Why often being late-funded is better than being heavily-funded (early)

As a long-time practitioner in online travel (since 2004), I had a chance to learn what type of companies are more & less likely to succeed in building significant long-term value. One of these learnings is that funding and M&A strategy are a great differntiator for the outcome companies and more specifically founders and key employees may experience in the space.

Starting off with some definitions:

Heavily funded — a company that acquires significant funding before reaching product-market-marketing fit. The heavily funded thesis is that the market opportunity is clear which means competitors are racing against one another, and out-spending the competition is the way to conquer the market. Often times, a significant portion of this capital is spent on customer acquisition costs and non-proprietary assets that help generate traction quickly and gain market share. A common way to identify this pattern is if investors own the majority of the company already before it reached its fit.
Trivago, HotelTonight, GetYourGuide, Traveloka, Tripping & Hometogo are good examples.

Light funded — a company built with little or no funding until it reached product-market-marketing fit at scale (a minimum threshold could be 1 million bookings per year). Booking.com, Agoda, Skyscanner, Kiwi.com are good examples.

Late funded — a light funded company that receives funding after it reached product-market-marketing fit. Booking.com & Agoda were such cases (via M&A), Skyscanner’s 2013 investment from Seqouia is the text-book example, as is Travelstrart’s 2016 investment from Amadeus Capital . In all four examples the companies were ‘proven winners’ in their original niche, and the funding is used to reach global scale and expand their niche organically or via small acquisitions.

Product-market-marketing fit — In a mature distribution market, and most online travel niches are mature and ripe with efficient marketing channels and established competitors, finding a product-market fit is often not good enough. For what good is your differentiation if you cannot acquire customers at scale (in profitable unit economics), and do so better than established competitors? This point is critical in this analysis and is often ignored by investors of heavily funded companies who appreciate the traction and are less critical on the difficulty to turn negative CAC to a positive one at scale without product or marketing excellence.

Basic assumptions used in this essay:
- Starting a company is not a light decision, but rather a commitment to invest the best years of your working career in the efforts to build a lasting organization.
- Founders carefully consider the various financial paths in which they can build their company, and the option to choose between light funded and heavily funded is available to good founding teams.
- Starting capital / incubation stage is ignored as it is rarely a strategic driver (albeit it is highly dillutive to the founders and can make even an light funded company one with a very founder-unfriendly cap table, as was the case for kiwi.com)
- Developing your founding team is ignored as it is a case-dependent decision, but one must align their funding strategy with their founding team.

The 5 questions every founder has to answer in choosing their funding strategy

1. Did you achieve product-market-marketing fit or are you just marketing profitably at small scale or using your savings to do marketing at negative ROI?
   A. There is nothing wrong with marketing profitably at small scale (commonly long-tail), and we spent the first years at FindHotel doing exactly that. Same is true for the starts of Booking.com, Skyscanner and likely many other less glorified but successful companies. Marketing at the long-tail is a good way to learn about demand (however non-equally distributed), and a good way to learn how competitive your product is in the market and measure the distance you need to cover in order to move up from the long-tail. In most of the niches within the travel industry the long-tail is long enough to build a decent product and kickstart a company without needing much external funding (a recent such example from VacationRenter). Naturally, beginning in the long-tail and finding small scale is different than finding a scalable customer acquisition channel, but it is still better than the heavily funded alternative of acquiring in the mid-long tail at a loss.
   B. The assumption that you can run an entire company on negative customer acquisition costs & later use scale advantages in commissions and conversion rate optimization to turn negative CAC to a positive one while continuing to increase scale is highly speculative and being highly marginal while scaling makes you very dependent on the market. The example below taken from Trivago’s Q1 2018 investors presentation demonstrates the risk of working on low (often negative) CAC margins when they are being pressured.

