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, Khosla 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.