Allocation investing has a number of perverse effects on financial markets. For example, in the 80s and 90s venture capital was deemed to be a successful, independent asset class. As a result, many funds decided to allocate some portion of their capital to VC. These pools of capital were so large that they caused the VC industry to grow orders of magnitude larger – many say larger than it should be. In turn, this led to many bad venture investments that drove down returns in the industry (these problems were further exacerbated by the fee structure of VC that encouraged funds to get large and rapidly “put money to work”).

Another perverse effect caused by allocation investing happens in public stock markets when investors decide to allocate a portion of their funds to specific sectors. I recently heard some money managers saying they wanted to allocate portions of their funds to “social media”. Combining this “allocated” demand with a constrained supply (due to the small float of many of these IPOs) can lead to prices that are disconnected from fundamental values. In this scenario, supply will try to match demand, which means mediocre social media companies will go public and non-social media companies will reposition themselves as social media companies or acquire social media companies. They will be chasing the “social premium.”

We saw this happen in the 90s with the rush of companies to reposition themselves as internet companies. In that case, many non-professional investors ended up owning shares in crappy companies when the music stopped. The primary difference now is that the flagship companies like LinkedIn and Facebook have excellent fundamentals. Hopefully this time the market will be discerning and value investing will win out over allocation investing.

I sketched some notes for the class which I’m posting below. I’ve written ad nauseum on this blog (see contents page) about venture financing so hadn’t planned to blog more on the topic.  But since I wrote up these notes already, here they are.

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1. Best thing is to either never need to raise money or to raise money after you have a product, users, or customers.  Also helps a lot if you’ve started a successful business before or came from a senior position at a successful company.

2. Assuming that’s not the case, it is very difficult to raise money, even when people (e.g. press) are saying it’s easy and “everyone is getting funded.”

3. Fundraising is an extremely momentum-based process.  Hardest part is getting “anchor” investors.  These are people or institutions who commit significant capital (>$100K) and are respected in the tech community or in the specific industry you are going after (e.g. successful fashion people investing in a fashion-related startup).

4. Investors like to wait (“flip another card over”) while you want to hurry. Lots of investors like to wait until other investors they respect commit. Hence a sort of Catch-22. As Paul Graham says:

By far the biggest influence on investors’ opinions of a startup is the opinion of other investors. There are very, very few who simply decide for themselves. Any startup founder can tell you the most common question they hear from investors is not about the founders or the product, but “who else is investing?”

5. Network like crazy:

• Make sure you have good Google results (this is your first impression in tech). Have a good bio page (on your blog, linkedin and about.me) and blog/tweet to get Google juice.
• Get involved in your local tech community.  Join meetups. Help organize events.  Become a hub in the local tech social graph.
• Meet every entrepreneur and investor you can.  Entrepreneurs tend to be more accessible & sympathetic and can often make warm intros to investors.
• Avoid anyone who asks you to pay for intros (even indirectly like committing to a law firm in exchange for intros).
• Don’t be afraid to (politely) overreach and get rejected.

6. Get smart on the industry:

• Read TechCrunch, Business Insider, GigaOm, Techmeme, HackerNews, Fred Wilson’s blog, Mark Suster’s blog, etc (and go back and read the archives).  Follow investor/startup people on Twitter (Sulia has some good lists to get you started here and here).
• Research every investor and entrepreneur extensively before you meet them. Entrepreneurs love it when you’ve used their product and give them constructive feedback.  It’s like bringing a new parent a kid’s toy. Investors like it when you are smart about their portfolio and interests.

6. How much to raise?  Enough to hit an accretive milestone plus some buffer. (more)

7. What terms should you look for?  Here are ideal terms.  You need to understand all these terms and also the difference between convertible notes and equity.  More generally, it’s a good idea to spend a few days getting smart about startup-related law – this is a good book to start with.

8. Types of capital:  strategic angels (industry experts), non-strategic angels (not industry experts, not tech investors), tech angels, seed funds, VCs.

• VCs can be less valuation sensitive and have deep pockets but are sometimes buying options so come with some risks (more).
• Industry experts can be really nice complements to tech investors (especially in b2b companies).  (more)
• Non-strategic angels (rich people with no relevant expertise) might not help as much but might be more patient and ok with “lifestyle businesses.”
• Tech angels and seed funds tend to be most valuation sensitive but can sometimes make up for it by helping in later financing rounds.

9. Pitching:

• Have a short slide deck, not a business plan. (more)
• Pitch yourself first, idea second. (more)
• Pitch the upside, not the mean (more)
• Size markets using narratives, not numbers (more)

10.  Cofounders: they are good if for no other reason than moral support. Find ones that complement you. Decide on responsibilities, equity split etc early and document it.  (Legal documents don’t hurt friendships – they preserve them).

11. Incubators like YC and Techstars can be great.  99% of the people I know who participated in them say it was worth it.

12. To investors, the sexiest word in the English language is “oversubscribed.”  Sometimes it makes tactical sense to start out raising a smaller round than you actually want end up with.

Today, the venture financing industry is going through a similar segmentation process. Venture capital has only existed in its modern form for about 35 years.  In the early days there were relatively few VCs. Entrepreneurs were happy simply getting money and general business guidance.  Today, there is a surplus of venture capital and entrepreneurs have become increasingly savvy “shoppers.”  As a result, competition amongst venture financiers has increased and their “customers” (entrepreneurs) have flocked to more specialized “products.”

Some of this segmentation has been by industry (IT, cleantech, health care) and subindustry (iPhone apps, financial tech, etc). But more pronounced, especially lately, has been the segmentation by company stage.  Today at least four distinct types of venture financing “products” have become popular.

1) Mentorship programs like Y Combinator help startups ideate, form founding teams, and build initial products. I suspect many of the companies they hatch wouldn’t exist at all (and certainly wouldn’t be as savvy) if it weren’t for these programs.

2) So-called super angels provide capital and guidance to a) hire non-founder employees, b) further product development c) market the initial product (usually to early adopters), and d) raise follow on VC funding. Often current or former entrepreneurs themselves, super angels have gone through this stage many times as founders and angel investors.

3) Traditional VCs (Sequoia, Kleiner, etc) help companies scale and get to profitability. They often have broad networks to help with hiring, sales, bizdev and other scaling functions. They are also experts at selling companies and raising follow-on financing.

4) Accelerator funds (most prominent recently is DST) focus on providing partial liquidity and preparing the company for an IPO or big M&A exit.

In the past, traditional VC’s played all of of these roles (hence they called themselves “lifecycle” investors). They incubated companies, provided smalls seed financings, and in some cases provided later stage liquidity. But mostly the mentorship and angel investing roles were played by entrepreneurs who had expertise but shallow pockets and limited time and infrastructure.

What we are witnessing now is a the VC industry segmenting as it matures. Mentorship and angel funding are performed more effectively by specialized firms.  Entrepreneurs seem to realize this and prefer these specialized “products.”  There is a lot of angst and controversy on tech blogs that tends to focus on individual players and events. But this is just a (sometimes salacious) byproduct of the larger trends. The segmentation of the venture industry is healthy for startups and innovation at large, even if at the moment it might be uncomfortable and confusing for some of the people involved.

Also, Fred Wilson’s interview with Howard is a must watch.

I am a proponent of convertibles, but only with a cap (I’ve written about the problems of convertibles without caps before and never invest in them).  I believe that pretty much every other seed investor who advocates converts also assumes they have a cap.  So any discussion of convertibles without caps seems to me a red herring.

There are two kind of rights that investors get when they put money in company.  The first are economic rights: basically that they make money when the investment is successful.  The second are control rights: board seats, the ability to block financings and acquisitions, the ability to change management, etc.  Converts give investors economics rights with basically zero control rights (legally it is just a loan with some special conversion provisions). Equity financings normally give investors explicit rights (most equity terms sheets specify board seats, specific blocking conditions, etc) in addition to standard shareholder rights under whatever state the company incorporated in (usually CA or Delaware).

To the extent that I know anything about seed investing, I learned it from Ron Conway.  I remember one deal he showed me where the entire deal was done on a one page fax (not the term sheet – the entire deal).  Having learned about venture investing as a junior employee at a VC firm I was shocked. I asked him “what if X or Y happens and the entrepreneur screws you.”  Ron said something like “then I lose my money and never do business with that person again.”  It turned out he did very well on that company and has funded that entrepreneur repeatedly with great success.

You can hire lawyers to try to cover every situation where founders or follow on investors try to screw you. But the reality is that if the founders want to screw you, you made a bet on bad people and will probably lose your money. You think legal documents will protect you? Imagine investors getting into a lawsuit with a two person early-stage team, or trying to fire and swap out the founders – the very thing they bet on.  And follow on investors (normally VCs) have a variety of ways to screw seed investors if they want to, whether the seed deal was a convert of equity.  So as a seed investor all you can really do is get economic rights and then make sure you pick good founders and VCs.

Seed investing is a people business.  Good entrepreneurs understand this.  Ron was an investor in my last two companies and never had any control rights but had massive sway because he worked so hard to help us and gave such sage advice.  And most importantly, he carried great moral authority. We always knew he was speaking from deep experience and looking out for the company’s best interests – sometimes against his own economic interests.

Like it or not, the seed investment world runs on trust and reputation – not legal documents.

In many ways, what [prominent seed funds] are saying is that they’re just smarter, and as such will outlast all the copycat and wannabe seed funders as well as the stale VCs with a fresh coat of paint. But then — Kim Kardashian is the only one who can make a living tweeting. At some point it will be quite obvious whether the super angels’ investments and strategy succeed or fail.

Here’s the key point these analyses overlook: It’s not the seed investors who are smarter – it’s the entrepreneurs. Consider the case of the last company I co-founded, SiteAdvisor. We raised our first round of $2.6M at a $2.5M pre-money valuation. After the first round of funding, investors owned 56% of the company. Moreover, the $2.6M came in 3 tranches: $500K, another $500K, and then $1.6K.  To get the 2nd and 3rd tranches we had to hit predefined milestones and re-pitch the VC partnerships. Had we instead raised the first $1M from seed funds, we would have been free to raise the remaining money at a higher valuation. In fact, after we spent less than $1M building the product, we raised more money at a $16M pre-money valuation. We never even touched the $1.6M third tranche even though it caused us to take significant dilution. This was a very common occurrence before the rise of seed funds, due to VCs pressuring entrepreneurs to raise more money than they needed so the VCs could “put more money to work.” When SiteAdvisor was eventually acquired, we had spent less than a third of the money we raised. Compare the dilution we actually took to what we could have taken had we raised seed before VC:

Professional seed funds barely existed back then, especially on the East Coast. And even if they did, I’m not sure I would have been savvy enough to opt for them over VCs. I thought the brands of the big VCs would help me and didn’t really understand the dynamics of fund raising.* Today, entrepreneurs are much savvier, thanks to the proliferation of good advice on blogs, via mentorship programs, and a generally more active and connected entrepreneur community. For example, Founder Collective recently backed two Y-Combinator startups who decided to raise money exclusively from seed investors despite having top-tier VCs throwing money at them at higher valuations. These were “hot” companies who had plenty of options but realized they’d take less start-to-exit dilution by raising money from helpful seed investors first and VCs later.

