Different types of risk

The idea that founders take on “risk” is a misleading generalization. It is far more informative to separate the specific types of risks that founders assume, including:

– Financing risk: You can’t raise money at various stages because you haven’t hit accretive milestones or your space isn’t appealing to investors.

– Product risk: You can’t translate your concept into a working and compelling product.

– Technology risk: You can’t build a good enough or, if necessary, breakthrough technology.

– Business development risk: You can’t get deals with other companies that you depend on to build or distribute your product.

– Market risk: Customers or users won’t want your product.

– Timing risk: You are too early or too late to the market.

– Margin risk: You build something people want but that you can’t defend, and therefore competitors will squeeze your margins.

At the early stage, the main way to mitigate these risks is to recruit great people as cofounders or early employees. You shouldn’t recruit people that will give you a high likelihood of reducing these risks. You should recruit people that give you an unfair advantage. You should try to win the game before it starts.

Startups are hard, and risky. But if you lump all the risks together, you are playing the lottery. Talented entrepreneurs identify specific risks and do everything they can to overcome them.

What’s the right amount of seed money to raise?

Short answer:  enough to get your startup to an accretive milestone plus some fudge factor.

“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!).

The problem with tranched VC investments

In venture capital, tranching refers to investments where portions of the money are released over time when certain pre-negotiated milestones are hit.  Usually it will all be part of one Series of investment, so a company might raise, say, $5M in the Series A but actually only receive, say, half up front and half when they’ve hit certain milestones.  Sometimes something similar to tranching is simulated, for example when a VC makes a seed investment and pre-negotiates the Series A valuation, along with milestones necessary to trigger it.

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.