Busting a Big Fundraising Myth

By Kera DeMars October 22nd, 2019

raising_unprofitably
There is a myth in the fundraising world, and today we’re going to bust it.

Here’s the myth:

Growth is so important to a business (and to investors) that it’s worthwhile to focus on unprofitable growth.

Of course, unprofitable growth means that you’re not making any profits.

A lot of founders believe that it’s more important to grow your user base than to focus on earning revenue. And that to do this, you need to raise VC money.

For some businesses, this approach might make sense. For others, not so much.

But before you spend months trying to raise money to hit certain growth milestones, you should ask yourself two questions:

  1. Does my company have a network effect?
  2. Does my product increase in virality from acquiring more customers?

If you’re not sure how to answer these questions… stay calm. We’re gonna unpack this right now.

Network Effects

Let’s start by defining “network effects.”

Network effects means that every user you have makes the platform more valuable for your next user.

An example of this is Uber. 

Every time a new driver signs up for Uber, riders face lower wait times for their rides.

And every time a new rider starts using Uber, that means more demand (and more money) for drivers.

In this case, the user experience will be wildly different if Uber has 100 users or 1 million.

On the flip side, Salesforce (a B2B SaaS company) doesn’t improve for one user simply because others are using the product.

Salesforce could have 100 users or 1 million users, and the experience won’t change for anyone.

So, Salesforce doesn’t have a network effect.

Now, companies with strong network effects can seriously benefit from raising VC money. 

Why? Because (like in the case of Uber), companies with strong network effects need to capture the market and demolish the competition in order to win. 

And VC money can help them get there.

Oh! One more thing about network effects… 

A lot of companies use machine learning in their companies. To build successful machine learning programs, you need a large data set (that’s how the technology learns, and ultimately improves the product). 

If your company’s success is based on machine learning, it might make sense to raise VC money and use that money to acquire new customers/users.

These customers might not be bringing in revenue, but they are improving the product for all your future users by giving you more data to work with.  

Virality

Now, maybe your company doesn’t have network effects… but does it have virality?

When something is “viral”, that means it’s spreading quickly throughout the internet.

If your company has virality, that means that your existing users are bringing new customers onboard.

For example, Calend.ly (a scheduling tool) doesn’t have network effects, because the app is the same for a user regardless of how many other people are using it.

But in order for a Person A to schedule a meeting using Calend.ly, they share their link with Person B.

Person B gets exposed to Calend.ly through that interaction, sees how the product works, and signs up.

Calend.ly is, in effect, outsourcing their marketing to their existing user base.

In this case, it makes sense for the Calend.ly team to raise VC money. 

(Note: Calend.ly did not raise money, but likely would have grown even faster had they done so.)

Outside capital will allow Calend.ly to spend a lot of money on acquiring Person A and still see exponential growth.

This is because Person A does the work of bringing on Person B without any cost to the company. 

Person B might bring on 2 more users. Those users might bring on 4 more users. And so on.

In this example, Calend.ly can afford spend unprofitably to acquire Person A because they will see it pay off in the long term. 

It all boils down to one thing...

Unit economics.

It took me months to realize that understanding unit economics is critical to the success of a business.

Unit economics refers to the cost of acquiring and onboarding a customer compared to how much money a business makes from that customer.

For example, a business with good unit economics might be spending $50 to acquire and onboard a customer, but they're making $100 from that customer. 

On the other hand, a business with bad unit economics is spending $100 to acquire and onboard a customer, but only making $50 from them.

If your company has bad unit economics, raising a big round probably won’t help you right now – having more money in the bank won’t help you lower your acquisition costs or improve your margins. 

Plus, most VCs won’t pour a bunch of money into a business with bad unit economics. 

So, what’s your next move?

Take a look at your business.

Do you have network effects and/or virality? If the answer is YES, then it probably makes sense to raise VC money. This is because for every customer you pay to acquire, you’re acquiring many more customers for free.

So, more money will help your business win.

If the answer is NO, then raising a huge amount of money isn’t necessary right now. 

That said, you might find yourself in a situation where you know revenue is coming your way, but you haven’t seen it hit your bank account yet.

If this sounds like your business, and you’re thinking of raising a big round of funding to keep from defaulting on your bills… there are other options.

It could be that revenue-based financing is a better solution than traditional VC investment (more on that here).

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