How Much Should You Raise?

I listened to the Masters of Scale episode on raising money yesterday. Reid Hoffman makes a strong case that entrepreneurs should raise more than they think they need.

The core of the argument boils down to planning for the unknown.

Reid makes the point that tech startups, especially the kind created in Silicon Valley, are usually experimenting with new technology or unproven business models. They must navigate a long path of experimentation to uncover insights which will hopefully lead to product-market fit. They do not know the formula for success. Raising more enables them to continue in the face of unexpected setbacks, give a shot at their Plan B (or "Plans B" as Reid calls them), and take advantage of unforeseen opportunities when they present themselves.

The alternate viewpoint is that you can build successful internet businesses without raising much outside funding. These business are sometimes called 'lifestyle business', but I prefer the term 'cashflow businesses'. They grow revenue incrementally and expand their ambitions according to their means. They are usually operating with understood business models and lower technology risks, and are not necessarily attempting world domination. Example of successful cashflow businesses are Basecamp, Distrokid, Plenty of Fish, and the many listed on Indie Hackers.

An interview with Brian Chesky, Airbnb's founder, towards the end of the episode lists some of the benefits of raising less money:

I think startups raise way too much money. The less money you raise, the more control of the company you keep. But more importantly the more constraints you create. They develop a scrappy culture. The scrappy culture requires you to build more novel solutions, use fewer out-of-the-box software things and you end up just building a scrappy, more frugal, more startup like environment. I would make sure that you give away control grudgingly.

- Brian Chesky

It's important for the entrepreneur to first understand what kind of a business they are trying to build. Some questions to ask are: can this market support a venture-scale business (i.e. what are the size and growth trajectories of TAM / SAM)? Do market conditions allow the creation of cashflow businesses, or is there a winner-take-all dynamic? Markets where there are network effects (e.g. marketplaces) or large infrastructure requirements (e.g. cloud storage) are for instance not as suitable for the creation of small businesses. The competitor with the most resources will get ahead and over-time squeeze out every other player. Reid makes this point in the podcast too:

It’s easy to err on the side of caution—to raise less and to spend less. But there’s a potential mortal risk in being conservative. You might think you’re best serving your investors by being as efficient with capital as possible, but that’s actually not true. You reward your investors by creating a successful company. And raising only $20M might mean losing the $20M if your competitors out-spend you.

- Reid Hoffman

Reid's argument rings true once an entrepreneur decides that they are indeed building a venture-scale business. One should perhaps raise more money than one thinks is necessary.

This episode was thought-provoking, educational, and gave me lots to chew on. I'm happy that Reid has decided to share his experience and point-of-view with the rest of us. I'm looking forward to the rest.