Will there be there a seed fund crash? Seed fund returns are highly correlated with VC returns which are highly correlated with public markets and the overall economy. I have no idea what the state of the overall economy will be over the next few years. Perhaps it will crash and take VCs and seed funds down with it. But I do have strong evidence that prominent seed funds will outperform top-tier VC funds, because I know the details of their investments, and that their portfolios contain the same companies as top-tier VCs except the they invested in earlier rounds at significantly lower valuations.  So unless these prominent seed funds were incredibly unlucky picking companies (and since they are extremely diversified I highly doubt that), their returns will significantly beat top-tier VC returns.

* Note that we have nothing but gratitude toward the SiteAdvisor VCs – Rob Stavis at Bessemer and Hemant Taneja at General Catalyst. They offered what was considered a market deal at the time and supported us when (almost) no one else would.

I think of people who aim to create more value than they capture as “builders” and people who don’t as “extractors.” Most entrepreneurs are natural-born builders. They want to create something from nothing and are happy to see the benefits of their labor spill over to others. Sadly, the builder mindset isn’t as widespread among investors. I recently heard a well-known Boston VC say: “There are 15 good deals a year and our job is to try to win those deals” – a statement that epitomizes the passive, extractor mindset. The problem with VC seed programs is they not only fail to enlarge the pie, they actually shrink it by making otherwise fundable companies unfundable through negative signaling.

The good news is there is a large – and growing – class of investors with the builder mindset. Y Combinator and similar mentorship programs are true builders: their startups probably wouldn’t have existed without them (and the founders might have ended up at big companies). There are also lots of angel and seed investors who are builders. A few that come to mind: Ron Conway, Chris Sacca, Mike Maples (Floodgate), Roger Ehrenberg, Keith Rabois, Ken Lehrer, Jeff Clavier, Betaworks, Steve Anderson, and Aydin Senkut. There are also VCs who are builders. Ones that I’ve worked with directly recently include Union Square, True, Bessemer, Khosla, Index, and First Round.

Given that there is a surplus of venture money, entrepreneurs and seed investors now have the luxury of choosing to work with builders and avoid extractors. Hopefully over time this will weed out the extractors.

If the company made the mistake of including big VCs in their seed round, they’ll face this situation raising their Series A.  If the company was smart and only included true seed investors in their initial round, they won’t face this issue until their Series B.

Here’s a typical situation. Say the startup raised a Series A at a $15M post-money valuation and is doing pretty well. The CEO offers the existing VCs the option of leading an inside round but the insiders are lukewarm and suggest the CEO go out to test the financing market.  The CEO does so and gets offers from top-tier VCs to invest at a significant step up, say, $30M pre. The insiders who previously didn’t want to do an inside round are suddenly really excited about the company because they see that other VCs are really excited about the company.

This is what I call the nightclub effect*. You think your date isn’t that attractive until you bring him/her to a nightclub and everyone in the club hits on him/her. Consequently, you now think your date is really attractive.

Now the inside investors have 3 choices:  1) Lead the financing themselves. This makes the CEO look like a jerk that used the outsiders as stalking horses. It might also prevent the company from getting a helpful, new VC involved. 2) Do pro-rata (normally defined as: X% of round where X is the % ownership prior to round).  This is theoretically the best choice, although often in real life the math doesn’t work since a top-tier new VC will demand owning 15-20% of the company which is often impossible without raising a far bigger round than the company needs. (When you see head-scratchingly large Series B rounds, this is often the cause). 3) Do less than pro-rata. VCs hate this because they view pro-rata as an option they paid for and especially when the company is “hot” they want to exercise that right. The only way to get them down in this case is for management to wage an all out war to force them to. This can get quite ugly.

I’ve come to think that the best solution to this is to get the insiders to explicitly commit ahead of time to either leading the round or being willing to back down from their pro-rata rights for the right new investor. This lets the CEO go out and find new investors in good faith without using them as stalking horses and without wasting everyone’s time.

* don’t miss @peretti’s response.

He often spends $3,000 for a weekend of food for Mr. Schwarzman and his wife, including stone crabs that cost $400, or $40 per claw.

Mr Schwarzman pays a lower tax rate than police officers, firefighters, soldiers, doctors, and teachers. This is the due to the fact that money managers’ “carry fees” are treated as capital gains instead of ordinary income.

Last week the House passed a bill that would partly close this loophole. Sadly, with few exceptions, VC’s are lobbying against this bill, arguing it would hurt innovation, small businesses, and lots of other good stuff.  As one prominent VC recently said:

[H]aving those higher taxes be levied against venture capital investments in small businesses strikes me as self-defeating when it is the single largest job growth area.

The argument seems to be that this tax will hurt small businesses. The phrase “small business” is chosen deliberately by VC lobbyists: most people, when they hear it, think of hard working immigrants pursuing the American Dream. In reality, the only thing this bill will hurt are money managers. As Fred Wilson says:

Changing the taxation of the managers will not reduce the amount of capital going to productive areas. The sources of the capital; wealthy families, endowments, pension funds, and the like, will still put the capital in the places where they will get the highest after tax return. And these sources of capital, if they are tax payers, will still get capital gains treatment on their investments in hedge funds, buyouts, and venture capital. And the fund managers will still have to compete with each other to get access to that capital and their incentives will still be to produce the highest returns they can produce, regardless of whether they are paying capital gains or ordinary income on their fees.

As Fred also argues, removing this tax break will encourage more people to go into jobs that produce tangible goods:

We have witnessed financial services (think asset management, hedge funds, buyout funds, private equity, and venture capital) grow as a percentage of GNP for the past thirty years. The best and brightest don’t go into engineering, science, manufacturing, general management, or entrepreneurship, they go to wall street where they will get paid more. And on top of that, we have been giving these jobs a tax break. That seems like bad policy. If we force hedge funds and the like to compete for talent on a more level playing field, then maybe we’ll see our best and brightest minds go to more productive activities than moving money around and taking a cut of the action.

Fred is absolutely correct. For me, though, removing this loophole just comes down to basic fairness. A fireman who runs into burning buildings shouldn’t pay a higher tax rate than a financier sunbathing on a yacht eating $400 crabs.

These LPs wield tremendous power, yet very few of them understand how startups or venture capital actually works. I was reminded of this recently when I saw this quote from a prominent fund-of-funds, justifying their investment in a 30-year old venture firm:

“As the amount of money raised by venture firms shrinks, older firms that were around before the dot-com bubble will benefit,” said Michael Taylor, a managing director at HarbourVest. “These firms have track records, brand names and knowledge about how to avoid making mistakes that younger firms do not necessarily have,” he said.

These older firms do often have track records – they’ve survived precisely because at one point they delivered good returns.  But it’s a mistake to assume that — because VC brands and institutional knowledge persist – past returns will predict future returns.  Here’s why.

VC brand names do not persist.  From the perspective of VCs and entrepreneurs, VC brands rise and fall very quickly. Given the excess supply of venture dollars, top tier entrepreneurs are frequently selecting their investors, not vice versa.  The VCs most sought after are mostly new firms:  big firms like Andreeson Horowitz, Union Square Ventures, and First Round, and micro-VCs like Floodgate (fka Maples), Betaworks, and Ron Conway.

VC firms don’t accrue institutional knowledge. VC returns are driven by partners, not firms. Studies have shown this, as will a quick perusal of the big exits at prominent VC firms. When key partners switch firms or become less active, VC firms retain very little residual value.  Some service firms — for example consulting firms like McKinsey — invest heavily in accruing institutional knowledge by developing proprietary methodologies and employee apprenticeship programs.  VCs develop no real IP and rarely have serious apprenticeship programs.

There is an old saying among big company CIOs that “no one gets fired for buying IBM.”  It’s much easier for a fund-of-fund partner to defend investments based on a VC’s track records. It’s a safe but bad strategy.

To intelligently invest in VC firms, you need to roll up your sleeves and dive deep into the startup world.  You need to learn about the startups themselves, assess the entrepreneurs, use their products, analyze market dynamics – all things that good VCs and entrepreneurs do. If you want to understand a VCs brand and abilities don’t look at their track record in the 90s – ask today’s entrepreneurs.  The answer will likely surprise you.

Unfortunately, very few LPs do this.  As a result, a massive amount of R&D capital is being misallocated.

For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this. Bad VCs don’t, and waste time on things like interviewing potential customers and building spreadsheets that estimate market size from the bottom-up.

The only way to understand and predict large new markets is through narratives. Some popular current narratives include: people are spending more and more time online and somehow brand advertisers will find a way to effectively influence them; social link sharing is becoming an increasingly significant source of website traffic and somehow will be monetized; mobile devices are becoming powerful enough to replace laptops for most tasks and will unleash a flood of new applications and business models.

As an entrepreneur, you shouldn’t raise VC unless you truly believe a narrative where your company is a billion dollar business. But deploying narratives is also an important tactic. VCs are financiers — quantitative analysis is their home turf. If you are arguing market size with a VC using a spreadsheet, you’ve already lost the debate.

Most financial markets start out with a productive purpose. Derivatives like futures and options started out as a way for companies to reduce risk in non-core areas, for example for airlines to hedge their exposure to oil prices and transnationals to hedge their exposure to currency fluctuations. The sellers of these derivatives were aggregators who pooled risk, much like insurance companies do. The overall effect was a net reduction in risk to our economy without hampering growth and returns.

Then speculators entered the market, creating more complicated derivative products and betting with borrowed money.  This was defended as a way to increase liquidity and efficiency. But it came at the cost of making the system more complicated and susceptible to abuse. Worst of all, these so-called innovations increased the overall risk to the system, something we saw quite vividly during the recent financial crisis.

Venture capital is a shining example of capitalism just like Adam Smith pictured it, where private vice really does lead to public virtue.  Consider, for example, two of the largest areas of venture investment: biotech and cleantech.  Here we see the best and brightest – top science graduates from places like MIT and Stanford – devoting their lives to curing cancer and developing new energy sources.  These students may be motivated by good will, but need not be, since they will also get rich if they succeed.

A strong case can be made that the financial industry needs significantly more regulation, particularly around big banks and derivatives markets. But it would be a tragic mistake to create regulations that hinder angel investing and venture capital.  From the outside, VC and Wall Street might appear similar, but the closer you get, the more you understand how different they really are.

Actual venture financings work nothing like this simple model would predict.  In practice, the equilibrium states for venture financings are: 1) significantly oversubscribed at too low a valuation, or 2) significantly undersubscribed at too high a valuation.

