As entrepreneurs struggle to find pre-seed and seed-stage funding, I hear a growing narrative vilifying the traditional VC model. That’s unfair. “Power Law” venture capitalists have never made their expectations unclear. They invest in high-risk, high-potential businesses. They expect rapid growth, leading to a lucrative exit. They accept that only a few of their investments will be responsible for most of the return, but they need every investment they make to demonstrate that potential. That is the “Power Law,” a small number of investments will have a disproportionate impact.
The challenge is not the “Power Law” venture model. I would argue that without this funding model, some of the most successful brands in our industry would not be around. It is not any one model that creates the funding challenge. It is the lack of alignment between the founder and the funder.
Most emerging CPG businesses do not align with “Power Law” venture. That is the fundamental flaw in most fundraising efforts. Entrepreneurs try to take the square peg that is their business and stuff it into the round hole of a VC. This misalignment starts early in the lifecycle with the first convertible note or SAFE.
Think about the convertible note or SAFE and what needs to happen for an investor to realize a return. The businesses must grow large and fast enough to warrant a priced round of capital that converts the note or SAFE. Then, it needs to continue to proliferate to attract an acquirer. This happens, but not often as we think or read.
I want to throw out the model-centric approach to raising capital. It serves us poorly. What I mean by model-centric is that fundraising efforts focus on the VC model and its structure and terms. I’d rather see an alignment-centric approach.
Alignment funding starts with a conversation between the entrepreneur and the investor. The entrepreneur lays out their vision for the business. This includes the purpose and impact, risk and opportunity, pace of growth, and how much capital will be needed. Then, the conversation shifts to how the investor’s capital can be unlocked, achieving a desired return on investment and allowing the entrepreneur to grow their business in a capital-efficient and resilient manner.
The results of the above conversation should dictate the investment’s structure and terms. Let’s look at an example.
Elliot’s Wellness is a $3MM mission-driven business with strong margins and is self-manufactured. It’s carved a niche in a decent category but not an explosive one. The business had a slight loss this year but a clear path to profitability. Their five-year growth hypothesis has the business going from $3MM to $15MM with a double-digit EBITDA. The business needs about $1MM in capital to get there. This could be a good investment but not one that fits the “Power Law” venture model.
If the founder and the funder have a conversation about the business’s vision, they can develop the proper investment structure. Elliot’s Wellness aims to perpetuate its mission while building a profitable and sustainable business. The investor wants a solid return on investment and a path to participate in any long-term upside. They agree to an investment using a variable-based redeemable equity structure.
Elliot’s will receive a $1MM investment in return for preferred redeemable shares. 75% of the shares can be redeemed for 2x the purchase price. The redemption will happen through quarterly payments equal to 1% of net revenue. The investor will retain 25% of the shares. The expectation is that within five years, the investor will have received $1.5MM for the 75% redeemed and have a path to participate in any long-term upside.
The above is a simplified explanation. The critical point is that through conversations, the investor and entrepreneur align around a structure that allows the entrepreneur to build the business effectively and provides the investor with the desired outcome.
The alignment funding concept will take much more exploration than what can be accomplished in one article. I will be banging this drum for a while. If we toss out the model-centric approach and focus on alignment-oriented conversations, we will see more capital flowing and better outcomes for all involved.
I’d welcome any conversation. Please feel free to reach out. We will explore this more on a webinar hosted by the Hirshberg Entrepreneurship Institute on Wednesday, December 6th at 1 P.M. Pacific time. Here is the link to register. I will also speak at the financing seminar by Bob Burke and Mike Burgmaier in Boston on December 14th. Here is the link to register for that event.
