Founder bets are confusing
Great entrepreneurs are necessary, but do not seem sufficient
As the year wraps up, we enter a season of gratitude. One of the things for which I am particularly thankful is that my role as an investor puts me in conversation with so many awesome and fascinating entrepreneurs. I love hearing people talk about what they’re passionate and knowledgeable about.
Few people are better experts in their field of choice than founders, and that makes chatting with them a pleasure.
I’m hearing more and more about this idea of a “founder bet” as a key element of certain early-stage investors’ decision-making processes.
A founder bet, as Ben from Village Global describes, is essentially an investment decision that is so founder-weighted that it overshadows all other potential criteria for investment.
These basically only happen at the earlier stages of a startup — they are incredibly rare to see at/after Series A, because by that point the startup is expected to have real traction for prospective investors to evaluate.
Clearly it can work (according to Pitchbook, Village Global is investing out of their 3rd fund and has more than 500MM AUM — which is quite successful for an emerging fund) but I do not care for founder bets.
Here’s why.
Founders aren’t corporations
The first reason I don’t care for founder bets is because people, even founders, aren’t corporations. As a VC, my goal is to make money for the Limited Partners who entrust me with their hard-earned capital by making good investment decisions into early-stage corporations. I don’t think the presence of an exceptional founder is strongly correlated with the likelihood of that particular corporation’s success.1
On the other hand, I would agree (and I think those who make founder bets would too) with the inverse of that statement: a lack of exceptional founders on the team is a strong negative signal about the likelihood of the corporation’s success.
This is critical because corporations are my financial vehicle for generating returns for my own LPs. In order to get to the valuations necessary to really be a win, corporations need to grow to a point where they can survive the loss of particular individuals in the management team. I struggle to get to conviction that startups I’ve seen identified as founder bets will accomplish this.
Moreover, because my mandate is to invest in early-stage corporations to create financial outcomes, my underwriting needs to evaluate the corporation – which is likely to retain the same industry, problem, product, and market even if the founding team composition changes.
Warren Buffett said it well:
When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
He wasn’t talking about founders per se, but it applies as much to them as to leaders of more established firms. A truly great founding team will know when to break it off, shut it down, and move on – and also mark my investment down to $0.
After all, about half of unicorns are started by second-time founders — they must have had first-time founder experiences somewhere.
If the only compelling thing about an investment candidate is an individual, I have serious doubts about the potential of the firm to get to a point where it becomes attractive to later-stage investors.
The problem matters
Moreover, while angels and some early-stage investors may make a decision solely based on founding team awesomeness, eventually somebody that our great founders go to for capital is going to consider the potential of the startup to be a fund returner. That potential is very much a function of the market and pain point.
There’s a real question as to whether or not it is useful to anybody – founders, investors, early-stage employees – to back founders if we lack confidence that somebody with this perspective would invest in them?
My answer here is a resounding “no”, though there are certainly valid counterarguments. Perhaps the easiest to make is to bring up the idea of a pivot, when a startup changes its direction.
Pivots are normal in early-stage ventures as a response to reality getting in the way of founders’ dreams.
I unequivocally support founders when they make a well-reasoned, informed decision to pivot. But I do not like the idea of investing before a planned pivot.
I have two issues with this.
First, while I don’t put founder quality above and beyond everything else, I’d agree with investors who make founder bets that founder quality matters, and furthermore that founder-market fit is critical. My view is that if founders intend to pivot, I should diligence their founder-market fit in the new market, which is typically more difficult to assess while it’s in the future.
Second, pivot execution is really, really hard. Before coming to the University of Chicago, I saw a fairly well-capitalized, publicly traded firm attempt and fail to execute a pivot from the inside. I’m not sure why it’d be easier at a lean startup than a successful scale-up. Even if I have conviction in the new founder-market fit, I’d rather not underwrite the risks of a pivot, and invest after it’s complete.
Relationship checks are risky
The other view towards early-stage investing is viewing early-stage founder bets as a “relationship check”, or an investment to build the relationship with the founder. The idea is that this will give them an opportunity to watch the founder, support them, and give the fund an in with the founder during a later, larger financing round.
Put in more financial terms, this is somewhat similar to a call option on investing in a future funding round — especially if the early-stage term sheet includes pro rata rights.2
My impression is that this is particularly attractive to multi-stage funds because the initial investment sizes are just so much smaller than what they’re used to doing that it’s easy for the successful outcomes to pay for the unsuccessful outcomes.
That definitely has potential for the funds that can afford it, and I have no experience playing in that space.
It requires a pretty specific sort of fund strategy in order to drive VC returns, and I just haven’t encountered a fund whose strategy in this space I feel I’ve understood well — from the inside, or from the outside.
From a founders’ perspective too, this seems like risky behavior.
Let’s say I am an investor at fund B, which is considering an investment in a startup. If I know that fund A made a relationship check investment, and is declining to exercise their pro rata rights, that does not send a strong and positive signal me.
Great founders are critical to successful startups. We’re all on the same page about this.
But I’m not yet convinced that they’re enough on their own.
What am I missing?
It is theoretically possible to invest directly in a founder as opposed to a corporation. This is not considered market behavior by VCs as shown by this X exchange. A more normative way to do this would probably look similar to an Income Sharing Agreement — which is essentially a debt instrument, and therefore not a good fit for VC’s desired returns.
It’s similar to a call option in that an early-stage investment with pro-rata rights gives the investor the opportunity, but not the obligation, to invest in the following financing round — and they’d only take advantage of this if the price had suitably increased since the past round. It’s not really a call option because:
options have a strike price, and there’s not a strike price for the future purchase (though this could in theory be negotiated)
options have an expiration date, and pro rata rights typically don’t