Why do venture markets function this way?  Pricing in any market is a function of the information available to investors. In the public stock markets, for example, the primary information inputs are “hard metrics” like company financials, industry dynamics, and general economic conditions. What makes venture pricing special is that there are so few hard metrics to rely on, hence one of the primary valuation inputs is what other investors think about the company.

This investor signaling has a huge effect on venture financing dynamics. If Sequoia wants to invest, so will every other investor.  If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.

Part of this is the so-called herd mentality for which VC’s often get ridiculed. But a lot of it is very rational. When you invest in early-stage companies you are forced to rely on very little information. Maybe you’ve used the product and spent a dozen hours with management, but that’s often about it. The signals from other investors who have access to information you don’t is an extremely valuable input.

Smart entrepreneurs manage the investor signaling effect by following rules like:

- Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides space and mentoring.  If a big VC has any involvement with your company at the seed stage, their posture toward the next round has such strong signaling power that they can kill you and/or control the pricing of the round.

- Don’t try to be clever and get an auction going (and don’t shop your term sheet). If you do, once the price gets to the point where only one investor remains, that investor will look left and right and see no one there and might get cold feet and leave you with no deal at all. Save the auction for when you get acquired or IPO.

- Don’t be perceived as being “on the market” too long.  Once you’ve pitched your first investor, the clock starts ticking. Word gets around quickly that you are out raising money. After a month or two, if you don’t have strong interest, you risk being perceived as damaged goods.

- If you get a great investor to lead a follow-on round, expect your existing investors to want to invest pro-rata or more, even if they previously indicated otherwise.  This often creates complicated situations because the new investor usually has minimum ownership thresholds (15-20%) and combining this with pro-rata for existing investors usually means raising far more money than the company needs.

Lastly, be very careful not to try to stimulate investor interest by overstating the interest of other investors. It’s a very small community and seed investors talk to each other all the time. If you are perceived to be overstating interest, you can lose credibility very quickly.

I’ve never meant my arguments to be about where it is better to start a company. California is a phenomenal place to start a tech company. NYC is a great place as well. (Note to Matt – it’s hard for first time founders everywhere). To me, the important question isn’t which place is better, but rather how we import the things that make the Valley great into NYC. As I said last year:

New York City has many of the same strengths as Silicon Valley – merit-driven capitalism, the embrace of newcomers and particularly immigrants, and a consistent willingness to reinvent itself.   Silicon Valley will always be the mecca of technology, but now that people here are getting back to, as Obama says, making things, New York City has a shot at becoming relevant again in the tech world.

I spent the past week in California and had the honor of meeting some legendary venture investors. I was deeply impressed: they are legends for a reason. Of course, they are incredibly smart and hard working and all of that, but most impressively, it was clear that they truly believe in making big bets on ambitious, seemingly wacky ideas to try to change the world. Every VC has this rhetoric on their website, but – at least in my experience – most just want to make incremental money on incremental technologies. (Side note: I noticed that the more powerful the VC, the more likely they were to pay close attention, show up on time, and not bring phones/computers into meetings.  I guess when you are changing the world, emails can wait an hour for a response).

California should be NYC’s role model and ally. The enemy should be people and institutions who make money but don’t actually create anything useful. In NYC, this mostly means Wall Street, along with the Wall Street mindset that sometimes infects East Coast VC’s (emphasis on financial engineering, needing to see metrics & “traction” vs betting on people and ideas, etc).

Matt should do what’s best for his company. God knows it’s hard enough doing a startup – you don’t need to carry the weight of reinvigorating a region on your back as well. That might mean moving to California. Meanwhile, forward-thinking investors and founders in NYC will continue trying to make things that change the world – in other words, trying to make NYC more like the Valley.

For example, Fred Wilson says about VC:

You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage…. I think “back to the future” is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits

Similarly, Bill Gurley writes:

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future.

All of these analyses start with the assumption that aggregate venture-backed exits (acquisition and IPOs) will remain roughly constant. I don’t see why we need to accept that assumption. The aggregate value of venture-backed startups, like all valuations, is a function of profits generated (or predicted to be generated). In technology, profits are driven by innovation. I don’t see any reason we should assume venture-backed innovation can’t be dramatically increased.

For example, innovation has varied widely across times and places – the most innovative region in the world for the last 50 years being Silicon Valley. What if, say, Steve Jobs hadn’t grown up in Silicon Valley? What if he had gone to work for another company? Does anyone really think Apple – and all the innovation and wealth it created – would exist if Jobs hadn’t happened to grow up in a culture that was so startup friendly? Jobs is obviously a remarkable person, but there are probably 100 Steve Jobs born every year. The vast majority just never have a chance or give a thought to starting a revolutionary new company.

Some people blame our education system, or assume that there is some fixed number of entrepreneurs born every year. I think the problem is cultural. As much as we like to think of our culture as being entrepreneurial, the reality is 99% of our top talent doesn’t seriously contemplate starting companies. Colleges crank out tons of extremely smart and well-educated kids every year. The vast majority go into “administrative” careers that don’t really produce anything – law, banking and consulting. Most of the rest join big companies. As I’ve argued many times before, big companies (with a few notable exceptions) aren’t nearly as successful as startups at creating new products.  The bigger the company, the more likely it suffers from agency issues, strategy taxes, and myopia. But most of all: nothing is more motivating and inspiring than the sense of ownership and self-direction only a startup can provide.

Whenever I see a brilliant kid decide to join Goldman Sachs, McKinsey, or Google, I think to myself: a startup just died, and as a result our world is a little less wealthy, innovative, and interesting.

Yesterday, one of the 40 or so startups I’ve invested in (either personally or through Founder Collective) had a well-known VC back out of a term sheet for no particular reason besides that they decided they no longer liked the business concept. It’s the first time I’ve seen this happen in my career.

In later stage private equity (leveraged buyouts and such) it is a common trick to “backload diligence” – you give the company a quick, high-valuation term sheet, which then locks the company in (the no-shop clause prohibits them from talking to other investors for 30 days or more). Then the firm does their diligence, finds things to complain about and negotiates the price down or walks away. If they walk away, the company is often considered “damaged goods” by other investors who wonder what the investor discovered in diligence. This gives the investor a ton of negotiating leverage. In later stage private equity, this nasty tactic can work repeatedly since the companies they are buying (e.g. a midwestern auto parts manufacturer) are generally not part of a tight knit community where investment firms depend heavily on their reputation.

I learned the basics of VC when I apprenticed under Jeremy Levine and Rob Stavis at Bessemer.  It was at Bessemer that I learned you never back out on a term sheet except in cases of fraud etc. I never saw them back out on one nor have I heard of them doing so. In fact, I remember one case where Rob signed a term sheet and while the final deal documents were being prepared (which usually takes about a month), the company underperformed expectations. The CEO asked Rob if he was going to try to renegotiate the valuation down. Rob said, “Well, if you performed better than expected I don’t think you would try to renegotiate the valuation up, so why should I renegotiate when you performed worse than expected.” That’s how high quality investors behave.

Besides simply acting ethically, firms like Sequoia and Bessemer are acting in their own interest: the early-stage tech community is very small and your reputation is everything. Word travels fast when firms trick entrepreneurs. What happened yesterday was not only evil but will also come back to haunt the firm that did it.

Howard is also the founder of Stocktwits. Stocktwits is potentially genuinely disruptive in that it dis-intermediates Wall Street. It is one of those things that some people think is a toy now but could end up being the next big thing.

Anyways, here’s the interview:

The pace of innovation in the New York area is very impressive right now. Some of the top entrepenuers in the country are building and scaling companies in the NY ecosystem - Ron Conway, yesterday in an email to me (published with his permission)

With the announcement of Roger Ehrenberg’s new fund – IA Venture Strategies – NYC now has another top-tier seed fund.  I’ve had the pleasure of investing with Roger a number of times. He’s not only a great investor but also a huge help to the companies he invests in. It’s great that he’s going to be even more active and I hope to work with him a lot more in the future.

The NYC tech scene is exploding. There are tons of interesting startups. I’m an investor in a bunch and started one (Hunch) so won’t even try to enumerate them as any list will be extremely biased (other people have tried). I will say that one interesting thing happening is the types of startups are diversifying beyond media (HuffPo, Gawker) to more “California-style” startups (Foursquare, Boxee, Hunch).

In terms of investors, NYC now has a number of seed investors / micro-VCs:  IA Capital Partners, Betaworks, and Founder Collective (FC – which I am part of – has made 7 seed investments in NYC since we started last year).  The god of seed investing, Ron Conway, who I quote up top, has recently decided to become extremely active in NYC. One of the nice things about having small funds is we don’t need to invest millions of dollar per round so we all frequently invest together.

NYC also has mid sized funds like Union Square (in my opinion and a lot of people in the industry they have surpassed Sequoia as the best VC in the country).  We also have First Round, who very smartly hired the excellent Charlie (“Chris”) O’Donnell as their NYC guy.

Then we have the big VCs who have also been increasing their activity in NYC.  Locally, we have Bessemer (Skype, LinkedIn, Yelp) and RRE.  Boston firms that are very active and positive influences here include: Polaris (Dog Patch Labs), Spark, Matrix, General Catalyst, and Flybridge. Finally, some excellent California firms like True Ventures have made NYC their second home.

The one thing we really need to complete the ecosystem is a couple of runaway succesesses. As California has seen with Paypal, Google, Facebook etc, the big successes spawn all sorts of interesting new startups when employees leave and start new companies. They also set an example for younger entrepreneurs who, say, start a social networking site at Harvard and then decide to move.

Some VCs understand this. The ones that do try to stand out by, among other things, 1) going out and finding companies instead of expecting them to come to them, 2) working hard on behalf of existing investments to establish a good reputation, and 3) just being friendly, decent people.  Believe it or not, until recently, #3 was pretty rare.

As a seed investor in about 30 companies, I’ve been part of many discussions with entrepreneurs about which VC’s they want to pitch for their next financing round.  More and more, I’ve heard entrepreneurs say something like “I don’t want to talk to that firm because they are such jerks.” In almost all cases these are well-known, older firms who come from the era when capital was scarce.

Every experienced entrepreneur I know has a list of “toxic” VCs they won’t deal with. (Often because of horror stories like the “partner ambush“). There are so many VCs out there that you can do this and still have plenty of VCs to pitch to get a fair price for your company and only deal with decent, helpful investors. It sounds kind of crazy, but being a reasonably nice person has become a competitive advantage in venture capital.

The first thing to try to figure out is whether what you are building will eventually be on the incumbent’s product roadmap. The best way to do predict this is to figure out whether what you are doing is strategic for the company. (I try to outline what I think is strategic for Google here). Note that asking people who work at the incumbents isn’t very useful – even they don’t know what will be important to them in, say, two years.

