On funding misfits
How to make a fund that doesn't have to give a damn what the rest of the market thinks?
For three years I worked as an investor at Icebreaker, a fund that does pre-seed investments in Finland, Sweden and Estonia. And by pre-seed I don’t mean ploughing $5m into founders who were employees number one to five at Google, I mean the real stuff. Companies that weren’t shiny… companies that VCs wouldn’t automatically fund based on the team’s CV.
At Icebreaker what enabled us to do real pre-seed was a thesis focused on backing domain experts. Underpinning this thesis were two beliefs
That domain expert founders have an advantage when it comes to reaching product market fit because they are solving problems for people just like themselves
That investments in domain expert led companies were priced much better than the hot pre-seed deals that the whole world was chasing after
However, one thing that surprised me was that backing domain experts created a number of disadvantages. Disadvantages that began to surface when it was time for our portfolio companies to raise the next round of funding.
These fundraising challenges aren’t limited to domain experts, they affect pretty much all founders outside the VC mainstream (whether due to the space they’re in or the pedigree they lack). Our focus on domain expertise as our north star criteria simply meant that we had a higher proportion of outsider founders in our portfolio. Thus we became acutely aware of the fundraising challenges that outsiders face.
We didn’t just note these challenges stoically. The difficulties that our band of misfits had trying to secure future capital had a darker effect on us. We felt a constant urge to take the easy route and invest in mainstream founders. This would give us easy uprounds that we could show our LPs and reduce our exposure to fundraising risk.
For the most part we succeeded at resisting this urge. However, the entire experience led me to notice a little discussed structural reason why VCs prefer to back the already privileged. A reason that affects VCs even when they don't think that these privileged founders are better. Namely that, VCs know how much harder fundraising is for outsider founders and try to avoid taking on companies with such heightened fundraising risk.
In the rest of this post, I will walk through the fundraising challenges faced by outsider founders and why those challenges sometimes cause even the VCs who believe in them to not to fund them. Then I'll propose an investment strategy that allows VCs to back them without caring about fundraising risk.
Why is fundraising so hard for outsiders
There are two types of outsider.
Background outsiders → these are people who don’t come from VC central casting - they aren’t the former exited founders, startup scenesters, finance bros and management consultants that VCs love to invest in
Space outsiders → these are people building a company in a market that VCs believe is either too hard (overcrowded, slow customer adoption etc.), too small, or just don’t know about
These outsiders face different types of challenges. Background outsiders often struggle with knowhow and investor bias. While space outsiders typically get rejected because of half baked thinking re the markets they’re in.
Background outsider challenges
Challenge 1: They don’t know how to speak VC
Background outsiders often struggle to raise because they simply don’t know how to. Most of these founders started their businesses because they wanted to solve a real problem. They aren’t startup scenesters, suave consultants, or pedigreed investment bankers. They haven't been dreaming of venture capital their whole life and consequently haven't read all the literature or listened to all the podcasts. They don’t have 15 friends who've raised before to practise their pitch with and review their deck.
For the funds that want to invest despite this lack of knowledge, they still have to consider whether their VC colleagues will feel the same way when it’s time for the company to raise their next round of funding. Because the teams don’t ‘speak VC’, you can’t just put them in front of Sequoia. Here’s an example:
At Icebreaker, one of our founders went fundraising, and I was back channelling with a VC they had pitched. I was surprised to hear she was on the cusp of rejecting them - the business was doing well and it fit her fund’s thesis. Her reason? She was concerned that they didn’t seem to know what pre- and post-money meant. It made them seem incompetent.
She questioned the team’s competence because they didn’t speak VC.
Background outsiders need ‘polish’ - and that means work for you as a fund.
That being said, with some effort it's possible to teach founders to talk the talk. And quite a few funds are willing to put in the effort. First Round and EF have programs to get their founders pitch ready in a short space of time. Moreover, there are a lot of resources funds can point founders to: the likes of YC will show you how to put together a Seed deck, my own site Pitchdoctor has a guide to the perfect startup blurb, NFX has tons of resources.
Challenge 2: They don’t look like the people VCs fund (yes this is about bias)
Evaluating founders is a dark art. How do you know if someone you’ve only spent 30 minutes with is going to be a great founder? My answer is “you can’t. The industry's answer is “pattern matching” (or as I like to call it reading tea leaves).
