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One Investor Isn’t Enough

A company’s success is highly reliant on peer validation of investor decisions. This stunts diversity and must change if we want the best founders working on the biggest opportunities.

Say you’re an entrepreneur building something new and different, and you know you need capital. After pitching up and down Sand Hill Road (and all over South Park), you’ve finally found a believer, someone who sees what you’re trying to do and thinks you and your colleagues are the team to do it. Great! Now you can focus on building your business, right?

Nope. Get used to more of the same. You probably raised just enough to reach your next milestone but not enough to achieve self-sustaining profitability, which means you’ll be raising funds again soon. After all, on average, startups raise more than three rounds of funding. I know what you’re thinking: “But this investor is a true believer, and given how hard it was to convince others, they’ll sign up for the next round as well.”

Nope. It does happen, but it’s rare. In general, every round you raise has to be led by a new investor. Part of this is about dollars: Your seed-stage investor writes $500,000 checks out of a $50 million fund, but your A-round investor writes $5–10 million checks out of a $300 million fund. That seed investor will participate in the larger round (doing what’s called their pro rata, to keep their ownership share the same), but if they led the round, they’d burn through their fund too quickly and would be unable to lead enough investments to make their model work.

Even if your investor has the money to lead later rounds, you’ll still likely find yourself pounding the pavement again. Imagine you’re an investor, and you see another investor — a peer you respect — leading follow-on rounds for most of their portfolio companies. One of those companies comes knocking on your door asking you to lead a round, and of course your natural question is: “Why isn’t your existing investor doing it?” There’s no good answer.

For pretty obvious reasons, you can’t say, “Well, they’re a bad investor, and I really need new blood.” Even if it’s true, bad-mouthing existing investors will never get you new ones. You can’t say, “Well, they like us, but even though they lead follow-on rounds in 90 percent of their companies, they don’t like us enough to lead one for us.” You’ve just told this new investor that you’re in the bottom 10 percent of your investor’s portfolio. Now there’s no chance they’re going to invest. If the investor who knows you really, really well doesn’t want to write a check, no one else will.

To prevent this problem, the industry has the habit of not leading follow-on rounds. Again, not that it never happens, but it can’t be the common pattern, because the company that breaks it gets a black mark. I’ve had many investors (including some who invested in Puppet, the company I founded) tell me they follow this habit religiously, for exactly this reason. “Nope, as much as I like you, you’re going to have to get the money from someone else.”

Out you go.

Thankfully, venture investors recognize the downsides of this and build deep networks of firms and individuals who frequently work together. There are even later-stage firms that specialize in following specific investors whose track record they trust. But while this pattern was developed for good reasons, it also has downsides that no amount of networking or help can compensate for.

First, of course, it means most CEOs spend a huge percentage of their time either directly raising money or doing the work necessary to do so later. You might not have wanted to become best friends with loads of investors, but if you’re taking venture capital, that’s your job now. Given that investors are professional meeting-takers, they’re available to meet for coffee any time, so this can be hugely time-consuming. Then, when it comes time to actually raise a round, you should expect that to consume your life for at least three months. And that’s if things go well. Oh, and because you’re only raising to the next milestone, that’s three months out of every 12.

This time sink is pretty bad if you live near all the investors you need to meet, but what if it’s a flight to the Bay Area instead of just a drive? If you’re one of the top companies, they’ll come to you, but if you’re not, it’s one more reason you have to work harder than the companies they love. It was only in our late-stage rounds when we had luck getting investors to come to us, and we were in Portland, only a 90-minute flight away. I can’t imagine trying to raise money in a place that — shudder — requires a connecting flight. I nearly killed myself in a rented PT Cruiser (the first available car at SFO) trying not to be late to an investor meeting, and, of course, he passed on us anyway because I could not convince/did not want his buddy to join us as COO.

This all adds up to a massive tax on the companies that succeed, where CEOs become experts in fundraising rather than experts in building great companies, which is, of course, stupid. But it has a much worse impact on who and what can get funding in the first place.