If what you are doing is strategic for the incumbents, be prepared for them to enter the market at some point. This could be good for you if you build a great product, recruit a great team, and are happy with a “product sale” or “trade sale” – usually sub $50M. If you are going for this size outcome, you should plan your financing strategy appropriately. Trade sales are generally great for bootstrapped or seed-funded companies but bad if you have raised lots of VC money.

If your product is strategic for the incumbent and you’re shooting for a bigger outcome, you probably need to either 1) be far enough ahead of the curve that by the time the big guys get there you’re already entrenched, or 2) be doing something the big guys aren’t good at. Google has been good at a surprising number of things. One important area they haven’t been good at (yet) is software with a social component (Google Video vs YouTube, Orkut vs Facebook, Knol vs Wikipedia, etc).

The final question to ask is whether your product is disruptive or sustaining (in the Christensen sense).  If it’s disruptive, you most likely will go unnoticed by the incumbents for a long time (because it will look like a toy to them). If the your technology is sustaining and you get noticed early you probably want to try to sell (and if you can’t, pivot). My last company, SiteAdvisor, was very much a sustaining technology, and the big guys literally told us if we didn’t sell they’d build it. In that case, the gig is up and you gotta sell.

How entrepreneurs handle shutting down is very important.  First, try to return as much capital to your investors as you can (after paying off employees and other important debts – but don’t waste money on an expensive legal process). Second, if you’ve developed IP, spend a few months trying to sell it to recover as much capital as you can (often investors will offer a “carve out” to incentivize entrepreneurs since the likely return to investors will be under total number of preferences).  Don’t go off starting a new venture before you’ve properly closed down your current one (I’ve seen this twice recently – very bad form).  Finally, for your own learning as well as your reputation, write a detailed post-mortem about what went right and wrong and send it to your investors, and then try to follow up with in-person discussions.

Here’s the good news.  One of the great things about angel and venture investors is that failure is accepted, as long as you do it in the right way. Venture investors will often fund entrepreneurs who’ve lost their money in the past. They understand that if you build an interesting product and, say, market forces turn dramatically against you, that’s a risk they took — and the type of risk they will take a again. Also, entrepreneurs tend to be judged by their wins (max() function), not their average.  You’d be surprised how many entrepreneurs have failures in their past that no one remembers once they have some success.

“Accretive milestone” is a fancy way of saying getting your company to a point at which you can raise money at a higher valuation.  As a rule of thumb, I would say a successful Series A is one where good VCs invest at a pre-money that is at least twice the post-money of the seed round.  So if for your seed round you raised $1M at $2M pre ($3M post-money valuation), for the Series A you should be shooting for a minimum of $6M pre (but hopefully you’ll get significantly higher).

The worst thing a seed-stage company can do is raise too little money and only reach part way to a milestone. Pitching new investors in that case is very hard; often the only way keep the company alive is to get the existing investors to reinvest at the last round valuation (“reopen the last round”). The second worst thing you can do is raise too much money in the seed round (most likely because big funds pressure you to do so), hence taking too much dilution too soon.

How do you determine what an accretive milestone is? The answer is partly determined by market conditions and partly by the nature of your startup. Knowing market conditions means knowing which VCs are currently aggressively investing, at what valuations, in what sectors, and how various milestones are being perceived.  This is where having active and connected advisors and seed investors can be extremely helpful.

Aside from market conditions, you should try to answer the question: what is the biggest risk your startup is facing in the upcoming year and how can you eliminate that risk?  You should come up with your own answer but you should also talk to lots of smart people to get their take (yet another reason not to keep your idea secret).

For consumer internet companies, eliminating the biggest risk almost always means getting “traction” – user growth, engagement, etc. Traction is also what you want if you are targeting SMBs (small/medium businesses). For online advertising companies you probably want revenues. If you are selling to enterprises you probably want to have a handful of credible beta customers.

The biggest mistake founders make is thinking that building a product by itself will be perceived as an accretive milestone. Building a product is only accretive in cases where there is significant technical risk – e.g. you are building a new search engine or semiconductor.

Now to the “fudge factor.”  Basically what I’d recommend here depends on what milestones you are going for and how experienced you are at developing and executing operating plans. If you are going for marketing traction, that almost always takes (a lot) longer than people expect.  You should think about a fudge factor of 50% (increasing the round size by 50%).  You should also have alternative operating plans where you can “cut the burn” to get more calendar time on your existing raise (“extend the runway”). If you are just going for product milestones and are super experienced at building products you might try a lower fudge factor.

The most perverse thing that I see is big VC funds pushing companies to raise far more money than they need to (even at higher valuations), simply so they can “put more money to work“. This is one of many reasons why angels or pure seed funds are preferable seed round investors (bias alert:  I am one of them!).

First, let me say the quality of the individual partner making the offer matters a lot.  However, in my experience, there is a only rough correlation between a VC’s brand and the quality of the individual partners there.  There are toxic partners at brand name firms, and great partners at lesser known firms.

There are only two situations I can think of where the firm’s brand really matters.   First, if you manage to raise money from a particular set of the top 5 or so firms, you are almost guaranteed to be able to raise money later at a higher valuation from other firms. In fact, there are VC firms whose explicit business model is simply to follow those top firms.

The other way a VC firm’s brand can help is by giving you credibility when recruiting employees.  This matters especially if you are a first-time entrepreneur whose company is at an early stage.  It matters a lot less if you’re a proven entrepreneur or your company already has traction.

In my opinion that’s about it in terms of the importance of the VC’s brand.  Too many entrepreneurs get seduced into thinking they’ve accomplished something significant by raising money from a name brand VC.  Also, remember that if you are raising a seed round, the better the firm is, the worse it can actually be for you if that firm decides not to participate in follow on rounds.

The most important question to ask before taking seed money link

The challenge of creating a new category link

Man and superman link

The new economy link

Why content sites are getting ripped off link

Software patents should be abolished link

Climbing the wrong hill link

Google and newspapers: the false choice of opting out link

New York City is poised for a tech revival link

To make smarter systems, it’s all about the data link

The one number you should know about your equity grant link

Why you shouldn’t keep your startup idea secret link

Ideal first round funding terms link

The reality is ideas don’t matter that much.  First of all, in almost all startups, the idea changes – often dramatically – over time. Secondly, ideas are relatively abundant. For every decent idea there are very likely other people who’ve also thought of it, and, surprisingly often, are also actively pitching investors. At an early stage, ideas matter less for their own sake and more insofar as they reflect the creativity and thoughtfulness of the team.

What you should really be focused on when pitching your early stage startup is pitching yourself and your team.  When you do this, remember that a startup is primarily about building something.  Hence the most important aspect of your backgrounds is not the names of the schools you attended or companies you worked at – it’s what you’ve built.  This could mean coding a video game, creating a non-profit organization, designing a website, writing a book, bootstrapping a company – whatever.  The story you should tell is the story of someone who has been building stuff her whole life and now just needs some capital to take it to the next level.

Of course a great way to show you can build stuff is to build a prototype of the product you are raising money for.  This is why so many VCs tell entrepreneurs to “come back when you have a demo.”  They aren’t wondering whether your product can be built – they are wondering whether you can build it.

Last year two friends of mine who are both very successful, serial entrepreneurs — Eric Paley and Dave Frankel — were brainstorming ideas for what to do next when the thought occurred: why not make their next startup a new kind of venture firm, the kind we had wished existed back when we started our first companies?

So this is what we, along with a bunch of other serial entrepreneurs, decided to do. We call our new firm Founder Collective. Joining us are Mark Gerson (founder of Gerson Lehrman Group), Zach Klein (co-founder of Vimeo/Connected Ventures), Bill Trenchard (co-founder of LiveOps), and Micah Rosenbloom (co-founder of Brontes). We expect to add more founders over time.

We think of ourselves as part of a new wave venture firms led by Y Combinator, First Round, Maples, Ron Conway/Baseline, and Betaworks, among others, that have adapted to a world where venture capital is abundant but authentic seed capital and, more importantly, mentorship from experienced entrepreneurs, is scarce. We have many similarities to these firms and also some differences:

1) We have a small fund – approximately $40M – and intend to keep it that way. This means seed investments are our entire business — they are not options on future financings. Hence our interests and the founders’ interests are aligned. This also means we are happy with smaller exits if that’s what the entrepreneur wants to do.

2) Each person involved in Founder Collective is an entrepreneur, most of them currently running startups full time (my full-time job is CEO/co-founder of Hunch).

3) We believe the best people to predict the future — and create it — are fellow entrepreneurs, not former bankers drawing graphs and developing abstract theses.

4) We try to be respectful. We’ve all sat in countless meetings where VCs show up late, email while you are presenting, and generally act arrogant and dismissive. We try really hard not to be like that.

5) We’ll make investments anywhere in the world but tend to favor our home turf – New York City and Cambridge, MA. New York is a hotbed for online media and advertising startups. In Cambridge, there is a constant flow of ideas coming out of places like MIT that just need a little capital and guidance.

We realize the word “Collective” sounds a bit radical, even socialist. This is deliberate. While we have an actual fund — we are not just a group of angel investors — we also have a unique structure where active entrepreneurs lead investments, work hard to help their investments succeed, and share in the profits when they do.

Think of it as peer-to-peer venture capital.

The most common mistake entrepreneurs make is to base their choice solely on the investors’ “celebrity” value (by “celebrity” I generally mean in the TechCrunch sense, not the People magazine sense).  Picking celebrity angels might help you get a little more buzz when you announce the financing and a few SUL tweets, but that’s about it.  A startup is a long trip — what you should care about is whether, through the ups and downs and after the buzz dies down, the investors will actually roll up their sleeves and help you.

That isn’t to say that being a celebrity and being helpful are mutually exclusive.  Ron Conway is a celebrity (in the startup world) and is one of the hardest working investors I know. But there are other celebrity investors who I’m a co-investor with in a few companies who literally don’t respond to the founder’s emails.  And these are successful companies where the founder sends them only occasional emails about really important issues.

The second biggest mistake is picking angels that benefit the lead VC.  A lot of times when VCs guide entrepreneurs to certain investors what they are really doing is “horse trading” – they want you to let in so and so, because so and so got them into another deal, or will help them get into future deals.

It’s also smart to pick a varied group of people.  If you want a few celebrities to create some buzz, fine.  You should also pick some people who are connectors – who can introduce you to key people when you need it (varying connectors by geography and industry can also be helpful).  Also very important are active entrepreneurs who can (and will) give you practical advice about hiring, product development, financing etc.

Finally, don’t spend too much time agonizing over this.  One particularly silly situation I was involved with was where the CTO had invited me to invest but then the CEO decided he wanted to put me through multiple interviews before he’d let me in.  He probably spent a day of his time deciding whether to give me some tiny fraction of the round. Eventually he dinged me because I wasn’t famous, but at that point I was frankly kind of relieved since the CEO seemed to have such a bad sense of how to prioritize his time.