Pattern matching involves trying to see if a founder looks and acts like other founders who have been successful before and combining this with a very large dollop of gut feeling (nobody likes to admit this part).
Looking for patterns puts outsider founders at a disadvantage because - they aren’t from the startup scene. Background outsiders worked for the “wrong” companies in the “wrong” roles and went to the “wrong” universities to stimulate VC interest.
If you came from the beauty industry and want to revolutionise it, you are unlikely to have a CV that looks like that of someone trying to fix data science. Unfortunately due to pattern matching; it feels like VCs are way more excited by founders with CVs of the data science variety.
And these are just the patterns people will admit to looking for. There is also the matter of gut feeling. If every successful founder a VC has seen is a man, or white, or even tall then why wouldn’t their gut be confused about someone who doesn’t fit the mould (only 25% of businesses that raised VC in 2023 had any women in the founding team).
I’d be happy to wager that a black, female, clone of Travis Kalanick, would struggle to raise as much money as he did. VCs wouldn’t “be able to get conviction on the team…”
VCs are acutely aware that other VCs are biased for and against certain founder profiles, and the impact this has on a company's fundraising prospects. Therefore, even when they are excited by a deal, they ask themselves - “who on earth is going to fund this next year”. If there are no good answers, initial excitement can quickly turn into rejection.
Space outsider challenges
What is a space outsider
VCs talk about market size a lot. Because for VC maths to work your market size needs to be able to support a $1bn+ company. However, how they evaluate market size in practice is quite fuzzy. VCs do a kind of mental triage when they hear about your market. They immediately classify it into into one of three buckets:
Hot
No opinion
Cold - ‘obviously’ too small / competitive / hard
If you fall in either of the bottom two categories - the chips are stacked against you. You are a space outsider.
VCs having no-opinion on your space makes things harder for you as they typically default to the belief that a market that they’ve never thought about is too small. However, they generally are open to being convinced of your Market’s Size if you do your homework. Where the real challenges lie for founders and the funds that back them is if VCs decide that your space is ‘cold’.
Challenge 1: VCs suffer from groupthink when it comes to ‘cold’ spaces
Investors are actively biased against cold spaces. By this I mean that there is almost nothing you can say or do to convince an investor that a space they have decided is ‘cold’ is ‘hot’. This is often fatal for a company’s fundraising prospects because cold markets are by definition unable to support venture scale outcomes. A VC who thinks a company’s market is cold will reject it no matter how good they think the product is.
What makes this worse for founders is that investor opinions on whether a space is hot or cold are not individualistic but rather determined by the VC hivemind. If the hivemind decides a space is ‘hot’, 90% of VCs will fall over themselves in agreement and if groupthink says ‘cold’ 90% of them will run for the hills.
Who decides what is hot or cold? Everyone and no one. In practice it’s some combination of what the big funds (Sequoia, Benchmark, Founders Fund, a16z etc.) are investing in, what exits have happened recently, and what podcasts / blog posts VC influencers have produced recently. A great case study for this is crypto’s rapid rise and fall from grace - the space went from hot as the sun in 2021 to uninvestable by 2023 and everybody fell in line.
The negative consequences of this for founders in ostensibly cold spaces are obvious. The consequences on fund strategy are more interesting but less intuitive.
Groupthink around cold spaces means that, even if you are one of the 10% of funds that disagrees with the hivemind about a ‘cold’ space, it’s often suicidal to invest in startups operating there. The hostility of the fundraising landscape for startups in that type of space means that even if you are right there’s a good chance that the company’s next fundraise will fail. The result is a world where most funds are constrained by the need to invest into companies in spaces that the rest of the market likes regardless of their own individual opinions.
How can funds be immune to what other funds think
From my perspective there are two things wrong with the status quo:
Deserving outsiders have a very hard time raising capital
The rare funds that want to back outsiders often don’t do it because they are acutely aware of the fundraising challenges these outsiders will face in the future
I’ve spent the last few years mulling over how to fix the second problem (the first is intractable). At its core, the question I’ve been trying to answer is:
How do you design a fund which can invest in misfit people in unloved spaces without having to give a damn what the rest of the market thinks?
