Does raising money mean you can start scaling?

Howard Marks · September 6, 2013 · Short URL: https://vator.tv/n/31d3

Don't die by your own sword - stay flexible as long as possible

In startup-land, people seem to equate raising money with having a sound business that’s ready to scale.   I'm here to tell you it doesn't work that way.

One blessing I have is that I get to work with many different entrepreneurs. I enjoy working with first time entrepreneurs because of their ambition and self-belief. They have a better chance of producing “black swan” successes, which is exciting. But one thing I love about older founders is that they don’t let successfully raising money go to their heads.

I’m here to argue that yes, raising money is good, but no, it doesn’t say anything about the health or feasibility of your business. What it does say that the entrepreneur is good at enrolling investors into his/her vision.

Growth vs Discovery mode

First consider: What is your reason to start spending? The wrong is answer is ‘because I have it.’

The main challenge, as we’ll discuss below, is that startups need to internalize two different attitudes – one of confidence to raise money, and one of introspection to put it to good use.

A lot of companies try to change as soon as they get money. Their gut wrongly tells them their business plan has been validated because they received an investment. They feel the money can and should be spent on ways to grow the company, so they shift into growth mode by hiring more employees, paying themselves, hiring salespeople, buying paid ad campaigns, and spending on overhead.

I’m here to tell you something else should come first: graduate out of discovery mode.

What is discovery mode?

Discovery mode is where an entrepreneur fine tunes their product before releasing it to the world. Discovery mode is when the entrepreneur figures out where they fit in the marketplace, and which aspects of the business scale and which don’t. They learn who their customers are and what they expect, what the metrics that matter are. In short, they learn what really matters to the business.

Discovery mode both promotes and requires mental flexibility.

On a more somber note, weaknesses inside the founder team are also key issues to evaluate while in discovery mode. And the truth is, sometimes you need to replace your co-founders.

When should you switch from discovery to growth mode?

New entrepreneurs, no matter how much money they receive, should try to stay in discovery mode as long as possible. It’s what a lot of what the companies at StartEngine do – they discover, pivot, and change.

Investors, especially VC’s, argue that the shift to growth mode should be done quickly. They argue that as an entrepreneur you’re always being chased by competitors and want to be a first mover. It’s a big selling point on why to raise VC – they point out that if you don’t grow, someone else will and they will put your out of business.

But I don’t think the competitor is your biggest danger. The biggest danger is yourself. You are far more likely to die by your own sword than wind up killed by a competitor.

I want startups and first time entrepreneurs to be more frugal and stay in discovery mode longer. But more that just worrying about the money, I want them to understand when it is right to shift from discovery to growth.

Most important: it should never be the financing event that dictates whether to shift or not.

As soon as that first money is raised, many entrepreneurs try to move out of discovery mode too quickly and shift into growth mode without really thinking their situation through. STOP and ask yourself this question: Am I ready to leave the discovery mode?

Clearly investors should promote the idea that startups need to have clear metrics for terminating the discovery mode. Keep in mind, though, that investors probably are not aware of exactly the challenges the startup has faced and is facing.

Money can be both a curse and a blessing.

Here’s a problem I see often: Once the money is raised, investors pressure the entrepreneurs to start spending. Do investors know that this directive is a bad idea?

No.

Why not? Because the founders didn’t communicate it.

Investors are always thinking about growth mode. If I’m an investor, I want to invest in a company that will use the money I give to them to produce a sizable return.

Which is a more compelling argument: “give us money to figure out our product” or “train’s leaving the station – are you on board?”

So the founder/CEO didn’t transmit the right message because the CEO was doing his job, which is getting everyone excited enough to write a check.

Just remember, the real challenge of the CEO is that you need to appear fearless, but have the guts to be introspective about the reality of your business behind closed doors.

Money might give you a badge of approval, but it doesn’t dictate your future. As I mentioned before, the big mistake many companies make is thinking as soon as they raise money they should begin to hire new employees. And it’s not true.

Set your key metrics for discovery mode graduation

Today, you can get data analytics for free on the web with Google Analytics and on mobile phones with Flurry. Decide on which metrics really matter. You don’t have to reinvent the wheel – this is where a mentor can help you.

Some metrics that I like to look for are: Lifetime value of a customer, average revenue per buyer, cost of a paying customer, registration rates, etc..

For example, if you think the lifetime value (LTV) of your customer is $300 and in reality it is $60 but costs $80 to acquire, you’re going to go out of business. Your company will die. If you follow startups, you don’t have to look far for examples of where this happened.

Think about a consumer business. You know cost of acquisition at a low scale, so instead of 10 users you decide to test with 100 or 300 users. You now need to see if that particular metric scales. Most of the time when buying paying customers through Google Adwords and Facebook you find that the more you buy the higher the cost. This is in a way a reverse corrolation to what you would expect: higher spending yields lower costs. On the Internet, it does not work that way.

Sometimes you’ll see that the lifetime value of your customers has gone way down because now you’re doing volume and its not at precise. Is the process still profitable? Yes? Wonderful! You know you can scale at that metric. Now repeat with every other metric you can think of.

What about your demographic and audience? What do they expect? Can it be stretched? What about different audiences? Try pricing changes. Try the funnel on the website or the mobile app.

Discovery mode can be expensive and take a long time. It definitely can’t just be done in a day – but it is worth it.

You have to execute the business plan without executing yourself.

Just remember that when you’re in discovery mode, it is ok that you fail some market tests. You can pivot in discovery mode because you give yourself the right to pivot. But when you’re in growth mode, you don’t have the right. When you’re in growth, everyone expects you to grow and expand your user base.

Two Dreaded Outcomes to Avoid

What happens to a company that blows through that first million? They turn around and try to raise more money, even though they don’t have enough to show for having spent that initial investment.

Invariably, those unfortunate entrepreneurs who shifted too quickly did so because they were confused as where they were in lifecycle. They made the mistake of thinking they were in growth mode – spending money on scaling the business – when they were still in discovery mode – spending money defining the business.

Once the money is spent, young entrepreneurs are usually faced with this situation:

The Cram Round – Founders raise money at a lower valuation than the first round and now understand what anti dilution clauses really mean. With the lower evaluation, all the initial investors and the founders will be crammed down and lose a good portion of their equity. If it was a convertible note, in most cases the investors will not convert and leave the founder hanging in no man’s land. Tough situation.

Founders can also go out of business but then everyone loses.

Conclusion

Founders need to set clear metrics to exit discovery mode and enroll their investors into the process. That partnership will reduce the artificial pressure to scale before companies are ready.

Like I mentioned above, you are usually your own worst enemy when it comes to building a business. Running out of money because of pre-maturely scaling is similar to dying by your own sword. That’s why at StartEngine, we encourage our entrepreneurs to stay in discovery mode as long as necessary.

 

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Howard Marks

co-founder Activision, CEO Acclaim Games, Managing Partner of StartEngine.

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