Conflicted Capital

I’ve spent a long time wrestling with how to advise founders about investors and the conflicts of interest generated by opposing incentives.[1] These considerations are especially important when a founder thinks about fundraising. The founder needs to figure out how to treat internals, how to balance the incentives of those internals with new investors, how to assess the various conflicts that might arise and the likelihood of those conflicts. This is exhausting and seemingly unavoidable.

Part of the analysis here is to figure out what to do with investor attestations to being the most “founder friendly,” as if this term is a talisman. Investors hold up their hiring prowess, willingness to grant extraordinary voting powers, secondary offers, etc to show how they are friendlier than everyone else. Unfortunately, no amount of upfront promises can make up for the fact that investors are definitionally conflicted with founders any time the financial interest of the LP diverges from the founder.

This conflict doesn’t make investors bad or immoral. In fact, the vast majority of the investors I’ve met, even those that have fired founders, are good people. It’s deeper than that, even. Investors mostly want to do the right thing for founders. There are emotional and business reasons for this impulse, but ultimately the fiduciary responsibility has to win. Founders need to understand that venture investing is a business where friendship is an input or an outcome, and not the other way around.

Rather than trying to tease apart every instance at which investors and founders might find their incentives misaligned, I think it would be helpful to focus on one particular divergence since it seems to surprise founders every time. This scenario plays out every time a company raises a round that an internal investor could lead. This means that the company has a multistage investor on the cap table which has the capital and mandate to lead the round in progress.

This type of conflict used to be rare, but it seems to be popping up in every round I see. Ever larger numbers of VC funds are now multi-stage, which means they generate internal conflicts at any round they want to lead. Many angels now have sidelines in running SPVs,[2] which makes them multi-stage investors with the same type of conflict as the VC. Finally, given how closely rounds now follow one another for hot companies, the time in which an investor can think about something other than her position for the next round has shrunk. Every interaction a founder has with an investor is colored by this dynamic.

To name the incentives for the founder at fundraise:

  • Least distracting process

  • Best possible terms

  • Best possible partner for building a large company

  • Balanced cap table

  • Not piss off the internals[3]

To name the incentives for the investor at fundraise:

  • If the belief is that the company is a future $100B behemoth

    • Lead the round and build ownership

    • At lowest price possible to win

  • If the belief is that the company is good not great

    • Lead the round if the price is right

    • Maintain ownership

  • If the belief is that the company is not good

    • Help the round get done by someone else to preserve brand

    • Maintain most ownership in case the company surprises to the upside

Many founders approach internals at the very start of a new fundraise, which allows the internal investor to choose first. This gives the investor significant leverage in any resulting negotiation. The investor’s decision also sends a signal to the rest of the market about the company’s prospects, which could sour a fundraise.[4] In this scenario, the founder needs to treat the investor like Schroedinger’s cat - keep the investor in the dark about the fundraise until such time as the founder wants information to leak.

This is a tricky dynamic since the internal investor often has information rights, probably wants to be helpful, but does want an early look at the deal. However, the best thing for the company would be a clean and competitive process. The “founder friendly” move here would actually be for the conflicted internal to proactively recuse himself from the fundraising conversations until explicitly invited in by the founder. This is unlikely to happen.

Instead, a founder needs to take control of the fundraising process even before talking to internal investors.[5] I generally advise founders to do something along the following lines:

  1. In the months leading up to a fundraise, create touch points with likely future leads, i.e. coffee meetings. At the very least, this gives the founder a group of investors that can be activated when necessary. In the best case, this can lead to pre-emptive offers.

  2. When the founder determines that the company is ready to raise, the founder needs to prepare a deck, practice a pitch, and decide which funds and partners are top choices.

  3. Once the founder has that set together, start scheduling initial meetings with external investors. 

  4. Once those meetings are on the calendar, approach the internals and say “Ok, we’ve got strong interest for an A, and are going to run a process, we’d love for you to take the lead here. Can we set up a formal meeting?”

    1. If the investor declines the meeting and says “we’re not interested in investing at this time,” then the founder and investor need to figure out a narrative for the rest of the world about why the investor is passing. This is unlikely to happen without first having a meeting.

    2. If the investor is interested, she’ll often ask to meet in order to “practice the pitch.” The founder should decline a practice meeting and push for a formal partnership meeting, citing the process and desire to not waste the investor’s time with a “practice” pitch.[6]

  5. Run the process.

To be sure, there are significant nuances in running a process under these circumstances. Founders would do well to have an unconflicted third party with significant experience here to ask for advice on the evolving dynamics. Barring that, remember that an awful lot of awkwardness can be smoothed over by simply being polite.

