, the metric that matters most to VCs is usually revenue growth rate. Particularly for an early-stage startup, this is the right metric, because it is the most basic answer to the question of whether customers care about the company's product and the company has the potential to become a large business.

Growth at what cost?

Unfortunately, growth without context quickly becomes more of a vanity metric than a success metric. The question that needs to be considered is growth at what cost? Few would dispute that growing 3X and adding $10 million in revenue by consuming $1 million in investment is terrific. Likewise, most would agree that growing 3X and adding $10 million in revenue for $100 million in investment is appalling.

Extreme examples are pretty clear; it's the less dramatic examples that become very confusing. Unfortunately, founders and investors aren't having the debate about high-quality versus low-quality growth frequently enough, and the wrong incentives can lead reasonable people to catastrophic rationalizations.

Not all growth is created equal. There is “good growth” that supercharges the business and allows for reinvestment into a virtuous cycle, and “bad growth” that ultimately leads to an unsustainable burn and a masked death spiral. Founders always need to be asking themselves, their teams and their investors: “Growth, but at what cost?”

The peril of “go big or go home”

Investors today have overstuffed venture funds, and lots of capital is sloshing around the startup ecosystem. As a result, young startups with strong teams, compelling products and limited traction can find themselves with tens of millions of dollars, but without much real validation of their businesses. We see venture investors eagerly investing $20 million into a promising company, valuing it at $100 million, even if the startup only has a few million in net revenue.

Now the investors and the founders have to make a decision -- what should determine the speed at which this hypothetical company, let's call it "Fuego," invests its treasure chest of money in the amazing opportunity that motivated the investors? The investors' goal over the next roughly 24 months is for the company to become worth at least three times the post-money valuation -- so $300 million would be the new target pre-money valuation for Fuego's next financing. Imagine being a company with only a few million in sales, with a success hurdle for your next round of $300 million pre-money. Whether the startup's model is working or not, the mantra becomes "go big or go home."

The marginal-dollar problem

After this fundraise, everyone at Fuego agrees to hit the gas, hard. Burn rates jump from $200,000 a month to more than $1 million per month. Experiments that previously were returning $1.50 over time for every dollar invested start to return $1 as money is pumped into scale, but everyone agrees that’s okay. It just means that the customer pays back the cost of acquisition more slowly.

As the investment keeps scaling up, soon only $0.80 comes back for every $1 invested. This poor return is upsetting, but growth is the mantra and Fuego's executives and investors rationalize that this can be fixed later. Eventually, as the company scales further, $0.50 comes back for every $1.

Scale quickly reveals the inefficiency of a startup's model. But does the overfunded startup take a step back and try to fix the diminishing return of investment? Rarely -- until it's too late. The desperation for growth drives the startup to chase the marginal dollar at increasingly greater costs, enduring rapidly increasing losses. We call this "the marginal-dollar problem."

Money has no insights on how to fix a broken business.

 

This develops a habit that is hard to break and the startup will get worse and worse at solving this diminishing returns problem over time. This problem is further exasperated as the return on most growth investments in startups (more features, more engineers, more support, more brand marketing, etc.) are much harder to quantify and take time to evaluate. The burden to grow at any cost drives the startup to accept exceptionally poor returns on its investments.

How the marginal-dollar problem kills you

Companies are pretty good at knowing what their best “hypotheses” are in product, sales and marketing. Each marginal investment, on average, will perform worse than the higher confidence hypothesis that was previously tested. As a company attempts to unnaturally scale, it will make lower and lower confidence investments that will typically perform worse and worse -- all in the name of chasing the marginal dollar. If the startup wasn't trying to triple an already ambitious valuation, they could proceed prudently, reject investments that don't sufficiently return and harden their best thesis into a model that generates high-confidence results. Instead, they end up trying to spend their way out of the hole.

To illustrate this challenge with an example that affects many B2B startups, let’s consider the marginal-dollar problem from the standpoint of building a sales force (this is going to get a bit in the weeds -- bear with me).

Imagine Fuego's average sales rep is getting paid $100,000 and is bringing in $250,000 in sales -- against a $500,000 target. On the surface, this looks additive -- that's still $150,000 in contribution! Except it doesn't account for the cost incurred by product, sales engineering, account management, marketing, support, G&A and all the other teams this employee burdens.

