Chris Dixon

When Google released its search engine in 1998, its search results were significantly better than its competitors’. Many people attribute Google’s success to this breakthrough technology. But there was another key reason:  a stubborn refusal to accept the orthodox view at the time that “stickiness” was crucial to a website’s success. Here’s what happened when they tried to sell their technology to Excite (a leading portal/search engine in the late 90s):

[Google] was too good. If Excite were to host a search engine that instantly gave people information they sought, [Excite's CEO] explained, the users would leave the site instantly. Since his ad revenue came from people staying on the site—“stickiness” was the most desired metric in websites at the time—using Google’s technology would be counterproductive. “He told us he wanted Excite’s search engine to be 80 percent as good as the other search engines,” … and we were like, “Wow, these guys don’t know what they’re talking about.” - Steven Levy, In The Plex (p. 30)

Famed investor/entrepreneur Reid Hoffman says world-changing startups need to be premised on “accurate contrarian theories.”  In Google’s case, it was true but non-contrarian to think users would prefer a better search engine. What was true and contrarian was to think it made business sense to get users off their site as quickly as possible. The business model to support this contrarian theory wouldn’t emerge until years later, and by then Google would already have become the world’s most popular search engine.

The financial term “derivative“ refers to a security whose value is a function of another security such as a stock or bond.  The most common types of derivatives are futures – the obligation to buy a security at a future date at pre-agreed upon price – and options – the right to buy something at a future date at pre-agreed upon price.

In theory, the primary societal purpose of derivates is for businesses to hedge against “exogenous” risks.  For example. Southwest Airlines is famously prudent about buying futures on oil to mitigate the effect of fluctuating oil prices on their core business.

In practice, most derivatives are bought and sold by speculators. One of the first speculators was a philosopher names Thales, who Aristotle described in his book Politics (Book 1, Part XI):

There is the anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but is attributed to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was of no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.

Valuing options was a mystery until 1973 when the Black-Scholes model was invented. The main practical outcome of this model was the idea that the value of an option was determined mostly by the volatility of the underlying security.

One way to understand the important of volatility is to think of options as the opposite of insurance policies. Suppose you are selling insurance on houses in one region that is prone to catastropic events and another that isn’t. Rational insurers would price insurance policies higher in the catastrophe-prone areas.

Startups are inherently very volatile – their price can increase or decrease dramatically in short periods of time. Having an option on a startup is the economic opposite of selling insurance in a catastrophe-prone area.

The US tax system has some rules related to startup options.  The first rule is that there is a special class of options called ISO options that can be granted to employees. ISO options are tax exempt until the options are exercised, which allows employees to receive them and not be liable for taxes until they actually realize cash gains. This rule only applies if the options are assigned a strike price equal to or greater than the “fair market value” of the company’s common shares. The fair market value is normally assessed by an outside valuation firm (a so-called 409A valuation) and usually ends up being significantly lower than the last round VC valuation (a rule of thumb for early-stage companies is the strike price will be approximately 20% of the last VC valuation).

When you are granted options in a startup there are a couple of important things to keep in mind:

1) You should know your percentage ownership of the company’s “fully diluted” outstanding shares (number of shares of the company including the option pool).

2) You should understand that if you leave the company, you normally have 90 days to “exercise” the options (purchase the shares you have the right to buy) before you forfeit your options. Normally the company has no obligation to inform you of this possible forfeiture, and in fact the standard practice is to hope the employee forgets and loses the options.

3) You should know the “preferences” on the company.  The preferences normally equals the amount of money raised. If the company sells for near or less than that number the common shareholders, and hence the employees (who own options on common shares), will receive little or no money.

The strike price of the options is somewhat important but, if you study options theory, not nearly as important as the volatility of the underlying stock. Financially, what matters most is having a reasonable percentage of options in a company with lots of volatility (and hopefully a stock price that has an upward slope).

Cool infographic about our core technology at Hunch, what we call the “taste graph.”  My favorite stat is that we have >25,000 API clients making >400,000 calls per day (many clients seem to be devs building not-yet-release apps).  Upcoming infographic will focus just on API usage and growth.  And yes, crazy as it seems, we have Assembly and C code, which was necessary to optimize core inner loops which are extremely computationally intensive.

(click for full size)

Having raised a number of VC rounds personally and observed many more as an investor or friend, I’ve come to think there are a set of dominant best practices that entrepreneurs should follow.

1. Valuation: Come up with what minimum valuation you’d be happy with but never share that number with any investor.  If the number is too low, you’ve set a low ceiling. If your number is too high, you scare people off. Just like on eBay, you only get to your desired price by starting lower and getting a competitive process going. When people ask about price, simply tell them your last round post-money valuation and talk about the progress you’ve made since then.

2. Never tell VCs the names of other VCs that are interested.  Reasons: 1) if you are overplaying your hand that could send a negative signal.  Most VCs know each other and talk all the time. 2) it is possible they’ll get together and offer a two-handed deal in which case you have less competition.

3. I think the optimal number of VCs to talk to seriously is about 5.  That is usually enough to get a sense of market but not so much that you get overwhelmed.  You should pick these VCs carefully – this is where trusted, experienced advisors are critical.

4. If there is a VC you really like, have a “buy it now price” and if they hit that valuation (and other terms are clean) do the deal.  Otherwise, say you’d like to “run a process” and include them in it.

5. Try to set timelines that are definite enough that investors feel some pressure to move but not so definite that you look dumb if you don’t have a term sheet by then.  (Investors have an incentive to wait – “to flip another card over” as they say – whereas entrepreneurs want to get the financing over with asap). Depending on where you are in the process, say things like “we’d like to wrap this up in the next few weeks.”

6. Once you start pitching, the clock starts ticking on your deal looking “tired.”  I’d say from your first VC meeting you have about a month before this risk kicks in.  You could have a great company but if investors get a sense that other investors have passed, they assume something is wrong with your company and/or they can wait around and invest later at their leisure.

7. The earlier stage your company is the more you should weight quality of investors vs valuation.  For a Series A, you are truly partnering with the VCs.  You should consider taking a lower valuation from a top tier firm over a non top tier firm (but probably any discount over 20% is too much). If you are doing a post-profitable “momentum round” I’d just optimize for valuation and deal terms.

8. Term sheets:  talk about terms in detail over the phone.  Only accept a term sheet once you have decided that if it matches what was described you are prepared to sign it.  After sending a term sheet VCs get worried you’ll shop it and usually want it signed in 24 hours.

9. Get to know the VCs.  Talk to their other portfolio companies, read their blogs, call references, etc.  You will be in business with this person for (hopefully) a long time.

10. Timing.  While it’s ideal to raise money once you hit the milestones you set out initially, you also need to be opportunistic.  Right now, for example, seems to be a really good time to raise a VC round.  You could make a ton of progress over the next 6 months but the market could tank and end up in a worse place than you would be today.