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.

The risks of being a small investor in a private company

With the passage of the JOBS act, it seems that many more Americans will soon be able to buy equity in private companies. I am no expert on the law, but I have been investing in private companies for about a decade, and during that time I’ve seen many cases where large investors used financial engineering to artificially reduce the value of smaller investors’ equity. Here are a few examples.

1) Issuing of senior securities with multiple liquidation preferences. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m, getting 4x senior straight preferred

Company gets sold for $30m. Management gets $3m carveout, Series B investors get $27m, and Series A investors get zero.

2) Issuing of massive option grant to management along with new financing at a below-market valuation. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred for 10% of the company.

Company is doing well and is offered a Series B at a significantly higher valuation. Instead, large investor invests $5m at below-market valuation, getting 40% of the company, and simultaneously issues options worth 50% of the company to management.

Result: Series A investors are diluted from 10% to 1% of the company, even though the company was doing well and in a normal financing would have only been slightly diluted.

3) The company is actually multiple entities, with the smaller investor investing in the less valuable entity. Example:

Company has entity 1 and 2. Small investors invest in entity 1 that licenses IP from entity 2. Value of IP increases and entity 2 is sold and eventually cancels entity 1′s license, making entity 1 worthless.

4) Pay-to-play or artificially low downrounds. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m in pay-to-play round (meaning any investor that doesn’t participate has their preferred shares converted to common). Smaller investor doesn’t have the cash to re-invest in Series B, but deeper pocketed investors do.

Company sells for $10m. Series B investors get $10m. Series A investors get nothing.

There are ways to protect against these shenanigans. Protections can be written into the Series A financings documents (pro-rata rights, ability to block senior financings, etc). There are also some legal protections all minority investors are granted under, say, Delaware or California law. But usually even when these protections exist (and they exist far less frequently these days than in the past), smaller investors usually can’t, say, invoke blocking rights by themselves (indeed, it’s often not economically viable for smaller investors to hire lawyers to review every financing document for every company they invest in). Another way smaller investors can protect themselves is to set aside capital amounting to, e.g. 30% of every investment made, in case they need it later for defensive purposes (I do this). But in my experience this is all very complicated and difficult to execute in practice, even when the small investors are “professional” investors. I worry it will be even harder for “amateur” investors to protect themselves.

Outsource things you don’t care about

A fundamental principle of business is that you do things in house that you think can give you a competitive advantage and outsource things that you don’t. At an early-stage technology company this means you do in house: product design, software and/or hardware development, PR, recruiting, and customer relations/community management. Ideally, most of these activities are led by founders. You should outsource legal, accounting, website hosting, website analytics etc. (Unless you are starting a company where one of those activities can give you a competitive advantage, e.g. a securities trading startup would need to have in-house legal).

A lot of startups over outsource. A few years ago, you’d sometimes hear tech startups say they were going to outsource software development. Thankfully, founders have gotten smart about this and it rarely ever happens except as a stopgap. It is still common for startups to hire outside PR firms. If you decide to hire an outside PR firm, that means you don’t care about PR. Just because you are willing to spend some of money on it doesn’t mean you think it’s important. You probably shouldn’t hire an investment banker during an acquisition unless your company is later stage. And you might occasionally use an outside recruiter but the core recruiting activity needs be done by founders.

Some tips for interacting with the press

Here are a few things I’ve learned over the years about the best ways for entrepreneurs to interact with the press (by press I mean blogs as well as traditional media).

– Don’t be afraid to ask what the rules are. Is this on or off the record? If they are writing an article about your company, do they require exclusivity? What is the angle of the story?

– Don’t use a PR firm unless you are so successful that you need someone to help you manage inbound press interest. Most journalists, when talking candidly, will tell you they’d vastly prefer getting an email from the founder of a startup than a PR firm. If you’re Bill Gates, it is understandable that you have someone reaching out for you. If you are a small startup, having a PR rep contact a journalist says “I’m not competent enough to reach you” or “I don’t respect your time enough to reach out directly.”

– Treat journalists with respect. Tech/business journalists often interact with rich and powerful people, some of whom treat them disrespectfully. Like entrepreneurs, journalists are usually interesting people with diverse interests. You’ll probably like them if you talk to them and might even become friends.

– Unless you’re a super hot startup, the existence of your company is not a news story. Exclusives of launches, financings and acquisitions are usually news stories. Trend stories that you are part of could be a news story. Relating your startup or data your startup generates to something already newsworthy (journalists call this “pegging”) can dramatically increase your chances of getting covered.

– Whether you like it or not, the press will put your company into a category, and might run “horserace” stories comparing how the companies in your category are doing. The best you can do here is to try to choose which category you’ll be put into. Arguing that you have no competitors or are creating a new category is pretty much impossible.

– Try to put yourself in the mindset of the journalist. How will this story get them on Techmeme or featured by their editors? What were their most successful recent stories? Do background research on any reporter before talking and read a bunch his/her articles.

– Don’t just contact reporters when you need them: try to be helpful even when you don’t. Sometimes, I get calls to talk about, say, the state of the venture market or asking for some background on a tech sector that is new to the journalist. My guess is they appreciate this and are more responsive when I contact them about a possible story.

And then, suddenly, it works

The other day a friend was demoing a new app he was working on. My first reaction was: “Yeah, yeah. This is nicely executed version one of those ideas I’ve seen 50 times.” My second reaction was: “But I could say that about pretty much every successful startup I’ve seen over the last 10 years.”

Most of the time, important new ideas don’t succeed on the first attempt or even the first ten attempts. But then they do, and it seems to happen suddenly. It’s hard to tell why this is. It’s probably a combination of timing (riding some fundamental shift in technology or culture), and execution (getting the product just right).

An idea getting tried over and over tends to be a positive signal (which is one reason that competition is overrated). It’s very easy when you spend lots of time around startups to get cynical. You could tweet and blog predictions that every new startup will fail and how the ideas are derivative and you’d be right 95% of the time. The hard part – and what matters for founders and investors – is figuring out the right mix of timing and execution to finally get it right.