I'm becoming an increasingly big fan of infrastructure services like Amazon's
EC2 and S3. The reason is simple: You pay for what you need at around the time
that you need it. This is the point I made when recently interviewed by Erica
Naoone of MIT Technology Review in an article aptly and succinctly titled "Cheap
Infrastructure".
In the interview I was my usual, highly opinionated self,
but this particular statement that made it into the article jumped out at me:
"There's no correlation between the amount of money an entrepreneur actually
needs and the money a venture capitalist puts into the business." Of course,
there are some qualifiers here: I'm talking about software companies and I'm
talking about the Series A investment (first institutional money). Also, if I
had done the interview in writing, I likely would have said there's
little correlation instead of no correlation. But, my larger
point still stands. The way the system works, you often don't raise what you
need, you raise what you can.
But lets shift gears just a little bit, before we get deeper into the VC
funding stuff.
In the early stages of an internet startup, one thing that's always difficult
is predicting the level of infrastructure that is needed to support the
volume of users/customers. Entrepreneurs often overestimate how popular their
software is going to be. There's also the notion that too much infrastructure
is better than to little because "you only have one chance to make a first
impression." Finally, there's that whole nagging thing about reliability and
uptime.
The net result, before EC2/S3 and similar services, there were few
options. Costs were relatively high and somewhat "spiky" (you bought a few
servers, threw them into a co-lo, bought more servers, etc.). There wasn't a
good way to handle this common situation: "Hey, we only have X users right
now, and we expect to grow by Y%, but we need to make sure we can handle Z users
just in case we get written up on TechCrunch or get on the front page of digg."
You ended up compromising somewhere. Either you spent little (and
dealt with spikes if/when they came as best you could) or spent too much,
resulting in a fair amount of "unused capacity".
Now, back to the VC funding part. When my co-founder, Brian
Halligan first kicked off HubSpot, we
thought a lot about the capital needs of the company. I funded the seed round.
We later successfully raised some angel funding -- about $1 million. We felt
that was enough to get us to the next "milestone" (product launch). The
rationale we had was reasonable: Raise a little money early, raise more
money later. By raising money "closer to when we needed it", we felt we could
continue to reduce the risk, increase the value of the company, and ultimately
dilute less. And in fact, this is how the VC process sort of works. You raise
a Series A, Series B, etc. and each round is targeted at getting a company to
the next "milestone". The problem is, it's awfully "spiky" . This led us to
ponder the other side of this spectrum. In theory, the "optimal" path would be
for us to sell just enough shares every month based on the cash needs of the
company at whatever the right "price" is at that time.
In a way, the Y Combinator folks do
this as the first step. They give founders just enough to get through the first
few months and build a prototype. Many of the YC startups then go on to raise
follow-on funding from VCs. But at that point, the funding process looks like
the usual -- it becomes "spiky" again. We don't have a pure incrementally
scaling model for startup funding anywhere.
Of course this scalable funding model probably only works in theory -- and
even then, it's a stretch. There are lots of reasons why this doesn't work in
practice. Here are just a few:
1. There's no efficient way to appropriately "price" the shares that
frequently.
2. Entrepreneurs don't want to worry about whether they'll have the cash
they need next month.
3. There's likely not going to be agreement on how much cash should
be burned month-to-month.
4. There'd likely be some friction and transaction costs.
There are ways to mitigate some of these challenges, but I still don't think
it's practical and would work. My VC friends (and yes, I do have those), would
likely agree.
But, the geeky and analytical side of me still finds the purity of this model
appealing for the same reason I like Amazon's EC2. You get what you need and
grow incrementally instead of spikily (yeah, I made the word up).
What do you think? Yes, the idea is crazy and wouldn't work, but just
how crazy is it?
One thing I've been pondering this weekend is figuring out why startups
fail. But, in order to figure that out, I had to first decide what constitutes
failure. The more I thought about it, the more I realized that a
definitive failure is when the startup simply stops trying. And, the
only reasons to stop trying are that you run out of cash, or you run out of
commitment -- or both.
