Avoiding Existential Risk
Funding's New Efficient Frontier
Investors select portfolios that offer the highest expected return for a given level of risk (or the lowest risk for a desired return). Thank you, Harry.
The efficiency frontier represents an optimal diversification of portfolios and only applies indirectly to individual investments.
However, it's possible to move the efficiency frontier by choosing a portfolio of companies that each have a broader range of achievable outcomes— effectively producing more non-zero outcomes with the same initial risk.
For most venture capital investors, every seed check relies on a future check at a higher valuation. Then, founders make decisions and navigate the paths from idea to product-market fit to scaling, backed by that seed check...
Which still relies on someone else's later (and bigger) check.
This “next round” risk is not mitigated as the company increasingly spends to grow.
Will later-stage investors agree on what progress looks like?
Or who is the best team?
Or how to value the company?
Or have funds ready to deploy in the first place?
If any of these are a “no” despite progress made since the seed round, that next check may not exist.
This is an existential risk. Seed-stage venture capital is too often built on a foundation of an existential risk – no later-stage capital.
This risk increases exponentially for those who choose to scale first and survive second. Every dollar of cash burn increases the need for a larger check from a smaller pool of potential investors– to overcome an ever-higher mountain of deficits.
What increases the risk of getting later capital?
“Hot” sectors cool down
Valuations stagnate or drop
Timelines extend due to external events or a necessary pivot
What reduces the risk of getting later capital?
Business model that only needs one funding round to sustain high growth
More customers, revenues, and margins
Market with multiple large, competing potential acquirers (versus a monopoly)
Investors that can accept multiple liquidity options (IPO, acquisition, PE, ESOP)
Founders deserve the option to opt out of existential risk.
Opting Out
We see signs of seed investors taking this existential risk seriously, as it is ultimately their problem, and good founders recognize this.
Indie VC announcement
@jefielding - https://twitter.com/jefielding/status/1744147266355478782
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Capital Efficient Growth with Zoom and Veva
Capital Efficient Businesses - Elad Gil
Edison Partners’ Kelly Ford Buckley on capital-efficient investing in underserved markets
Capital Efficiency is the new VC filter for startups
Can Unicorns Overcome Their Big Losses? It Depends
Capital Efficient Company list
Like any VC trend, you can bet some of this is trend-chasing, just like VR, AR, Metaverse, AI, delivery drones, smart homes, wearables, or SPACs.
But let me show you how founders can truly take this existential risk off their backs (and investors can still earn a great return).
Alongside a small but mighty cohort of investors, we've been doing it for a couple of years at Capacity Capital. This is the real nuts and bolts of how this works so founders can spot the signal (truly profit-aligned investors) from the noise (pattern-matching investors chasing shiny objects - or rather, shiny projections).
Capital-inefficient businesses must raise more money than efficient ones.
Optimizing the Outcome
Consider five scenarios illustrating what this means for the founder and investor.
Every high-growth company has a distribution of potential outcomes, from zero to IPO. The optimal funding mix can't be determined beforehand, yet founders often pour layer after layer of equity. This is unnecessarily dilutive for both parties and can cause misalignment if the eventual outcome strays, as most do, even slightly from the speculative grand slam that was originally pitched. Optionality (and autonomy) is critical to optimizing financial outcomes for founders and investors.
Before I show you numbers and scenarios, let's clarify what we want to invest in.
To maximize both survival and outlier success, we look for founders intent around:
building sustainable growth (via bootstrapping tactics and profitability) and;
using targeted venture capital to remove the constraints of profitability when there is an inflection point.
Upon identifying those founders, we want to see enough initial investment to define and solve the right problem, reach profitability, and create more options. We seek an inflection point that requires venture capital but as few rounds as possible.
This results in less dilution for both the founders and the early investors, creating far more choices of viable exit scenarios. A massive exit or IPO isn’t required to “return the fund” — but it doesn’t remove that path.
To make this work, founders must focus on first principles:
find customers and compounding revenue
build a product informed by customers and delivered by a great team
manage with fiscal and business model discipline
The result? Fewer failures, more wins with a higher probability of overall success.
Good outcomes are more likely when the funding fits, and the only way to consistently find funding that fits along the growth path is to create optionality.
Scenarios
To get specific, we will invest $200k for rights to 10% of a company, of which 9% can be redeemed for 3X. (Redeemable Equity).
This is one of the deal structures we use, but the same principles can also work for other flexible deal structures:
Revenue-based debt finance with additional warrants
Profit share with an equity kicker
Right to profits or distributions with some kind of upside tied to equity
Now, let’s play out the post-investment scenarios:
A - Series A, Scale, Exit
B - Grow into later Series A, Scale, Exit
C - No Additional Raise, Scale, Exit
D - No Additional Raise, Grow, No Exit
E - No Additional Raise, No Exit, Incomplete Redemption
A - Series A to Exit
“Plan A” is my hope for every company we invest in. Our round helps them confirm product market fit, scalability, and profitability - fundamentals that a Series A will help scale. If it makes sense, we may continue to raise VC through the whole alphabet, but capital-efficient businesses require less dilutive capital to scale quickly.