Disclosure: This post is entirely self serving, as I consider myself a non-celebrity but hard working small investor.

Here’s the problem.  A few years into the program, approximately 25 teams have gone through it.  The sponsoring VC funded one team and passed on the other 24.  None of those other 24 have gotten financing from anyone else.  Why?  Because once you go through the program and don’t get funded by the sponsoring VC, you are perceived by the rest of the investor community as damaged goods.

Most early stage investors are bombarded with new deals.  There is no way they could meet with all of them, or even spend time seriously reading their investor materials.  In order to filter through it all, they rely heavily on signals.  The person referring you to them is a very big signal.  Your team’s bios is a very big signal. And if you were in the seed program of a VC who has a multi-hundred million dollar fund and who decided to pass, that is a huge signal.

Meanwhile, the unsuspecting entrepreneurs think: “I was at a prestigious VC this summer – this will look great on our bios and company deck.”  The truth is exactly the opposite:  the better the VC, the stronger the negative signal when they pass.

Thus, the most important question to ask before taking seed money is: How many companies that the sponsor passed on went on to raise money from other sources?

The best programs don’t have sponsors who are even capable of further funding the company.  Y Combinator simply doesn’t do follow ons, so there is no way they can positively or negatively signal by their follow on actions. (Although now that they have taken money from Sequoia people are worried that Sequoia passing could be seen as a negative signal.  I just invested in a Y Combinator company and was reassured to see Sequoia co-investing).  Other seed programs lie somewhere in between — they aren’t officially run by big VCs but they do have big VCs associated with them so there is some signaling effect.   (I would call this the “hidden sponsor” problem.  I didn’t realize the extent of it until I got emails responding to my earlier seed program posts from entrepreneurs who had been burned by it).

The most dangerous programs are the ones run by large VCs.  I would love for someone to prove me wrong, but from my (admittedly anecdotal) knowledge, no companies that have been in large VC seed programs where the VC then stopped supporting the company went on to raise more money from other sources.

As has been widely noted, startups – especially internet-related ones – require far less capital today than they did a decade ago.  The VC industry has responded by keeping their funds huge but trying to get options on startups via seed programs.  Ultimately the VC industry will be forced to adapt by shrinking their funds, so they can invest in seed deals with the intention of actually making money on those investments, instead of just looking for options on companies in which they can invest “real money.”  In the meantime, however, a lot of young entrepreneurs are getting an unpleasant introduction to the rough-and-tumble world of venture capital.

Disclosure:  I am biased because as an early stage investor I sometimes compete with these programs.

About 6 years ago, when I was working at Bessemer as junior investor, I was at a dinner with a group of friends and acquaintances.  The guy sitting next to me was a business school student who spent most of the dinner talking about how he was trying to get a job in venture capital.  He never bothered to ask me what I did for a living and I never mentioned it.

Now, I wasn’t a particularly important venture capitalist, but getting a job in the industry is all about meeting as many people who work in it as you can.  The fact that he happened to be sitting next to one was potentially serendipitous – had he only bothered to ask questions.

Mr. Swensen manages Yale University’s endowment and is the inventor of the so-called “Yale Model.”  Basically this is a model for people who manage the largest pools of capital in the world – universities, pension funds, wealthy family funds, etc.  The major idea behind the Yale Model is to put significant portions of one’s fund into “alternative asset classes” like venture capital.   Yale had phenomenal returns for many years (until this year, which was a disaster) and thus was copied by fund managers around the world.  This created demand to invest hundreds of billions of dollars into VC funds.  This in turn radically increased competition amongst VCs, thereby driving down their returns (public pension funds like California’s release the returns of their VC investments and they aren’t pretty).

What this means is that there are lots of VCs out there with huge funds and very little chance of getting “carry” (performance fees), since most will have negative returns (and they know it).  So instead they are collecting management fees (typically, 2% of the fund for 10 years, so 20% of the total fund).  They need to justify collecting these fees, which is why if you hang out with VCs you’ll often hear them talk about needing to “put more money to work.”  I would bet that the new investors were the ones arguing for Twitter to raise more and more money, even if it meant a higher valuation.  I’ve seen it happen many times.

@rafer Never ever sign a term sheet without your atty’s review. sry but thats crazy talk @cdixon http://bit.ly/UOgiC myreblog http://bit.ly/cJ9d0

I’ll agree that entrepreneurs, especially first timers, should have lawyers review everything they sign.  But I stand behind my main point:  you can’t outsource the understanding of key financing and other legal documents to lawyers.

Here’s just one of many examples of why.   A company I know was recently confronted with the following trade off.  Get a higher valuation with full ratchet anti-dilution or a lower valuation with weighted average anti-dilution.   The only way to assess this trade off is to understand what these terms mean and try to compute the expected value of the two offers.   In this particular case what matters is the likelihood of a future down round.  This is a business judgment, not a legal one, and the people best able to make it are business people.

You also need to consider your personal utility function.  For example, as a founder, I don’t care very much about anti-dilution provisions because I figure in the cases where it matters I will already have been fired and my equity crammed down.

My point is you can’t leave these judgements to lawyers.   They don’t have the expertise to make these expected value calculations nor do they understand how various scenarios affect the founders personally.

Another common mistake entrepreneurs make is let their lawyers argue over terms that don’t matter.  This puts deals at risk and costs money.  You need to understand what they are arguing over to decide when it matters and when it doesn’t.

You learn about these legal issues from experience, by talking to lawyers, by talking to experienced advisors, and by reading blogs and books (every entrepreneur should read The Entrepreneur’s Guide to Business Law).

If you look at the backgrounds of partners in VC firms, they generally either came in as a partner after being a successful entrepreneur or worked their way up in VC.  There are books written on how to become a successful entrepreneur, so here I’ll just focus on the other common path – career VCs.

First, you should understand how VC firms are structured.  Every firm is different, some have no junior people, some have just a few, and some have a lot.

The key distinction between junior and senior people is whether they can write checks – meaning they can independently lead a deal.  If you can’t write checks, you have to get a check writer to sponsor an investment you like.  Check writers get almost all the credit and blame for an investment.

The hierarchy within VC firms is basically as follows:  (There has been a wave of title inflation in VC lately, so I’ll put the inflated titles in parentheses).

Partners – Owners of the firm.  Get the most of the management and carry fees.  Can write checks.

Principals – Usually get small piece of carry.  Can write checks.  (Inflated title:  Partner;  in which case it’s hard to tell the “real” partners from the principals).

Associates – Usually post-MBA or 4-6 years work experience.   Usually get little to no carry and can’t write checks.  (Inflated title:  Sr. Associates or Vice President).

Analyst – Usually right out of college.   They do research or cold call companies.   No carry and obviously can’t write checks.   (Inflated title:  they just don’t list a title or say something vague like “investment professional”).

As you can see with the title inflation this is all pretty confusing.  It’s meant to be.  VCs want entrepreneurs to take their junior people seriously.  (Which, by the way, entrepreneurs always should:  even though they can’t directly write checks, they can be extremely influential)

You can break down working your way up in VC into 3 challenges:

1) Getting a job in the first place.  The two most common places to break into VC as a junior person are after undergrad or business school.  VCs are heavily biased toward certain top schools.  On the MBA side, the industry is dominated by Harvard and Stanford.  Undergrad, the VCs I know only recruit from Wharton, Harvard, Stanford and maybe a few other elite schools.  (Please don’t accuse me of elitism-I’m just reporting on elitism, not promoting it). Even if you go to one of these fancy schools it’s still not easy to get a job.  You need to network like crazy.  I did a whole bunch of volunteer research projects for VCs when I was in business school.  I came up with lists of investment ideas so when I got a few minutes with a VC, I could show them I was obsessed with this stuff.  Other things that help you:  computer science or other relevant technology background.  Single best thing is to have started a company (even if it didn’t succeed).

2) Going from non-check writer to check writer.  This might even be harder than breaking into VC.   There is kind of a Catch-22 here:  you can only gain credibility by having led deals, yet you can’t lead deals until you’ve gotten credibility.  Some partners are nice and let high level junior people “virtually” lead deals, join boards etc so they can get credit.  My advice here is to try to get your hands on a checkbook, even if it means leaving a top tier VC and going to a second tier one. Too many junior people hang around top tier firms waiting to get promoted.

3) Once you get your hands on a checkbook, then you just need to find the next Google/Facebook and invest before anyone else figures it out.

If you really want to break into VC and aren’t just now graduating from a top school, my top suggestion would be to go start a company.  If you don’t have the stomach for that, the next best thing is to work in a VC-backed portfolio company, hopefully in a role where you get some VC exposure.

And, finally, if you just want to work in finance, try to get a job at a hedge fund or a big bank.   Breaking into VC so hard that it’s only worth it if you really love startups.

Here is the VC chooser topic in embedded widget form (anything you create on Hunch can be embedded anywhere):

Which VC firm should I pitch? – make thousands more decisions on Hunch.com

Like everything on Hunch, this topic is completely user generated (“topic” is our word for what some people would call a “decision tree”). Users have full control over the questions it asks, the results (in this case VC firms), the descriptions, and a lot of more advanced functionality for “sculpting” the decision tree. If you go to the VC topic’s About page you can see that so far 7 people have contributed 86 firms and 5 questions to this topic (other topics have a much wider range of contributers, this one for example). The VC topic has been played (used by non contributors) 506 times, many of those users coming in via Google organic results for phrases related to pitching VC firms.

In addition, the results are all “trained” to be associated with responses to questions – meaning users have taught Hunch what to “believe” about each of the firms. For example, in red is what Hunch believes about Union Square Ventures:


Users who find mistakes can just click and fix them, similar to how you fix things on Wikipedia.

So if you see anything missing or that you’d like to change, feel free to do so. I was one main people who worked on this particular topic so it is biased toward my tastes (e.g. Hunch’s own VCs – Bessemer and General Catalyst – rank extremely high).

If you don’t like Hunch’s Q&A process you can jump directly to the See All page, and then using the filters on the left to drill down.

If you are not logged into Hunch, the VC firms you see will be ranked by their popularity amongst all Hunch users. Hunch personalizes the rankings specifically for you if you create an account and answer what we call “Teach Hunch About You” questions. For example, when I am logged in and go to the Hunch page for Bessemer I see this on the right sidebar:

Meaning that Hunch has learned to statistically correlate the questions I’ve answered about myself with liking Bessemer. At this point Hunch has statistically significant data (over 40M user feedbacks total) in most of our ~5000 topics so it usually works really well.

History has shown that incubators are really hard to pull off. In fact, the results from incubators in the 90s were apparently bad enough that the word itself carries a bad connotation in VC/startup circles.

