Back in B-school we had a professor who loved to talk about resource parsimony in entrepreneurship.  Resource parsimony – spending your money wisely – seems like a pretty obvious rule of thumb for any business, doesn’t it?  Yet for some reason, over and over, and over again, I see entrepreneurs spending money where they shouldn’t.  And one place entrepreneurs mistakenly spend money (or more often, where they tell investors they want to spend money) is on CapEx: plant capacity, furniture & fixtures, “adequate” square footage in a prominent office building, et cetera.  Here’s the bottom line: how you talk about capacity expansion, and how you have spent your dollars in the past, has a major impact on your chances of securing financing from venture capitalists and angels.

Sophisticated investors listen closely to how you make decisions about capital expenditures and capacity expansion.  If fact, many VCs use this information to judge your overall business acumen, and decide how many strings will come with their money. Depending on what you say and do, your past CapEx and future plans can be a big plus, or cost you significant points.

So what’s the right answer to the CapEx question?  Don’t spend money you don’t need to spend!  Let me be more specific:

Fancy Offices

You may think that having a nice office in the center of town shows investors how well your company is doing.  WRONG!  Your P&L, balance sheet, and statement of cash-flows do that.  VCs visit your offices so they can meet the management and employees, verify what they saw in the offering memorandum, and make sure the company isn’t wasting the previous investor’s cash on gold faucets.

Don’t splash out on location, square footage, or furniture and fixtures unless retail consumers will be making purchases there.  They are the only ones impressed by such trappings.  If you have fancy offices, but are on the hunt for capital, ask yourself: “Do I plan to buy more [insert fancy office item here] with the money from my upcoming angel round?  Do I think my angel investors would be happy to pay for more of these [insert item]?”  I think you’ll find that the answer is ‘no’, they wouldn’t be happy.  Then you have to ask yourself: “how am I going to explain all these excessive purchases?  How can I convince my prospective investors that I won’t make such bad buying decisions with their money?  How can I show them I understand their goals, and that mine and theirs are aligned for the most part?  How can I show them I really understand business, and I’m not a wannabe interested in appearing successful rather than being successful?”  Tough questions!

On the flip side of this, renting Spartan offices in a suburb of your city, buying used stuff (if you can’t lease it instead), and holding on to as much cash as possible, all win major points with investors.  I recall a biotech company’s bare offices (in a rundown warehouse on the edge of town) being mentioned repeatedly by every investor in the round as an investment merit and proof of the CEO’s sophistication and dedication to investors.  There are few places where spending less actually gets you more.  But this is one of them.

Preparing for the Deluge

I have always enjoyed designing and planning things – especially complex systems.  Perhaps that’s one reason I spent so many years producing concerts, and why I enjoy business planning, and developing financial models.

Your start-up’s financial models should be fully-formulated, so you can quickly model several future scenarios by “wiggling” input values.  How many customer service reps do you have per customer?  What are sales/salesperson/month?  What is the price of coconuts?  Inputs like these are the basis for your models.  One of the models you might show investors is a “good case” scenario, alongside your “not-so-good case” and “worst-case” scenarios.  That’s all well and good.

But many entrepreneurs fall into a common trap: actually building the capacity to serve all the customers in their “best-case” financial model.  Sometimes entrepreneurs build capacity even greater than the best-case projection.  For example, one organic farm business I know of had been leasing a small 1/8 - acre pilot greenhouse, as they perfected their innovative organic farming technique.  When they decided to turn things into a proper business, they took out a $2 million mortgage on 75 acres in North Carolina, built the world’s most technologically-advanced greenhouses on 2 of those acres, and left the rest fallow.  According to their projections, they would be using less than half of their total available acreage by year 5.

Series “A” investors injected several million dollars into this company – a portion of which went to paying that mortgage every month.  The founders and the investors both justified the purchase of the full 75 acres by citing the many years a field must lie fallow in order to be certified organic.  But there are lots of ways to attack that problem, without buying 35-times more capacity than you need.   After all, they were using the 2 acres immediately, weren’t they?

The purchase of that 75-acre plot proved to hurt the company almost as soon as they planted their first vegetable.  When several other things went wrong, the mortgage cost became a major headache: every month a bill came due for a resource that returned zero dollars to the company – a bill that was 35 times larger than it had to be.

The founders and Series “A” investors can say what they want, but that 75-acre farm was simply the fulfillment of the founders’ – farmers and soil geeks all – dreams.  It had nothing to do with ensuring profitability and revenue maximization, and everything to do with the visceral desires of management to own a symbol of their “arrival” to the world of venture-backed entrepreneurship, and perhaps to inspire them to fill those acres with vegetables.

The CEO and CFO – both founders, and both fired by the board within 15 months of the Series “A” – wanted to prove they had succeeded.  But in fact they had barely begun.  And ultimately they failed, in part because of the hubris of buying that huge plot of land. 

The VCs suffered too: most coughed up more dough (at a lower company valuation) to save the company from bankruptcy.  For them, the 75-acre farm began as a blot on an otherwise well-crafted pitch and business plan.  But it was, in fact, the first drop in a deluge of management missteps. 

It’s situations like these that lead some investors to view over-building capacity - especially at launch - as a big red flag signaling deeper problems with management.  Merely mentioning plans for grand capacity-building can put a good investor off.  In this case investors looked the other way.  Will they do the same in your case?  Would you want them to?

You don’t have to buy a 75-acre farm to be guilty of overbuilding capacity.  Have you ever noticed that when you have one pen, you keep it and use it for weeks – but if you buy a box of pens they seem to disappear rapidly until you have only one left?  That’s too many pens.  And if, in your young startup, you go to Staples and buy a box of pens, order the fastest computers for everyone, lease a few extra square feet of office space for those hires down the road, and buy the mahogany filing cabinet instead of the plastic one – you are building too much capacity.  It’s a mindset.  VCs hate it.  Get out of it and get into resource parsimony (spending money wisely).

In business the future is unknown, and one of the entrepreneur’s most important jobs is preparing their business for whatever may come.  Many entrepreneurs interpret “preparedness” as “capacity”, because they are, after all, preparing for wildfire revenues…right?  Entrepreneurs are optimists, and that is a great thing.  But reality has a lot more setbacks – that cut deeper and last longer – than many entrepreneurs’ grand visions.  You must make sure those setbacks don’t take too big a bite out of your cash pile – and that means running lean and mean, stretching your capacity utilization in the good times to 105%.  If you don’t, then one day the temporary hard times are going to cut a little too deep for a little too long, and turn your business dead.  Permanently.