One Investor Isn’t Enough

The success of companies and founders in modern venture-backed startups is highly reliant on peer validation of investor decisions. Part 4 in a series.

Originally published on NewCo Shift.

Say you’re an entrepreneur building something new and different, and you know you need capital. After pitching up and down Sand Hill Road (and all over South Park), you’ve finally found a believer, someone who sees what you’re trying to do and thinks you and your team are the ones to do it. Great! Now you can focus on building your business, right?

Nope. Get used to more of the same. You probably raised just enough to get to your next milestone, not enough to get to self-sustaining profitability, which means you’ll be raising again soon. After all, on average startups raise more than three rounds of funding. I know what you’re thinking: But this investor is a true believer, and given how hard it was to convince others, they’ll sign up for the next round instead.

Nope. It does happen, but it’s rare. In general, every round you raise has to be led by a new investor. Part of this is about dollars: Your seed-stage investor writes $500k checks out of a $50m fund, but your A-round investor writes $5-10m checks out of a $300m fund. That seed investor will participate in the larger round (doing what’s called their pro rata, to keep their ownership share the same), but if they led the round they’d burn through their fund too quickly and would not be able to lead enough investments to make their model work.

Even if dollars aren’t the restriction on your first investor leading later rounds, you’ll still likely find yourself pounding the pavement again. Imagine you’re an investor, and you see a peer investor leads follow-on rounds for most of their portfolio companies. One of those companies comes knocking on your door asking you to invest, and of course your natural question is: Why isn’t your existing investor leading? There’s no good answer to that question.

You can’t say, “Well, they’re a bad investor, and I really need new blood”, for pretty obvious reasons. Even if it’s true, badmouthing existing investors will never get you new ones. You can’t say, “Well, they like us, but even though they lead follow-on rounds in 90% of their companies, they don’t like us enough to lead one for us.” You’ve just told this new investor that you’re in the bottom 10% of your investor’s portfolio. Now there’s no chance they’re going to invest. If the investor that knows you really really well doesn’t want to write a check, no one else will.

To prevent this problem, the industry has the habit of not leading follow-on rounds. Again, not that it never happens, but it can’t be the common pattern, because the company that breaks it gets a black mark. I’ve had many investors (including those invested in Puppet, the company I founded) tell me they follow this habit religiously, for exactly this reason. “Nope, as much as I like you, you’re going to have to get the money from someone else.”

Out you go.

Thankfully, venture investors recognize the downsides of this and build deep networks of firms and individuals who frequently work together. There are even later-stage firms who specialize in following specific investors whose track record they trust. But while this pattern was developed for good reasons, it also has downsides that no amount of networking or help can compensate for.

First, of course, it means most CEOs spend a huge percentage of their time either directly raising money or doing the work necessary to do so later. You might not have wanted to become best friends with tens of investors, but if you’re taking venture capital, that’s your job now. Given that investors are professional meeting-takers, they’ve got time to meet for coffee any time, so this can be hugely time consuming. Then when it comes time to actually raise a round, you should expect it to consume your life for at least three months. And that’s the success case.

This time sink is pretty bad if you live near all the investors you need to meet, but what if it’s a flight to the bay area instead of just a drive? Oh, if you’re one of the top companies they’ll come to you, but if you’re not, it’s one more way you have to work harder than the ones they love. It was only in our late-stage rounds we had luck getting investors to come to us, and we were only in Portland, an hour and a half flight away. I can’t imagine trying to raise money in a place that shudder needs a connecting flight to get to. I nearly killed myself in a rented PT Cruiser (the first available car at SFO) trying not to be late to an investor meeting, and of course, he passed on us anyway because I could not convince/did not want his buddy to join us as COO.

This all adds up to a massive tax on the companies that do succeed, where CEOs become experts in fundraising rather than experts in building great companies, which is, of course, stupid. But it has a much worse impact on who and what can get funding in the first place.

Again, put yourself in the head of an investor. You look at tens of potential investments a day, and you have far more opportunities than time or money, so you have your pick of what to invest in. On the one hand you’ve got a woman or a person of color pitching a company that sells to markets they deeply understand, maybe something more focused on customers who look like them. On the other hand, you’ve got a Harvard-educated CS grad who’s found another great use for AI in the cloud.

What we want is for the decision to be made based on what’s the best investment, who’s the best founder, but it’s not. It’s obviously not. If it were, you wouldn’t see such rank discrimination in the world of VC, where women and people of color are almost entirely excluded.

Instead, a key factor is whether the investor believes this person can raise another round. Note: It’s not whether the person actually can, because you don’t know that until you try it. It’s whether the investor thinks they can. And, of course, investors know that women and people of color don’t fit into the pattern of other investors, so they pre-discriminate in expectation that later investors would have anyway. I mean, why give someone $500k if the company won’t be able to raise another round anyway? You’ll lose all your money.

Like with all patterns, it’s as much about the company as it is about the founder. It’s not just about who gets money, it’s about what kinds of problems are worth solving, and what kinds of customers make good markets.

Silicon Valley has a well-known fondness for investing in products that solve the needs of white boys who just got out of college and are having to learn to live on their own, but less obvious is that this means they often consider other customers to be worthless. It is fantastically hard to convince an investor to back a product built for women, or people of color, or international buyers, when the investor is none of those things.

That is, it’s not just about investing in people who are different — it’s that their ideas are different, the problems they care about are different, and the markets they want to attack are different.

In a world where you’re taking risks, where you’re actually focused on brilliant founders in big markets, those differences would be positives, they’d be signs you can do something ground-breaking. But when that world requires multiple rounds of belief, where failure at any round destroys your company, suddenly those differences become reasons for people to say no, for companies not to get funding, for founders not to get support.

There are some firms out there, like K9 Ventures, who make these bets anyway and recognize that it turns their job into finding follow-on rounds for existing investments rather than just finding new companies. Too many investors either don’t see the consequences of this pattern, or preemptively admit defeat and just don’t even consider investing in a company that they are concerned couldn’t get another round.

Once again we see how a key aspect of venture, one that exists for good reasons, has pernicious consequences that help to explain how the world of venture works today, in all its glory and misery.

There’s no obvious fix to the problem, as either an investor or an entrepreneur, if you truly do need capital to grow but you don’t fit the pattern. One of your best defenses is to focus on profitability first, so you don’t need those follow on rounds and the levels of approval required to make them happen, but that’s not possible for every firm, and even when it is it can result in heavy compromises on growth.

Thankfully, there are now firms out there focusing on founders who are women and people of color. These firms will help in multiple ways. First, of course, they’ll provide the direct funding that is not currently available to so many great founders and companies, but second, they’ll begin to build out those networks of social proof that will enable these companies to get as many rounds as they need, rather than just the ones they can provide.

We’re going to need a lot more firms like that to truly unlock the potential of venture capital, to bring world-changing solutions to those who can get the most benefit, wherever they are and whoever they are. I’m hopeful that the competition these new firms bring will change the behavior, and the opportunity, of the existing ones enough to make the difference, but what’s really going to shift behavior is when the companies invested in by these companies start to deliver outsized returns specifically because they don’t fit the pattern.

That’s what I’m looking forward to.