Here’s why incubators are so hard to make work. Every successful startup requires a great entrepreneur focused solely on that company’s success. You can’t just take a great idea and have a great entrepreneur work on it for a while and then pass it off to a mediocre entrepreneur. It just won’t work. Maybe you can do that after the product is launched and gaining traction. But this is hardly an incubator. It’s more just like an early-stage entrepreneur transitioning to an advisory role – a pretty common practice a few years into a venture.

And maybe you can find exclusively great entrepreneurs to take over the companies, but then what you are doing is much more like active advising/investing, or “hatching” companies, as some VC’s now call it, presumably to avoid the dreaded I-word.

From VC’s perspective, one of the most annoying things an entrepreneur can do is “shop” a term sheet.  That means after they’ve offered you a term sheet in writing you take it to other investors to try to get a better deal. Most VCs I know won’t even send anything in writing until you have verbally agreed on all essential terms precisely to avoid this possibility.

Why are investors so sensitive to this?  First of all, no investor wants to think they are “just money” – the idea that you want to get an explicit auction going suggests that.

More importantly, what often happens is that once a VC has offered you a term sheet – especially if that VC is well respected – other VCs suddenly become interested.  It is pretty much guaranteed that if Sequoia offered you $4M pre, there are many other investors who, simply because of Sequoia’s offer, would offer you a higher price.  So if Sequoia allowed their term sheets to be shopped they’d never get deals done.

Some entrepreneurs think they are being savvy by shopping a term sheet but I would strongly caution against it.  The VC/startup community is extremely small and this will usually come back to bite you.

Note that I am not saying an entrepreneur shouldn’t get a competitive process going and try to get the best deal with the highest quality investors.  You just need to do it in the right way.  Discuss things verbally and only accept a term sheet when you have agreed on all significant terms.  At that point, assuming the term sheet agrees with what you said, you should sign it and return it within a day or two.  (Don’t say you need to wait for you lawyer to review it – if you want to be an startup CEO you need to learn how to review and evaluate term sheets.  Have your lawyer teach you about term sheets before you receive them.).

Also, don’t shop a verbal offer.  You can’t go to, say, Greylock and tell them Accel offered you 4 pre.  First of all they might collude.  Secondly it’s very likely to get back to Accel (they all know each other) and you might lose both deals.  What you can say is “I’m planning to wrap things up by X day and I have a lot of interest” and see what Greylock does.

The answer is that besides cold hard cash the other currency in venture capital is information.  A VC will meet with pretty much anyone they deem “serious” in order to gather more information, which they can then use to discover interesting investments, do better diligence on potential investments, impress entrepreneurs and other VCs with their knowledge, gossip with other VCs about recent deals and trends, and give seemingly informed advice to their portfolio companies.

I’m not saying VCs are trying to take your trade secrets and give them to competitors.  The vast majority of VCs would never do this.  Instead, they are after much more general, innocuous information, like the rough valuations of recent financings, what companies and markets are “hot,” what products are getting popular, what marketing tactics are proving successful, and so on.

Imagine you were a professional sports bettor but none of the existing information sources – Internet, TV, etc – existed.   The only way you could get information was by talking to people who actually saw the sporting events live. This is kind of what it’s like to work in venture and why VCs are so desperate for information.  There is very little publicly written about what’s really going behind this scenes. Occasionally juicy tidbits will come out on blogs like TechCrunch, and some moderately useful stuff appears daily in peHUB and other VC newswires – but crucially missing are the valuations, cap tables, competitive offers, companies’ performance, and pretty much everything else people really want to know.

In the way they cross-polinate information, VCs play a role with startups similar to what consulting firms like McKinsey play in the Fortune 1000 world.  They spread best practices around from one firm to another, in the end, on average, making everyone more efficient and informed, while also reducing informational advantages

My advice to entrepreneurs is not to run and hide.  Instead, you need to learn to play the game.  Meet with as many VCs as you can.  They are great sources of high level information.  Such and such assets are cheap right now.   Startups are having success with a such and such marketing channel.  A certain venture firm is eager to deals in your space.  Staying in the information flow is one of the main reasons many serial entrepreneurs angel invest on the side.

Just go to these meetings with the proper expectations – the VC’s eagerness probably has more to do with gathering information than investing in your company.

Investor sentiment, the old saying goes, is a horse race between fear and greed.  The fear and greed in venture capital is all about investing in or missing out on the next Google.  No VC stays up at night worrying about missing the next startup that’s flipped to Google.  The way you get VCs interested is to convince them there’s a small but non-negligible chance you’ll create a billion dollar (valuation) business.

I’ve learned this lesson first hand on both sides of the table.  One example:  A good friend of mine was starting a company a few years ago.  I was excited about the idea and tried to help him raise venture money.  After the entrepreneur pitched some VC friends of mine, I was surprised when the they came back to me to say they are passing because “it seems like a smallish, ‘lifestyle’ business.”

The entrepreneur had made a very good pitch for why his product was valuable, why he could create a profitable business, that he was very smart and well prepared, and so on.   What he needed but failed to do was leave the VC with the nagging thought that this could be the “the next big thing.” Part of this was because of the entrepreneur’s natural modesty.  Some people don’t have the chutzpah to aggressively assert that their idea is the next big thing, even when, deep down, they truly believe it.  In everyday life, this kind of modesty is a virtue. When pitching VC’s, it is the single worst thing you can do.  (If deep down, you don’t believe your idea will be the next big thing – don’t raise VC money.  Once you raise VC you are committed to going for the billion dollar exit whether you like it or not.)

I don’t know if this obsession with the upside outlier case is a good strategy from the VC’s perspective or not.  Granular VC return data is hard to come by.  I tend to think it is a good strategy – one Google or Facebook (and a lot of other billion dollar exits that aren’t nearly as famous) can make up for a ton of misfires.  And the anecdotal return numbers I’ve heard from VCs suggests it works.   But I don’t really know.

The reason the odds of you getting dinged are that high are:

1) In most VC firms all it takes is one partner to say “This is really stupid – I hate it” to kill a deal.

2) Although by the time you pitch, the lead partner has probably told the other partners about you and probably sent around a memo, the non-lead partners probably didn’t pay attention, and only really do when you are presenting.

Good VCs have a much lower post-partnership ding ratio, because they work hard to socialize a deal and really get their partners to focus on it before asking the entrepreneur to present.   For example, I used to work for Rob Stavis at Bessemer and he had a much lower post-meeting ding rate.  This was because he spent a lot of time talking to his partners beforehand (“socializing the deal”), and if they had good objections he got them early on.  (Ps. Hopefully the VC will work extra hard to pre-sell the deal if they ask the entrepreneur to drop everything and fly across the country.)

The very worst thing that can happen in a partnership meeting is what I call the “partner ambush.”  Basically this is when the partner who brought you in (the “lead” partner), who you’ve met with for many hours and fully understands your company and is excited about investing in it, realizes midway through the meeting things are going badly and decides to try to save face by turning on the entrepreneur.

I had this happen to me when I was raising money for my last startup, SiteAdvisor.   Basically what happened is me and my co-founder Tom Pinckney walked into this big, well known VC firm at 4pm to a room of very tired looking guys (yes, they are all male) who had been hearing back-to-back pitches all day (side note:  always try to present in the morning).  No one introduced themselves or said hello, which was a bit unnerving.   The first questions were clearly hostile to the very idea of a consumer security startups (for a bunch of bad reasons, most VCs vastly prefer enterprise to consumer security – especially on the east coast and back in 2005).   One of them literally laughed at the idea of marketing via search engines (this is the east coast – believe it or not many VCs our here still don’t know what (white hat) SEO is and how important it can be).   Then the partner who brought me in said “Well, Chris, why not make SiteAdvisor into an enterprise product” basically turning on me and the whole concept of the company.  Things went downward from there.  To add insult and injury, the lead partner never even bothered to call me to ding me afterwards – in fact I haven’t heard from him to this day.

In retrospect, that would have actually have been a very good investment for the VC if they had actually given our pitch a fair hearing.  Which gets me to my final point:  I think VCs are making a mistake by putting so much emphasis on the partnership pitch.  There is some positive correlation between presenting to a room full of (sometimes hostile) VCs and building a successful startup, but not a very high one.

Besides missing good investments, the emphasis on the partner pitch leads VCs to invest in bad companies.  An investor friend of mine was recently talking about a failed startup he invested in:

Toward the end of the company, when things were going very badly, I went in and spent a day sitting with the entrepreneur and watching him work.  At that point I realized his one skill in life was pitching investors.  He had no idea how to manage people, build a product, get stuff done, etc.

The current early-stage VC process is optimized to favor people who are good at pitching partnerships, not necessarily people good at creating successful startups.

For those who don’t know, most VC’s get paid by so-called 2 and 20.  The 2 refers to the 2% of the fund they use to cover operating expenses and pay their salaries.  The 20 refers to the (normally) 20% “carry” fee – the percent of the profits they make for their investors that they get to keep.

Now I fully support carry fees – it is very similar to equity in a startup.  VC’s should get paid when they make money for their investors.

The problem is the management fees.  2% made sense back when VC funds were much smaller, but not now that they have gotten so large.  As peHUB said in their email newsletter today, Benchmark had an $85M fund in 1995 but today has a $500M fund.  That seems to be the typical trend for most big VCs.

Let’s do a little math.  2% of $85M is $1.7M.   Assuming 8 partners, that means salaries are in the $100-$200K range.  Much higher than national averages but, by the standards of finance, they aren’t getting “rich.”  2% of $500 is $10M, so each partner is probably getting $1M+ in salaries.   Over the 10 year life of the fund that’s $10M.  Even on Wall Street that is considered pretty rich.  And they get that money even if they make only bad investments and don’t return a dime to their investors.

This is why you see VCs raising bigger and bigger funds, why you frequently hear them say things like “I need to do 2 deals this year” and, worst of all, why you often see VC’s arguing for larger round sizes even if the startup has no productive use for the additional money – and even for the same percentage ownership.   In other words, in many cases VCs argue for a higher valuation just so they can “put more money to work.” Why?  If you raise a $500M fund and tell your LPs you are going to invest it over, say, 4 years, then its pretty hard to go back to them after a year and say “thanks for the $10M in management fees, I decided not to make any investments this year.”

VC’s seem to be a big fan of performance-based compensation when it comes to startups.  They should adopt it for themselves as well.

I looked through his ideal term sheet and from my summary reading the only thing I disagree with is full acceleration on single trigger (company is acquired).  The term I favor regarding single trigger is to have acceleration such that the founders only have a maximum N (say 12) months remaining. This seems to me a reasonable compromise so that 1) the founders only have to stick around at the acquirer for a maximum of N months (since they will probably be miserable at BigCo if they have to stay longer) 2) the acquiror gets some comfort that the founder will stick around long enough to integrate the startup into BigCo, thus getting the full value out of the acquisition.

