The Problem with Chapter-Based VC Financing

Originally a thread on X/Twitter:

There’s a major structural flaw in how the VC ecosystem works that we don’t talk about enough.

It’s a flaw that creates confusion and bad advice for Founders.

And it’s a flaw that makes no sense when you dissect it.

Building a startup isn’t an overnight task. A successful startup can take years to find product market fit and then many more years to scale and become a market leader. The journey takes time.

But the journey also takes money.

And the journey is funded one milestone at a time.

To abstract the concept, here’s an interesting thought exercise:

Would you ever consider purchasing a book one chapter at a time where the cost of each subsequent chapter costs more than the first?

The benefit of this structure is that if you don’t like how the story is evolving you don’t have to finish it or pay for the entire book.

You’ve invested time and money into getting part way to what hopefully will be a satisfying ending but you don’t have to finish it.

The purity of making a money/time decision throughout your reading experience is that it puts pressure on the author to hook you over time and deliver against a growing set of expectations.

Great authors make reading the next chapter addictive and almost compulsory.

This is venture capital in a nutshell.

Instead of asking a Founder how much money they’re going to need from the formation of the business to self-sufficiency, a Venture Capitalist breaks the journey into pieces.

Each step of the journey is equivalent to reading another chapter in a book that’s still being written.

And a Venture Capitalist reserves the right to evaluate future investment decisions based on how much they like the story so far and what the author says is coming soon.

This isn’t an inherently bad structure, but there’s a wrinkle that causes problems for almost every startup.

The issue: What if you specialized in funding the writing of the early chapters of a book and didn’t have the money to fund the writing of the middle and later chapters?

Your job as an “early chapter funder” would be to work with the author to summarize the story that was told in the early chapters and then market it to a set of potential readers who specialize in reading the middle chapters.

Nobody will ever find out the ending of a storyline if you can’t excite a “middle chapter funder” with your summary and ultimately have them explain to a “later chapter funder” why they should pay a lot of money to find out the ending to the story.

What’s crazy is that the venture capital space has evolved to a level of segmentation where the journey is hyper-fragmented.

It’s no longer about a Founder courting an early, a middle and a late-stage investor. It’s about raising capital 6-8 times, each from a different lead!

This means that when you fund a chapter you have to believe there are other funders who will like the story and will be willing to pay to see the next chapter written.

It’s not about what you like. It’s about what you think THEY will like which is a major structural flaw.

Structural Problem: Uncertainty changes how stories are written

If VCs would commit to funding multiple chapters, Founders and VCs could agree on what a “great story” would look like and build it together. This isn’t happening, so stories morph to appeal to downstream capital.

Structural Problem: Non-consensus investments are tough

The system discourages funding stories off the beaten path because there’s uncertainty around finding someone else who will fall in love with the story.

Structural Problem: Many VCs and Founders have become Carnival Barkers

The system discourages “truth tellers” and encourages putting “Snapchat like filters on a startup’s results”. Many VCs and Founders see their job as getting their companies funded at all costs.

Structural Problem: It’s too easy to spend someone else’s money

Early chapter funders have stopped asking questions about how much money it’s going to take to write the entire book. And mid-chapter funders let the book get longer and longer. All because it’s not their money.

To be clear, by no means am I suggesting that the answer is for VCs to fund startups from inception to going public or a strategic sale.

The structure of today’s ecosystem has both features and flaws that are worth internalizing.

First chapter specialists are important given how large the base of the pyramid is and how difficult it is to find undiscovered talent.

But it would be nice if they were “truth tellers” and only shouted about their truly great authors and stories (which is not going to happen).

Getting a market read as a story is being written is a great way of making sure that proximity bias is minimized.

But it would be liberating if these market checks took place once or twice over the course of writing a story instead of after every chapter.

And it’s great that Founders can keep changing their story as long as they can find someone to fund it.

But it would be healthy to constrain a Founder such that a complete story is written for a reasonable investment and in a reasonable amount of time.

The unfortunate truth is that the system is what it is and isn’t likely to change anytime soon.

But there will likely be VC firms that decide it’s worth breaking out from the “norms” to offer a more complete value proposition to Founders. Only time will tell.