Hypermassive Early-Stage Venture Rounds Increase Founder Risk
The battle between temptation and self-regulation begins.
Dear Founders,
A couple weeks back I was talking about YC, demo days, and how it made us think through our beliefs at Comet Labs. I also brought up the concept of SoftBank’s Vision Fund as a Black Hole. It got my mind whizzing a bit and going off on too many tangents, all hypothetical with little basis on quantum anything. At the end of the day, the Vision Fund is having an impact on early-stage investing and we need to understand it.
Now, I’ve re-written this damn thing three times and ultimately landed here as a simple letter to you, the founders of early stage startups, and perhaps my future self when/if I scamper back into that odd existence of the startup damned.
As founders of venture-backed companies, there are really only two important things to keep in mind:
- The burden of proof is on you. It’s your job to to prove your vision is valuable and to make it successful. The Valley is here to help, but no one else is going to do it for you.
- You get compensated when you’re proven correct with an exit… NOT at an investment round.
Whew! Well, that wasn’t so hard now, was it?
I bring this up in the context of SoftBank’s Vision Fund, and why I’m having such a hard time getting it. I had to whiteboard the heck out this thing — in solitary confinement, then with my cellmate and Comet brand director Derek Embry — and we came up with a couple interesting concepts that have helped me get a grip on something massive and unprecedented in the venture landscape: the $100M+ early-stage raise.
My conclusion? Ignore it.
I know, I know — it’s nigh impossible to ignore. Big money is super sexy.
The black hole analogy for the Vision Fund is good because its internal mass is so breathtakingly huge. I mean, look at their portfolio:
It looks like a gravitational well, or half a tornado, with Brain Corp at the bottom with their “measly” $110M (or, as Recode puts it, $0.11B).
Ignore it.
Here’s why:
- $100M at early-stage limits your ability to pivot if you learn something new about your customer.
- $100M at early-stage limits your options for exit.
- $100M at early-stage isn’t defensibility.
Raise your rounds, make your mistakes, keep on chipping away at building amazing things. Don’t raise a lot of money or post high valuations with the aim of attracting the fastest path to success. Don’t do it.
Life is short, so let’s stop getting distracted and get back to work. Focus, focus, focus!
Myself included, and this is the last time I’m going to think about the Vision Fund… until they come to me with $100+M. Then maybe I’ll think about it again.
Yours in the grind,
Andrew
PS — if you want to know why I think founders should ignore this new wave of ultra large funding rounds, read on… if you dare.
One Fund, One Vote: The Art of Managing Authoritarian Voices
$100M from one investor at early-stage limits your ability to pivot if you learn something new about your customer.
Raising money from a venture fund is kind of like votes in an election. It’s not that investors know a given company will win, they’re just casting ballots with the belief that the company will win.
Sure, we early stage VC weirdos cast votes in lots of different elections hoping “1 out of X” will be a big winner, but at the end of the day there are thousands of ways startups fail regardless of how much money they raise.
In our current universe, a company can now raise $100M+ from a single investor at an early stage in it’s evolution.
With a minimum check size of $100M, the voting power of the Vision Fund is extremely high. That much cash, especially in early-stage companies that have not yet proven their business model, gives the recipient a massive competitive advantage over all others working in the same space.
But $100+M comes with a price, namely a company valuation high enough to warrant such an investment.
This is fine because the basis of startup valuations is more art (or hustle) than science. But once you establish that valuation, its stuck to your company like spit from a llama.
So let’s say you raise a grip of cash at a high valuation. It’s now up to the team — founders AND investors — to prove your company is worth more than the new, massive valuation and start your glorious march toward startup success.
But as it invariably will the sky falls as some fatal flaw presents itself. An unknown unknown. One of the thousand possible pitfalls. Zounds.
Then it’s time for a change and by the luck of all leprechauns, this happens to be the very best thing in the world startups are really good at. If a startup is the only one on the world doing its thing, pivot away and take all the time you need.
But startups rarely operate in a vacuum, and for most startups there’s at least ten others working on a similar concept with each at similar phases in their development and understanding of the market. The line between success and failure is blurry and a combination of multiple factors. Cash is definitely one of these factors, but not the only one.
Of the following, which company will pivot faster?
- The company that took a $100M investment — and the requisite board seat that ought to entail; or
- A competitor that raised less money, has less runway, and is still fighting for their very lives on a cash flow basis.
Our thinking is the latter. This highlights one of the flaws of large check sizes for early stage companies:
The Vision Fund is shifting Series D to Series A, reducing founder flexibility by eliminating gates founders should pass through to access greater capital.
So the advantage for the startup taking big money isn’t speed. It’s the opposite: time. They have more resources, a longer runway, and an investor that believes enough in them to invest $100+M to help weather major storms during a startup odyssey of epic proportions.
But all that time gives startups a false sense of confidence that their solution is the correct one before anything is actually demonstrated.
What they lose is the urgency to get stuff done and cut the BS; to jump on any opportunity or signal of a customer pain point, because the company’s life is at stake.
Money often makes people do stupid things. Big money and high valuations make people complacent. That’s the reality for most of us mortals, and it’s everything we’re taught not to be as early stage entrepreneurs.
