What happened to the finance function?
How fear is squashing financial innovation and basic math
If the check is six figures or greater, someone at the table should be accountable for the financial expertise.
Capital providers who are unwilling to do this part of the job are screwing founders and stifling financial innovation.
Don’t get me wrong, I am all for lowering the barriers to becoming a capital allocator. More diverse perspectives - yes, please. There are some incredible folks whose money is well worth taking for reasons well beyond finance.
But here is the kicker, nearly all startup finance is 8th-grade math. All too often, early-stage investors are granted an expert’s halo. If you know what PERMDAS is, you’re qualified to be a startup finance guru.
So why is there a lack of financial acumen in startup finance right now?
To start, one thing should be clear. This is the fault of capital allocators, not founders.
Founders have one of the most difficult jobs in the world. They have a responsibility to understand their finances but is unrealistic to expect information symmetry when a company is too young to have a CFO. They should be able to expect some level of (albeit biased) expertise on the other side of the table - from investors.
However, early-stage investors no longer come bundled with any financial inclination. That’s an add-on only available if you walk to the back of the store and ask for it. Whether it is a zero-interest-rate phenomenon or just the success of the venture marketing machine, financiers don’t always come with financial inclination anymore*.
So why is there a void of finance savvy around the table?
Incentives beat intellectual integrity.
Here is how it all starts:
Founder: How should I raise this money?
GP: Use a YC SAFE or NVCA priced-equity docs.
Founder: What are those? Why so?
GP: They’re docs that have been used a thousand times. Tried and true!
Founder: How helpful! Where are those?
GP: They’re open-sourced. Here is the link! Now, let’s talk terms.
And here is what was really said:
Founder: I’m busy as hell and not an expert in startup finance. You’re a finance expert, right? Can I trust you to tell me how to:
Get the cash I need
Not get screwed
GP: I’ve raised a fund. So yes, I am a finance person. You need money so that you can find the next investor to put more in. Imagine what our equity will be worth then? Therefore, the key is not to rock the boat with this round, so it looks simple for the next investor.
Founder: Okay, you're the finance person.
And here is what really happened:
Fear-driven lazy startup finance
True – template venture capital deal docs are well-litigated and easy to do deals with. They are awesome, and one of many ways Venture has done a standup job at lowering costs and barriers to its capital. This is only helpful if venture capital is the tool for the job, however.
The founder is being sold a path they believe will minimize short-term funding risk. They’ve got enough risk already, so choosing the least risky path is rational.
However, optimizing for the next round is far from financially savvy. In fact, Bernie Madoff is more qualified to give this advice, for at least he consciously knew his value as a capital provider was a function of finding the next investor.
Yet, GPs are riddled with fear of deviating from the singular financial pathway they think they understand - the venture treadmill. They only work with companies who are committed to getting on the treadmill, and they are only good for passing them on to the next, hopefully, larger, fund. Every successful fund they’ve encountered used this model to return money to their LPs, so they should too.
As a result, fear drives the capital strategy.
VCs hesitate to tackle the 8th grade math which may prescribe a different capital strategy than continual rounds of VC. Founders assume their investors know something they don’t, and go along with it. Few founders have the leverage of Rand Fishkin or Sam Altman to dictate their own terms. They entrust financiers.
They get years of financial gaslighting instead. Nobody took the time to understand:
Whether or not the founder’s exit ambitions match their investors
If there are cheaper ways to fill the capital need, such as debt
The true cost of equity for founders
Control that will get ceded to investors
Optionality around ownership structures (eg - shared ownership)
Expected growth rates
If these questions and basic math still point toward venture capital - load ‘err up!
However, great companies will offer tasty equity to capital providers. Great capital providers will tell them to find cheaper capital instead.
**Debt to the rescue?
If the company can afford it, typically so. When the long-term cost of equity is taken into account, debt is usually the cheapest option.
There are also plenty of other innovative funding structures too.
But isn’t this too complicated?
***GPs will offer a million reasons why any deviation in the capital stack is too complicated.
If you can understand debt and interest rates, you can understand revenue shares, dividends, redemptions, or any other “innovative” funding structure. Again, PERMDAS!
Remember, this is fear talking. It isn’t malice. And it isn’t stupidity. I’ve spoken to countless GPs who love the idea of other forms of funding, but count themselves out of trying it. I’ve been in that seat too. Yet, when the founder shows up with a company that needs something other than vanilla equity, they can’t break the ranks.
So how do we break the cycle of lazy, fear-driven finance?
The new fundraising environment is the window we needed.
A lot of great companies are not going to find the funding they thought was waiting for them from venture capitalists. Whether it is a new company or a VC-backed one looking for that next round, they’re going to need to find alternatives.
Founders - if this sounds like your company, demand more of your investors. Ask about alternative funding structures and expect them to be able to explain why these may or may not be fit - in simple language. And read up yourself!
Investors - do the work. This especially applies to the 95 billion dollars raised by emerging managers since 2021.
Diligence is no longer a race; it is an exercise in Why. Find this Why and decide if it matches up with the capital you raised from your investors.
Don’t get spooked by other forms of funding. Just go back to PERMDAS and figure out how this actually affects the company’s investability.
Have a portfolio company that needs capital to get to the next stage? This could be the next round, or dare I say, profitability. Consider non-VC sources. It may be the best thing you ever did for the cap table and your ownership.
This is a call for intellectual integrity. The void of finance expertise is not a finance issue. It is an issue of investors having the gumption to do their finance jobs.
*To be fair, today’s proliferation of financiers do come with many other good things for building a business which their stodgy “financier” ancestors did not.
**As another legacy funding tool, the same exact dynamic exists amongst lenders.
***This GP likely has LPs who are proliferating the same false story about being able to deviate from their vanilla fund strategy.
Innovative Finance Amplifications (Oregon Edition?)
Great read! There are many alternatives and thus it's ideal time to explore all the ways to access cash. I'm seeing Series A down as well so makes sense for early stage founders and investors to not count on a future round. Never know the macro factors ahead!