VC Hierarchy Of Funding
Raising capital is a game, and once you understand that game then you can decide whether or not you want to play and how. Often many founders are not told the rules and end up playing something they can never win. Garry Tan published a Tweet on this topic, this article elaborates in-depth to help you better understand.
Structuring the game off of Maslow’s Heirchacry of Needs, I’ve created the Venture Capital Hierarchy of Funding as a representative model. It works such as the more you have of the bottom of the pyramid increases the likelihood of raising capital. If you just have the top, it’s a lot harder to raise capital.
And finally, the game has nothing to do with how good you are of an Entrepreneur nor has anything to do with fairness. If you want to play, get rid of those notions.
The Rules Of The Game From Most To Least Important
- Hot Round/Who Is Investing
If Reid Hoffman were to write your startup a check today, even in the idea phase, you are guaranteed that other investors would jump onboard. You would also gain access to a lot of resources ranging from guidance from great mentors to free hosting credits from services like AWS.
The reason why is because investing is hard. Knowing if something is going to create a return in 10 years is like seeing the future with tarot cards. A lot of ideas sound great but it’s not enough to convince someone to write a check, especially if an investor is not super knowledgeable in the space. Having another well-known investor on the round creates a mixture of FOMO, trust, and risk-mitigation.
2. Your Pedigree With Great School Or Job
Translation, this means that you went to Standford/MIT/Harvard or had a senior level position at Google/Facebook/a large tech company. If you need outside validation on this topic, quickly Google both ‘Schools That Produce The Most VCs’ and ‘Schools That Raise The Most VC Funding’. The correlation speaks for itself.
At this stage of the game, it’s about access. Being in those environments give you access to networks and people that you can build relationships with and go after funding. There is also the belief that if someone is smart enough to get into a top-school or work at a top company, they are smart enough to figure out how to grow a successful company. Yes there are flaws, but remember we’re playing the game and its about following the rules to win.
3. Hot Industry/Sector
Having you ever heard that VCs are like the sheep and herd towards the same type of investments? Right now the hot investments are in the Blockchain, A.I. and Healthcare. Past stampedes of funding have been around virtual reality, the sharing economy, mobile apps, social networks, etc. Even if your company has good traction, it can be harder to raise capital if it’s in an outlier market.
This occurs because when a new market emerges, by the time the market reaches maturity there are only going to be 1–3 incumbents that are successful, but its never clear who the winner will be at the beginning. Examples include ridesharing and how now its Uber vs Lyft or in streaming its Netflix vs Amazon vs Hulu. Many of the smaller competitors have failed or of no consequence. Do you remember the number of search engines that were around in the early 2000’s and now its just Google?
Tons of startups in the same hot space get funded around the same time because VCs fear losing out on the trend. They want the slim chance of taking home the grand prize that will produce Facebook like returns to carry their fund.
4. Successful Past Startup
As we move into higher into ranks of the hierarchy, these items are valued less by VCs which makes it harder to raise if they are stand-alone signals. Being a successful past founder makes it easier to raise capital because you have proven you know how to run a business, can generate returns, and you likely already have a network in place that you can tap into.
Traction should be the number one metric used to validate a startup. No one can argue with month over month growing number of users and/or revenue. But unfortunately, traction ranks lower than other areas unless its enough traction that creates an overwhelming urge of FOMO.
Also, Entrepreneurs should understand that funding is not about opportunity, it’s about fear. When investors fear they are going to miss out on something they jump on it, when they think its an opportunity they wait to see how it goes.
6. Novel Idea
We’re at the top of the pyramid and the least likely to get funded is a novel idea. To be clear, if you have a great idea combined with going to top school or worked at a top company, you have a great chance at funding. But a novel idea by itself will get you nowhere.
In reality, this is the only spot on the pyramid that’s in the right space. Ideas are a dime a dozen. Without the ability to execute, they are worthless. No ideas should be funded just because it’s revolutionary.
How To Play The Game
Now that you have an understanding of the rules, how do you play if you do not have access to investors like Reid Hoffman, do not have the pedigree, and you’re not in a hot sector? It’s relatively simple with a few sacrifices.
Also to be clear, you should understand why you are starting a business. Changing yourself or your company to get funding does not guarantee success, and most importantly does not equate to you being happy. But if you want to play the game of funding, here is how:
1) Try to attend a top name school or work for a top tech company. Spend 2–3 years developing relationships to gain the access you need.
2) If the above is way too hard or too long, find co-founder(s) that have the pedigree that you need. Make sure you give them equal splits of equity because uneven splits is a red flag to VCs.
3) Pivot your startup to a sector that is hot and booming in the future. You might not be passionate about this sector but it will increase your chances of getting funding.
4) Network with successful founders. Have them contribute to your company by giving them roles such as advisors or taking board seats, and have them make introductions to funding sources.
5) Gain a behemoth amount of traction. The ironic fact about this route is that by the time you gain the right amount traction, you will no longer need VCs.
Warning — Think Deeply Why You Are Playing This Game
Just because you are playing this game does not make you a better Entrepreneur and does not guarantee the success of your company. You might be compromising areas of yourself and your business that may lead you to be unhappy.
Entrepreneurship has been around for hundreds of years, and at its core, starting a company is about turning a problem into a business venture by providing a solution that people are willing to pay for. It’s not about raising large sums of money, being in the limelight, or other various attributes tech blogs might fawn over.
The modern-day machine has twisted and mangled this very simple meaning and people often lose sight of why they are founders. Be careful that you do not compromise yourself and your vision for the sake of raising money.