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  • Writer's pictureJeff Waggoner

Unicorns and Thoroughbreds

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Unicorns and Thoroughbreds

There is a great deal of noise out there about gigantic venture rounds and the need for speed. I say noise because there are circumstances for big rounds, hyper-scaling, and throwing caution to the wind and there are circumstance for the opposite of all of those. These factors are often missing from all of that noise. Knowing which is right for your company, whether it is yours as a founder or investor is a critical thing to understand and come to agreement on. It is also critical for understanding how to apply the concepts of capitally efficient scaling.

First, let us understand the factors or forces at work in this decision. Those are:

  • Availability / Cost of Capital

  • Agility and competitive positioning of Incumbents and Competitors

  • Barriers for New Entrants

There also are misconceptions and dangers around round size that should be understood.

Availability / Cost of Capital

Not surprisingly, capital allocation from investors is a market. Venture capital becomes easier to obtain when other alternatives to investment become less attractive. If you think about investment, attractive comes down to yield for risk, a match in risk profile, and sometimes the more subjective match of personal / social objective. The investment in a startup is pre-prepackaged into a financial product with a very specific profile long before the individual partner at a VC firm reads the pitch from the entrepreneur.

We are in a relatively long cycle that started after the 2008 global economic downturn. During that time, capital was withdrawn at a tremendous rate and put into low yield but safe instruments. If you raised or tried to raise from 2009-2014, you know that was a time of lower capital availability for Angel, Venture, and even Private Equity. It was certainly possible to raise, but not as easily as post 2014. As capital became unfrozen in the last 3-4 years, investors have faced the challenge that the stock market is not exceptionally attractive. We heard of new market highs during this time, and, despite volatility, these highs have generally been maintained. However, there is little or no growth there. The rapidly changing economic story in the Middle East, where pure oil economies have had to come to grips with the fact that their exclusivity over oil has limits, has increased political instability as well as inspired capital flow to the US in both individual flow to US instruments as well as sovereign funds. Similar effects for different reasons have occurred in China, Asia, and South America as well. The net result is that we have enjoyed a 3-4 year period of record holdings of capital by Private Equity and Venture Capital firms.

The glut of dry powder has overwhelmed the opportunity space; meaning there is more money than good investments. These factors combine to make raising capital relatively easy, capital rounds larger, and has spawned a boom of venture capital and private equity funds all innovating to source good investments. According to CB Insights, in 2008, the average Series A rounds was $4.9M, today that average is $11.3M, but there are much larger rounds; I know of series A rounds as high as $50M. These numbers can vary considerably by where one raises funds with capital surplus pressures, and other factors, being higher in the bay area and New York. China has even larger rounds in their burgeoning markets.

It is worth remembering that these trends are cyclical; the glut of capital will end, it is only a question of when.

Agility and competitive positioning of Incumbents and Competitors

Startups disrupt incumbents; that is their nature, but there are many different types of incumbents and power structures. When a business model of an incumbent leaves significant value on the table, startups and competitors enter the space and fill the gap. Even when the status quo is an inefficient, dis-satisfying process rather than another company directly competing, there will likely be stakeholders whose business will be affected by your startup. However, incumbents put up barriers to entry and often have substantial resources to put up new barriers in the presence of a new competitor. Competitors who have entered the space ahead of a specific startup also put up, perhaps new, barriers to entry. A startup must either overcome or circumnavigate, preferable in most cases, those barriers. That requires some combination of ingenuity and capital.

The amount of capital a startup needs as well as the market competitive risk it faces is a function of the competitive landscape it faces. Companies facing entrenched competition with substantial barriers will need more capital; if they have a compelling story about how they will use that capital to overcome those barriers, they may be able to get it.

Barriers for New Entrants

A common and reasonable question of all investors is how entrepreneurs will create an unfair advantage. Most people think of either patents or first-mover advantage in answer to this. There are businesses where this is true, but most software should not be patented (and often cannot be) and first mover advantage can be overcome by other’s speed. I will write a future blog post of unfair advantage, but the most common unfair advantage is the personal experience of your team, your network, and the relationship you build with your user / customer contacts that drive your unique way of thinking about the problem and the product/service that only you and your team can build. When this combines with the inertia (in perspective and process) and structural roadblocks those incumbents have to pivoting, your startup has a meaningful unfair advantage.

Creating these advantages can take a combination of perspective, deep understanding, and capital.

Misconceptions and Dangers

There are a great many unicorns out there, companies growing to a valuation over $1B. Many of them are companies with great ideas that followed the path of capital efficiency I have laid out in several of my blogs, and when they had achieved product / market fit they did a great job of both adhering to the principles of rapid, well-aligned growth and attracting a lot of capital. Some of these unicorns and unicorn wannabes also attracted large amounts of capital early on. For some of them, first-mover advantage was not the issue so much as rapid scale. If you think about a company like Uber, what is their unfair advantage? It comes down to a unique but easily copied business model. If you analyze Uber’s strategic positioning from the beginning, it developed and proved a business model on a small scale, then took on much more capital and started to scale it rapidly market by market with the primary focus being on market development and the speed and efficiency of performing that activity. While there were early patents, they were centered on pricing algorithms, narrow patents on elements of the business model; the primary focus of their unfair advantage was speed. As they have built substantial capital reserves, they have shifted into a different posture and have spent the last three years filing and developing a much broader and deeper set of patents reflecting their incumbent status as well as their likely pivot into autonomous vehicles. Note also that during the last three years, they have been dealing with some of the organizational challenges and customer / community impacts of having scaled so quickly. The misconception I hear from many is that they skipped many of the steps of capital-efficient scaling. They didn’t; they simply recognized that once they reached the business model validation and growth stages, speed was more important than efficiency and because they could attract significant capital, they were able to move to that end of the growth approach spectrum. They likely made a great many more mistakes because of that shift than we hear about and the public ones have been numerous.

