Don’t let your investors fool you!
We are at peak market right now in edtech and future of work. Very large checks are getting written to my startups, who are in a much earlier stage than they can possibly use the capital. As I wrote about in Continuous Inbound Fundraising, my advice to founders is to always take the money from credible inbound inquiries. I’ve seen three downturns, and they always come. When they come, the number one cause of death is running out of cash. I’ve seen really great companies die from lack of cash. So take the money.
However…
What do you do as a founder when your seed stage startup just put $20M in the bank? Sounds like a great problem to have, but it can be ruinous to your company if not handled properly. Here is why.
First, someone writing you a check that big validates your feeling that you must have gotten things right. To some extent that is true, but more likely you know 100x more than they do about how right you are currently, and the answer is probably that there are a lot of things to work out on your report card before you can really claim to have product market fit (PMF). The problem is that the natural reaction to feeling validated is to stop working on all of the pesky details of finding PMF and go into execution mode. Whatever magic you have, whatever habits you’ve formed, whatever growth loops you have, whatever channels you’ve discovered, you begin to scale those up and come up with iterative changes, rather than taking big 10x bets.
Second, you start hiring people. But wait, you say, don’t people add value? Can’t we do more with more people? Unfortunately not for pre-PMF startups. Fred Brooks wrote a great book called The Mythical Man Month on why adding to a team doesn’t improve development projects. The same is true for startups. Adding people beyond a certain point, which I think is a two pizza team (6–8 people), results in increased communications and less coherence and less real work getting done. Yet, startups are grueling and every employee of a startup that just got $20M is going to come up with really good reasons why they need help. And most founders don’t know how to manage or lead yet, so they give in to these requests and the team grows.
The other big ramification of these two shifts — execution mode mentality and growing the team, is that you get much less nimble. When it was just the founders, you could literally change what you were doing overnight. Now, you have big investors, a big team, and goals to hit. You can’t just pull the rug out from under the company. This results is mediocrity. Instead of taking a chance on an adjacency which looks compelling through your experiments, you try to keep doing what you have been doing AND the new thing. Since your team is unwieldy now and you don’t have the management capability to do two things well at once, the new thing gets starved of capacity and never develops. Next month, YC funds someone just focused on that idea, and it works and they outstrip you in months.
Finally, investors who write large checks really like to receive stock. That stock is always preferred stock, which has preferred terms in it. It has things like anti-dilution protection in case you do a down round. All of this makes a ton of sense post-PMF because you have an actual company and need to execute. But in a pre-PMF startup, it makes no sense at all. Preferred terms like anti-dilution make founders more conservative. They implicitly state that if you change course and run out of money, you have screwed up and we are going to take our pound of flesh. Investors are not usually evil people. But they are also almost never prior founders. So they don’t understand the ramifications of imposing these terms on the mentality of a founder.
A pre-PMF company’s greatest asset is that the founders have experimented a lot in their market and learned a ton about user behavior and what people want. Anything that constrains their ability to use that knowledge significantly decreases the value of the company. Unfortunately this is hidden, because no one can properly value the thing you did not do.
In summary, raising a ton of money early is both the best thing (because you don’t run out of money) and the worst thing (you settle for mediocrity) that can happen to a pre-PMF startup. My advice is to address the downsides head on with your team and investors before the check is written. This means that you do SAFEs instead of equity investments and walk away from big checks with preferred terms. This means that your team knows that money is just going to sit in the bank. Everyone understands you are going to take big bets and don’t actually believe that you have PMF yet. For serial founders in my portfolio, they have been through it and do this naturally. As a first time founder, believe me that these things will happen and try to level up here before the lesson gets painful.
