On fundraise incentives: why the 2022 vintage soured

A real milestone for any company is to close a fundraise successfully, when after those many stressful months all the documents have been signed, and the money is finally in the bank. What the enthusiastic LinkedIn-posts betray, is that not all raises are glamorous, and plenty more aggravating than exciting, with the cap table taking the damage. This is especially true of the 2022 vintage (i.e. companies who needed to raise money in that year). After the booming previous year, with record multiples commonly exceeding 10 times revenue, the market put a brake on venture capital (VC). This article is about the internal struggles of having to raise in a tough market, and how the board room dynamics change from bullish bravado to everyone hedging their own bets.

1. A successful fundraise?

It was the second quarter of 2022, the Covid-19 pandemic was as good as over, and things were looking up in the world. The young founders had built a successful online company during this time, and had their minds set on a first institutional funding round. They had seen the recent fundraise successes, and had been working on creating a pipeline of VC-firms for their own company, pitching vehemently. Through their hard work, they were able to land a couple term sheets, but only after a lot of no’s. Valuations were lower than they had hoped though, not a lot of wiggle room there, but getting term sheets from respectable local VCs was an achievement on its own. They were comfortable that they would land positively with their existing investors, who had stood with the company during those difficult early years. Those had not been easy, and as a result the founders had to give away quite a large share of their ownership early. This was even recognized by the VCs, who had told the founders a fresh equity incentive would be on the table if they were partnering up.

Their other shareholders had a different perspective. The terms were dilutive for them, which was no surprise. But having kept the company afloat for those early years, reading the concessions they would have to make left a bad impression: liquidation preference, board seat, reserved matters, and more. They also pushed back on the equity incentive, as they knew it was common to put that on pre-money terms. The valuation being on the low end of their own estimates, as they had reported within their own organizations on the high 2021 multiples, made them a lot more hesitant than the founders had expected.

A tough negotiation with the VCs needed to follow, which got stretched over multiple weeks. By now, the market turndown was becoming more apparent, so the VCs took a stand: take it or leave it. The more active investors, in the meantime, had been looking in their own circles for an appetite to join in, on their terms. This showed them that under their smaller LPs and angel network, there was solid interest. This made their decision irrefutable: they were going to do it themselves. What was underestimated however, was that this turned the raise into a different game, with changed stakes and incentives. This was all invisible at first, as the investors were able to bring in a few warm leads on SAFEs that closed within weeks. The initial sentiment was good on all sides, as every euro that the newly found investors brought in was an immediate relief on cash flow, and a burden the existing ones didn’t need to carry. But the sentiment would not last.

The agreement was that every stakeholder, including the founders, would put their best foot forward in finding new investors, with the hope that enough would be found to cover the runway they actually needed. But not everyone had the network or the appetite to do this effectively. Some were pitching hard, but others had already received approval to cover their share if needed, as their belief was strong and they wanted to prevent dilution. Others, including the founders, knew they were unable to pitch in altogether and had to absorb the dilution. On top of that, with the incentive off the table and the runway already looking better after the first checks landed, the founders would be focused on the business again. Everyone had consented to best effort, but what that effort entailed was never aligned.

After a few months, the round had closed with the majority coming from new investors, and the existing investors funding the rest. But what looked like a successful raise on paper, did not feel like the accomplishment it actually was. This is not an isolated case study, but a recurring pattern across the 2022 vintage, with consequences the individual companies carry with them until today.

2. The information problem

Looking from the outside in, everyone's behaviour had made perfect sense: nobody had made a mistake, or broken a contract. But that is rarely the story that gets told, as that narrative is fundamentally about people’s own perspectives, not structures: an investor who didn't pull their weight, founders who lost focus halfway through, a shareholder who held to their own valuation until the end. While this does yield great dinner conversation, it does not give us an understanding of how everyone’s decision on how to act was made. Knowing that would have made it possible to adapt the underlying structures proactively and change the outcome.

