How Fundraising Actually Works
Stop publicising your raise!
A Tale of Two Rounds
Like most first-time founders, we wasted a lot of time fundraising. This was because we didn’t understand how fundraising actually works. We reached out cold to investors and asked for warm introductions from our network, but never realised these seemingly sensible actions were leading us to our doom. It took us 9 months to raise $250k, which was a terrible use of our time.
With our second startup, we raised >$1m in 4 days. The VC had already done their homework about us and our thesis before we met for the first time. We learned how fundraising actually works: you shouldn’t reach out to VCs because in 90% of VC deals, they reach out to you!
This post explains how to be in that 90%. We cover the following topics:
The economic theory of Adverse Selection and how it applies to fundraising
Why cold outreach AND warm introductions both don’t work
The concept of backchanneling, which actually works
The Theory of Adverse Selection
Adverse Selection was first observed in the market for second-hand cars. The seller of the car always had more information than the buyer, which led the buyer to be suspicious that there were hidden problems. This hugely drove down prices, which meant people with functioning second-hand cars no longer wanted to list them. It led to a death spiral where only the worst cars remained on the market at rock-bottom prices.
There’s a similar problem with early-stage fundraising. The founder, who is the seller of the asset, has more information about their company than the investor, who is the buyer. This is why there are no fundraising marketplaces: investors suspect that only the worst startups would appear, as better startups would’ve been able to raise money without needing a marketplace.
The same thing applies to public pitch events. The fact that you’re pitching is further proof that no one has funded you yet, so don’t do it!
Why Cold Outreach Doesn’t Work
Investors’ inboxes are flooded with founders reaching out cold about their startups. Unfortunately, these startups have already fallen prey to Adverse Selection. If they were a good investment prospect, they would have found someone who could recommend them to the investor instead (see next section). Investors therefore ignore the vast majority of their cold emails from founders. Don’t waste your time with this.
Why Warm Introductions Also Don’t Work
A slightly better strategy is the warm introduction. Rather than reaching out cold to an investor, the founder first finds a mutual connection (“ally”). They then ask the ally to introduce the founder to the investor so they can then pitch the investor.
This is better because the investor will likely at least read the email from the ally. However, the Adverse Selection problem remains! The fact that the founder wants to pitch tells the investor that the founder has not yet finished raising money. Why haven’t they managed to raise money yet? Maybe because they’re not pitching a good investment. If they were, surely other investors would’ve already funded them?
In this situation, investors often take the call with the founder and then drag their feet. They reply slowly to emails, schedule meetings weeks/months in advance, or just ghost. They’re concerned about Adverse Selection and don’t want to be the first to invest. This process can drag on for months (or even years) - it’s why it took us 9 months to raise just $250k with our first startup.
How Fundraising Actually Works - Backchanneling
The best strategy is a small twist on the warm intro, which is called backchanneling. Rather than asking the ally for an introduction, instead you should just ask them to say to the investor something like:
“Hey have you met [X founder] yet? They’re amazing at [Y product or Z market] and I heard they may be raising soon…”
If the ally does this, and the investor values their opinion, they will ask for an introduction to the founder. The founder then takes the call and remains vague about their fundraising plans. Because they’re not asking for money, there’s no proof that no one has turned them down yet for funding. They therefore don’t trigger the Adverse Selection problem and may be a hot startup!
Investors all talk to each other, so they all know which startups other investors are talking to. If you backchannel effectively enough, investors will drive the process towards a term sheet for you. They will draft all the docs, you don’t even need a deck. If they’re keen, they can decide in days rather than dragging their feet for months. This is why we raised our last round in 4 days, rather than 9 months!
Wrapping Up
In this post, we explain the theory of Adverse Selection and how it applies to fundraising. The key takeaways are:
Avoid any public evidence that you’re actively fundraising
Don’t waste your time with cold email, or even warm introductions
Instead, ask your network to backchannel to generate inbound investor calls
This post may feel fairly grim because of the gamesmanship, so we want to end on an optimistic note. The stronger your network, and the more they rate you, the easier it will be to backchannel. You strengthen your network by consistently doing good work and treating people well. Isn’t that a nicer way to spend your time than cold emailing investors and pitching at pointless events?
Big thanks to an anonymous investor who taught us the “dark arts”.
Great post