This is the third in a set of essays drawn from watching the interactions between investors and founders during several hundred Series A and B in the last few years (The first two are https://blog.aaronkharris.com/abundant-capital and https://blog.aaronkharris.com/distributed-capital). If you are wondering how this dynamic impacts your company, please reach out at [email protected]

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[1] https://blog.aaronkharris.com/investors-and-their-incentives

[2] Special Purpose Vehicle - basically an insta-fund that has a single position.

[3] There are quite a few ways to piss off the internals. The founder could take an outside offer at the same or lower price than the insider’s offer. The founder could refuse to grant super pro rata. The founder may need to renegotiate pro rata. All of these present potential problems and are even more stressful if the internal is also a board member.

[4] https://www.ycombinator.com/library/3N-process-and-leverage-in-fundraising.

[5] This principle holds at every round, but becomes more complicated once a company has a formal board. Founders should not actively hide information from the board, but do need to hold board members at arms length when appropriate. The nuance in how this is done is tricky and varies depending on the situation.

[6]There are quite a few tactical paths at this point that can only be solved with sufficient context.


Distributed Capital

In theory, the hard part about finding capital for unproven founders with unproven technologies in unproven markets should be that no one wants the risk. There was a time when that was true, but it isn’t anymore.[1] For a founder, the issue is different: venture capital is abundant, but it’s not very evenly distributed.[2]

There are groups of founders to whom this uneven distribution is an advantage. These founders are well connected or pedigreed and can use their access to capital as an advantage in building their startups. That’s good for them, and they should use every advantage they have.

But the world of startups would be better overall if capital could more easily find great startups. That should be a given, but in looking at the various bottlenecks in the system, it is clear that, at least some of the time, some of the parties involved are actively impeding access and distribution. Other bottlenecks are the result of the fact that venture markets are immature.

Manufactured impedance

Professional investors are in something of a bind when balancing accessibility and exclusivity. On the one hand, the best investors generally believe that returns are driven by significant outliers. These outliers are unlikely to come from an expected source or pattern match precisely on previous outliers. This means that investors would be best served by having the largest possible funnel and the least biased filtering mechanisms. In other words, investors should treat any and all inbound investment opportunities as potentially incredible and equal weight their attention to them.

However, this presents a set of problems. Investors who tout their willingness to look at everything equally and actually do so will lose their auras of exclusivity. This aura is important in convincing founders to contact the investor and later when investors try to win deals - when given the opportunity, most people choose exclusive clubs over inclusive clubs.

Then there’s the practical problem: capital may be abundant, but good people and their time are scarce. Let’s say, for instance, an investor decides to follow the “evaluate all inbound” model. This investor actively markets that she’ll meet every company that emails her. The strategy works and the emails pour in.

That investor will then need the time to meet hundreds of companies each week. Software can help route and filter, an application process can eliminate some number of in person meetings, but the investor will need partners and staff to deal with volume.[3] New partners and staff cost money, which means raising more funds. Larger teams and larger funds start to impact exclusivity, as does the greater numbers of investments dictated by adding people and looking at more companies.[4] Investors who want to pursue the abundance path will get caught in a recursive loop that seems dangerous to their model.

Structural impedance

The other set of barriers to capital distribution exist because venture markets are relatively new and immature. There are many markets without local venture capital investors. Foreign investors may be interested, but face challenges in understanding the nuances of those markets and those founders.[5] This impedes the flow of capital to companies that should get it.

Because venture markets are relatively new, they are also unnecessarily opaque. Information within these markets is rightly viewed as incredibly valuable, and so it is rationed by those who have it. This makes it hard for new entrants with money to figure out where to put that money. Instead, LPs are required to route it through the professional venture investors that have access to information about what companies are raising and which are not. The analogy here would be an equities market which forced university endowments to call hedge fund managers to discover what stocks exist.

There are a number of other structural bottlenecks to evening out the distribution of capital. What is so interesting about these and the manufactured bottlenecks is that they could all be solved by either a new common set of behaviors, or an intermediary that made it significantly easier for startups to access the sources of capital already looking for them.[6]


This is the second in a set of essays drawn from watching the interactions between investors and founders during several hundred Series A and B in the last few years. If you are wondering how this dynamic impacts your company, please reach out at [email protected].

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[1] See https://blog.aaronkharris.com/abundant-capital

[2] Apologies to William Gibson for bastardizing one of my two favorite quotes about the future and technology. The other is from Arthur C. Clarke: "Any sufficiently advanced technology is indistinguishable from magic."

[3] Operating under the assumption that the investor can successfully generate inbound interest.

[4] Partners at venture funds are primarily evaluated on the quality of their investments. This means they have to actually make investments, especially early in their careers.

[5] When Rappi first launched, US investors failed to understand the radical differences in their economics relative to US counterparts. These differences were driven by dramatically lower employment costs and urban densities that were only apparent if you’d studied Latin America enough.

[6] To some extent, YC’s Demo Day does this for seed stage companies. However this function has not yet been replicated at later stages.