Let's assume the total loaded cost for a rep is $400,000. In a rational world, the cost of these reps couldn't be justified; however, the CEO doesn't want to lose that average $250,000 in top-line growth, despite the cost. If Fuego is largely encouraged to "grow at any cost," losing $250,000 in revenue for each dismissed sales rep isn't an option.

Worse yet, as the CEO struggles with the underperformance of the reps projecting toward missing the annual sales plan by a large margin, that CEO has a choice of whether to focus on fixing the problem or finding a way to close the revenue gap. How could one make up that gap? Hire more of the inefficient reps? Go big or go home! Sounds crazy, but it’s happening every day in the startup world.

Multiply that scenario across dozens of sales reps (and similar underperforming activities on other teams) and you quickly understand how chasing the marginal dollar of growth can kill a business. As the CEO keeps doubling down on a machine that isn’t working, Fuego shows growth, but at a cost that is unsustainable and will lead to its inevitable failure. This is how big venture rounds kill startups.

Capital has no insights -- it is rarely the constraint

Fuego, like many startups, has financed the business on one big assumption -- that capital is the major constraint to startup scale. If a company has more capital, it will scale faster. On this assumption, why not raise as much as possible and go as hard as possible at every startup? Our research suggests that this is rarely the case and that the most challenging constraints to growth and success are rarely capital.

Capital can be used to hide these constraints for a period, but typically capital only magnifies the problems over time. Money has no insights on how to fix a broken business. Great businesses solve these problems first and then use capital to intelligently scale models that are clearly working.

We’ll fix it as we scale

We often hear founders and investors argue that the problems in their companies can be fixed as the company scales. It's not hard to imagine Fuego acknowledging the major problems with the economic engine of the business, but rationalizing that capital can be used to both scale the model and fix the model at the same time. This is very seductive logic, because it allows everyone to keep playing the grow-at-any-cost game while pretending that the problems will get solved later.

Unfortunately, we almost never see this work (for fairly obvious reasons). Scaling a business is hard and nearly always yields less efficiency over time. It takes so much effort to scale without losing yield on nearly any productivity metric that the dream of scaling while increasing productivity is typically a mirage.

Sell the dream, buy the nightmare

From the outside it’s so obvious -- Fuego needs to hit the brakes. Returning $0.50 for every $1 invested cannot be fixed at scale. Unfortunately, in the pursuit of growth, people lose focus on the costs until it’s too late.

Fuego's VCs invested with the goal of building toward a billion-dollar exit. They invested because they believed in Fuego's potential -- why would they go slow? That would be admitting to themselves and everyone else that the investment thesis was invalid. They convinced the partners at their funds that this was going to be the next home run, how can they pause now?


Every attempt at scaling up an inefficient experiment dramatically decreases the likelihood of success for a startup.

The burden on the founders is immense. The founders sold the VCs on this billion-dollar future. How can they get cold feet now that the cash is in the bank, even if the model is broken? If they cut back on the burn, talented people will get the sense the company’s prospects are dimming and leave. Appearances must be maintained!

This works for a while -- everyone is drinking the same Kool-Aid -- until the company needs to ask its investors for more money and inevitably hits the enthusiasm gap. One reason that scaling a bad experiment is so detrimental in the long term is that the incentive to keep scaling doesn’t go away, but the investors often become unwilling to fund it when the company inevitably runs out of cash.

Build a better engine or hope not to explode

Every attempt at scaling up an inefficient experiment dramatically decreases the likelihood of success for a startup. Capital is a multiplier of the good and bad at a startup. A startup can use capital to compound activities that are working or compound activities that are not working. Unfortunately, venture capital often drives founders to do that later. It is incredibly difficult to fix the multiplication of bad mistakes. This is why VC is so dangerous: venture capital incentivizes companies with good vanity metrics to start scaling bad experiments.

Think of your company as a car in a race to cross the country with an engine that's leaking gasoline. The faster you accelerate the engine, the more the car leaks and the greater the risk of explosion. You have two options. You can slow down the car, pinpoint the problem and fix it; or, you can just keep pouring more gas into the tank, hoping for an infinite supply, and accelerate at maximum speed -- all the while praying that the fuel leak doesn't lead to a catastrophe along the way. So the car goes faster and faster with a decreasing rate of efficiency and an increasing probability of tragedy.

So about that warning label, perhaps it should be: “Founders: Burn Responsibly.”

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