On founder laundry

Why rich VCs get richer, and why you want them on your cap table

I was in the second week of a role at a VC fund and was about to reject a startup that had just pitched me. I thought the idea was mediocre, they didn’t have discernible traction, and the founding team weren’t particularly compelling. It was a seemingly straightforward decision. Before I shot them the rejection email that I’d drafted, I told my buddy (think handler) what I was about to do. I was advised to think about it for a few more days before pulling the trigger.

This was strange; we had never waited in other similar cases. In fact, we prided ourselves on getting back to entrepreneurs quickly. Why were we hesitant? In my buddy’s own words they wanted to pause for thought because “Fund X had invested so there must be something there”.

This and countless other interactions like it are examples of a concept that I call Founder Laundry. Most founders enter the world dirty and are only made “shiny” (i.e. attractive) to VCs through pedigree or traction. Founder Laundry is an ability that a small number of funds have which automatically endows any founder they have invested in with an extremely powerful halo effect (side note: "If you aren’t sure whether your fund has this ability, it doesn't). The phenomenon has a number of effects:

• It goes some way to explaining why the ‘best’ funds remain the ‘best’ over time 

• It explains why Tier 1 funds make crazier investments than their Tier 2 brethren

• It enables companies to raise where the market otherwise wouldn’t give them the benefit of the doubt (with positive consequences when these investments are smart non-consensus bets and negative ones when they are mediocrities)

Founder Laundry is the natural outcome of early stage investors’ obsession with Team. VCs repeat incessantly that Team is the most important determinant of whether a startup will be successful. However, knowing whether a team you have spent no more than two hours on the phone with is God’s gift to entrepreneurship is really really difficult, so VCs rely heavily on pedigree when evaluating this. We dress this up in fancy language and call this ‘pattern recognition’, but in reality what we are doing is outsourcing our decision making to your previous employers. The underlying logic is that, if you were good enough for Stripe you are good enough for us. 

Even the most pedigree resistant VCs struggle with this because most venture funds have committees. Imagine trying to convince your colleagues that a prospective hire is a genius without resorting to pointing to status symbols like the fact that they went to Harvard or were employee number 2 at Google. I’ve tried several times and I can tell you first hand that saying things like “I thought they seemed really sharp”, just doesn’t hit the same as name dropping Klarna.

Investors use historical successes to make themselves certain about the fundamentally uncertain. These can be anything from the successes of a founder’s previous startup to the employer they used to work for, or even the achievements of people that happened to study at their alma mater (MBAs are overrepresented in fundraising statistics). Founder Laundry is the natural extension of this. A small number of funds are so prestigious that having them on your cap table is seen as a sign of historical success akin to being an early employee at a Unicorn. Any founder / company they touch becomes hot by association. Essentially the VC world decides that a fund is the best student in the class and therefore that the optimal investment strategy is to copy their homework.

The canonical example of a fund with this ability is YC. The halo effect they provide is so strong that if you took a bottom decile YC company and removed its association with them, there’s a good chance that the same company would struggle to raise a seed round. It is the reason why every demo day it feels like the entire venture world takes to Twitter to complain, yet year in, year out they come back cheque books open.

The harsh reality of fundraising risk means that being able to make a founder ‘hot’ by association is every investor's dream. VCs are acutely aware that even when things are going well, most of their portfolio companies are at the mercy of external investors to keep the lights on. This risk is taken so seriously that one fund I worked for actually had ‘Ability to Fundraise’ as part of their deal assessment criteria. An explicit acknowledgment that no matter how much they liked a team and no matter how well the company was doing, if the rest of the market wasn’t on board it was game over.

Founder laundry lets you be contrarian

Being a fund whose investments are perceived this way is the holy grail. If you can improve your portfolio companies’ fundraising chances by 50% by merely being on the cap table, this not only benefits them but you. It means that:

• Mediocre performers get an extra 12 - 24 month lifeline to figure out how to be great

• Your contrarian bets are way more likely to pay off

I find this latter point fascinating, so I’m going to spend the rest of this post unpacking how it works.

VCs whitter on about how the best way to make returns is to be contrarian and right. However, this paints an incomplete picture of the path to success for non consensus startups because it ignores fundraising risk. The following scenario plays out thousands of times each year:

1. Fund A makes a seed investment in VR (a space which everyone hates right now)

2. The VR company starts succeeding and achieves good, not exceptional, ‘Series A metrics’ - $1m ARR, 3x growth etc…

3. The company tries and fails to raise a Series A round and shuts down - everybody is sad

In this scenario the VR company’s near term success suggests that Fund A was contrarian and right, however, in the end it doesn't matter. The rest of the market fails to ‘get conviction around the VR industry’ so the experiment ends prematurely. Fund A would have been better off investing in something more ‘fundable’. After a few experiences like this most funds in Fund A’s position end up conforming with the rest of the market’s tastes.

For a contrarian investment to actually work, one of three things need to happen:

1. The company needs to be so successful that everyone is forced to change their mind by the time of their next fundraise 

2. The company needs to be able to take your investment and run with it without additional capital

3. The company needs to get lucky and find a non-consensus fund to back them

Being a fund that can launder founders and teams, allows you to escape this. When you make a contrarian investment as one of these funds, the entire market contorts itself to understand why their instincts are wrong and you are right. Meaning that a VR company in your portfolio is no longer out of favour but rather the hot ticket - the market might even decide that the whole VR category is hot again because of your investment. 

Consequently, the YCs of this world lead a charmed life. They are uniquely able to invest in founders that look atypical (with obvious implications for founders from minority groups and with non-traditional backgrounds) and industries that are out of favour and can remain confident that the market will at least hear them out when it comes to the next round. They are enabled to make decisions on their own merits rather than having to predict what other VCs will think.

Taken to its logical conclusion, Founder Laundry means that there are some billion dollar companies that would not have made it, had a fund without this halo effect not led their round. More darkly, it also means that some companies which shut down as failures might be world changing companies right now had they been associated with the right backers.