2. What are you signing on when building a heavily funded company?
Some founders may not consider that at first, but if your promise is purely to deliver revenue growth using effective marketing (the case for most consumer travel sites mentioned earlier), you are building a heavily funded company, with its perks and perils.
Main perks: you get to sit on industry (or fund-raising) event panels, get frequent Techcrunch mentions, and have a chance to pay above-the-market salaries to build your all-star team. Oh, and you get to over spend your competitors (startups or established) on customer-acquisition costs, helping you meet your/your investor revenue targets.
Main perils: your team mainly came for the money and isn’t motivated much by building a long-lasting business (which is where most of your payoff is), creating crucial misalignment of interests. You are under constant pressure to meet projections you made with little/no data, and even if you achieve them, there are no guarantees there would be an exit scenario at any valuation nearing what your last investors (those with a liquidation preference) paid for.
Again, these fears may seem theoretical, but I have seen this happen over and over again in the consumer travel space. For instance in 2012, when Priceline Holdings bought Kayak, Expedia reacted with buying a control stake in Trivago. That left other hotel metasearch players without a natural buyer, and we have yet to see a significant transaction or an increase in value in the hotel metasearch space since. Only last month Booking acquired activities distributor FareHarbor, Within a day Tripadvisor followed with Bokun, leading the consumer focused ticketing and activities startups (who raised dozens of Millions each), to reconsider if the consumer position they worked so hard to quickly build (mostly at negative CAC) has an M&A exit path at all, as it is not big enough for an IPO. They have been racing and raising significant funds, but went in the wrong direction as the big players (Booking, Expedia, Tripadvisor, Airbnb) consider activities as ancillary to their existing offering and not a stand-alone consumer value proposition worth spending negative CAC for. Will these startups get a chance to pivot & will that succeed are two big questions, the first one will be answered very soon.

3. Is there a good reason for you to be heavily funded now?
There are great examples where going heavily funded was a brilliant decision that worked well for the founders & the company. The most relevant examples in the past decade are Uber (and competitors) & Airbnb, and I will focus on the latter. As soon as Airbnb proved its product-market-marketing fit, it became clear that signing hosts and thus securing supply is the key to Airbnb’s network effects, and that the global nature of the accommodation market (plus the fact Wimdu forced it to think global in 2011) requires simultaneous scaling across the world. That was a great reason to raise significant funding while the founders were still able to maintain 40% holding even after raising $3.3Bn until 2017 (see below).

Airbnb’s cap table as estimated by Startup Book in March 2017.

A different example of a logical heavy funding event was Kayak’s $192m round and acquisition of competitor Sidestep in 2007, when the two companies combined generated $85m in revenues. That move allowed Kayak to eliminate the only key competitor and conquer the market in the US flight search and paved its road to an eventual IPO in 2012, but also moved much of the upside to the funding entities, leaving the founders with single digit holdings.

4. How far can you go without raising significant funds?
Often, that answer is further than you think. My favorite example in our generation is Kiwi.com, founded in 2012 and employing over 2.000 staff, while selling an estimated 200k flights per month. Kiwi.com has raised just €1.5M on its way to finance a company that likely spends over €5M a month on overhead alone, while enjoying an EBITDA of +€10M in 2017, on its way to an estimated valuation of €400M (though it hasn’t been transacted in these levels yet). Update: General Atlantic invested $125M in Kiwi and is now its majority owner (Aug 2019)

How did Kiwi.com achieve that? First, they found their product fit elsewhere than they originally thought it was. The original idea (called Skypicker), was to combine two low cost flights to one metasearch offer & show the links to the two airline websites, where customers had to complete the two bookings and hope their first flight won’t be delayed, or they would lose the second one and need to buy a new ticket while stranded at the airport. That was a very low value business, and marketing was difficult as they were acting as a metasearch, competing with the likes of Kayak and Skyscanner on customer awareness at the top of the funnel and earning low ad fees per referral. Eventually they learned that there is more room in the market for a guaranteed service that fulfills the original value proposition of interlining two airline tickets that aren’t sold together, but also covers the customer in case the first flight was delayed. That move required them to become the merchant on record of the transaction and serve the customers, but also allowed them to charge booking fees in a market that mostly lives without them. Since other booking sites compete in metasearch on the commodity that are single flights or official connection flights, Kiwi.com was able to add both a unique product & do it with higher revenues per visitor, making it an instant success story that scales globally and has a much more valuable model than its traditional competitors such as Edreams Odigeo, Travix, CheapFlights.com and even Expedia.

