Post Category → Venture Capital

Why VCs No Longer Require Warm Intros

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Once upon a time, the startup and VC ecosystem was a very opaque and fragmented place. Each non-SV market had at best a handful of meaningful check writers who were very geography-centric (local) in their funding. Even Silicon Valley had only a few dozen VCs, who very much expected you to move closer to them if they were going to fund you. Seed funds and accelerators were not a thing. The idea of a “pre-seed” round would be considered comical.

In that earlier, simpler time, much discussion revolved around the importance of the “warm intro.” So much so that I had to write posts like: “Why I (Still) Don’t Make Investor Intros.” Venture capitalists used the way that you were introduced to them as an important signal for a founding team’s chops. Candidly, this is not entirely unreasonable. A whole lot of what a founding CEO does is build relationships with key people in the market, and “sell” the vision so that other players will make an incentives-aligned contribution to the cause: join the team, buy the product, write a check, etc. There is some logic to the idea that if a CEO can’t convince anyone credible to introduce them to a VC, well, can they convince key employees, or key customers, or key commercial partners?

Times change. Now the image of elite VCs sitting in their gilded towers waiting for founders to jump through X or Y hoop just to be given 15 minutes to sit in a conference room chair seems… a bit dated. Sure, the go-go years of 2020-2021 have ended and we’re now in a bit of a reset of power dynamics between founders and funders, but nevertheless the whole process of how top founders get connected with VCs today looks very different from 10-15 years ago. In fact, at the high end of the market, it’s flipped. Rather than founders scrambling to get intro’d to VCs, it’s now VCs scrambling to get intro’d to founders. Multiple articles were written about “VC burnout” as VC partners and associates were, in some cases, under extreme stress trying to get access to good deal flow.

What changed? The Disney-fied story you’ll hear is something like “VCs have become more enlightened.” Relying on intro’s was too “good ol’ boys” chummy. It excluded talented people without connections. It reinforced biases and prejudice. Now our far more modern funding ecosystem is “open,” transparent, meritocratic, with a more level playing field.

Okay, perhaps. I won’t say that narrative is entirely false, but it’s most definitely incomplete. The bigger-picture reason is: competition, and a proliferation of alternative signals for team quality.

In How Angels & Seed Funds compete with VCs I wrote about how changes in the structure and timing of funding rounds produced an entire industry of check writers who preceded VCs in a company’s funding pipeline. Angel investors have been around for a long time, but as the SaaS revolution started dramatically dropping the cost of starting a startup, resulting in an explosion of people trying their hand at entrepreneurship, angels started professionalizing. You now had angel networks and syndicates that could collectively fund an entire round of millions of dollars. They were soon followed by “seed funds,” leaner, faster VCs who led rounds much earlier in a company’s life-cycle relative to more traditional VCs who typically dove in around Series A.

Parallel to the professionalization of angel networks and seed funds came startup accelerators, which were a result of the then-newly emerging seed ecosystem, but also a catalyst for its further evolution. The explosion of young startups who weren’t yet looking for millions of dollars, but for whom a few hundred thousand would make a meaningful impact, begged for a university-like talent sorting service provider that could apply a branded signal onto credibly vetted teams, thus helping them get later funding.

For a period of a few years, there was an elegant symbiosis between the “seed ecosystem” of accelerators, angel networks, and seed funds, on the one hand, and larger VC funds who showed up around Series A, on the other; much like how elite universities sort and credential students, for a price, and funnel them into top-tier employers.

We can pause for a moment here to recognize that this development alone significantly eroded the importance of the “warm intro.” Accelerators and angel networks rarely required warm intros. They had “open application” style ways of connecting with founders, which rarely required references or other connections. This meant a higher volume of applicants of more varied quality, but because the checks were smaller (less concentrated risk), and these orgs staffed themselves with people trained (in a way) to separate wheat from chaff, this significantly expanded the top of the funnel for startups entering the funding market.

At the tail-end of the seed pipeline, once you were accepted/funded by a top accelerator or angel network/seed fund, this served as a credible alternative to the less institutionalized “warm intros” of yesteryear. Someone had already put in effort to get to know you and filter you from the volume of B and C-players in the market, and so VCs grew more comfortable taking those meetings even if a classic introduction wasn’t part of the package.

But unlike centuries-old non-profit universities, the seed ecosystem was made up of dynamic businesses and service providers eager to claim more market share. And so they did.

