Presenting Founder Collective

As readers of this blog know, I’m a huge fan of the startup and venture capital world but also a sometimes critic of how the venture capital industry works. For a long time I’ve wanted to do more than talk about this and actually start a new kind of venture firm, designed the right way from the ground up.

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 important question to ask before taking seed money

There is a certain well respected venture capital firm (VC) that has a program for fledgling entrepreneurs.   The teams that are selected get a desk, a small stipend, and advice for a few months from experienced VCs.  I could imagine back when I was starting my first company thinking this was a great opportunity – especially the advice part.

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.

The problem with taking seed money from big VCs

I recently met an entrepreneur who was raising money for his startup.  Six months prior, he had raised seed money (<$1M) from one of the increasingly popular seed programs big venture firms are offering (big venture firms = roughly $100M fund and larger).  As a potential investor, the first question I asked him is “is the big venture firm following on?”  The answer was no.  What this means is the entrepreneur is going to have a *really* tough time raising any more money at all, because what all potential investors think is “if this top VC that has hundreds of millions of dollars and knows this company the best doesn’t want to invest, why would I?”   What the entrepreneur didn’t realize is that when you take any money at all from a big VC in a seed round, you are effectively giving them an option on the next round, even though that option isn’t contractual. And, somewhat counterintuitively, the more well respected the VC is, the stronger the negative signal will be when they don’t follow on.

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.

Why seed investors don’t like convertible notes

A popular option in seed round financing is a convertible note instead of setting a valuation in an equity financing.  A convertible note is basically a loan where the investors convert the debt into equity in the next round of financing at a step up.  A common step up is 20%, which means for every dollar the investors lend, they get $1.20 worth of shares in the subsequent round.

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.