5. Are you aware of the advantages of remaining low-funded?
This point is perhaps the most neglected aspect of funding strategies. Remaining low-funded is a trade-off that has its own perks and perils.

The perils are easy enough to figure out:

• Differentiating at the early stages is very difficult, as you need to rely as much as possible on partnerships to build your product cheaply, making it likely that your original offering is traditional, and as a result: harder to market to ambitious candidates (or investors).
• Your progress is dependent on your ability to market profitably, and almost surely you begin in the long-tail or have concentrated your efforts in a single marketing channel, and encountering growth barriers may look like the end of the world. It sure did look like that to us in the first time it happened in 2013, and we have seen it 3 more times since, roughly every 18 months. Yet, we are live and kicking and have come out stronger after every such round, as explained by Ray Dalio’s Principles book in the following graph:

• You cannot pay above the market salaries and shortcut your way to learning by leveraging others experience. That has its upside too, as your team joins for reasons other than salary and is much more eager to learn how to succeed in your niche than having experienced workforce who ‘has been there and done that’ (something that heavily funded companies often do).
• Managing cash-flow well becomes a key trait you must master, or you can lose the company unexpectedly when crisis arrives. Ben Horowitz’s quote below sums it up nicely…

But the hidden perks help develop the good to becoming great

• Your employees are your partners and not just another stakeholder. That gives you the opportunity to tie them to the company’s long-term success with a share structure, achieving alignment of interests with almost every individual on your team who thinks long.
• You have the time to find your product-market-marketing fit, and can search for it for as long as your cash and motivation allows. In the balance between time & money, time is far more valuable while you are searching for your fit (as long as you can live to pay the bills). Having signficant investor funding comes with a ticking time bomb of IRR expectations of your investor which in turn leads them to seek a 10X type of outcome (read here about the implications of IRR for VC). That means that in a purely rational scenario, a VC that suspects you are not heading in that 10X outcome direction will ask for the remaining of their money back or force a cheap sale-off, instead of having you holding on that investment for an endless period of search. Hence, when you raise those heavy funds you have to run, no time to think and rarely a chance to ‘pivot’ your way to success. Looking at my favorite examples of success in the travel industry (Booking.com and Skyscanner), it is clear that they needed time to find their growth model, with their liquidation/significant fund-raising events happening 9 and 11 years after founding, and these were great companies with excellent time to market.
• You can keep a low profile and reduce competition. While I would also like to sit on industry panels and discuss various trends, I never get invited because my FindHotel maintains low profile in the industry. In 8 years of existence we have never issued a PR statement, never had a company profile on an industry site, and never gave an exclusive interview to discuss a feature we released. We can thus develop our strategies quietly and focus our marketing where it matters: on customers & on attracting the right talent. Competition has extremely hard time understanding if we are doing anything smart, and if it would be up to me they will not hear about us until the day of our IPO… Compare that with heavily funded companies like the vacation rental startups which haven’t even proved a financial viability and already see a crowded space.
• More important than all: you cannot scale until you nailed it. Until you got your product-market-marketing fit, until you got the right team and lead them to execute effectively, until you found your +$1Bn opportunity, until you reach scales that make that fund-raising round you were never built for, an obvious choice for a visionary, long-term thinking investor, who invests in you instead of owning most of your potential outcome.

Given the choice and with the benefit of time, I would have not have it any other way, and believe the same is true for most consumer travel startups out there, and their (prospective) investors.