Let me elaborate a bit. Lets say your startup had an unlimited amount of
cash (hypothetically). Whenever you needed money, you'd go to the money tree,
pick some more cash, and go back to your business. If this were the case, it's
likely the number of startup "failures" would be vanishingly small. Why?
Because you haven't failed yet, you simply haven't figured out the model that
works. As long as you still had commitment, you could keep going indefinitely.
Of course, there's no such thing as unlimited cash.
Similarly, lets say you had a day job, and your startup didn't really require
any cash. And, you were fanatically committed to your vision or idea. In
theory, you could run your startup for decades and still never really
"fail". You'd just keep going and rather than being a failure, you'd be a
startup that hadn't succeeded yet. As long as you were committed, you could
just keep going.
So, with that set of abstract concepts in place, let's dig in a little
deeper.
Constraints On Cash and The Paradox of Venture Funding
Given that you have a finite amount of cash, how long your startup can
survive is a function of how much cash you put in (revenues + funding) and how
much you take out (expenses). You'd think that a venture-funded startup would
be more likely to succeed, because it has longer to "figure it out" (i.e. more
time to get to success). But, I'm not sure that's true. What ends up happening
is that VC-funded startups tend to increase their expense-base such that their
time horizon is actually pretty short (about 1.5-2 years on a Series A
funding). On the flip-side, a bootstrapped startup might not have a large
influx of cash, but might actually have more time to figure things out.
As an example, my first startup was bootstrapped. No VC funding. We did
things the old-fashioned way. We charged people money, and spent less than we
made. We were profitable from our first year of existence (and remained that
way for 9+ straight years). We were profitable, because we had no
choice. How much we spent was always a function of how much we made. In
the long run, we didn't grow as fast as we might have otherwise, but overall we
succeeded.
Contrast this to a couple of venture-backed competitors of this bootstrapped
startup. They had each raised $25MM+ in venture funding. Of course, this was
in the midst of the bubble, but the lesson is still similar (it's an issue of
magnitude). These companies ran through their cash, and couldn't get funding to
keep going. They failed.
This is just one data point, and it would be silly to try and generate any
conclusions from it. But, it does generate an interesting idea:
Perhaps startups should simply be trying to give themselves enough time to
figure out what will work. And, the time available is not a function of the
amount of cash raised, but the amount of cash being consumed.
Profitable startups don't consume cash -- they generate it. Hence, they've got
more time.
For the record, my current startup, HubSpot, is venture-funded. This means I have some work to do
to figure out how to get to the point of having an infinite amount of time to
figure things out (otherwise known as becoming profitable). The good news is that profitability is something we actually talk about (which you would think would be a common conversation in startups, but it's not).
In a follow-up article, I'll discuss the tradeoffs between bootstrapping and venture funding a startup. Having seen it from both sides, I'm beginning to form an opinion (always a dangerous thing).
For those of you that are
regular readers, you know that as a policy, I don't often do site reviews of
other startup-related websites -- let alone pour gushing praise on a single
one. But, every know and then, I feel compelled to make an
exception.
If you're a startup
entrepreneur, head on over to
Venture
Hacks, read their content and subscribe to their RSS feed. You'll be glad
you did.
Disclaimer: I don't know
Nivi and Naval (the guys behind the site) and I have no personal bias or
conflict. I simply love the content on the site.
The reason I like the site
so much is that it provides a rare glimpse into the black box of venture capital
(and venture capitalists). For the most part, the industry is pretty closed and
very few (except insiders) really get a glimpse into the details of the
process. The reason is simple: For those that know enough to write about it,
there' s rarely an incentive to do so. For those that don't know the innards of
the business, you're not going to learn much that you couldn't pick up on your
own through other sources. VentureHacks is the rare case where the authors know
what they're talking about and are brave enough to actually do it. As
an added bonus, they're witty and edgy too.
5 Reasons to Read
VentureHacks
1. VC Negotiation
Is An Art Form: As an entrepreneur, there are few things more
"nuanced" that you'll deal with than raising institutional capital. Even if you
decide not to raise venture capital, a lot of these skills and deal-terms will
likely show up in other dealings you have (strategic partners, M&A
transactions, etc.).