Abundant Capital

The venture capital industry was built on the premise that both capital and high quality companies are scarce. For most of the history of the industry, this has been true. I remember sitting at demo day in 2011 and marveling at the fact that the combined capital of all the VCs in the room was less than that controlled by the hedge fund at which I had worked. But the model is wrong. Venture capital is abundant, and that fact should fundamentally change how founders fundraise.

This scarcity model has shaped the structure of startups and VCs - most of what an early stage startup does is designed to convince a VC to invest. Companies treat VCs as a limited resource that is both hard to access and hard to convince. Investors do their best to perpetuate this idea because it allows them to retain control of the pitch and fund dynamic.[1]

Something interesting happens, though, whenever a company has a signifier of quality - a YC demo day slot, a high quality angel, pedigreed founders, or, even better, strong growth. In these cases, there are investor feeding frenzies, leading to oversubscribed rounds, ever climbing prices, and investors willing to accept ownership targets they - until recently - would have termed unacceptable.

To be sure, there have always been bidding wars in private equity (of which venture is a subset), but these bidding wars are so frequent now as to be approaching the norm. If capital was actually scarce, this wouldn’t happen, there wouldn’t be enough money to create so many bidding wars.[2]

Bidding wars aren’t the only evidence of capital abundance. The VCs are changing their businesses because of this abundance, whether or not they admit the reason. The evidence is in the new funds that seem to launch on a daily basis, the multi-billion dollar growth funds that have become increasingly common, and the ownership targets at various rounds that continue to drop.

At the same time that capital has become more abundant, founders have become smarter about fundraising. There are now a huge number of blogs, classes, essays, guides, and advisers ready to help founders navigate the previously opaque world of fundraising. As a result, founders can approach each funding event with a clear plan of how to run a process. Running an orderly process further increases the chances that a company will see competitive bids.

As a thought experiment, assume that the abundance model is here to stay. It is also safe to assume that founders will not suddenly forget their newfound knowledge about process. I think this should encourage founders to think about changing fundraising in a few major ways:

  1. Founders should approach every fundraising as an auction. This is what each process already is, but the auction is inefficient. There’s lots of language and pseudo-moral arguments about why this is bad, but most of those fall apart if capital is abundant.

  2. Founders should expand their funnels beyond the traditional VCs. These VCs hold a marketing and branding advantage, much of which is built around the signal to later rounds. If, however, each round is an auction, this benefit evaporates. YC’s demo day proved this funnel expansion works at seed, and there’s no logical reason it should fail at later rounds.

  3. Once a founder has the information produced by this process, she can decide whether to minimize dilution, maximize price, or optimize around the partner. The answer will change based on the situation, but having access to the choice is important.

Founders are hesitant to run this model because they fear that running an auction will create a negative quality signal. Investors encourage this belief because it allows them to keep deal flow proprietary. This is flawed logic. The quality of a company can’t be determined by the investors to whom that company talks when raising money. The quality of a company is determined by whether or not the company is good, and good companies should take advantage of abundant capital markets.[3]

This is the first in a set of essays drawn from watching the interactions between investors and founders during several hundred Series A and B in the last few years. If you are wondering how this dynamic impacts your company, please reach out at [email protected].


Thanks to Adora Cheung, Janelle Tam, Ilya Sukhar, and Nabeel Hyatt for helping me think this through, even though our conclusions might differ.

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[1] Perhaps more importantly to the investors’ business model is that this dynamic creates a reason for the existence of VCs. If founders and LPs both internalized how non-scarce capital actually is, they could find one another directly, bypassing VCs.

[2] It’s important to remember that, even though capital is abundant, it remains unevenly distributed. There are companies that struggle to raise money - some of these may be bad investments, but many are good. This is a problem of access rather than capacity, which is a whole different issue.

[3] When a company IPOs, it opens ownership up to anyone who can afford a share. Imagine, for a second, an investor arguing that this is a sign of low quality.


Goodbye YC

I sent this email to the whole team at YC yesterday:

When I joined YC 7.5 years ago, there weren’t many people around. PG and Jessica were still running things. We had offices in Mountain View, Palo Alto, and on Kearny street, but they were nearly always empty. The only meeting on any calendar was the lunch on Thursdays where we’d talk about companies over takeout or at a table in a crowded restaurant.

The ways in which we’ve changed since then have been amazing to see. YC has grown in every way imaginable. The scope of what YC funds is larger. The team is bigger and more capable. The number of companies is pushing towards some ever receding upper bound. There’s more software, a larger community, and more programming designed to help YC founders build better futures.

I feel a deep sense of pride and honor at the part that I’ve played in that change and growth. I recall the first conversation I had with Aaron King about the Series A for Snapdocs. The questions he and I worked through were the kernel of the Series A program. I am amazed to see the directions in which Janelle is now building YCA. I’m grateful for the part I played in our conversations about growing beyond seed investing - conversations which eventually took shape as YCC. And, of course, there are fifteen batches worth of applications, interviews, dinners, office hours, and demo days rattling around in my head.

