Notes on raising seed financing

Last night I taught a class via Skillshare (disclosure: Founder Collective is an investor) about how to raise a seed round.  After a long day I wasn’t particularly looking forward to it, but it turned out to be a lot of fun and I stayed well past the scheduled end time.  I think it worked well because the audience was full of people actually starting companies, and they came well prepared (they were all avid readers of tech blogs and had seemed to have done a lot of research).

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.

Options

The financial term “derivative“ refers to a security whose value is a function of another security such as a stock or bond.  The most common types of derivatives are futures – the obligation to buy a security at a future date at pre-agreed upon price – and options – the right to buy something at a future date at pre-agreed upon price.

In theory, the primary societal purpose of derivates is for businesses to hedge against “exogenous” risks.  For example. Southwest Airlines is famously prudent about buying futures on oil to mitigate the effect of fluctuating oil prices on their core business.

In practice, most derivatives are bought and sold by speculators. One of the first speculators was a philosopher names Thales, who Aristotle described in his book Politics (Book 1, Part XI):

There is the anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but is attributed to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was of no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.

Valuing options was a mystery until 1973 when the Black-Scholes model was invented. The main practical outcome of this model was the idea that the value of an option was determined mostly by the volatility of the underlying security.

One way to understand the important of volatility is to think of options as the opposite of insurance policies. Suppose you are selling insurance on houses in one region that is prone to catastropic events and another that isn’t. Rational insurers would price insurance policies higher in the catastrophe-prone areas.

Startups are inherently very volatile – their price can increase or decrease dramatically in short periods of time. Having an option on a startup is the economic opposite of selling insurance in a catastrophe-prone area.

The US tax system has some rules related to startup options.  The first rule is that there is a special class of options called ISO options that can be granted to employees. ISO options are tax exempt until the options are exercised, which allows employees to receive them and not be liable for taxes until they actually realize cash gains. This rule only applies if the options are assigned a strike price equal to or greater than the “fair market value” of the company’s common shares. The fair market value is normally assessed by an outside valuation firm (a so-called 409A valuation) and usually ends up being significantly lower than the last round VC valuation (a rule of thumb for early-stage companies is the strike price will be approximately 20% of the last VC valuation).

When you are granted options in a startup there are a couple of important things to keep in mind:

1) You should know your percentage ownership of the company’s “fully diluted” outstanding shares (number of shares of the company including the option pool).

2) You should understand that if you leave the company, you normally have 90 days to “exercise” the options (purchase the shares you have the right to buy) before you forfeit your options. Normally the company has no obligation to inform you of this possible forfeiture, and in fact the standard practice is to hope the employee forgets and loses the options.

3) You should know the “preferences” on the company.  The preferences normally equals the amount of money raised. If the company sells for near or less than that number the common shareholders, and hence the employees (who own options on common shares), will receive little or no money.

The strike price of the options is somewhat important but, if you study options theory, not nearly as important as the volatility of the underlying stock. Financially, what matters most is having a reasonable percentage of options in a company with lots of volatility (and hopefully a stock price that has an upward slope).

 

There are two kinds of people in the world

You’ve either started a company or you haven’t.  ”Started” doesn’t mean joining as an early employee, or investing or advising or helping out.  It means starting with no money, no help, no one who believes in you (except perhaps your closest friends and family), and building an organization from a borrowed cubicle with credit card debt and nowhere to sleep except the office. It almost invariably means being dismissed by arrogant investors who show up a half hour late, totally unprepared and then instead of saying “no” give you non-committal rejections like “we invest at later stage companies.” It means looking prospective employees in the eyes and convincing them to leave safe jobs, quit everything and throw their lot in with you.  It means having pundits in the press and blogs who’ve never built anything criticize you and armchair quarterback your every mistake. It means lying awake at night worrying about running out of cash and having a constant knot in your stomach during the day fearing you’ll disappoint the few people who believed in you and validate your smug doubters.

I don’t care if you succeed or fail, if you are Bill Gates or an unknown entrepreneur who gave everything to make it work but didn’t manage to pull through. The important distinction is whether you risked everything, put your life on the line, made commitments to investors, employees, customers and friends, and tried – against all the forces in the world that try to keep new ideas down – to make something new.

Showing up

Mark Twain famously quipped that “80 percent of life is showing up.” Running a startup, I’d say it’s more like 90 percent. For example, I frequently hear from founders how it’s hard to recruit programmers. It is indeed hard. But great programmers are out there, and can be found in places where other people simply aren’t showing up.

Back in 2005 when I was starting SiteAdvisor with Tom Pinckney (one of my cofounders at my last two startups and non-graduate of high school) we were trying to recruit great programmers. At the time, startups were certainly not the hot thing, especially on the East Coast. We were based in Boston so decided to spend time at MIT where we figured there must be smart programmers. We went to places like the Media Lab and basically just sat ourselves down at lunch counters and awkwardly introduced ourselves: “Hi, my name is Chris Dixon and this is Tom Pinckney and we are starting a company and would love to talk to you about it.” Most students ignored us or thought we were annoying. I remember one student staring at us quizzically saying “startups still exist?” Most of our trips were fruitless. At one point after a failed trip we were on the Redline back to our office in downtown Boston and joked, depressingly, that we felt so out of place that people looked at us like time travelers from the dot-com bubble.

Our first breakthough came after a series of trips when a particularly talented programmer/designer named Hugo Liu re-approached us and said something like “hey, actually I thought about it and your idea doesn’t suck.” Then his friend David Gatenby talked to about joining us. We eventually recruited Hugo and David along with a brilliant undergraduate Matt Gattis. We had finally broken through. Matt and Hugo now work with us at Hunch along with some of their friends from MIT they brought along.

People who say recruiting is easy are probably recruiting bad people. People who say recruiting is hard are right. People who say it is impossible just aren’t showing up enough.

Founder Stories

Erick Schonfeld from TechCrunch asked me a few months ago if I’d be on a TechCrunch video show where we interviewed startup founders. I love startups. While other people watch sports on Sunday, I prefer to sit around with friends and chat about what new startups have launched, how they are doing, what product and marketing strategies are working, etc.

Erick originally called the show “Startup Sherpa.” The word “sherpa” implied that I was giving people advice. The people we invited to the show were either my peers or people who knew far more than me, so I felt very uncomfortable with that title. I really like to hear “war stories” (a term used in venture capital) but calling it that would have been disrespectful to military people who fight actual wars versus the inconsequential battles we have amongst startups and investors. So we chose “Founder Stories” instead.

I don’t get paid by TechCrunch and they don’t have a fancy editing budget so what you see is effectively live. I probably make an ass out of myself a lot. I actually haven’t brought myself to watch most of the episodes because I can’t stand all my verbal tics like saying “etc” and “you know.” The saving grace of the show is the incredible people we get to come on to share their stories. I think they participate mostly because it’s TechCrunch – the premier tech blog – and also because they know I love startups. I want to try to learn from the founders’ early experiences rather than ask questions about “hot topics” or “gotchas.” I like to think of “Founder Stories” as a show that I would have wanted to watch when I was a first-time entrepreneur. That’s how I explain the show to potential guests and also how I think about it when Erick and I come up with questions.

The show is available as a free podcast on iTunes here. It’s also on TechCrunch here.

I’ve never talked to Mike Arrington about this but I’d like to thank him for making long form and respectful content available to entrepreneurs and investors. Erick has also been great, along with Josh Zelman who is the AOL/TechCrunch video producer.

I’d love to hear feedback and suggestions for how to improve the show.