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Venture Capital Reckoning: How Much Money is Too Much Money?

By Megan O’Brien, Brainyard Business & Finance Editor
March 12, 2020

In short:

  • In the oft-frothy world of VC-backed startups, investor cash often comes with clauses that may sink promising companies
  • Wag is a case study in what can go wrong when growth is prioritized over running the business
  • Here are signs that hyperscaling is driving you to the edge, and three ways to rein it in

When Softbank Group’s Vision Fund took the VC world by storm in 2016, it generated a tsunami of buzz. Not just for sheer size — it dwarfed the next seven largest funds combined — but by offering outside investors the option of a guaranteed fixed return.

With $100 billion to spend, largely from Saudi Arabia and United Arab Emirates wealth funds, Softbank went on a unicorn hunt.

This month, Brandless, a direct-to-consumer personal care company to which Softbank pledged $240 million, announced that it would shut its doors. The once-promising startup is the first Vision Fund-backed venture to close and an inflection point in a rough period for SoftBank. Brandless took $100 million from the Vision Fund and had been in line for the additional $140 million if it hit certain financial targets. It was shuttered before it could cash in. Meanwhile, Wag, a struggling dog-walking startup, bought back its stake from Softbank at the end of last year for considerably less than the $300 million originally invested.

And after the shrinking valuation of Uber and the notorious implosion of WeWork, in November Softbank revealed its first quarterly loss in 14 years – a whopping $6.5 billion.

We’ve seen the scenario play out repeatedly, albeit usually on a more modest scale:

  1. Innovative company bursts onto the business scene promising to change the world.
  2. Venture capital firms flood the company with funding, creating an aggressively high valuation.
  3. Said company underperforms, or outright fails.

What causes smart, cash-rich companies to founder?

In their 2018 book, Blitzscaling: The Lightning-Fast Path to Building Massively Valuable Companies, authors Chris Yeh and Reid Hoffman introduced a controversial concept. Blitzscaling is “about growing at a rate that is so much faster than your competitors that [it] makes you feel uncomfortable. In short, blitzscaling is prioritizing speed over efficiency in the face of uncertainty.”

Softbank and other venture capital firms seem to have taken the approach to heart — though, according to the authors, not quite in the right context.

It’s time to admit that even in the cash-strapped world of startups, there’s such a thing as too much money.

Aggressive or Reckless?

2019 was a banner year for VCs. There are more venture capital funds than ever. According to the Pitchbook-NVCA Venture Monitor, the VC industry deployed $136.5 billion to U.S.-based companies by the end of 2019. A decade ago, venture capital invested only $27.4 billion. That’s an increase of nearly 400%.

So far, so good, right? Technology has allowed new, innovative businesses to be created faster. They need money and venture capital is able, and more than willing, to provide it. By all accounts, this seems to be a mutually beneficial relationship.

Here’s the catch: The money is flowing uphill. That huge sum isn’t being distributed across a large number of businesses. Instead, it tends to go into “supergiant” VC deals for a small clique of tech darlings. And there is a clause: The money needs to fund rapid-fire growth.

pros and cons of venture capital

Blitzscaling may be a good strategy, selectively deployed. But today it is too frequently used indiscriminately and recklessly, the proverbial hammer that turns every opportunity into a nail. VC firms are flooding companies with capital hoping they will become the next WhatsApp. But founders need to ask themselves: Is the foundation and structure in place to support explosive growth?

The reality is, most startups cannot successfully pursue — and do not benefit from — hypergrowth. Instead, the cash and its clauses lead to a lack of focus, financial irresponsibility and a prioritization of scale over profit. As we have seen multiple times over the past few years, those tendencies do not bode well for business longevity or success in the public market.

The Curious Case of the Dog in the VC Paradigm

Let’s take a deeper look at Wag. The dog-walking service was founded in 2014 to be the “Uber for dogs.” Prior to its venture round of funding, it had raised $61.5 million. When it approached SoftBank, Wag was reportedly seeking $100 million. Instead, SoftBank offered $300 million for a non-majority stake.

This of course begs the question: Why exactly does a dog walking startup that doesn’t hire walkers and that’s already raised over $60 million need $300 million?

The purported answer: To vault Wag into the leadership position in the pet care market. Problem is, Wag wasn’t ready to scale like that, and the pressure revealed serious cracks in the business. These were covered in detail in a CNN investigation, where an employee reportedly said, “When they started expanding, that’s when things got messy.”

Indeed. To handle the hyper-growth, Hilary Schneider, a former executive at LifeLock, was appointed CEO. Soon after, two of the three Wag cofounders, brothers Jonathan and Josh Viner, left to start their own investment fund, poaching a few Wag employees along the way. Schneider began appointing new leadership in the Bay area, effectively pushing aside executives at the original Los Angeles headquarters. Throughout Wag, employees viewed the new executive team as “disengaged,” aggressively pursuing expansion above all else.

The execs also failed to account for several serious problems with Wag’s business model.

First, as we’ve seen in various takedowns of the “gig economy,” depending on independent contractors to deliver your core service is risky. Wag had no effective way of vetting, training and licensing walkers, yet it rapidly increased its volume of customers and contractors. Incidents with walkers arose. Some were inexperienced and unprepared. There were runaway dogs, animal abuse, theft and even deaths. Lawsuits ensued. The response from Wag’s customer service team was essentially: “We couldn’t handle our volume, we weren't trained properly, there were no expectations when it came to incidents.”

Things weren’t exactly rosy from the contractor side either. Thirty-eight thousand dog walkers sued Wag for worker misclassification because they were required to work off-the-clock, resulting in their being paid less than the required minimum wage under California’s labor code. The workers prevailed in a lawsuit that cost Wag over $1 million.

