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.

Asking questions

Small children are great at asking questions. Their questions are simple, direct, and utterly without ego. If you spend time with 2-5 year olds, you’ll find yourself answering a near infinite series of progressively more challenging questions. This is one of the main paths by which children learn about the world.

ex. Child question: “Why is the sky blue?”


Adults are generally bad at asking questions. Adult questions come with long preambles, caveats, and agendas. Adult questions don’t seem to be designed to learn about the world, they seem to be designed to avoid looking dumb.

ex. Adult question: “I know the sky isn’t actually blue, and that if I look up, I know there’s nothing between me and outer space except air and maybe some clouds. Beyond that, there’s outer space. Outer space is effectively black because there isn’t light. Yet the sky often, though not always, appears to be various shades of blue. What triggers that blue? Is it something about how light interacts with air? Or gravity? Magnetic fields?”

The contrast between child questions and adult questions is striking, but it isn’t a function of age, it’s a function of conditioning. At some point, children get social signals that asking questions makes them appear stupid. This can come from a frustrated parent, annoyed teacher, or mocking friend.

Kids internalize this feedback and start to ask fewer questions as they grow up. The scope of things about which adults ask questions get narrower and narrower, shying away from things that are new or hard to understand. At the same time, adult questions get longer and longer. Most of this length isn’t important for the question, it is meant to prevent the audience from thinking the questioner is stupid.

These questions aren’t terribly useful to either the questioner or the questionee. If you’re not sure what this type of question looks like, watch a congressional hearing. The questions are meant to prove points, not produce knowledge.

Adult questions reinforce their own badness. When an adult spends most of a question proving his own intelligence, the question doesn’t produce new knowledge. This reinforces the perception that questions aren’t worth practicing. Without that practice, the questions continue to get worse.

I’ve been thinking about questions because I noticed that I’ve become increasingly self conscious about not knowing things, and cover for that by asking adult questions. Some of this is a function of the fact that I’m older and some of it is a function of the fact that my job involves giving a significant amount of advice. I noticed, as well, that conversations in which I ask simpler questions are more enjoyable and more interesting. These conversations lead to new ideas and better plans.

I’m particularly conscious of this dynamic in conversations with founders. Many founders believe that adult questions are the best questions because of their interactions with investors. On the one hand, investors tell founders that asking questions is a good thing. On the other hand, founders are judged for asking questions that are “too basic.” Founders who do things without asking questions first are generally rewarded for being “fast” whereas those that ask some questions first are derided as being “slow.”

However, successful startups are not defined by the questions that a founder asks. They are defined by what a founder does with the information at hand, and how quickly. Founders who acquire new information quickly and act are more successful. Founders who dither or get caught in infinite loops of ignorant execution generally fail.

Founders and investors would have better conversations if each side dropped the pretense of needing to “look” smart and asked child questions. This isn’t a complex task, but it does require focus.

The way I’m working on this is to stop myself each time I’m about to ask a question and figure out what I actually want to know, and then see if I can just ask that specific question in no more than a single simple sentence. If the question does not produce a satisfying answer, I’ll try to understand if it is because I worded the question poorly, or did not provide enough context. If I need more context, I’ll add one or two sentences of context, and ask the question again.

This strategy does not always work: I don’t always catch myself in time, I sometimes ask poorly worded questions, sometimes the question requires more context than is practical. However, I’ve found that the act of thinking about the question I want to ask and examining it in this child/adult dichotomy has helped me ask better questions, have better conversations, and learn more things. That’s enough of a reason to continue doing it.

Fooled by experts

Experts are generally right until they're wrong. Unfortunately, it's very easy to get fooled into thinking that experts are always right. This is because they are...experts. They are authoritative and knowledgeable. This is especially true when it comes to trying new things in existing fields. We are biased into believing that knowing a lot about something confers an ability to predict the future.

The problem with expertise is that it doesn't necessarily come paired with an openness to new ideas. Expertise can be used to shut down new ideas and avenues of exploration just as easily as it can aid in invention. I've been guilty of this when hearing about new ideas. In fact, it often feels easier to shut things down than to use what I know to figure out how to make something new actually work.[1] Perversely, being negative may make someone seem like more of an expert than they are, creating a negative feedback cycle.

When you don't know much about a subject, you're free of the constraints of what has been tried. That means people who are inexpert will often have wilder ideas. Sometimes, that's called naive or stupid. However, when those ideas happen to work, then it's called genius or groundbreaking.

That doesn't mean that every problem can be solved by creative ignoramuses. There seems to be a level of expertise which, when paired with the right environment, is conducive to productive creativity. I wish I had a way to know those levels for different areas.

Without a clear set of rules to use in evaluating expertise, I instead try to evaluate founders based on what I can learn from talking to them. This is especially true in areas that I understand fairly well. While there are certain things I might expect a founder to understand about what they're doing, I'm much more interested in how they think and test assumptions. This is part of how I try to figure out if I'm investing in potential (good) or track record (not so good).

One of the tricks in doing this is to see whether or not the tests that founders run cause them to ask increasingly interesting questions. Coming up with questions is a good sign of creativity, while answering them well builds the expertise necessary to actually get something done.

Technology increases the likelihood that a seemingly naive approach to a problem will work because it reduces the iterative cycle of trying that approach. Given enough time and resources, you could try every single solution[2]. In the real world, though, we have to pick solutions to work on. This is where the good founders are separated from the bad ones. The good ones get better and more open as time goes on, while the bad ones get more closed down and start rejecting ideas out of hand.

The same is true for investors. The best ones use new knowledge to open up new ideas, while the worst use it to close out entire categories of ideas.[3] That's short sighted because the world constantly changes, which makes new things possible. Founding and an investing in those new possibilities is what creates the companies that change the world. That creates new areas in which to be expert, starting the cycle all over again.

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[1] https://archive.org/stream/ERIC_ED211573#page/n0/mode/2up

[2] And enough monkeys at enough typewriters will eventually produce Hamlet.

[3] This is different than investors who understand the limits of their expertise and focus on specific sectors. An investor can be sector focused and open to lots of new ideas within that sector, just as an investor can say they'll invest in anything only to shoot down every idea.

Thanks to Craig Cannon for feedback.