Aligning Founders, Employees, and Investors
Ask yourself why someone is offering you something too good to be true.
Something most people seem to have forgotten over the last 5 years: a venture capital fund size should dictate its investment strategy and it certainly does shape its incentives. Smaller, earlier-stage funds need outsized returns from many smaller investments - it’s all about the returns (and the carry). Larger, later-stage funds have a much different model. Size is the enemy of returns, and it’s all about management fees. They have different incentives: raising the next fund, deploying in high volume, large check sizes, and lower expected returns. Founders should seek alignment with funds incentivized to help their particular stage. Founders should ask themselves why a fund would offer them $50m when their ask and model dictated they only needed $25m. Maybe that investor needs to invest larger amounts because their fund model dictates it. Just look at the below to understand how many more people may have had this “problem”…
Matching the fund stage focus is critical. Seed funds help early with team building, market orientation, and product development. Series A investors help with some of that but focus a lot on exploring go-to-market strategies, building brand awareness, and business model refinement. Series B investors invest to prove the GTM strategy and get the growth mechanisms refined. And growth funds further assist in scaling. Founders and employees should find investors targeting their specific stage for maximum impact. It’s rare any investor is great at everything and their fund sizes reflect the strategy they want to employ.
Optimal alignment comes from pairing the right company stage with the right fund (and therefore check) size and stage. Funds too small for a company’s stage can undercapitalize a company or lack support for future rounds. Funds too large for a company’s stage can lead to three scenarios: 1) one where the check size is too small for the investor to care about because no matter how well the investment goes, it won’t impact their fund returns or 2) the fund will insist on outsized ownership that makes future fundraises a challenge or can cause pressures on how they encourage the company to be run or 3) the fund can offer their check size at a higher price. Option 3 was an easy pitch to founders over the last few years: “We believe in you so much, we’ll give you more capital and longer to build at a higher price”. It’s hard for founders to turn that level of support down. Nobody likes fundraising so why not raise more capital!?
But taking too much money at too high a price can actually backfire. A certain “massive late-stage strategic investor”’s massive fund proved that capital isn’t necessarily a cure-all or a real barrier to entry. In fact, it can make you bloated and slow - the antithesis of startup success. What really ends up happening with overvalued rounds where more capital than necessary (+ a nice buffer) is the preference stack increases beyond the progress of the company. That leaves little room for error for the founders and employees, particularly with a closed IPO window. Without getting into cap table math, a future down round or acquisition can wipe out founder and employee equity. We’re in the midst of seeing this and much worse as the mid and late stages freeze and recaps are quietly becoming regular occurrences at all stages. Few funds have an incentive to say the quiet part out loud, but raising the right amount of capital at the right valuation is key to aligning founders, employees, and investors.
Every good long-term relationship is based on trust, transparency, and incentive alignment. It’s up to founders to diligence their investors as much as investors to diligence the company in which they invest. To produce the best outcomes for everyone and to do right by your employees, understand the investor’s incentives and insist on alignment.