It may seem counter-intuitive – startups want to have as much cash on hand as possible in order to grow quickly, right? – but startups with an over-capitalization problem can kill their hopes of a good exit. How do you detect it, deal with it or prevent it?
Venture capitalists invest to grow their money over a relatively small number of years – five to ten, say, depending on the time window for their funds. They want a return within that window, preferably one gained by an IPO or an acquisition so that the equity they own is bought by somebody for far more than it cost the VC to buy it in the first place.
This means they need the startup in which they have invested to grow fast. They do not want their money locked up in a startup that doesn’t grow fast enough – or worse, doesn’t grow at all. But you can’t accelerate a company faster than its market will bear. VC impatience can’t beat market forces.
VCs throwing in a lot of cash can seem like a very good idea. Having more money than needed, particularly in straitened times, provides a longer runway for a startup. It’s a cushion – a safety measure. Perhaps the idea is to have a mega-round, after which no more money will be needed – ever – because the company will become self-funding. That’s a major bet on the future.
There is a company marketing aspect to VC fundraising as well. The more money investors put in, and the more rounds there are, the more valuable the company can appear to prospective customers. VAST Data has used this marketing tack.
In May 2021 VAST co-founder and CMO Jeff Denworth said after an $83 million round: “Today’s announcement is intended to raise visibility to our mission and to elevate our profile in the hearts and minds of the strategic customer prospects who are looking to make massive bets on our technology in the years to come. At $3.7 billion, we’re now worth more than many of the household name brand storage and cloud infrastructure products that VAST competes with.”
But having more money than needed can produce wasteful spending habits. “We don’t need positive cash flow just yet. We can fund the growth from cash in the bank.” An over-funded startup stops thinking in lean-and-mean, money-is-scarce terms and starts splashing cash about – hiring costly consultants, making the offices look top class, moving mountains of cash to advertising and marketing, over-spending on customer acquisition, and relying on support to fix problems rather than engineering to build a better product.
The excess of money is used as a crutch to shore up poor business practices. A more cash-efficient company would put money aside for a rainy day while it learns to stand, walk, and run on its own feet.
How can you tell if a startup which has raised boatloads of cash is not spending it in a gluttonous way? A good sign is cash flow positivity. A second is a consistently high and/or accelerating customer revenue growth rate. Beyond that it is more subjective.
We asked ex-Datera CEO Guy Churchward questions to find out more.
Blocks & Files: Can you identify any over-capitalized storage startups?
Guy Churchward: Tintri, Datrium, Datera, and Violin were all over-capitalized for different reasons … Tesla was but look at it now. Commvault was, but seems to have turned the corner.
Then there are the handful of $200+ million [VC]-invested companies. How do they create success for the investors as it’s not just about growth and spending but creating a return!
Blocks & Files: How does over-capitalization come about?
Guy Churchward: Over-capitalized companies can happen through dreaming, drifting, lack of real accountability and large gravitational market shifts that just pull the rug and send a company into a spiral that changes a company’s fortunes from fantastic to frenetic.
Blocks & Files: What kinds of over-capitalized companies are there?
Guy Churchward: It’s a super tricky topic. Over-capitalized is basically a company that’s taken in more money than it is perceived to be worth from assets – the ‘valuation’ – and that’s subjective based on who’s doing the valuation, and its market phase.
Blocks & Files: Market phase?
Guy Churchward: There is the ‘dream’ phase, the ‘what if’ phase, and the ‘reality’ phase. The ‘dream’ phase is a company’s ‘worth’ when it just finished MVP (minimum viable product), has perhaps a few customers in beta or ‘paid production’, and looks like it can change the world. The perceived value from the board is an enormous multiplier and buyers buy on the dream!
The ‘what if’ phase is when a startup deploys a solid set of productions and can show it can replicate, but has no scale … so a large company would look at it and assume ‘if we had that product and amplified what it did into our base through our channels, can you just imagine how big we can make it’. The multiplier is high on forward-looking revenue but not as high as dream – it’s more pragmatic, but still buying on future promise.
The ‘reality’ phase is a business that’s already professionally run, has a client base and an acquirer would have a 360-degree view on the business and buy on the balance sheet – growth, retention, market size, competitive pressures etc. So this is a low forward multiple or sometimes a multiple on trailing revenues.
On top of that, if an company has been capitalized but the terms of each round have got more aggressive as the money is harder to find, there is a possibility the capitalization table and preference load means the company will find it hard to make any money for anyone except the owners of the senior round. So for the investors in that round they are OK, but for the employees and early investors the company is over-capitalized. They have been diluted to irrelevancy.
Blocks & Files: How do you detect over-capitalization?
Guy Churchward: This means you basically subjectively look at companies that have taken in a load of money, over a long period of time, have had great promise but have not had an event. VCs love selling in the ‘dream’ stage but if this doesn’t happen they like to get out in the ‘what if’ stage. But they will hold and invest if they think they can create a massive return – a multi-billion-dollar acquisition or an IPO.
Who was buffing their feathers a few years ago and has gone quiet? What companies took in a load of money? You thought they were going to IPO and now you wonder who on Earth would bother buying them.
If they get too big, and their client base is identical to their competitors, and it’s ‘just another mousetrap’ – then what’s the exit strategy?
This means you have a zombie company. On paper it might look good but likely the investment is written off – they missed their window!
On the other end of the spectrum, if you look at small companies that change their CEO, by some degree you can say they were over-capitalized. That means the board has concluded that the investment they have put in versus the results the exec team has afforded them are not conducive to future investments. They have to make adjustments as their assets that they paid for are not in the right math. That stops them wanting to invest more, and stops any new investors. The thing you hear here is ‘it doesn’t look like the current investors have got a good return’. So that’s when you have a startup that drifts around …
Blocks & Files: Are there types of over-capitalized companies?
Guy Churchward: I look at three different types.
1. The early startups that got massive funding from tech titans are blowing cash like water on marketing but there isn’t a lot of substance – aka companies that shout louder than serve. Generally they get rolled up or tucked in.
2. The companies that got unicorn funding, have an impressive growth, shouty marketing but they are just another mousetrap in a market space [in which they] can’t IPO and they hope for a purchase. But they just have nothing unique, they are a second source and therefore the board will be wondering what happened when the year-on-year growth slows and they are burning too hard. For example, four-plus years of 40 percent growth, then a tail-off on a company that is burning more than it’s making.
3. The company that’s been around a long time. It’s taken the innovation death spiral already, is totally catering to its existing base, has cut costs to try and survive, and now is like an ocean liner without propulsion. It needs the model to change somehow.
Ugly, but these are called zombie companies. They look alive, but they just are not. The employees are exhausted and just waiting for someone to buy them so they can move on.
Blocks & Files: Who is to blame for over-capitalization?
Guy Churchward: In storage, in all these situations, it’s never the fault of an individual but the collective responsibility of the board and the management and the market dynamics.
If a CEO is a tech founder and given too much rope then they can drift. But if they are jumped on, then the entrepreneurial side is quashed and you never get to bet.
If a CEO is left too long is that his/her fault, or the board’s? Should they change them, help them or install someone to coach them? If a company refuses to take an exit because a board member is greedy and misses their prime, then the blame drops on the management – but perhaps it’s not them.
It’s far easier to detect over-capitalization after the fact. No VC will publicly admit a company in which they have invested – and for which they have acquisition or IPO hopes – is over-capitalized. And neither will the board or CEO.
Denial is the name of this game – until reality bites.