Other contractors became frustrated by the company’s lack of protections, not to mention the 40% cut it took of their payments, so many set up their own businesses using the contacts they had garnered from the Wag app.

Instead of focusing on these structural problems, Schneider and her team were fixated on global expansion that never materialized.

Such is the blessing and the curse of excessive capital: You have the means to pursue hyper-growth, you are expected to pursue hyper-growth, but oftentimes you really shouldn’t be pursuing hyper-growth.

No surprise, after continued poor financial performance and a never-ending string of controversies (particularly the infamous NDA incident), Schneider resigned, and Garrett Smallwood, VP of product, partnerships and corporate development, was appointed CEO. Shortly thereafter, Smallwood announced plans to lay off employees, part ways with SoftBank and streamline the business.

“As a more focused company with a solid capital base that is right-sized to the needs of our business and strategy, we have plenty of runway to execute our plans to accelerate our progress toward profitable growth,” he wrote in a memo announcing the buyback from SoftBank. “Both our management and our investors see an amazing future ahead for Wag as we refocus on delivering sustainable growth.”

It seems Smallwood understood the lesson: One may want to be the next unicorn, but that doesn’t make the unicorn costume fit. High valuations mean high expectations. Employees and customers vocalized concerns, but Wag wasn’t agile enough to address serious problems in its business model. Leadership was too distracted by demands for hypergrowth.

How To Avoid Being Wagged

An overabundance of capital can cause “shiny object syndrome.” Companies burn through cash, throwing money at initiatives that may not benefit the core mission. In addition to wasting capital, this results in businesses losing traction in their markets, becoming distant from their primary products and customers and thus losing the agility to pivot the offering when necessary.

This is all avoidable.

Recommendation: Spend money like it’s your own. At a 2015 StrictlyVC event in San Francisco, startup investor Chamath Palihapitiya told attendees, “It’s fine to fail. But if you fail because you didn’t have the courage to move to Oakland and instead you burned 30% of your cash on Kind bars and exposed brick walls in the office, you’re a $#%*ing moron.” Excess has become so emblematic at startups that even valiant efforts by the HBO show “Silicon Valley” to parody it fell short of actual reality.

Financial irresponsibility doesn’t just come in the form of luxurious office perks. In a time of plenty, the more dangerous risk is chasing strategies that will ultimately bring low returns. When you are flush with cash and under immense pressure to expand, you’ll pursue initiatives or investments that look good on paper but won’t necessarily help your company get to cash-flow profitability.

Even when you are growing fantastically well, look upon every dollar as a scarce resource. Foster a culture of frugality and cost efficiency, even if it means forgoing a rock-climbing wall in the office. Part of what makes a company great is learning how to innovate and operate within a budget. Managing to a budget forces startup leaders to identify the initiatives that make the most sense for the business, because they can’t afford to go down rabbit holes. The mindset of “we can do everything because we’ve got the money” has led to the downfall of numerous companies.

Don’t take cash you don't need. Funding at 110% is great; funding at 200% or 300% is probably too dangerous to pursue.

Recommendation: Prioritize communications with an investor relations team. When you raise more and more capital to continue expansion, it results in equity dilution, meaning you have less say in your company’s future. Now, as you’re trying to chart the course of your ship, you have multiple hands on the wheel — not all of them pulling in the same direction.

And, VCs can lose focus on your business as they add shiny new companies to their portfolios.

While you may not be able to wrest back full control or attention, a capable IR function, normally under the CFO, will go a long way toward keeping everyone in sync and is a worthy way to spend some of that cash. Here’s how to build an investor relations practice.

Hiring Plan: Investor Relations Specialist

Recommendation: Remember that profitability isn’t just a nice-to-have. Growth over profit is a key characteristic of the inclination towards blitzscaling that manifests in a three-part plan:

  1. Disrupt the industry.
  2. Push out incumbent competitors and crush upstarts.
  3. Take over your newly created, wide open, competition-free market and then plot a path to profitability.

Those first two steps tend to trip up most companies. Some cannot grow to that level because there’s not enough market demand for their product or service. Others cannot because their internal structures and processes are not well-enough developed to handle growth. Even if they do manage to push through without cracks in their foundation manifesting, some have prioritized growth over profit for so long, their path to profitability is nebulous at best. In other cases, competitors inconveniently resist being crushed. After all, true blue ocean concepts are precious few and far between.

Yes, some companies have gotten big fast and found their business models later. However, that is the rare exception, not the norm. For most, finding sustainable growth in conjunction with profitability, or at least a clear path to profitability, will position them better for long-term, viable success and eventually a smooth and well-orchestrated IPO.

Back in 2012, Silicon Valley venture capitalist Bill Gurley tweeted, “More startups die of indigestion than starvation. Focus wins. Doing too many things fails.” Those words ring truer than ever today as promising companies continue to fall to the fois gras effect.

There’s no formula that defines “too much capital.” It’s dependent on your company, industry, leadership, market demand and numerous other factors. However, if the amount of funding is forcing your business into premature scaling that you’re not built or ready for or that the market won’t support, it’s time to consider new sources of growth funding —and there are many.

In the immortal words of TLC, don’t go chasing waterfalls. Just stick to the rivers and the lakes — where you can be successful and profitable.

Megan O’Brien is Brainyard’s business & finance editor, covering the latest trends in strategy for CFOs. She has written extensively on executive topics as a former content creator for Deloitte’s C-suite programs. Reach Megan here.

  
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