Elite accelerators and other seed players started forming their own later-stage funds, or investing in VC funds much more tightly aligned with their own interests. If there was money to be made in later-stage rounds, why let some other fund make it? Seed players also started leveraging their control over the top of the funnel to exert pressure on later-stage VCs, requiring them to accept higher valuations, weaker governance rights, and other forms of limits on VCs freedom to operate. See: Startup Accelerators and Ecosystem Gatekeeping.  What had started as a nice complement to the business needs of VCs had now evolved into a direct competitor and gatekeeper.

VCs, being who they are (hardly tender souls afraid of competing), were not simply going to accept these seed-stage upstarts taking control of the ecosystem. The stakes are too high. VCs started evolving and competing, in many cases very successfully. See: Why Startup Accelerators Compete with Smart Money. The significant weakening of the “warm intro,” with many 7-figure check-writers openly inviting founders to send cold e-mails, is a result of this competition. If VCs didn’t want accelerators and seed investors choking them off from the entire pipeline of top startups, they had to get comfortable stepping out of their gilded towers a bit and spending more time filtering through the masses themselves.

Thus the erosion of the VC warm intro is less the result of a newly enlightened VC industry, and more a response to changing market dynamics requiring VCs to loosen up if they want meaningful deal flow. Making the warm intro merely optional is just one way VC is evolving. VC “scouts” – often very young people aligned with a VC fund and incentivized to identify early talent – are a kind of VC-aligned white-label of angel investors. See First Round Angel Track. Some VC funds are going further and creating their own accelerators. See Sequoia Arc.

My personal impression is that elite VC funds identifying and responding to competition from seed players, and themselves creating seed-stage arms of their funds, has been the nail in the coffin of the “golden era” of startup accelerators. It’s very true that some meaningful accelerators still exist, most notably Y Combinator, but it’s quite obvious now that accelerators no longer serve the central role in the seed ecosystem that they once did. It’s hard to imagine accelerators regaining their prominence among the very top tier of entrepreneurs without a significant revamp of their business models, including their pricing.

Ironically, elite startup accelerators once branded themselves as an alternative to a stodgy and antiquated university system, and yet now they themselves are seen, in some circles at least, as unnecessary and overpriced. The truth is accelerators are a service provider, with a relatively high price. It should surprise no one that the market responded by offering similar services (sorting, signals) at other price points. In the golden era of accelerators, a hustler would flaunt dropping out of Stanford or Harvard and joining YC or Techstars. I see a lot more elite founders today skipping accelerators entirely and just getting funded by a seed fund or nimble VC, accumulating a less centralized portfolio of signals, while saving significant dilution in the process.

This is not at all to suggest that the most elite startup accelerators are going away anytime soon. They absolutely have their place, particularly for founders in contexts where they struggle to acquire credible early signals; one key example being international founders in smaller markets. But all accelerators are facing credible competition and erosion of their pricing and brand power, as entrepreneurs at all levels, including those at the very top, realize that the value proposition of accelerators (signals for follow-on funding, a network, advisory) is often replicable at substantially lower levels of dilution.

At one level, the big picture story here is competition between different kinds of funders: angels, seed funds, accelerators, and VCs, all competing for each other’s turf, with different business models and price points. The number and variety of check writers grew significantly, changing power dynamics between founders and funders, and forcing the latter to become more flexible in order to access deal flow.

At a higher level, we see competition between signals. This post is ultimately about warm intros, which are one of many possible signals for the quality of a founder team. The “open application” style of accelerators and seed funds demonstrated that there were other ways to vet the quality of founder teams, and VCs eventually started integrating those other signals into their filtering repertoire.

We may be moving away from the warm intro as a central signal for startup quality, but we will never move away from the need for signals themselves. When people criticize the university system, they’re often criticizing its price, or its effectiveness, but they’re not criticizing the fundamental underlying “service” that elite universities and even standardized tests provide: talent sorting and signals. That service still needs to be provided somehow. The emerging theses are that there are ways of doing it better, cheaper, faster, etc. This is most definitely true, even if it’s also true that the older systems still have their place.

Developing alternative signals that produce results is legitimate improvement and market evolution. Competition between signals is not zero-sum. There’s room for more. But complaining about how existing signals are unfair or exclusionary without offering viable alternatives is (candidly) just whining. Not helpful. What we want to work and what actually works are two separate things.

