May 21, 2023
Overcoming the Funder’s Dilemma & Getting Financial Products to Market
Happy Sunday, friends. In every Speaker Series and RBFN Podcast episode, I end up touching on one topic that we all wrestle with, and that no one has a blueprint for. You can hear Jacob Haar from CIM talk about it in our latest podcast episode here. I used to think of it as The Lender's Dilemma, but now I think it's bigger than that. It's the Funder's Dilemma (though it may be more acute for a lender). It goes like this: it is incredibly difficult to grow a portfolio and a funding enterprise and maintain asset quality at all times. See, we all want to grow a big enterprise that funds as many businesses as possible within our respective thesis and that has maximum impact. That is, we want to achieve volume and scale (each person's definition of volume and scale may differ, but stay with me on the concepts here). But in order to grow a funding platform, you have to deliver returns. In order to deliver returns, your assets - your investments - have to maintain a high standard. And in order to have high asset quality, you have to get the best, or at the very least, good deals. The best/good deals do not always flock to the newest funding source or funding structure because there is a lack of reputation. Reputation is built through volume and scale. And so it goes.
So there's this tension between growth and asset quality. And that tension is really difficult to navigate. I've experienced it in VC and in RBF. As a VC, I would see tons of deals that just were not ready for - and would probably never be ready for - venture investment. This was especially true because in my early VC career I was investing just in Kansas, which did not at the time have a particularly vibrant startup ecosystem. Companies would come to us, and we would have to deny them any funding. But that hurt our ability to attract outside coinvestment into the deals we did want to do because it was very difficult to show any kind of track record. And in some of the deals we wanted to do, the founders were skeptical of a state-funded VC because we didn't have track record. So we faced a dilemma: do we do subpar deals in order to grow our track record, portfolio and reputation? Without reputation, we wouldn't see the good deals, and if we did, we'd be at a disadvantage in a competitive situation.
The same thing happened when we launched Novel. I had track record as a VC and Carlos had track record as an entrepreneur. We had an innovative financial product that worked for so many different kinds of businesses. But it was new, so whatever shine Carlos or I had built up in the prior years was dulled by the fact that founders didn't know what to think about our RBF product. It just wasn't that well known when we started with our first fund in 2018. Our job was to deliver returns to our investors, and it was challenging to do that with a new and weird financial product and skeptical customers! So we faced the same dilemma: how do we grow reputation and track record while balancing asset quality?
This is how every funding platform starts (unless you have such a shine from your prior endeavors that people implicitly trust you and want to work with you, but I think that's rare and exists only in cases where there's a brand name pedigree in your rear view). And it's what every investor in a new platform worries about -- will the team make subpar deals in order to get off the ground?
This, my friends, is The Funder’s Dilemma.
In VC circles, it's actually a bit of a trope. That is, LPs often know the first few deals might be a little less compelling than later ones, when the VC has a better reputation. That can be manageable in an equity portfolio, but a debt portfolio is different. Lenders can't do any deal just to get a deal done. They can't just open their credit box on day one and do subpar deals. Otherwise, their first deals will weigh down their portfolio as impairments, or worse, as losses. And losses - especially when they're experienced early - are very difficult to overcome. They can, in fact, be fatal to a funding platform.
So lenders in particular have to walk this tightrope carefully. It's made more difficult by the fact that the lender KNOWS they have to be careful. They KNOW a bad initial deal will be difficult to recover from. So they tighten up. It's only natural. And then they don't do any deal -- even the ones they would do on a normal day because they fear a loss so much that they can't pull the trigger on a good deal. They'll only pull the trigger on a great, riskless deal, which of course they never find. I've seen several smart investors and lenders move too slowly, and they end up unable to grow because they can't pull the trigger. If you listen to our latest podcast episode with Jacob Haar, he talks about this too.
So what to do? How do you get started, how do you achieve the balance of risk and growth, and how do you pull the trigger on that first deal with confidence? A similar challenge is how do you develop a new financial product and get it to market? Over the next several newsletters, I’ll share a simple framework for how to do just that. It goes like this:
Identify a market need.
Develop your thesis, product, and investment criteria.
Develop your diligence process and risk profile.
Test on a live deal (and hesitate to pull the trigger).
Gather feedback, learn, iterate.
Seems pretty simple, right? That’s because it is. It isn’t rocket science, but it is a useful framework that I think helps get new investors up and running, and that can help get a financial product designed, tested, and out the door. But here’s the thing. It’s a lot harder than it looks, and unless you have a process you will struggle to get from idea to market, and then to stay in market. I’ve decided that over the next few newsletter installments, I’ll go deeper on each of these and flesh out this framework in an attempt to offer up a way to think about systematizing decision making in a way that eliminates fear and emotion, and that gets lenders and investors to a decision efficiently. Here’s hoping it’s useful to you!
Stay tuned!