It turns out the solution has been hiding in plain sight. Pioneered first by a few funds philosophically opposed to blitzscaling and now quietly adopted by some more traditional looking VCs. The solution is to fund companies which meet the following conditions. Companies that:
Have a plan to break even after the round
Have business models that support rapid, self-funded growth
The first condition of this approach fixes the need to care what other VCs think because being break-even eliminates fundraising risk. The second ensures that the company can continue to accelerate (hopefully to a billion dollar valuation) without needing further capital injections.
Under this conception of investing, capital is provided to get the company to a place where it can scale aggressively on its own. As opposed to the traditional model where VCs fund companies to get to the next fundraising milestone.
Who is running this playbook?
There are two types of funds I've seen using this playbook
Anti-blitzscalers
Funds investing in unpopular areas
Anti-blitzscalers
The majority of funds running this playbook reject the mainstream approach to startup building insofar as they are not explicitly hunting for unicorns. Here I'm talking about the likes of Indie VC, Calm & D2. These players are animated by the belief (which I am somewhat sympathetic to) that the high failure rate of VC backed companies is largely due to needless blitzscaling. Based on this, they conclude that it's very possible to return a 3x+ fund with a portfolio of companies that don’t have the same all or nothing approach mandated by Silicon Valley lore.
These funds filter aggressively for investments that fulfil both the conditions above. However, given their reduced failure rates their fund models don’t require 100x exits to succeed.
Side note:
Interestingly a number of these funds have found that some of the companies they invest in end up looking like unicorns anyway (As of 2023 10% of Indie VC’s portfolio companies were doing >$10m in revenue).
Funds investing unpopular areas
Conversely, funds in this second category look almost identical to traditional VC. They are trying to invest in unicorns, and are largely unbothered by high startup failure rates. The main thing that separates them from standard thesis-driven funds is the fact that they select for companies that meet the criteria above. These funds do not see themselves as separate from mainstream VC. Instead they have adopted these criteria because their theses involves investing in companies that happen to be outsiders. Investing in self-sufficient companies is a tactic, not their raison d’etre.
Consequently, compared to the anti-blitzscalers, they are hard to identify. In fact, I was only able to find one example in the wild even though I’m certain there are many more. Adjacent run by Nico Wittenborn.
Adjacent looks like a regular thesis driven fund. It’s thesis is investing in Consumer Subscriptions, which in layman's terms means SaaS for consumers (e.g. Duolingo and Calm). In stark contrast to the likes of Indie VC, nothing on their website would betray the fact that Adjacent backs companies that don't need to raise more money in the future. In fact many of their portfolio companies have actually raised further funding post their initial investment.
The only way you could know that the fund has this strategy would be if you happened to listen to Nico’s 20VC appearance where he utters the following throwaway sentence:
Usually I structure the rounds in such a way that we can get to cash flow positive with those companies
Why does Adjacent have this strategy? Because VCs don’t care for consumer subscription companies. And that equals heightened fundraising risk. In Nico’s own words:
People don’t like Consumer Subscription until it does 10s of millions of revenue
Adjacent’s approach is a direct response to the VC hivemind that hates their thesis. By selecting for companies that don’t need to rely on VC belief to continue operating, they are able to still invest in the space they care about. Moreover, because of how quickly Consumer Subscription companies recoup their customer acquisition spend (often in 7 to 8 days) their portfolio companies can fuel their own growth by recycling cash.
The combination of these two features allows them to be certain that their investments will not just survive but also be able continue to scale regardless of what other VCs think.
This whole time the secret to eliminating the fundraising risk inherent in backing outsiders wasn’t changing how the market sees them, instead it was making how the market sees them irrelevant.
Implications for funding diverse founders
There is an emerging crop of funds at the seed and pre-seed stages focused on backing diverse founders. I have had several conversations with people at such funds where they lament how difficult many of their well performing portfolio companies find fundraising due to their outsider status. My suspicion is that a lot of the funds focused on backing diverse founders (textbook background outsiders) could benefit from taking a leaf out of this playbook.
While it is far from a panacea - an approach like the above that essentially sidesteps fundraising risk could form a core part of the solution. It would allow these funds to free themselves and their founders from an industry that is structurally skewed against them.