Underlying our case is a divergence between what each party considered to be the raise. Everyone agreed on the necessity to increase runway, but besides that, investors and founders were clearly protecting different things. The founders wanted institutional validation and market alignment into the next phase, including an uptick of their own equity incentive, while the investors were focused on valuation and control, both of which sat below their 2021 reference point. Everyone was protecting their own interests, mostly through loss aversion, which also points to why the solution of taking the round inside felt comfortable, substituting a known one-off cost for an unknown structural one. As such, there is a real distinction in how the misaligned interests played a role between the situation before that move and afterwards.

Before the shareholders came in, this was first and foremost an epistemological issue, meaning that it is grounded in what parties know and do not know about the situation, themselves, and others, and how they make decisions under such imperfect information. The theory of bounded rationality, coined by Herbert Simon, states that people create a mental model that is “good enough” for them, and work from there. As a result, the parties in this case were looking at a raise that first made sense to themselves: what valuation, with whom, and under what conditions.

Even though in hindsight there could have been more communication prior to starting the raise, to put this off as solely a communications problem is too easy: each party’s decision model feels complete to themselves. With there being no sense of anything missing, the need to discuss it also does not arise. Moreover, while pure information asymmetry can be overcome by sharing, a lack of self-knowledge or the existence of variables hidden to all parties cannot, so the picture always remains partial. Besides, even when by some incentive a party withholds information deliberately, that still results in the epistemological problem of it being invisible to the others, only the reason is motivational. In a raise led by founders, a conversation where their incentives are being discussed is not broadly shared.

But a different view of the situation is not the same thing as having misaligned goals: if information is invisible, it cannot be taken into account (or ignored), and if it is visible but contradictory, it is commonly suppressed. As a founder, for example, you would not have anticipated the shareholders rejecting the institutional terms outright, and you could not have known the power of their own network. As an investor, your model of what the founders needed was also partial, so you might not have the founders' need for institutional validation on your radar, nor that they had talked to the VC about their own equity incentive without them telling you outright.

This all changed when the term sheets came on the table, and the raise was taken inside. With the shareholders taking the lead and the equity increase conversation going up in smoke as a result, everyone was now operating within the same raise, so the epistemological misalignment ended: it was now about who was incentivized to do what.

3. The incentive mismatch

Principal-agent theory tells us that when one party acts on behalf of another, their interests diverge in predictable ways because the other is protecting different things, and that divergence can, to a certain degree, be contracted away. In our scenario, the founders, in representing the company, are agents of the whole cap table. In order to align their interest to them, there is an equity part to their compensation, on top of, or as in most startups and scaleups replacing a part of, their salaries. This is typically still their original ownership percentage only, but as we have seen in the case above, there are other ways, like reverse vesting, to reincentivize if needed.

This equity incentive plays an interesting double role. Not just because the possible expansion of that incentive was tied to having an institutional round, which was taken away, but also because the incentive was there to align the founders and shareholders on wanting to achieve the highest valuation possible. The way the founders were weighing both aspects indicates that, as far as their equity incentive goes, they preferred having a bigger slice of the pie over the total size of the (still illiquid) pie itself. And there is more: the biggest influence the founders have on their equity is by running the business as well as they possibly can, so they did not disengage from the raise solely because they were disappointed in their equity incentive, but because they reallocated their effort in exactly the way the incentive was initially for: growing the business.

In order to keep their efforts focused on the fundraise, other instruments could have been created. But just increasing the incentive as if there would have been an institutional round would only solve part of the misalignment, as the institutional validation a recognised venture round confers would still not have been reached. So a traditional incentive as per principal-agent theory would not suffice to fully focus the founders on the raise, because the relationship that needs aligning cannot be reached within its dimensional scope, regardless of its magnitude.

A similar mismatch between incentives and relationships stems from the disconnection between the shareholders in this case: what was understood by each to be best effort differed a lot. This is, again, an epistemological misalignment first, because within each party's simplified model, the phrase referred to something different, and the gap was invisible because the words were identical: a common syndication trap. Nevertheless, once everyone’s actual intentions became clear the underlying incentive misalignment between the principals also became tangible: the investors who were not planning to be active participants in looking for new investors, being in direct opposition to those who could or would prefer not to carry the burden to pitch in. This is present in general in every portfolio company: an angel investor needs to protect the relationship more to protect future deal and syndication access, while an institutional investor needs to protect their LP-reporting, leading to a heavier focus on data and information rights.

