How to Dilute Your Equity as Quickly as Possible
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Today's issue was prompted by a series of conversations I've had recently, in which I've asked founders to discuss the biggest mistakes they've made in their journey. The mistakes are many, of course, but one particular mistake has surfaced over and over again. A mistake that might not have been as relevant 10 years ago, but seems to be rampant today.
Let's dive in.
Fundraising is incredibly hard.
First, you have to package your entire business into a compelling narrative supported by fragments of facts and a not-small amount of hand waving. Once you’ve done that, you have to develop relationships with potential investors, cultivating low-key FOMO with each of them on investing in your company, without seeming like you actually need money. They all ask you for an inside look, but you have to hold off without seeming resistant, so you can later synchronize your conversations and advance them simultaneously.
Finally, once you’re ready, you have to organize and conduct pitch meetings all over the country during a two-week span, moving forward with your top handful of firms at the same pace so they (hopefully) offer you term sheets at the same time. In every conversation, you have to show interest and passion for working with each investor, while communicating that demand from other investors is also high (without actually coming out and saying so). And on top of it all, you have to drive this competitive process without seeming like you’re gaming people.
Walk this tightrope well, and with a little bit of luck you might close a round of financing.
Like I said, fundraising is fucking hard.
And yet, as hard as it is, it’s still easier to convince one finance guy trying to track 10-deals simultaneously that your business is on the right track based on knowable criteria than it is to interpret the fickle, amorphous desires of thousands or millions of potential customers and then satisfy those desires in a way that is 10x better than any other solution. Even typing that ludicrous challenge freaks me out.
No wonder so many first time founders, spinning inside that amorphous, pre-PMF (product/market fit) whirlwind, latch onto positive feedback from growth investors (defined here as: any capital source who will measure your success by your rate of growth). “After all, they’re paid to find companies with PMF,” the rationalization goes. “Maybe we already have it and just don’t know it yet.”
While a common response to the absurd challenge of finding PMF, raising growth capital before doing so is at best a pyrrhic “easy button.” At worst, it can kill your company.
The vicious cycle of raising growth capital pre-PMF
I recently led a group of growth-stage CEOs through an exercise in which each of them shared the most costly mistake they had made in building their company, or the mistake they most regretted. Nearly a quarter of them mentioned trying to fundraise their way out of finding PMF. The details were distinct, but at the core, their stories were the same:
We had some traction, but we weren’t sure it was full on PMF yet.
Nevertheless, investor demand was strong, so we raised growth capital and figured we’d find PMF as we grew.
With more capital (and less equity), we increased spending and built our organization.
Our investors pushed us for growth, so we doubled down on the moderate growth we had. We grew, but not like a rocketship.
Soon enough, we needed more capital. With a good-but-not-great growth rate, we raised with terms we weren’t crazy about but which kept us going.
With more capital (and less equity), we increased spending, still convincing ourselves we were building the right thing…
You can see how that story ends. The decision to raise growth capital before securing PMF starts a vicious cycle that burns through money and equity and investor goodwill at increasing speeds until you either somehow luck into PMF or burn out. (I say “luck into PMF” because PMF is most effectively found by small organizations focused on experimenting, and definitely not by larger orgs focused on execution).
What initially feels like success, instead often kicks off a long, exquisitely painful spiral to an explosion.
The Obstacle is the Way
Avoiding this common pitfall is simple, but also incredibly difficult. Here’s how you do it:
Find product/market before you raise growth capital.
Even if a few customers are begging you to grow. Even if you have the opportunity to build a great organization. Even if that voice in your head says you can for sure, no question, figure out product/market fit if you just have an extra million or two. Even if you need the money and the terms are amazing.
Even if investors are pre-empting you every day, and you don’t even have to run a fundraising process. Even if the whole story above doesn’t resonate because you can raise capital by just picking up the phone (this is real right now for some founders).
Even though finding PMF might be the hardest thing you’ll ever do.
Find product/market fit before you raise growth capital.
Sure, but I’m getting a lot of investor interest. They can’t all be wrong, right?
Well, if they want to fund your systematic experimentation until you find PMF, then have at it. Pre-PMF you should be targeting investors who want to sign on for experimentation, not growth. But if they’re expecting you to use their money to grow, then caveat emptor.
I get it. Being the founder of a pre-PMF (product/market fit) company is hard. And it matters when someone smart believes in what you’re building, especially when their belief comes with many millions of dollars. It feels like you’re succeeding.
But no matter how many growth investors want you to take their capital, remember that most investors have never built or operated their own company. And consider that the best investors, like Marc Andreesen from A16Z (who also founded Netscape), say things like this:
Whenever you see a successful startup, you see one that has reached product/market fit—and usually along the way screwed up all kinds of other things, from channel model to pipeline development strategy to marketing plan to press relations to compensation policies to the CEO sleeping with the venture capitalist. And the startup is still successful.
Conversely, you see a surprising number of really well-run startups that have all aspects of operations completely buttoned down, HR policies in place, great sales model, thoroughly thought-through marketing plan, great interview processes, outstanding catered food, 30" monitors for all the programmers, top tier VCs on the board—heading straight off a cliff due to not ever finding product/market fit.
(Emphasis mine)
No amount of investor love is an effective proxy for product/market fit. And nobody but you can tell for sure that you have it. Even if it requires turning down growth capital, stay nimble and experimental until you’re sure you’ve reached PMF.
As one founder in the group elegantly framed it, "Don’t turn on the afterburners until you are pointed in the right direction."
Things I read this week
One: The Dad-to-be Parenting Challenge (The Daily Dad)
The Daily Dad is the one email I open every day, and one that consistently adds value to my life. If I were a dad-to-be, I'd buy this no question. I may anyway.
LINK >>
Two: Storytime Chess
Speaking of being a dad, and of recommending products for which I don't get a commission, I've been over the moon impressed by Storytime Chess. My 5 year old went from not knowing how to play to asking me to play every weekend morning in less than a month. And he's beaten me (almost) legitimately.
Three: Long Distance Thinking (Simon Sarris)
Any citizen of the Internet is constantly pressured to condense our ideas. To bumper-sticker them in such a way that they are easily understood and shared. In many cases, this simplification necessarily loses something important in the reduction. And over time, this process risks reducing our ability to think expansively. Let's not do that.
LINK >>
Four: Level 5 Leadership (HBR)
This is a classic worth revisiting time and time again. Jim Collins outlines how the combination of humility and fierce resolve in a leader is the catalyst for their team achieving greatness.
LINK >>
Five: The power of a vulnerable, committed leader (I-O)
The second of a two-part examination of my own learnings about leadership (here's the first). I reread this after Level-5, and it's interesting both how similar my subjective learning was to Collins's research-based findings, and how fundamentally opposite both of those approaches are from what most of us think about when we think about strong leadership.
Want to dive deeper?
If you liked this, check out this list of my top posts, read and shared by thousands of entrepreneurs.
Here are a few of my favorites:
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