I know some lawyers are telling entrepreneurs they shouldn’t have any acceleration on single trigger because it will make the company less attractive to acquirers.  Having been through a couple of acquisition negotiations on the business side (I know many lawyers will say they’ve been through many acquisitions but lawyers only see 10% of what really goes on in the process), what I learned is that acceleration on single trigger doesn’t hurt you from an acquirer’s perspective as long as founders are incented to stick around for some reasonable period of time (approximately 1 year, not 2-4 years).

Actually, the negotiation over acceleration on acquisition ends up pitting the founders against the investors, not the acquirer.  The way the (rational) acquirer figures it, they are going to agree to pay, say, $100M for a company with founders who have built incentives to stick around (some vesting left).  If the founders get full acceleration, then the acquirer figures they are going to have to set aside, say, $10M for future incentives, so will only pay $90M to buy the company, thereby leaving less for the investors. I didn’t understand this dynamic until I went through the process myself.

Of course a lot of this depends on the type of acquisition.  If it is a small trade sale the acquirer will probably want the founding tech team to stick around for as long as possible.  If it’s a profitable business then BigCo will probably want to put their own managers in charge and only need founders to stick around for 6-12 months.

I definitely support TheFunded’s full acceleration on double trigger (company acquired and founder is fired).  In fact – I think I might be alone on this one – I support double trigger for all employees.  I don’t see why only founders should have this basic protection.

I didn’t see any mention in the term sheet of initial vesting of existing founder shares (maybe I overlooked it…?).  I think that this is a very important term and that founders should vest over 4 years from seed funding or perhaps starting a few months before (for “time served” as they say).  In my experience, entrepreneurs way overestimate the odds that greater initial vesting will protect them from the VCs, and way underestimate the odds that less initial vesting will protect them from their co-founders.   I don’t care if your co-founder is the greatest person in the world, things happen in people’s lives, moods change, relationships get complex, etc. and founders leave startups.  Pretty often.  A better way to protect yourself from VCs is to only do deals with high integrity ones.

There is a big difference, of course, between being a VC who generates profits and being a VC that an entrepreneur should want to work with.  A star VC might be good at picking companies and winning deals, yet actually be a real jerk who doesn’t help the company at all.  But often star VCs do have better rolodexes, can be greater help raising follow on money, and are more influential within the firm if you need to do a “difficult financing.”

Another thing to understand is that who you are first introduced to within the firm is very important.  Why?   1) if you are intro’d to the wrong guy (and in VC unfortunately it is almost always men), that guy might reject you right away whereas another partner might have found your company interesting.  Once one guy dings you the other partners won’t give you a fair hearing for fear of offending the guy who dinged you.  2) VCs can be internally territorial, so if you are intro’d to one guy and he likes it, he might feel like it’s “his deal” when in fact you’d be better off with another partner (then you are stuck with the “roommate switch” problem if you recall that Seinfeld episode).

From my experience, picking the right partner is very important.  For example, in two companies I seeded, the same top tier VC firm invested in later rounds.  In one case the partner has been super helpful, and in the other case pretty much absent.  As I mentioned above, the partner’s influence within the firm also matters.  A influential partner can, for example, “pound the table” to do a follow on financing when you need it.  What stage the partner is in his career also matters.  Junior partners will typically work harder, but might also have “sharper elbows” when, for example, you are selling the company since he needs to prove himself by making the firm money.

So how do you pick the right partner?  Looking at their portfolio can help, but really this is where you need experienced advisors/seed investors who know all the people involved, their reputations etc and can make warm intros.

An option on a share of stock of an early stage company is (for all practical purposes) equal in value to a share in that early stage company.  Not less, as most entrepreneurs seem to believe (and god forbid you think “the VCs have the option to put in more money” is economically advantageous to you).

Here’s why.  Black and Scholes (and Merton) won a Nobel prize for inventing the Black-Scholes model, which was the first model that somewhat accurately modeled options pricing.  Using this model, and making a few reasonable assumptions (the option is “near the money,” the maturity is sufficiently far away), the key driver of an option’s value is volatility (in fact, if you listen to option traders talk, they actually talk about prices in “vols”).   In public markets, options are usually priced at some fraction of the share price.  This is because public stocks under normal circumstances have volatilities around, say, 20% (at least they used to 10 years ago when I was programming options pricing algorithms).

The volatility of the value of a seed stage startup is incredibly high.  I don’t know if any data exists for what volatility estimate would be good to use, but for an informal analysis suppose the average volatility of a seed stage startup is 300%.  Then try putting 300% into the volatility field of a Black-Scholes calculator:

So if your share price is $1, an option (European Call is a fancy word for options similar to what are given out in startups) is worth $0.9993 dollars.

This is good news for start up employees, directors, and advisors who are awarded stock options.  Their options are economically as valuable as stock but have better tax treatment.

Here’s the bad news.  At least since I’ve been observing early stage deals (since 2003), so-called financial innovation in venture capital has been all about creating new kinds of options for investors, each one more obfuscatory than the last.

- The first way they create options is by simply doing nothing – telling the entrepreneur “great idea, come back in a few months when you’ve made more progress.”  The logic is: why would you invest now when you could invest in, say, 3 months with more information? (as VCs say, why not “flip another card over”).  This is obviously perfectly within their rights and logical, but ultimately, in my opinion, penny wise and pound foolish.   While the VCs might be successful with this strategy on a specific deal, in the long run they are hurting themselves reputationally and also probably by letting some good deals slip away.

- Next there is tranching – this is pretty literally an option.  Even if the pre-negotiated future valuations are higher, the option has basically the same value as a share at the current price.  Try the Black-Scholes calculator but changing the strike price to 10 (simulating the idea that the seed round is $1M pre and future valuation is $10m pre):

The point is with the super high volatility of startups, you can structure the option in almost any way and it’s still like giving someone shares.  (I discuss the problems with tranching in more detail here.)

- Next there was “warrant coverage.”  This is perfectly legitimate in many cases (e.g. as a “kicker” in a venture debt round, as part of an important strategic partnership), as long as the entrepreneur understands 1 warrant basically equals 1 share.  One mistake entrepreneurs often make is to focus so intently on nominal valuation that they don’t realize their “effective valuation” with warrants is much lower.  For example, if the valuation is $10M pre and you give 100% warrant coverage, the valuation is really $5M pre.

- Over the past few years with big VCs starting “seed programs” we’ve seen the emergence of situations where there is no contractual option but the signaling value of the VC’s potential non-participation gives them option-like value.  I discuss why I dislike these deals here.  (This might be one point on which Fred and I disagree…?).

- Super pro rata rights.  This is a new term that’s popped up lately.  Pro-rata rights are options, but seem like reasonable ones.  If as an investor I bought 5% of your company, pro rata rights give me the right to invest 5% in the next round.  They are arguably a reasonable reward for taking a risk early on.  Super pro rata rights mean if I buy 5% of your company now I have the right to invest, say, 50% of the next round.  This is a really expensive deal for the entrepreneur.  If an investors puts in $250K for 5% of your company now with super pro rata rights on 50% of the next round, I’d just for simplicity assume you sold ~20% (assuming the next round sells 30% and the VC does half of that) of your company for $250K.  (The actual analysis of the value of super rata rights seems tricky – maybe some finance PhD will figure out how to price them at some point).

Good VCs don’t mess around with this stuff.  They realize that real value is created when you invest in great people and innovate around technology, not finance.

- Investors get either common stock or 1x non-participating preferred stock.  Anything more than that (participating preferred, multiple liquidation preferences) divide incentives of investors and the entrepreneurs.  Also, this sort of crud tends to get amplified in follow on rounds.

- Pro rata rights for investors.   Not super pro rata rights (explaining why this new trendy term is a bad idea requires a separate blog post).  This means basically that investors have the right to put more money in follow on rounds.  This should include all investors – including small angels when they are investing alongside big VCs.  There are two reasons this term is important 1) it seems fair that investors have the option to reinvest in good companies – they took a risk at the early stage after all 2) in certain situations it lets investors “protect” their investments from possible valuation manipulation (this has never happened to me but more experienced investors tell me horror stories about stuff that went on in the last downturn – 2001-2004).

- Founder vesting w/ acceleration on change of control.  I talk about this in detail here.   If your lawyer tries to talk you out of founder vesting (as some seem to be doing lately), I suggest you get a new lawyer.

- This stuff is all so standard that there is no reason you should pay more than $10K for the financing (including both sides).  I personally use Gunderson and think they are great.   Whoever you choose, I strongly recommend you go with a “standard” startup lawfirm (Gunderson, Wilson Sonsini, Fenwick etc).   I tried going with a non-standard one once and the results were disastrous.  Also, when you go with a standard firm and get their standard docs it can expedite later rounds as VCs are familiar with them.

- A board consisting of 1 investor, 1 management and 1 mutually agreed upon independent director.  (Or 2 VCs, 2 mgmt and 1 indy).  As an entrepreneur, the way I think of this is if both my investors and an independent director who I approved want to fire me, I must be doing a pretty crappy job and deserve it.

- Founder salaries – these should be “subsistence” level and no more.  If the founders are wealthy, the number should be zero.  If they aren’t, it should be whatever lets them not worry about money but not save any.  This is very, very important.  Peter Thiel said it best here.  (I would actually go further and say this should be true of all employees at all non-profitable startups – but that is a longer topic).

- If small angels are investing alongside big VCs, they should get all the same economic rights as the VCs but no control rights.  Economics rights means share price, any warrants if there are any (hopefully there aren’t), and pro-rata rights.  Control rights means things like the right to block later financings, selling the company etc.  I once had to track down a tiny investor in the mountains of Italy to get a signature.  It’s a real pain and unnecessary.

- Option pool – normally 10-20%.  This comes out of the pre-money so founders should be aware that the number is very important in terms of their dilution.  Ideally the % should be based on a hiring plan and not just a deal point.   (Side note to entrepreneurs – whenever you want to debate something with a VC, frame it in operational terms since it’s hard for them to argue with that).

- All the other stuff (registration rights, dividends etc) should be standard NVCA terms.

- Valuation & amount- My preference is to keep all terms as above and only negotiate over 2 things – valuation and amount raised.  The amount raised should be enough to hit whatever milestones you think will get the company further financing, plus some fudge factor of, say, 50% because things always take longer and cost more than you think.  The valuation is obviously a matter of market conditions, how competitive the deal is etc.   One thing I would say is if you expect to raise more money (and you should expect to), make sure your post-money valuation is one that you will be able to “beat” in your next round.  There is nothing more dilutive and morale crushing than a down round.

In theory, tranching gives the VC’s a way to mitigate risk and the entrepreneur the comfort of not having to do a roadshow for the next round of financing.  In practice, I’ve found tranching to be a really bad idea.