This incoherence of the principal has an effect on their relationship with the agent: without a unified voice coming from the shareholders, there could have been no single shared contract to align the founders to all of their individual interests. This makes the difference between epistemological and incentivization problems more clear too: even if the information problem would have been solved by preemptively describing clearly what everyone meant by best effort, that would not have solved the incentive misalignment behind it. Creating a separate alignment contract for each investor with the founders would obviously be counterproductive and dimensionally incompatible, so the question becomes what instruments could have been used to create that alignment more structurally consistent, assuming aligning the principals between themselves first is not possible.

4. The limitations of contracts

The need for incentives to be structurally consistent does real work. One, it needs to be able to align people on factors that lie outside of what one can write down in a contract, because it is not governed within the existing relationship (the institutional validation) or needs to cover multiple heterogeneous actors (the best effort), in other words: be consistent with the existing structure. But two, it also needs to stay consistent when, inevitably, the situation changes.

When an incentive lies outside the boundaries of the people in the room, there is no obvious way to close the gap. The founders’ need for institutional validation serves a real purpose: it validates the company valuation externally and shows confidence from a dominant market player in the business, things an inside round does not provide. The fact that there were actual term sheets on the table makes their loss all the more salient. Any alignment contract between founders and shareholders will only be partially effective until an institutional round closes.

This dependency on a future contingency is one of the hallmarks of what is called incomplete contracting-theory. While it would technically be possible to write a contract to encompass all the possible scenarios, it would be prohibitively costly, if it were even possible at all given the partial picture frame everyone is working from. The more practical approach is to stop trying to get right the first time and let renegotiation around the uncertain aspects bridge the gap when you get there. This is also the generic answer for when incentives are changing because the situation changes: contracting more flexibly, like companies do all the time for sales incentives such as quotas and commissioning. In this case, the founders could have renegotiated their equity package when the circumstances had shown that the market recognized it as below-market. The shareholders also should have recognized that this founder incentivization is not just cash out, but a necessary alignment towards the future. 

Covering multiple heterogeneous actors at once is also tricky, because this is the realm of more informal contracts that impact the structure as a whole, like defined company-wide cultural values, or, specifically for our fundraise, the agreed on best effort. Going the individual route is not always a solution because of its complex and often contradictory nature. Because of the clear epistemological problems informal contracting suffers from, true alignment is difficult. One can try enforcing, e.g. by using cultural fit as a performance review metric, but the result is more often than not arbitrariness, which turns it into a control tool rather than true alignment. 

An alternative way that does actually align is to have the affected group self-enforce or self-select. This effect works entirely different from standard incentivization efforts, which are mostly focused around either money or power: it focuses on group dynamics and protection at the gate. In fundraises, this works two ways: investors choosing the company, but also vice versa. In practice, the latter does not always happen intentionally enough, especially when cash flow is tight and the runway short. The result is that on the non-contractable terms, the relationship starts with a real incentivization deficit that is hard to overcome.

5. Towards foundational alignment

The two open gaps in this business case, i.e. the missing institutional validation and the unaligned best efforts, remain and could not have been solved with traditional contracting. This points to a prior question, but for another article: asking what personal dimensions need aligning and whether those are actually alignable within the company structure. The existing tools are one-dimensional. What I am working towards represents the company and its stakeholders geometrically instead, opening up qualifications like distance (how far apart are parties actually), direction (are their incentives pointing the same way), and drift (where they once aligned, but not anymore).

In our story, representing the many fundraises in 2022 that happened without a LinkedIn-post commemorating them, existential fallout had been contained, but only on the surface level. Carrying a diffuse syndicated round at a premium valuation, while deferring institutional validation to the next rounds, is something the cap table does not forget. Ignoring this comes at serious cost, ranging anywhere from leadership disassociation to a potential down-round: the sour aftertaste of a rough vintage. The 2022 raise closed, but the gaps did not.

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