Does raising money mean you should start scaling?

Howard Marks is a serial entrepreneur and Managing Director of LA tech accelerator StartEngine. Before StartEngine, Howard co-founded Activision and founded Acclaim Games.  

Raising money and spending it wisely are two different games.

In startup-land, people seem to think raising money is a signal that their business is sound and they should start scaling as soon as possible.

But in my experience, raising money has no bearing on whether you’re ready to scale or not.  All it says is that the CEO is a charismatic salesperson who gets investors to buy into his or her vision.

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.  Regardless of funds raised, before you’re ready to scale, you’ll still need to do some hard work in what I call discovery mode.

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The wrong reason to spend

Why should you start spending money? The wrong is answer is ‘because I have it.’

The main challenge, as we’ll discuss below, is that startups need to internalize two conflicting attitudes.  First, they need to project confidence to raise money, but be able to switch on their powers of introspection to decide how to put capital to good use.

A lot of companies forget their roots as soon as they get money.

The Founder’s 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, running paid ad campaigns, and spending on overhead.

Why do teams do this? In their mind, their fundraising success is a major milestone – things are different now. Truth is, they’re not.

I’m here to tell you that you need to worry about this first: graduating out of discovery mode.

Things to consider before scaling

Discovery mode both promotes and requires mental flexibility.

The two most important considerations are team dynamics and where you fit in the market.

Weaknesses inside the founder team kill startups.

The number one reason I see teams fail isn’t because of running out of money, it’s because of quitting.  So before focusing on anything else, figure out how you will keep your team excited and stop key talent from quitting. The truth is, sometimes you need to replace your co-founders and start over.

The next considerations are ‘under the hood.’

You’re basically tinkering with everything at this stage – product, marketing, sales, partnerships, etc. You’re learning who your customers are and what they expect.  You’re learning what the metrics that matter are, what your funnel looks like, and what actions you want your prospects to take.  You’re tinkering with your marketing and sales channels. What sources of traffic are converting, and which channels are profitable, which aren’t?

The goal here is to find a situation where you can spend $1 and make $2 back.  When you’ve found that, then you can start spending money.  But without figuring out all the stuff we talked about above, you can’t spend responsibly.

When should you switch from discovery mode to growth mode?

It should never be the financing event that dictates whether to shift or not.

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.

You have to execute the business plan without executing yourself.

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.

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

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 comes with strings attached

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? Usually it’s because the founders were doing exactly what they needed to do to raise money.  In fundraising, the goal is to show that your startup will be successful.

How do you do that?

Put yourself in an investor’s shoes for a second. Investors are always thinking about growth mode because that’s the path to where they want to go – liquidity event. If I’m an investor, I want to invest in a company that will use the money I give to them to get ME my money back.

Which is a more compelling argument: “give us money to figure out our product and finish our discovery mode” 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.

As we saw above, the real challenge your face as a CEO is that you need to appear fearless, but have the guts to be introspective about what’s really going on in your business behind closed doors.

You need to nail your metrics to graduate discovery mode

Before we go into specific tactics, let’s talk about how to approach finding your metrics like an inventor.

What does that mean? Most people think they know what a tinkerer is, but I don’t think they really do. They see an inventor as someone who, in a stroke of genius, easily discovers the solution to the problem they’re wrestling with.  In my experience that’s not how it works.

I found one definition I like:  “Someone who manipulates unskillfully or experimentally“.  This may seem like a bad thing – it seems so imprecise.

Well guest what? This is exactly the sort of work you should be doing.  Theories come after experimentalists start breaking things and taking data points.

I’d like to add my definition of tinkerer: “someone who makes small adjustments and tests a lot of crazy ideas, but doesn’t get discouraged when they fail.” 

When I was growing up in France, I was always a tinkerer, and proud of it.  I’d always be pushing the boundaries of what I could do with my machine.  You can’t use theory to find out what people want – you can only discover it through taking action.  

How it applies to your marketing channels

Doing a small-scale test of every one of your marketing/sales campaigns is the exact definition of tinkering.   Go into it assuming most of them won’t pan out.  Thankfully, when you’re a tinkering with crazy ideas in marketing with a startup, the stakes are low – each time the experiment doesn’t work out, your downside is small.

But when your crazy idea does work out, the upside is huge.  When you hit, it’s likely to be profitable consistently.

For example, Dollar Shave Club created a video that went viral. And my friends, that was a cash cow for quite some time.

Got it?  Now let’s talk about the metrics.

Decide on which metrics really matter

This will be difference for each company.

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. You can’t have a negative margin but make it up on volume.

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 channel is profitable. Most of the time when buying paying customers through Google Adwords and Facebook you find that the more traffic you buy the higher each unit costs.  This is in a way a reverse correlation to what you would expect: higher spending yields lower costs.

Sometimes you’ll see that the lifetime value of your customers has gone way down because now you’re doing volume you’ve harvested all your ‘ideal’ early adopters. Is the process still profitable? Yes? Wonderful! Good news is 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.

This seems like it’ll take way too long

Guess what?  You’re right. Discovery mode will take a long time. It definitely can’t just be done in a day.  But I’ll guarantee you it’s worth it.

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 ways to fail

What happens to a company that blows through that first million? They turn around and try to raise more money, even though they haven’t hit any of their milestones.

How did we come to this?

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.

Burning Up All of their Runway – Founders can also go out of business but then everyone loses.

What now?

Founders need to set clear metrics to exit discovery mode and enrol 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 prematurely scaling is the same as dying by your own sword. That’s why I always advise entrepreneurs I mentor to stay in discovery mode as long as necessary.

Image credits: JUAN BARRETO/AFP/Getty Images, BERTRAND LANGLOIS/AFP/Getty Images