2. The Devil's In
The Details: Most entrepreneurs focus too much energy on the "obvious"
things like valuation. Fact is, there are other, non-valuation terms in the VC
deal (vesting, stock option pool, liquidity preferences, etc.) that have a
significant impact on the economics of your deal. It's easy to lure yourself
into thinking you should solve for the highest valuation. But, in most cases,
that's sub-optimal.
3. Great Advice Is
Hard To Find: As it turns out, good advice in the VC business is hard
to find. I would define good advice as a combination of competency (i.e. well
informed) and objective (i.e. non-conflicted). You can get close sometimes (via
lawyers, adivsors, etc.) but it's really hard to find great
advice.
4. It's Not Enough
To Be Smart: It's importat to remember that regardless of how smart you
are, VC negotiation is not just a matter of raw intelligence. Sure, it helps t
have a few brain cells to understand the dynamics of a deal, but a lot is hidden
away in the dark corners that you only ever learn by doing it. It's also
important to remember that the VCs do this for a living. Hopefully,
you don't (you're building businessees for a living). You may be twice as smart
as they are, but you're still at a disadvantage. Try to even the playing field
as much as you can.
5. It's
Intellectually Fascinating: Even if you're not planning on raising
funding yourself, I think you might find the whole VC game intellectually
interesting. Further, by getting yourself educated, you can perhaps help
someone else that's a total newbie navigate the waters (See
#3).
In short, go read
VentureHacks. It's worth the trip.
Nivi/Naval: If one of you stumbles into this blog article somehow, drop me a
line. As a small token of appreciation, dinner's on me.
This past week, I was on a
panel discussion at MIT on the topic of raising funding for an early stage
startup.
Also on the panel was
Michael Greeley from IDG
Ventures. Michael was representing the VC perspective whereas I was there
speaking primarily from an angel perspective (and alternative sources of capital
like friends, family and fools).
Here are some of the
questions that came up in the panel. Since I didn't take notes during the panel
myself, this is my best recollection from the two hour session. Please note that this is not legal advice
and if you are raising funding, you should consult counsel on all legal
matters.
1. If I raise
capital from friends and family, do they have to be accredited
investors?
Generally, yes. Though
there are ways for pool together interests from non-accredited investors, it's
usually not advisable as it can get tricky and complicated.
2. To raise VC
funding, do I need to have a complete management team
assembled?
Not necessarily. Many VCs
do not mind considering startups that have an incomplete management team. Some
will actually see gaps in the management team as a positive as that is an area
that they can help with and bring value to the startup.
3. How do I
negotiate the highest pre-money value for my
startup?
Entrepreneurs are often
overly obsesssed with the pre-money valuation of their startups. Though this is
an important factor in the negotiations, it is by no means the only one. Often,
non-valuation factors like corporate governance, control and preference issues
end up being much more important than the valuation. Entrepreneurs should look
at the deal as a whole and understand the details.
4. Do investors
read business plans?
For the most part, no. A
great business plan will not guarantee funding (or for that matter, even a
meeting). If you find the crafting of the business plan helpful, then you
should do it. But, investors do not generally require a detailed, written
business plan.
5. Do I need to
have formed a legal entity before approaching
investors?
It's not required for
investors prior to approaching them for funding, but is often a good idea
because it is relatively simple and inexpensive to do.
6. How do VCs
value companies?
This is an imperfect
science. A common approach is that VCs will determine what the company could be
worth at the time of an exit (IPO or acquisition). They then work backwards
from there, determining what percentage of equity they need to own to generate
the desired returns for their limited partners. Of course, they apply this
approach across a portfolio of investments expecting that a small percentage
will generate significant returns.
7. How do I find
angel investors for my startup?