Similarly, celebrating the weakening of the warm intro, much like celebrating the weakening of institutionalized education and testing, is not the same thing as pretending (delusionally) that we don’t still need effective + efficient talent sorting and signaling. Universities letting go of the SAT as a hard requirement does not mean some highly talented students won’t still use it as their preferred talent signal.

It’s the same with the warm intro. Sure we can talk about how it’s unfair and exclusionary, and that it’s a good thing that there’s a broader menu of signals available, but the fact is for many teams it still works. In fact, given how much bigger the market has become, with a larger diversity of credible intro sources (respected founders, senior executives, and angels being the best options), the warm intro today is arguably much less “chummy” than it was in the tighter, narrower networks of a decade ago. If you can get a strong warm intro (note: lawyers are not strong warm intros), I highly recommend you use it. In a crowded market, anything that can credibly differentiate you is worth using.

The wheat will somehow get separated from the chaff. That’s a fact. More ways of doing that (a wider variety of effective signals) is a good thing. But I would caution anyone from turning this story into some kind of “you can be whatever you want, if you try” warm-and-fuzzy narrative. Startup entrepreneurship is still brutally competitive and meritocratic (albeit imperfectly); exclusionary by design, just like any high-stakes industry or sport. Some barriers, like the warm intro requirement, have been loosened. But that’s meant the number of entrants has multiplied 10-fold.

The competition among funders has gotten much more intense, but so has the competition among entrepreneurs. The strongest teams will always use credible, unambiguous signals to differentiate themselves from weaker players in an increasingly crowded and noisy market. Some of those signals will be elitist, because the entire point is to identify the elite.

End-note: The topic of intros and signals often gets understandably lumped into discussions of “diversity” in the startup ecosystem. If you’re interested in my candid thoughts (as a latino from a low-income background) on that topic, see: Diversity in Startups: Whining, Warring, Winning. 

Milestone-Based Valuation Caps for SAFEs and Convertible Notes

TL;DR: When it’s difficult to get aligned with investors on the appropriate valuation cap in your Convertible Note or SAFE, having a tiered milestone-based valuation cap can be a reasonable compromise. If you hit the milestone, you get the better (for the company) deal. If you don’t, investors get the better deal. But avoiding ambiguity in the language is key.

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Equity rounds, including simplified/leaner seed equity, have always been preferred by founders for whom “certainty” over their cap table is a key priority. Equity allows you to lock in a valuation and certain level of dilution, which is often an optimal strategy in boom times when valuations are very juicy; though of course over-optimizing for valuation alone, to the exclusion of other factors (like liquidation preferences, governance power, investor value-add, etc.) is never a good idea.

But as of right now (December 2022), we are definitely not in boom times. The startup ecosystem has seen a dramatic contraction in financing activity, and uncertainty over valuations has taken over; with investors demanding that they move lower, and entrepreneurs struggling to accept the new reality.

Convertible securities (Notes and SAFEs) have always had the benefit of being more “flexible” and simple than equity. They have their downsides for sure, but in many contexts when speed-to-closing is important, and fully “hardening” a valuation is not possible, they make a lot of sense. But in times of maximal uncertainty, like now, even agreeing on an appropriate valuation cap can be tough. You believe you deserve more, but the investors, often citing all the apocalyptic data, say you’re being unrealistic.

A milestone-based valuation cap can be a good way of getting alignment on a valuation cap, especially if you’re highly confident in your ability to hit that milestone, but you have no credible way of getting an investor today to share your confidence. Investors tend to like valuation caps because they are asymmetrically investor-friendly – if the company performs well, the cap limits the valuation, but in a bad scenario, investors get downside protection (lower valuation at conversion). A milestone-based cap is a way of making the cap’s “flexibility” a bit more symmetrical, with upside for the company if it outperforms.

A milestone valuation cap would say something like (paraphrasing): “If the Company achieves X milestone by Y date, the Valuation Cap will be A. If it does not, the Valuation Cap will be B.”

Simple enough, but as always the devil is in the details. When using a milestone valuation cap, you want to minimize ambiguity and the possibility of disagreement in the future as to whether the milestone was in fact achieved.

Bad milestone language: “The Company successfully launches an alpha product to market.”

What do you mean by “successful”? In whose opinion? By what date? What constitutes a “launch”?