Again, put yourself in the head of an investor. You look at tens of potential investments a day, and you have far more opportunities than time or money, so you have your pick of what to invest in. On the one hand, you have a woman or a person of color pitching a company that sells to markets they deeply understand, maybe something more focused on customers who look like them. On the other hand, you’ve got a Harvard-educated CS grad who’s found another great use for IoT using AI in the cloud.

What should happen is that the decision gets made based on what’s the best investment, who’s the best founder. It’s not. It’s obviously not. If it were, you wouldn’t see such rank discrimination in the world of VC, where women and people of color are almost entirely excluded (women get less than 3 percent of VC, and African-Americans closer to 1 percent).

Instead, a key factor is whether the investor believes this person can raise another round. Note: It’s not whether the person actually can, because you don’t know that until you try it. It’s whether the investor thinks they can. And, of course, investors know that women and people of color don’t fit into the pattern of other investors, so they prediscriminate in expectation that later investors would have anyway. I mean, why give someone $500,000 if the company won’t be able to raise another round anyway? You’ll lose all your money.

Like with all funding patterns, it’s as much about the company as it is about the founder. It’s not just about who gets money; it’s also about what kinds of problems are worth solving and what kinds of customers make good markets.

Silicon Valley has a well-known fondness for investing in products that solve the needs of white boys fresh out of college who are learning to live on their own, but less obvious is that this means they often consider other customers to be worthless. It is fantastically hard to convince an investor to back a product built for women, or people of color, or international buyers, when the investor is none of those things. This is all even given that women are half the population and generally control spending in families. We’re talking about our innovation financing system ignoring a huge proportion of domestic spending and the problems of those who control it.

That is, it’s not just about investing in people who are different — it’s that their ideas are different, the problems they care about are different, and the markets they want to attack are different.

In a world where you’re taking risks, where you’re actually focused on brilliant founders in big markets, those differences would be positives, they’d be signs you can do something groundbreaking. But when that world requires multiple rounds of belief, where failure at any round destroys your company, suddenly those differences become reasons for people to say no, for companies not to get funding, for founders not to get support.

There are some firms out there, like K9 Ventures, that make these bets anyway and recognize that it turns their job into finding follow-on rounds for existing investments rather than creating deal flow. Too many investors either don’t see the consequences of this pattern or preemptively admit defeat and just don’t even consider investing in a company that they are concerned couldn’t get another round.

Once again, we see how a key aspect of venture, one that exists for good reasons, has pernicious consequences that help to explain how the world of venture works today, in all its glory and dysfunction.

There’s no obvious fix to the problem, either as an investor or an entrepreneur, if you truly do need capital to grow but won’t find many believers. One of your best defenses is to focus on profitability first, so you don’t need those follow-on rounds and the levels of approval required to make them happen, but that’s not possible for every firm, and even when it is, it can result in heavy compromises on growth.

Another option is to do what so many women and people of color have done for decades to get support: Be dramatically better than your peers. If your company really is that great, you’ll probably get the capital you need. But this is an unfair demand and of course doesn’t fix the systemic failure for the next entrepreneur. (Contrary to the myth, white men usually have to clear a much lower bar than those less commonly represented.)

Thankfully, there are now firms out there focusing on founders who are women and people of color. These firms will help in multiple ways. First, of course, they’ll provide the direct funding that is currently unavailable to so many great founders and companies. Second, they’ll begin to build out those networks of social proof that will enable these companies to get as many rounds as they need, rather than just the ones they can provide.

We’re going to need a lot more of these firms to truly unlock the potential of venture capital, to bring world-changing solutions to those who can get the most benefit, wherever they are and whoever they are. I’m hopeful that the competition these new firms bring will change the behavior, and the returns, of the existing firms enough to make the difference, but what’s really going to shift behavior is when the companies these firms invest in start to deliver outsized returns specifically because they don’t fit the pattern.

That’s what I’m looking forward to.

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