Ultimately, if the Vision Fund deploys $100M minimum checks in early stage companies, it must police itself against being too rigorous on how that money is deployed and allow founders the flexibility to change their strategy…even risking all in the process. If they don’t, investors risk bloating a solution to a problem that doesn’t exist, while sustaining something the market doesn’t want. And if that were the way, we’d all still be reading magazines and buying our duds at JCPenney (I do both, but am outside Amazon’s core demographic). Disruption is all about doing things better than the other guy, regardless of how big the other guy is.
Sometimes You Eat the Bar, and Sometimes the Bar Eats You
$100M from one investor at early-stage limits your options for exit.
One simple thought experiment we ran through at Comet HQ was to play “What would you do?” scenarios. It’s a fun, daydreamy kind of thing.
You’re walking down Market Street, and some geeks in a suit offer you $100M (or $0.1B). Would you take it?
Kneejerk? Heck yes I’d take it. That’s a ton of cash to play with!
We could:
- Grow large, massively inefficient sales teams and make big money mistakes bringing new concepts to market; or
- Rapidly flip the company in an acquisition or IPO, where we’ll face the ever increasing skepticism of a world outside Silicon Valley; or
- Acquire other companies to diversify our offering.
But then I realized something. Point #2 raises the second ugly head of this kind of massive investment in early stage companies:
High valuations end up limiting exit opportunities, effectively forcing startups toward an IPO.
Hey, I went to Stanford. I did my incubators, my d.school. I know things. And what I know is that there are way more acquirers who can afford to spend $20M buying a company than $200M.
A lot has been written about what defines a good exit, and how focusing on multi billion dollar paydays is a bit silly. From a statistical standpoint, founders taking on a high valuation limit themselves to an ever smaller pool of potential acquirers. At the same time, they put themselves at risk of a downround or a poor share price at IPO if they fail to execute.
In walking though this daydream, I’m starting to think a founder’s willingness to take the money will boil down to a confidence matrix, something like this:
Huh! Well gee whiz, I think I can automate some predictive startup maintenance here (thanks again, Stanford!):
If you don’t have proof of market pull, you shouldn’t raise ultra large funding rounds.
Good founders solve problems in the market. Hopefully they also know what they’re doing, know what they don’t know, and appreciate the risks of high valuations before demonstrated market pull. Nest was a great example (or so the legend goes), and we coach our startups to think in this vein. Money can plug a lot of holes — especially in AI where top engineering talent is costing upwards of $1M/yr — but it can’t fabricate demand for a product or service startups are building.
If there’s demonstrated market pull, and you have the opportunity, take the money — with a mountain of cash, even those of us with low confidence in our capability to win can win.
But be warned! Fail fast and fail often is absolutely the way, but fail having spent $100M+ trying and you’ve probably done something horribly wrong. And the internet will make fun of you. With bigger buckets of cash flowing into the system, an increasing number of founders with the opportunity for big money will take an unnecessary risk.
Again, founders are paid at the exit, the burden of proof is on you. That proof is market pull. One of the great things about multiple fundraising rounds is that it’s a gate function for company growth; a check to filter out companies with innovations that have limited value.
Experienced VCs manning these gates can be complete assholes (I’ve been called worse), but they’re experienced assholes who’ve played witness to both the occasional rays of startup glory but mostly the eternal bloodbaths of startup war.
D-Fence! D-Fence!
$100M from one investor at early-stage isn’t defensibility.
One of the first questions we ask all founders we meet through Comet Labs is around defensibility — what makes your startup so great that others will have a hard time of being just as great? Some of the good answers are: access to unique data sets gathered by proprietary sensors, core patents developed over years and applied to a specific vertical, or demonstrated first mover advantage with the “data flywheel” making your ML-based solution better, and better, and better… Bradford Cross wrote an excellent piece about this last year.
What’s important here isn’t necessarily the validity of the defensibility, but the belief by founders and Comet Labs that such defensibility will hold over time.
It might not!
Things change, new sensors are built, another computer vision company focused on radiology comes along and poof! Defensibility is out the window. That’s one of the risks we’re willing to take, and why venture money (i.e. helping companies grow faster than without it) works.
An ocean of cash is not defensibility.
It’s hard to pick winners. Even with experienced founders, even with massive first mover advantage and demonstrated exponential traction, even with all the ingredients you could possibly hope for in a startup, failure is still the most probable outcome for any startup we invest in. We know this, and it’s why we fight like crazy to support our founders and their teams however and whenever we can beyond money.
When a startup takes in massive equity rounds of $100M+, that sure does feel an awful lot like the investors are picking winners. Some of these are easy, as in yes I think it’s safe to call ARM, NVIDIA, and WeWork as “winners” in the Vision Fund’s portfolio.
But the other companies are still too early in either their own cycle or the cycles of the greater market to definitively say “thou shalt be victorious.” And the Vision Fund jumping into early-stage is skewing perspective for founders.
This letter isn’t to me, SoftBank, or even other investors. It’s to the founders. Just keep building awesome things and try your best not to get sucked too deep into this strange universe where hypermassive venture rounds are a possibility. They’re not, nor are they necessary, nor are they valuable to you as a founder.
Lean and mean, baby. Lean and mean.
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