Post Investment Equity: Raise a single $2M investment round in 12-18 months
Post Investment Path: Become break-even or better; operationalize scaling to create options - capital efficient enough to make additional venture rounds optional
Founder Upside: Multiple paths. Less pressure to dilute further unless necessary.
Investor Upside: For the investor, the likelihood of a win goes up. Higher multiples are possible at lower exit values creating a wider range of acceptable exit prices.
Upside Risk: Return scenarios depend fully on the acquisition price, but the fundamentals instilled greatly reduce the risk of a zero.
B - Later Series A to Exit
Post Investment Equity: A significant raise is planned post-break-even. A raise can be also be delayed for unplanned reasons: misalignment with the next valuation, a pivot to an inflection point takes longer than planned, in which case, valuation would suffer.
Post Investment Path: Build and grow a capital-efficient business model before raising a large round. Find sustainable revenue growth prior to the first raise.
Founder Upside: Some redemption of investors' equity rights reduces founder dilution, resulting in greater ownership at exit.
Investor Upside: If higher revenues and capital efficiency are achieved, that can lead to higher valuations than a faster raise. Even with some equity redeemed, the markup can be higher. (Comparable to dilution that would have occurred from additional rounds.)
Upside Risk: Redemptions create some liquidity pre-markup, and the remaining ownership returns depend on the acquisition price.
C - No Series A to Exit
Post Investment Equity: None
Post Investment Path: Break-even to profitable. Maintain cash-efficient growth only needing non-dilutive operational capital on the path to an exit.
Founder Upside: More redemption of investors' equity rights further reduces founder dilution, increasing ownership at exit.
Investor Upside: In a situation that typically leaves an investor near “zombie-land”. Potential for an early small multiple while maintaining an upside in a future exit.
Upside Risk: Liquidity from the redemption of equity rights takes some risk off the table prior to exit.
D - No Additional Raise, No Exit
Post Investment Equity: None
Post Investment Path: Break-even to profitable. Operational capital only.
Founder Upside: Max redemption of investors' equity rights, lowest dilution
Investor Upside: Potential for a small multiple even without a future exit.
Upside Risk: The timeline for an exit is likely to extend, but as long as the company doesn’t die there is a good probability of return multiple (not just a return of capital).
This is expected for the middle third of a portfolio. Better probability of 3X (instead of 0-1X).
E - No Additional Raise, No Exit, Incomplete Redemption
Post Investment Equity: None
Post Investment Path: Failure prior to raise, redemption, or exit
Founder Upside: Max redemption of investors' equity rights, lowest dilution
Investor Upside: Still potential for some returns prior to failure with temporary success
Upside Risk: If the business model never works, there is no return of capital.
To see these scenarios together:
Instead of the typically binary VC outcome, A or the low end of D/E, there are multiple legitimate outcomes for both founders and investors. We also see more reliable paths to VC-competitive returns and higher probabilities for life-changing outcomes for founders. (I’ll save probabilities for a later post)
NOTE: We roughly follow the expected multiple from Seed to Series A for our structured redemption multiple (3X). The average multiple from Seed to Series A has ranged anywhere from 2X to 4X over the past 15 years, so at this point, 3X is reasonable. (I highly recommend Nnamdi’s post on this) The multiple keeps us on par with other seed funds, except we are now talking about DPI rather than existentially riskier TVPI markups. The outcomes are similar whether the eventual return is from the Seed to A equity markup or the multiple through redemption of equity rights.
Less Risk = More Actual Winners (not only investors)
Founders Win
Founders with only a single significant funding round experience far less dilution and retain more control. Delaying significant fundraising until proven scalability and profitability means equity costs less, increasing their personal take-home.
It makes sense to idolize capital efficiency and those who go the farthest with the least.
Celebrating minimal fundraising over maximum raising reflects today's reality: $200,000 now stretches further than $2M did a decade ago, thanks to low-cost tools (lo/no-code, AI). Yet, average seed-stage funding has quintupled in a decade, with fewer deals. Follow-on fundraising has become more challenging and risky.
Prioritizing profitability doesn’t decrease the upside– it creates more options, reduces risk, and allows time to reach the next inflection point.
Successful examples include Microsoft and Adobe, which were profitable within a year. This may explain part of why Microsoft has also jumped into investing in a mix of revenues and equity.
Calendly raised a modest $550k seed round before securing $350M seven years later.
(For more examples, check out this list.)
Communities Win
A balanced approach retains more companies (and talent) locally and validates the importance of funders and incubators working in smaller innovation hubs.
For communities (like mine in Chattanooga), it’s key to nurture diverse fast-growth business paths, regardless of the funding. Over-focusing on multi-round venture capital neglects broader startup needs and can harm smaller communities.
Venture-funded startups, while newsworthy, are rare (1 in 100) and, even when successful, can lead to more talent leaving town after a successful acquisition.
It's critical for local ecosystems to focus on supporting all fast-growing companies… along multiple growth paths… by providing more optionality and autonomy.
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