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.