I’ve been thinking, recently, about the founders with whom I’ve had a chance to work. I’ve lost count of the number of incredible people I’ve gotten to know over these last years. Thinking back, it’s easy to see how the sheer weight of numbers can drive a person to be jaded about the problems that founders face. But the other night, as I spoke with a founder about a tough situation, I was reminded about how important it is to that individual that she gets the best possible advice. This is a lesson I learned time and again, and is something I hope I’ll never forget.

And then there’s the funny stuff. There were stolen air conditioners, barefoot pitches, robots that did not make sandwiches, update emails pulled from the I Ching, bandages, inhaled jet fuel, and literal blood on the interview floors. These are the things that I’ll remember long after everything else.

The truth is, I only meant to stick around YC for two years. Somehow, that two became two more, and then some more. As meaningfully as I’ve enjoyed my work here, it’s time for me to move onto something different and new and outside the bounds of what YC does. That’s a strange, exhilarating moment, and an important one for me and for my family. The pandemic provided the practical and existential nudge I needed to see the depth of this need.

To my fellow partners - thank you for your tireless work for our founders and for YC. Thank you for everything you’ve taught me, for all the strange conversations we’ve had, and for all the demo day presentations we’ve crafted.

To PG and Jessica and Trevor and RTM - thank you for giving me this opportunity and for making YC the kind of place I could love enough to stay long after I meant to leave.

To Janelle - thank you for building YCA with me and for being the best person I could imagine to take it into the future.

To everyone else - YC’s mission in the world is abstract. It could mean so many things, but it wouldn’t be anything without your work. Whether you are managing founder expectations about housing in the Bay Area, helping someone understand the mysteries of cap tables, talking someone down off the ledge of yelling at a reporter, or making sure that there will one day be an office to come back to, you are what makes YC a viable, vital force in the world.

I’ve never liked goodbye.

aaron

Raise less money

Over the last few years, I’ve noticed that good companies are increasingly over-diluting themselves in their seed and A rounds. Counterintuitively, dilution seems to rise along with price. One would expect the opposite correlation. Strong founders who command high prices should be using that higher price to sell less of their companies in exchange for money to grow. As I’ve tried to understand what’s going on, I’ve tried several arguments.

Somewhere in the last week, I’ve come to understand an error I’ve been making when talking to founders about how much money to raise. I realized that the conversation about raising always anchors back to the idea of adding “months of runway.” That always seemed appropriate to me because it was a measure of the amount of time a company had to stay alive. Staying alive seemed good since it increased the time a company had to find product market fit and to grow.

But I now realize that this is the wrong framing because simply staying alive is an inadequate goal for a company.  Founders start companies to find product market fit and grow. Venture capital is designed to speed growth, not to extend runway.

As a result, in recent conversations, I’ve started to ask founders: “How much could you get done in the next 12 months with the amount of capital you are planning to raise? If you’re a good company, you’re either going to raise your Series A - or Series B - in the next 12 months or have significant revenue such that you won’t need more capital.[1] If you’re doing badly, why would you want to keep working on this for 24 or 36 months? That’s a waste of your time.”

Founders who raise too much capital are acting out of fear rather than acting out of confidence. This fear made sense ten years ago when seed financing was relatively scarce. This is when much of the fundraising advice I read as a founder was written. However, the world has changed and so should the advice

Financing is more accessible to good founders than it has ever been.[2] Confident, competent founders should take the risk of running out of money vs. the certainty of over-dilution.

Good founders respond to this framework as it shifts the argument from one in which “winning” is about adding months of runway to the bank to one in which “winning” is fast and high quality execution - as evidenced by hitting milestones. It’s also easy to draw a straight line from this framing to the best companies. When a company raises a Series A nine months after launch - or Demo Day - with 80% of its seed funds in the bank, it’s apparent that those founders sold too much.[3]

A founder’s decision on how much money to raise in any given round is more art than science. It is a fraught decision since it necessarily forces founders to make predictions about the future. There is no perfect answer, and over-optimizing around any single factor is a mistake. However, it seems clear that shifting the goal of fundraising from adding runway to progress would limit both the amount of money companies believe they need and the dilution that founders take in the process of building successful startups.

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[1] And if this is true, investors will chase you anyway.

[2] Even during COVID. I did not expect this to be true, however, this market is one of the most active I've ever seen.

[3] Seeing this dynamic on a regular basis while running YC's Series A program is what led me to realize my mistake. Without fail, the founders raising the most competitive rounds have the most capital left, and thereby the most unnecessary dilution.

Thank you to Daniel Gackle and Michael Seibel for your thoughts and edits.