It should also be recognized that some extremely well-funded, high notoriety startups will fail and ultimately prove to have been poor investments. Big splash and big funding does not necessarily represent a well-run hyper-scaling startup that you should try to emulate. It goes much deeper.

The dangers of shifting to hyper-scaling are many; but that does not mean it is not the right approach. Some common issues include:

  • The organization outgrowing the leadership

  • The human / organizational growth challenge

  • Being the brightest target

  • Overcapitalization

When organizations scale very rapidly, the issues that can arise in strategy, people, process, compliance, customer service, and in many other areas can grow beyond the experience base and perspective of the organization’s leadership. These problems can often be addressed with training, mentorship, and peer networks but all of that requires a commitment to learn and grow. For most startups, keeping the founders engaged in the company, ideally in the organizational leadership roles with which they started is ideal. In most cases, it is challenging to replicate the passion and intensity of a founder. For this reason, it is important to drive that personal growth from the earliest possible stage.

Rapid organizational growth, even with excellent leadership in place, is challenging. The first challenge is the logistics of working capital, workspace, hiring, payroll, and benefits. Next, the hiring itself comes with the challenge of identifying the right structures and skills gaps, culture, and then interviewing and selecting the right candidates to fill those roles. This leads to the even greater challenge of onboarding, training, aligning, integrating, and monitoring / managing new hires at all levels. While those latter steps are more complex and arguably more critical, successful organizational growth requires all of these to be performed right.

Rapidly growing startups appear as bright targets on incumbent, competitor, and new entrant scans of the market. Many startups can go years without incumbents being aware of them; but hyper-scaling companies draw their attention. When that happens, responsive tactics may come to bear when those incumbents exercise their relationships with partners, suppliers, and even regulators or respond with changes in pricing, contract terms, or even business model.

The last common problem with hyper-scaling is overcapitalization. This term refers to the problem of the company having raised too much capital for its state of growth; yes, that is possible. There are two issues, the first is sloth, and the second is inability to raise. Sloth occurs when the management team has raised enough capital that the fire to build value is either diminished or misdirected. Lavish salaries, commissions, perks, parties, or even stadium-naming boondoggles are examples of this kind of situation. However, it can be more subtle. An example I've seen is where cash was flowing and the sales leadership thought an extended experiment in commissioning on $0 revenue partner agreements was a great idea. Not surprisingly, this resulted in a great many $0 revenue partners that would never contribute to the top line, a lot of happy then unemployed salespeople, and a lot of wasted capital. The second problem comes from raising a level of capital and then either failing to build sufficient value or having the market drop out. The result is that more capital is needed to maintain velocity, but the raise cannot be made palatable to both new and old investors. It is worth noting that this can happen simply by being at the right place and the wrong time. A capital market dropout can drive this and the only thing entrepreneurs can do is manage their preparation and response to such incidents. It is worth noting that quite a few companies fall prey to this and it is a significant contributor to the failure startups. I will address startup failure causation in another blog post.

Combining the Factors

Startup growth is a team sport and there will be a growing list of stakeholders who have a say in capital raises. That does not change the fact that, as founders, you have the responsibility to decide the right approach in the beginning and set the tone for how the company will grow and reflect that in each decision that is made in bringing on new investors.

One thing that remains true in this range of options is that the basics of product / market fit and product cohort hygiene are true independent of the level of funding a company receives. No company can afford to position themselves into a state where they either have no traction (revenue and the levers to grow that revenue) or worse, they have built a customer base of marginally happy customers who will churn when the opportunity arises.

Few companies are unicorns, more but still few are thoroughbreds. There is no shame in being a thoroughbred. Trying to be a unicorn when you are a thoroughbred has significant risks. They key is to know which you are.

When the company has the basis in product / market fit, huge and rapidly growing market, leadership team and ability to attract talent, competitive advantage, and ability to raise capital, they are in the venture-appropriate category. Hyper-scaling a company with its massive capital rounds is best when:

  • Competitive advantage is highly dependent on rapid scaling to build a leading market position, capture suppliers or distributors, or transform the entire marketplace

  • The founders have all of the other elements in place to raise massive capital

  • Boards and leadership teams are ready to address the substantial risks associated with that approach

For most startups, the challenges of sustaining 100-500% CAGR are best addressed with capitally efficient growth. In this way, the leadership team can understand and address the risks in rapid scaling while balancing the risks of overcapitalization.

If you are managing your approach to the capital raise process and scaling, we can help. With significant experience, at the C level and on boards in managing these decisions as well as in advising others in this process, we can help with process, knowledge, and objectivity. Please contact us.

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