First of all, the entrepreneur should realize that the milestones written in the document are merely guidelines and ultimately the VC has complete control over whether to fund the follow on tranches.  Imagine a scenario where the entrepreneur hits the milestones but for whatever reason the VC gets cold feet and doesn’t want to fund the follow on tranche.  What is the entrepreneur going to do – sue the VC?  First of all they have vastly deeper pockets than you, so at best you will get tied up in court for a long time while your startup goes down the tubes.  Not to mention that it would effectively blacklist you in the VC community.  So just realize that contracts are the right to sue and nothing more.  The only money you can depend on is the money sitting in your bank account.

Here are some other reasons both entrepreneurs and investors should dislike tranching:

1) Makes hiring more difficult: Hiring is super critical at an early stage.  A very reasonable question prospective employees often (and should) ask  is “How many months of cash do you have in the bank?”  How do you respond if the money is tranched?  In my first startup, our full round gave us 18 months of cash but the first trance only a few months.  Should I have said what I had in the bank- just a few months – and scare the prospective hire?  Or should I have tried to explain “Oh, we have 18 months, but there is this thing called tranching, blah blah blah, and I’m sure the VCs will pony up.”  Not very reassuring either way.

2) Distracts the entrepreneur:  The entrepreneur is forced to spend time making sure she gets the follow-on tranches.  In many cases, she even has to go present to the VC partnership multiple times (each time requiring lots of prep time).  Also, savvy entrepreneurs will prepare multiple options in case the VC decides not to fund, so will spend time talking to other potential investors to keep them warm.  So basically tranching adds 10-20% overhead for the founders that could otherwise be spent on the product, marketing etc.

3) Milestones change anyways:  At the early stage you often realize that what milestones you originally thought were important actually were the wrong milestones.   So you either have to renegotiate the milestones or the entrepreneur ends up targeting the wrong things just to get the money.

4) Hurts VC-entrepreneur relations.  Specifically, it encourages the entrepreneur to “manage” the investors.    One of the great things about properly financed early stage startups is that everyone involved has the same incentives – to help the company succeed.  In good companies, the investors and entrepreneurs really do work as a team and share information completely and honestly.  When the deal is tranched, the entrepreneurs has a strong incentive to control the information that goes to the investors and make things appear rosy.  The VC in turn usually recognizes this and feels manipulated.  I’ve been on both sides of this and have felt its insidious effect.

There are better ways for investors to mitigate risk – e.g. lower the valuation, smaller round size.  But don’t tranche.

Even in the good scenario when the VC does wants to follow on, you are likely to get a lower valuation than you would have had you taken money from other sources of funding (angels, micro-VCs like Y-combinator).   This isn’t obvious if you haven’t done follow on fundraising before, but I’ve observed it first hand many times.  The reason is you won’t have the freedom to go out and get a true market valuation for your company.  Suppose you have venture firm X as a seed investor and they offer you, say, a $6M pre money valuation for your follow on round (usually called the Series A).  Suppose furthermore that if you were free to get a competitive process going that the “true valuation” for your company would be more like $10M pre.  If you now go to another firm, Y, and pitch them, one of the first questions is going to be “Is X investing?”  You say yes, X has made you an offer.  Now what Y is thinking is either 1) “I should call up X and offer to co-invest at $6 pre,” thereby keeping you at an artificially low valuation, or 2) if that’s not an option (e.g. because you already have 2 VCs in the deal, because X doesn’t think Y is a high quality enough firm to co-invest with, etc) Y is going to hesitate to offer you a term sheet, for fear of being used as a stalking horse.  This is industry lingo for when the entrepreneur uses firm Y to get a higher priced term sheet which X then matches and excludes Y.  VCs really don’t like to be used as stalking horses.  So what having a big VC in as a seed investor does is prevent you from getting a competitive dynamic going that gets you a true market valuation.

Why are big VCs doing this?   If you have a, say, a $200M fund, spending, say, 5% of your fund to get options on 50 companies is a great investment.  You could look at this from an options valuation perspective (seed stage startups have super high volatility – the key driver of options price in the Black-Scholes valuation model).  More simply, just think of it as “lead gen” for venture capitalists.  Basically big VCs are spending 5% of their budget generating captive leads for their real business:  investing $10M into a companies at the post-seed stage.

These seed programs are relatively new so we are only starting to see the wreckage they will eventually cause.  I predict in a few years, after enough entrepreneurs get burned, what I’ve said above will be conventional wisdom.  Unfortunately there are a lot of good companies that will die along the way until that happens.

Disclosure:  I sometimes compete with big VCs for investments, so I am not disinterested here.

The appeal of convertible notes is 1) it defers the negotiation about valuation to the next round 2) it is often much cheaper in terms of legal fees (~$5k versus $20-40K).

Here’s why a lot of seed investors don’t like convertible notes:

1) Most importantly, they split the entrepreneur’s and investors’ incentives – for the subsequent round, the entrepreneur benefits from a higher valuation, the investor from a low one.   Most investors work hard despite this to help the company, but nevertheless the note creates friction between people who should be working in tandem.

2) On more than a few occasions VCs in subsequent rounds have said “I don’t want to give the seed investors a 20% step up.”  Sure, the step up is in a contract, but the investor in the subsequent round can always make their investment contingent upon modifying that contract.  In the end, it ends up pitting seed investors who wants their step up versus entrepreneur who wants to get the financing done, and the seed investor is forced to choose between getting the step up they deserve and being “the bad guy” who spoils the financing.

One increasingly popular compromise is to do a “convertible with a cap.”  What this mean is that you set a cap of $N million dollars valuation and a step up of M%, and on the subsequent round the seed investor gets the better of the two.  If the cap is low enough, this mostly rectifies #1 above since the investor has the economic incentive to increase the valuation above the cap.  It doesn’t rectify #2, however, but does have the benefit of being significantly cheaper in terms of legal fees than a proper equity financing.   There is nothing worse than spending 5%-10% of your seed round on lawyers.

Found that VC firms based in San Francisco, Boston and New York generally return more money on investments outside of their local geographies than on investments close to home.

The academics offer an explanation for this:

The paper suggests that this differential could be caused by VC firms using higher hurdle rates for long-distance deals. Such portfolio companies may require a higher level of managerial/monitoring effort, so more thought is given before offering up a term sheet.

Another explanation that many entrepreneurs would give: when you are far away, it’s harder to meddle with the company, telling them to outsource to india, create a facebook app, or whatever the trend du jour is.

(at least I think it is old..?)

via

also reminds me of the classic “day in the life of a vc”

5:45am – Alarm clock. Pick up Blackberry from night-stand, fire off an email to portfolio company CEO to demonstrate “round-the-clock” vigilance. Go back to sleep.

8:30am – Wake up. Decide whether to have breakfast in the kitchen, dining room, sunroom, veranda, or gazebo. Have “breakfast meeting” with Rex and Fido.

9:45am – Drop child off at nursery school. Banter with child’s teacher. Haha, that teacher doesn’t make in a year what I spent in Lanai over New Year’s. Wow. I haven’t been to Hawaii in three months. Call assistant, re: technology conferences in Hawaii.

10:30am – Arrive at office, remark loudly that these breakfast meetings are killing you. It’s been ‘go, go, go’ all year. The pace is killing you. Makes you wish it was 2002 again.

10:45am – Call CEO of semi-conductor portfolio company. Ask if he’s considered building a Services component to his business.

11:45am – Damn. Late for lunch. Sometimes they run out of the olive bread at Il Fornaio. Gotta run. Thank god for the Carrera. That damn 545 didn’t have any giddy-up.

1:15pm — Call CRM portfolio company CEO, remind him that blogging is hot. Has he ever thought about Customer Support blogs? That’d be cool.

1:30pm – Oops. Late for meeting with entrepreneur looking for funding. Hee. Finish game of “Minesweeper”.

1:45pm – Apologize for being late. It’s been ‘go, go, go’ lately. The pace is killing me. Our firm is a little different… all of our partners were operators, so we know what it’s like to run a company. We’re pretty conservative investors here – we only put money to work where we can really make a difference and add some strategic value. We try to be respectful of your time, so we’ll give you a “quick no” if this isn’t something that interests us…

2:30pm – Wow. 15 voicemails from entrepreneurs. “What’s the next step?” Why does everyone need to know what the “next” step is? I’ll tell you what my next step is… out my office door to the lunchroom. Ooo. Blackberry Odwalla. I love Blackberry Odwalla. Note to self: have wife buy See’s candy for the Office Manager who buys the juice next Christmas. Odwalla, Odwalla, Odwalla. I love Odwalla.

2:45pm – Shit. Sequoia has a term sheet out to Acme Intangibles. Find Associate. Why the hell didn’t we look at Acme? That fucking company is hot. Instead, you bring me this piece of shit company in storage management? Christ. Goddamn Associates never see the big picture. Oooooo… The TED conference. When is TED? Gotta get into the Monterey Plaza. Margaret stuck me at the Marriott last year. How much did that suck?

3:15pm – Fax term sheet to Acme. Wonder what the hell they do? No worries. Those guys at Sequoia diligence the hell out of deals.

3:45pm – Isn’t there any political candidate who still needs a fundraiser? How the hell did Gorenberg get Kerry? Stupid, stupid, stupid. Should’ve snagged Kerry back in December. What about the Senate? There must be a senator who needs electing.

4:15pm – Sharon Heights. Networking. Bob said the monthly dues are deductible, right? Bob rocks. Best accountant ever.

8:15pm – Sorry I’m late honey. It’s been ‘go, go, go’ all year. Can’t do this too much longer. Can Isabel stay late tonight to make some dinner?

 link

1) All startup employees – including founders! – should vest over 4 years from their start date (with a one year “cliff”).  When I used to work in VC I can’t tell you how many companies I saw where some random former founder who was long gone from the company and was only there for some short period of time owned some big chunk of the company.  Not only is this just plain unfair, it also means there is a lot less room for giving equity to employees and for raising new capital.  Even if you are founding a company with your best friend – actually, especially if you are founding a company with your best friend – everyone should have vesting.   If you have a lawyer who tells you otherwise, get a new lawyer.

2) Founders should always have acceleration on change of control!  In particular, you should have full acceleration on “double trigger” (company is acquired and you are fired).  In addition you should have partial acceleration on “single trigger” (company is acquired and you remain at company).  I prefer a structure where you accelerate such that you have N months remaining (N=12 is a good number).  This gives the acquirer comfort that the key people will be around for a reasonable period of time but also lets the founders get the equity they deserve without spending years and years at the acquirer.  Consider the scenario where your company gets acquired 1 year after founding and you have 3 years of vesting remaining.   Suppose further that you just aren’t a big company type and leave after 1 year.  In that case you would forgo half your equity.  It’s always surprising to me how much time founders spending focusing on valuation that might change their ownership by a few points when vesting acceleration (albeit under certain circumstances – but I have seen this happen) can have a far larger impact on their ultimate equity ownership.