Better milestone language: “The Company’s product/service achieves at least 10,000 daily active users by [Month + Year], with such metric to be calculated and reported in good faith using a consistent methodology determined by the Board of Directors in its reasonable discretion.”

Not 100% air-tight – it can often be unproductive to over-engineer the language, and too much distrust between investors and management as to calculating the milestone is a bad sign – but still far clearer and less subject to disagreement than the first one.

If you find yourself cycling in discussions with investors over what the “right” valuation is for your seed round, consider committing to a milestone-based structure as a way of (i) getting alignment as to what “success” looks like post-close, and (ii) bridging the “confidence gap” between the founding team and the money.

Startup Governance Choke Points: Protective Provisions

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As I’ve written many times before, one variable that makes the world of startup governance very different from other areas of corporate law is the substantial imbalance of experience and knowledge between the business parties involved. On one side you often have seasoned VCs who’ve been in the game for decades. On the other you often have an inexperienced entrepreneur for whom all of the complex terms in the docs are completely new. This imbalance leaves open numerous opportunities for leveraging founders’ inexperience to gain an advantage in negotiations either in deals or on complex board matters.

This can make the role that corporate lawyers play in VC<>founder dynamics quite pivotal. Whereas seasoned executives at mature companies usually rely on legal counsel for executing specific directives, but not for material strategic guidance, in the startup world good VC lawyers serve as strategic  “equalizers” at the negotiation table. This is why guarding against any conflicts of interest between your lead lawyers and your VCs is so important (see above-linked post). If your lawyers’ job is to help you guard against unreasonable demands or expectations from your counterparties, you don’t want those counterparties to have leverage over those lawyers. No one bites a hand that feeds them. VCs know this, and deliberately feed (engage and send referrals to) *lots* of lawyers in the ecosystem.

Because of this imbalance of experience, and even the tendency for some VC lawyers to not fully educate founders on the material nuances of deal terms and governance issues, I regularly encounter founding teams with overlooked “choke points” in their companies’ deal and governance docs. By choke points I mean areas where, if there were a material disagreement between the common stock and investors, the latter could push a button that really puts the common in a bind. It’s not unusual to find founders who simplistically think something like, “well the VCs don’t have a Board majority, so they can’t really block anything.” Trust me, it’s never so simple.

The hidden VC “block” on future fundraising. 

One of the most common hidden “choke points” I see in startup governance is overly broad protective provisions. These are located in the company’s Certificate of Incorporation (charter), and basically are a list of things that the company cannot do without the approval of a majority or supermajority of either the preferred stock broadly, or a specific subset of preferred stock. Given that the preferred stock almost always means the investors, these are effectively hard blocks (veto rights) over very material actions of the company. No matter what your cap table or Board composition looks like, these protective provisions mandate that you get the consent of your VCs for whatever is on that list.

Fair enough, you might say. The investors should have a list of certain things that require their approval, right? Of course. Balanced governance is good governance. But good, balanced governance terms should protect against the possibility of misalignment of incentives, and even conflicts of interest, in governance decisions for the company. In other words, they should prevent situations where someone can take an action, or block an action, purely out of self-interested motivations, while harming the cap table overall.

Very often so-called “standard” (there are all kinds of biases in what ends up being called standard) VC deal terms will give VCs protective provision veto rights over these sorts of actions:

  • creating any new series of preferred stock
  • making any change to the size of the Board of Directors
  • issuing any kind of debt or debt-like instrument.

The end-result of these protective provision is that, at the end of the day, you need your VC’s permission to raise any new money, because you can’t raise money without taking at least some of the above actions.

Let me repeat that so it sinks in: regardless of what your Board or cap table composition looks like – even if a VC is a minority holder, and the preferred don’t have a majority on the Board – the kinds of protective provisions that many VC lawyers call (air quotes) “standard” allow your VC(s) to completely block your ability to raise any new financing, no matter what the terms for that financing are. A “choke point” indeed.

Why is this a problem? Well, to begin with it’s a serious problem that I encounter so many founding teams that aren’t even aware that their governance docs have this kind of choke point, because nobody told them. A fair deal negotiation should require clear understanding on both sides. But more broadly, the problem is that VCs can have all kinds of self-interested reasons for influencing what kind of funding strategy a startup will take. They may want to block a lead from competing with them, for example. Or they may want to ensure that the follow-on funding is led by a syndicate that is “friendly” (to them) as opposed to one whose vision may align more with the goals of the common stock.

