The cost of raising too much capital

Most startups believe that raising more money is better. Startups are already undercapitalized relative to the incumbents that they’re trying to displace, so the more capital they have to close this gap the better.

While this is partially true, it comes with a very important caveat. And this is that the relationship only holds up to a specific point.

Having some money is almost always better than having no money. It lets you hire people, build a product, and hopefully get people to use that product.

However, raising money also carries a cost. Specifically, it sets a valuation for your company. And a valuation sets expectations.

Startup valuations reflect future expectations for the company, not its current performance. The company needs to use the capital it has raised to fill in the expectations set by its valuation. And the more you raise, the more difficult this becomes.

We can see that this is the case by thinking about the edge case of raising infinite capital. If a startup raised infinite capital, there would be a point beyond which it cannot put that capital to efficient use. Even if we ignore all other constraints, a startup is constrained by its market size and the time that it needs to spend to execute on projects so as to grow into that market. Taken together these factors create an upper limit for the amount of capital that a startup can effectively put to use in a given market during a given period of time.

When funding is readily available, you might be able to raise more than this upper limit. But just because you can doesn’t mean you should.

Beyond a certain point, the shoes you’re trying to walk in will just be too big. Your feet won’t grow fast enough, you’ll end up with blisters on them, and you’ll be forced to buy smaller shoes.

And that’s where this analogy breaks down. It’s easier to find smaller shoes than to structure funding at a lower valuation.

Also published on Medium.