I have spent the better part of a decade helping thousands of first-time founders raise their first round of outside capital, and evaluating thousands more for investment.
In all of these data points, I found a pattern that explains every single VC round.
In the last six months, I’ve seen this pattern play out more dramatically than ever before. Founders are failing to raise without ever really knowing why. I find myself bringing it up again and again to help folks who are raising.
So I decided to write about it. Because every founder should know exactly where they fall, and plan accordingly.
The only 3 types of rounds in venture capital
There are three core reasons why venture capitalists make an investment: faith, opportunity, and evidence. These reasons are sequential and cumulative: Some VCs will invest on faith but no evidence, but no VCs will invest on evidence but no faith.
Let’s break it down.
Faith-based investing
The difference between hope and faith is belief, and that’s what drives an investor to write a check at the earliest stage of a company—their belief in the founder or founding team. This belief might be based on firsthand knowledge of the founder—like a former coworker or a cousin you know well. Or it might be based on pattern-matching the founder’s background—making bets on founders with a certain university degree and two years of experience at specific hot startups or an AI lab.
All that is needed here is belief in the person or team, and little, or nothing, more. The result may be a friends-and-family round, or a giant pre-seed for a proven founder.
Of course, not everyone gets to raise on faith. If you don’t match the pattern, don’t have prior outcomes, and don’t have rich friends and family, you are probably not going to raise a faith-based round.
If that’s you, there’s no choice but to skip this round and go straight to the next one.
Opportunity-based investing
This is the stage at which investors start to look for more and clearer proof in the opportunity itself. The team still has to be strong—that’s table stakes. But now the team has started to show how they operate. They’ve started to target a giant total addressable market (TAM) and demonstrate an early competitive advantage. It might be an early prototype or a built-in distribution moat. Just enough to pique investors’ interest without needing prior firsthand knowledge of the founder. Most pre-seed and seed rounds today are based on opportunity.
Evidence-based investing
As the company grows and there is more evidence to scrutinize, investors start evaluating the traction itself. The team is still important, and the opportunity still has to be enticing. But neither of these is enough. At this stage, investors will look at a company’s business performance, make some forward-looking assumptions, and calculate how much the company is worth based on the net present value of its expected future cash flows. It’s Finance 101.
For founders, the first evidence-based round can be quite the cold plunge. All of a sudden, the numbers really, really matter. Not just top-line revenue, but also pace of growth, unit economics, quality of the revenue, and repeatability of the motion. This is when the dream you’ve been selling meets cold-hard-cash reality. And unless you are among the very rarefied group of absolute top performers, that reality might hit hard.
A growing chasm
Traditionally, the shift from opportunity to evidence happened around the Series A, but this has swung wildly over the years and varies a lot based on sectors and macro factors.
Notably, there used to be more overlap between opportunity-based and evidence-based rounds—the transition was more like going up a dial than turning on a switch.
Those days are well over.
I have never seen a bigger chasm between opportunity- and evidence-based investing than what I see today. It’s so wide that it’s more like a bifurcation—there’s a lot of VC money-chasing opportunities, there’s a lot of VC money-chasing hyperscalers, and there’s almost no VC money for anything in between.
The reason, of course, is artificial intelligence. The size of the opportunity created by the AI platform shift is unprecedented, which creates a lot of heat for certain companies at a very early stage—zero evidence necessary. The speed at which it’s happening is also unprecedented, and makes things super hard for everyone else. Even if you’re not AI-native, and even if that kind of growth shouldn’t and can’t be expected in every sector, hyperscalers like Anthropic are the new high watermark for evidence-based investing. For most companies, that watermark is phenomenally hard to reach.
This means that companies with traction that is anything less than phenomenal by hyperscaler standards are having a much harder time raising capital than ever before.
What this means for founders
Being a founder is not for the faint of heart. Once again, we’re living in unprecedented times. The way I see it, founders have two good choices, as well as some harder ones if they fall in between.
Option one is to go for broke. Raise as much as you can in your opportunity round. Raise as many opportunity rounds as you’re able. And then, swing for the fences. In finance-speak, you’re chasing alpha. Hypergrowth is possible in the age of AI, and for some founders, the best possible strategy is to go big or go home . . . the risk being the “go home” part.
Option two is to find your way to profitability. You can/should still raise as much as you can in your opportunity round, and raise as many opportunity rounds as you’re able. And then, focus on revenue and get profitable, fast. That way, you don’t have to raise against the shutdown clock or retain much more optionality for your business, and you may even seed-strap your way to a life-changing outcome. The risk here is stagnation, running out of motivation, and not finding an interested acquirer.
No man’s land
If you’re anywhere in between—if you have modest results and need more capital—your options are more limited, but you do have options. First, I’d focus on revenue quality and unit economics—even if your growth is more modest, you should be able to find investors who value strong business fundamentals. (You may have to go outside of VC to find them.) Second, keep your investors in the know—send consistent investor updates, and don’t wait until things get dire to ask for help. And finally, get creative—lower your burn and look for new sources of revenue, even if they’re not repeatable. (Pro tip: These days, you can do consulting and call it “forward deployed engineering” 😉).
For every perfectly executed startup, there are many, many more companies that took a much less storied path to exit and success. It is okay not to have it all figured out. It is okay if your growth doesn’t look like Anthropic’s.
The only bad decision is to lie to yourself about where your next round will come from.
The math behind selling a dream
A note about why this all happens. There’s a truism in VC that’s hard to understand if you’ve never been in the investor’s seat: A company with no traction is more attractive to a VC than a company with traction—unless said traction is absolutely stellar.
The roots of this are the mathematics of probability. In short, the expected value of a huge-opportunity, no-evidence company is higher than the expected value of a high-opportunity, okay-evidence company. This leads a VC to lean toward the unproven moonshot nearly every time.
Here’s some simple math to illustrate. (I’m oversimplifying, so don’t @ me.)
Company A is pre-revenue, but in a super hot space. To an investor, it might appear as having a 99% chance of failure, and a 1% chance of a giant outcome. The Expected Value of Company A is ($0*99%) + ($1B*1%) = $10M.
Company B is further along. It might have reached six-figure revenue, but it took a couple of years. All of a sudden, the VC is plotting a trend line against the revenue, and it doesn’t look exponential. So, the outcome probability curve changes. Company B has a lower chance of failure, say 10%, because it has some revenue. There’s still some tiny chance that revenue will accelerate. But given the evidence, there is now a lot more certainty that the most likely outcome for Company B is a smaller acquisition.
The Expected Value of Company B is ($0*10%) + ($10M*89.9%)*($1B*0.1%) = $9.99B. Lower than the day zero moonshot, Company A.
Different investors will plot different outcome sizes and likelihoods to come to their own decision. But as a general rule, in the eyes of VCs, companies that are on a high-certainty path to an okay exit will always suffer against companies that are on a lower-certainty path to a giant exit. It’s the nature of alpha.
And that’s why, once you’ve got revenue, it’s much harder to sell the dream.