Redefining ‘founder-friendly’ capital in the post-FTX era

For many founders in the startup community, a “founder-friendly” investor is one who stays relatively hands off. They cut the check and then watch the executive team run their business without getting involved in the day-to-day.

In 2021, investors overdid a version of “founder-friendly” capital that boiled down to founders continually raising capital and reaching record valuations, enjoying no inputs from their investors. In turn, companies across the board missed out on the balance brought by investors’ complementary breadth of guidance. Today, it’s clear many companies could have used that guidance, seeing as FTX is only our latest and most high-profile example.

Given new economic headwinds, it’s time for the startup community to redefine what “founder-friendly” capital means and balance both the source and cost of that capital. That means choosing between active and passive partners.

Some founders may be confident in their ability to execute on their vision, but most will benefit from investors who can share scaling best practices they’ve seen across companies and who know how to navigate downturns. Successful companies are created when investors and executives blend their expertise to see around corners, not when one side overpowers the other into silence.

Here are some key considerations for founders seeking a better balance of capital and external expertise for their businesses:

Factor in founder friendliness

The two most important elements that determine your company’s growth needs are your company’s stage and what you’re willing to pay for active investors.

At the earliest stages, when your company is still doing R&D and not yet generating revenue, it’s near-impossible to secure passive capital in the form of revenue-based financing or debt financing vehicles. Instead, you’ll be raising funds on the strength of your idea, total addressable market (TAM) and team’s experience.

If you turn to a more passive equity investor at this stage, you’ll likely miss out on a true champion for your vision who can validate and evangelize your cause to future investors. This approach can limit your company’s growth potential and valuations, so you should always choose an active capital partner at this stage.

When you’ve grown enough to begin scaling, you can choose between expertise and cost. If you want best practices for growing a company through new products or markets, active investors can offer a wider view of the market. This expertise is immensely valuable and founders who need it should be willing to pay for it with equity.

That said, if you’re confident in your ability to scale the company, you can shop around to mix debt and equity investments to minimize dilution while benefiting from some external expertise, if needed.

Established or pre-IPO stage companies are better candidates for passive capital from lenders or hands-off equity investors. At this stage, companies are already generating significant revenue and have a plan to reach profitability, if they haven’t already. Having a proven record of success makes these businesses more attractive targets for institutional investors with less domain expertise but significant funds to deploy in the form of debt or equity.

Understanding debt’s role in the equation

Debt has traditionally carried some stigma in the startup world and is critically underutilized compared to the mix of debt and equity financing in the public markets, where, according to an internal analysis, the S&P 500 is financed by about 70% debt and just 30% equity.

The source of this stigma stems from the assumption that having a brand name VC investor on the cap table will automatically de-risk future rounds and launch a company on its growth trajectory. The vote of confidence from a prestigious VC firm like Andreessen Horowitz or Sequoia can indeed create a halo effect for some companies, but as more firms have entered the VC asset class in recent years, there’s no longer the guarantee that an equity investor will make it easier to secure funding from other investors.

Founders may also worry that raising a debt round signals that the company is struggling. However, the fact that debt capital must be paid back is actually a sign that the company’s underlying financials are strong enough to support repayment. While an equity investor can simply write off a failing investment, lenders require a more rigorous level of due diligence before they approve funding.

Founders considering taking on debt financing should remember that there’s no stigma around a mortgage as long as it fits the homeowner’s budget. If your team can use the money responsibly, debt capital can take your company to new heights faster and at a much lower cost than equity capital. Debt can also be used to complement equity raises by extending your runway (think venture debt).

Types of debt

For a growing company, there are two major types of debt:

• Bank debt from large institutional banks.
• Non-bank debt from smaller, private lenders.

Bank debt aims to extend a company’s runway rather than fund growth, and in the case of venture debt, will likely be based on previous equity raises.

This is the kind of debt you hear about most in the startup and tech community. It often serves more as an onramp to banking services rather than helping a company scale. Bank debt is typically limited to a maximum of 20% of the equity capital you’ve already raised, which is not enough to move the needle for a high-growth business. But for established startups that purely need to extend their runway, it could be the simplest and best option.

If bank debt falls on the same end of the founder-friendly spectrum as the passive VC investor, at the other end of debt financing are private lenders. Such lenders are more likely to partner closely with your teams to drive growth, share a specific view on the business and provide capital as long as you use it rigorously. They may also offer a mix of debt and equity based on your needs.

This kind of debt comes with specific terms for payback and interest rates, but is available to a far wider range of companies, including early-stage or bootstrapped founders who are likely to benefit the most from this kind of partnership.

Choosing the best fit for your business

As a founder, I understand that you are the only person who can decide which capital option is the “friendliest” for your business. Before you reach out to an investor for a pitch meeting, reflect on your company’s stage, the level of expertise you have in-house and how much ownership you are willing to give up.

If investor input is just not a priority, seek out the cheapest capital option possible, which is likely to be a debt investment from an institutional investor. As long as your metrics meet the standard, you can raise the capital you need without having to give away a portion of your business to an investor who isn’t providing value equal to that equity.

If your definition of a founder-friendly investor is a dedicated business partner for your company, then a strong and active VC investor or a private equity investor using a mix of equity and debt financing could be the optimal fit.

Regardless of where your ideal investor falls on the curve of passive to active, it’s crucial to have an open conversation with your potential investors about the working relationship. This will ensure there are no surprises down the line when tough decisions need to be made.

It’s time to retire the old definition of “founder-friendly” capital and understand that it means much more than a big check and an absent partner. Particularly in this new market environment, we have to learn how to better value true partnership and welcome dissent.