I have encountered startup teams several times who think they are in control of their company’s fundraising strategy, again because they simplistically looked at just their cap table and board composition, only to have a VC inform them that, in fact, the VC is in control because of an obscure protective provision that the founders never even read.

Preventing / Negotiating this Choke Point

The simplest way to prevent your VCs from having this chokehold on your fundraising strategy is to delete the protective provision(s) entirely. That may work, but often it doesn’t. Again, balanced governance is good governance. It’s reasonable for VCs to expect some protections in ensuring the company isn’t willy-nilly fundraising with terms that are problematic. I agree with that. But as I said above, it’s also unreasonable for the VCs to expect a hard block on any fundraising whatsoever, regardless of terms.

A more balanced way of “massaging” these protective provisions is putting conditions or boundaries around when the veto right is actually effective. For example, you might say that the veto right is not enforceable (the VCs can’t block a deal) if:

  • the new financing is an up-round, or X% higher in share price than the previous raise;
  • is a minimum of $X in funding;
  • maintains a Board with specific VC representation;
  • doesn’t involve payment to a founder, to ensure they are objective.

There are all kinds of conditions you could add to provide that only “good” (higher valuation, legitimate amount of money, balanced Board representation, etc.) financings can get past a VC block. Putting this kind of list in a term sheet can be an excellent conversation starter with a VC as to what they see as the long-term fundraising strategy, and where their own red lines are. It allows you to candidly ask your VC, “OK, if the deal checks all of these boxes, why exactly do you still need a veto right over it?”

But if your VC simply responds with a “this won’t work, we need a hard veto on fundraising” position on the negotiation – at a minimum you now have valuable data as to this VC’s worldview on governance and power dynamics in their portfolio. See Negotiation is Relationship Building. Regardless of where deal terms end up, forcing a discussion about them, and requiring the other side to articulate their position clearly, still serves a valuable purpose. Sometimes you don’t have the leverage to achieve better balance in your deal terms, but it’s always a positive to at least have your eyes wide open.

Putting substantive deal terms aside, I enjoy helping founding teams understand that many of the most (air quotes) “founder friendly” investors in the market are still far from charitable actors, and can be quite clever and subtle in their methods for maintaining power, despite the “friendly” public persona. See: Trust, “Friendliness” and Zero-Sum Startup Games. Note: this is not a moral judgment, but just an acknowledgement of reality. You and I aren’t Mother Teresa either. Navigate the market with the clear-eyed understanding that everyone is following their incentives, and protect your company accordingly.

A less balanced, but still improved, configuration of these protective provisions is to create an exception if a VC Board member approves the deal. You might (understandably) think: how is this better, if the VC Board member can just refuse to approve? Without getting too in the weeds, Board members have fiduciary duties to the cap table overall, whereas non-controlling stockholders generally do not. So at least theoretically, you could call out, and even sue, a Board member if it’s blatantly obvious that they are blocking a particular deal for reasons that are more about their own interests than the company’s.

I say theoretically, because the smartest and most aggressive investors, if they really want to play games with pushing your fundraising strategy in their preferred direction (and away from the preferences of the common), will be quite creative in developing plausible deniability for their behavior: they blocked the deal because that other lead wasn’t “value add” enough, they don’t believe now is the right time to raise because of market conditions, they’re concerned about X or Y thing that at least gives them an argument that they are still looking out for the company. So don’t get too excited about these fiduciary-related exceptions to protective provisions. They’re not nearly as helpful as the better strategy of putting concrete bypasses to a protective provision veto.

To be very clear, I still see quite a few founding teams who are fully informed about these issues, have a candid conversation with their VCs about it, and still ultimately put in some kind of hard VC-driven block on fundraising. I of course also see plenty of teams who, as soon as we bring this topic up to them, dig their heels squarely in the sand and completely refuse to do a deal unless the VC vetoes are removed/modified. It depends on context, leverage, values, trust, etc. But in all cases it is a net positive for the inexperienced founding team to know what they are signing.

Startup governance and power dynamics are much more nuanced than just what your Board and cap table look like, or the usual 2-3 high-level terms that founders read in a term sheet, thinking everything else is just “boilerplate.” Ensure you’re surrounded by objective, experienced advisors who can help you understand those nuances, so the deal you think you’re signing is in fact the one on the table.