I’ve written before about how Capital Efficiency doesn’t exist and is an oxymoron. However, there is an important corollary to the non-existence of Capital Efficiency and that is The Curse of Over Capitalization.

Some days in Silicon Valley it feels like there are more investors than there are entrepreneurs. And there absolutely are more investors than there are good deals. There is simply too much capital chasing too few good deals. (Although it certainly doesn’t feel that way when you’re an entrepreneur trying to raise money for your own company. The question most entrepreneurs keep asking themselves is why isn’t that capital chasing me? While it it may not feel that way, the data suggest that there is indeed too much capital in the system — especially so at the seed stage, with more and more individuals and larger funds trying to invest in companies at this stage.)

Before we proceed, it is important to understand two important points about institutional venture capital. For most venture capital funds money is a commodity. It is a tool. They use that tool to buy ownership in a company. VCs care less about how much money they have to put in, and more about the amount of ownership they can get. VCs also operate in a limited time window that is determined by the duration of their funds. This time window is required by LPs (the folks providing the VCs the money to invest) as LPs are afraid to enter into an open-ended arrangement where they don’t know what the time horizon on the fund’s investments will be. This in turn gives VCs a short window of time (between 5-10 years depending on where in the life cycle of the fund they invest) to get a company to exit.

Now, combine those two motivations that venture investors have: 1) ownership, 2) quick growth, and what do you get? You get a situation whether investors are incentivized to put in more money into a company, not only to buy more equity, but also to fund the quick growth. In fact, it becomes a vicious circle. First, a company may get encouraged to raise more money that it really needs, just so that the venture fund can get to its desired level of ownership. Then the same company gets encouraged to spend that money to accelerate and to grow quickly, which in turn means it runs out of that money more quickly, and then needs to raise even more money.

This situation is not always in the best interest of founders. Founders typically get their equity in a company once — at the time of founding and then get diluted with each subsequent round of financing. For venture funds, they almost always have the ability to participate in future rounds to preserve their pro-rata and sometimes even increase their ownership position by investing more capital in future rounds.

For VCs working for funds that have a lot of money under management, the incentive is to encourage companies to grow quickly. Growing quickly is not a bad thing, but it forces the companies to spend more in order to try to accelerate that growth. This is when you start paying expensive recruiters for retained searches to fill out those open positions as quickly as possible with “experienced” people, this is when you hire that ridiculously expensive PR firm on a retained basis to get the company some attention, and this is also when companies begin to prioritize user-growth over figuring out what is the right revenue model for the company (see my post on Revenue Development).

The VC focus on quick growth is not without reason. Yes, sometimes it’s because the market opportunity demands moving quickly, but sometimes, VCs push growth on their companies more to push their own agenda, than what’s right for the company.

Whenever I’ve tried to describe this in the past, the next question is invariably: “Then why do founders raise more money than they need?” First, because any founder in his/her right mind knows that having a little bit of extra gas in the tank is probably a good thing. Having just a little more runway, so that in case things don’t go according to plan, they have a little cushion, a little buffer, and therefore a higher chance of survival. So that explains founders taking on a little bit more than they need, but why then do so many founders take on an excessive amount of capital? My answer to that is because every founder believes that they are different and smarter than the founders of other companies. Unlike all the other founders that went before them, they believe that they will have the will-power and the self-control to be able to spend the money wisely and to not waste it. But little do they know that they are human, just like everyone else.

Some founders like to think that if they raise a lot of money now, they will never need to raise money again. Baloney! Regardless of how much money you raise, you will be out raising money again in 12-18 months! This is because excessive capital becomes toxic for an early stage company. What’s another thousand dollars when you have a couple of million sitting in the bank?  Despite the best intentions even the most principled founders fall into this trap. They will invariably lose the financial sensibility that they had in their scrappy years. The company culture begins to morph and before you know it the company’s expenses balloon out of proportion. The same founders who a short while ago felt they would never need to raise money again, now start to justify why they need to raise another, and bigger, round to feed the monster that they’ve let loose.

Companies which end up raising monster Series A, Series B, or Series C rounds all seem to exhibit a similar pattern of problems, one that is akin to indigestion. The rush to hire results in a relaxation of “hire only A players rule.” The rush to get product built faster, results in a reliance on consultants, contractors, outsourced development and other faux pas, which invariably result in huge amounts of overhead costs, and often result in failed attempts at launching product. There are few cases where this can be the right approach, but it requires a very clear definition of what’s the core product, technology, and knowledge that needs to be built and retained within the company and what can indeed be done by an external team.

In some extreme cases over-capitalization and its supporting mantra of “growth first” often leads to the company subsidizing its product and offering it for free (see my post on The Case against FREE), and in the process failing to discover the right business model. Yes, there are some cases where growth makes sense, but companies need to be careful that in their attempt to achieve growth they don’t just give away the crown jewels. The example I use most often for this is Plaxo. Plaxo’s most valuable feature was that it backed up your contacts from Outlook. Outlook/Exchange were horribly unstable at the time and Outlook would often end up losing all your contacts in case of a file corruption. Plaxo saved my rear on multiple occasions because it had a copy of all my contacts that it would seamlessly sync back down to Outlook upon re-installation. But, Plaxo gave this feature away for free. What did they want to charge for? For removing duplicates from my contacts. I think I can live with some duplicates in my address book, but losing it altogether is something I couldn’t live with.

There are some venture funds (usually large funds) which seem to have over-capitalization as their m.o. I don’t believe they do it with any malicious intent, but they probably have lost the perspective that providing companies with the right amount of capital is more important than trying to achieve rocketship growth. Sometimes companies, the markets they operate in, and even the founders who start them all need time to mature, and no amount of capital is going to accelerate that. Nine women can’t make a baby in one month.

My advice to portfolio companies has been to raise the amount of capital that they can reasonably expect put to work in the next 18-24 months. Assuming they’re out raising again in 12-18 months, then that still gives them a buffer of 6 months. But if they claim that they will raise a mega round because they will never have to raise another round again, or worse yet, claim that they want to raise more because they “don’t like fundraising,” then all I can do is to call bullshit. If you really don’t want to raise another round, then prove that to me based on what really matters: Revenue. Or better yet, the ultimate measure: Profit.

You can follow me on Twitter at @ManuKumar or @K9Ventures for just the K9 Ventures related tweets. K9 Ventures is also on Facebook and Google+.