There's no single answer to
this. In major markets like Boston and San Francisco, many angel investors are
members of angel groups. These groups pool together expertise and resources in
order to make better investment decisions. Of course, there are also private
investors acting independently. Generally, you'll want to find investors that
have a background in the particular idea you are pursuing -- or, an affinity for
it. Angel investors often invest for reasons beyond just pure financial
return. One common reason is to stay involved in the entrepreneurial process
and help entrepreneurs build great companies.
8. How do I pick
the "right" VC?
There are a number of
considerations. First, you should verify that the VC makes investment in the
stage and type of company you are building. Also, it is important to remember
that you are not just picking a firm, you are picking a partner within
that firm. Ideally, you'll find a partner that has made similar investments in
the past and has knowledge of your market.
If you have any other
questions, leave a comment and I'll do my best to answer. Please remember that
I'm not a VC, and don't play one on TV. For content that is much better than
this, I strongly recommend
Ask The VC by
Brad Feld. It's a great source for information on the VC industry and the
process of raising money.
This week (Monday, April 2nd) was
the deadline for startup founders to apply to be selected for the upcoming batch
of startup companies to join Paul Graham's Y Combinator group. If this year is
like past years, YC will likely have received lots of applications (which means
Paul's going to be a busy guy for at least a week). And, if this year is like
years past, then not all great hacker-entrepreneurs will get
selected.
If you applied, and didn't get
selected, this could be because of one or more of the following
reasons:
1. You lack a co-founder: YC leans
heavily towards startups with at least two co-founders. It's possible you tried
to find a co-founder, but couldn't. Or that you found one, but it didn't work
out. Or that you just don't believe in co-founders just
yet.
2. The idea doesn't fit the
profile: YC seems to lean towards consumer internet ideas, or ideas for which
an early user community can be built quickly and monetization can be done
later. If your idea is to develop enterprise software for the steel industry,
chances are, you're not going to get picked.
3. Your application didn't stand
out: Paul's an awfully smart guy, but he's still not clairvoyant. If your
brilliance and passion didn't come through in the application, it's possible he
just fundamentally missed it. It happens.
4. You really don't have what it
takes: It's possible that you simply are not particularly suited for a startup
at this time and the smart folks at YC were able to figure this
out.
Lets assume for a minute that you
didn't make the cut at YC for reasons #1, #2, or #3. So, what
now?
I'm going to make you an interesting
offer: A chance to show off your hackepreneur
skills.
Basically, what I'd like to do is
find exceptional individuals that are really committed to building cool
technology and are determined not to go work for "the man" and want to do
something entrepreneurial (if you applied for YC in the first place, chances
are, you fit this profile).
Here's a high-level look at what I
have in mind:
1. You don't necessarily have to
have a co-founder.
2. You'd still have to be move to
Cambridge (or
already be in the vicinity).
3. I'll give you $15k to work for
the summer and impress me with your talent.
4. You have to be willing to work
on an idea that is not your own (we have a few laying around).
It's basically an opportunity to
join a small, highly entrepreneurial group working right on the MIT
campus and work on an interesting project -- and get paid a bit of money for
it. After the summer is done, either we talk each other into doing something
more permanent, you talk me into funding your original idea or we part ways as
friends and hopefully had a shared positive
experience.
If you're intrigued and think you
might fit the profile, send a detailed email to hackepreneur (at) onstartups.com. Ideally, you'd send me the same kind of information you sent in for your YC application (you can get an old YC form here, if you need it). If you're worried about revealing your idea, leave that part out. I've got the capacity to accept three or four of
you (assuming there is enough interest and we can work out a deal), but chances
are, I'll only pick one or two. I've got really high standards too.
Hope to hear from some of you. But
in the meantime, I wish you the best of luck with your Y Combinator application.
It would be great if you are one of the select few that make it in to Paul Graham's Gang For The Gifted. But if not,
perhaps I can provide an interesting "Plan
B".
Void where prohibited, no purchase
necessary, your mileage will vary and all the other usual
disclaimers.
April
2 is a significant date for many early-stage entrepreneurs as this is
the deadline for applying to Paul Graham's Y Combinator this summer. If
you don't know about Y Combinator, then I encourage you to read up on
it as they are one of the few groups doing anything remotely
interesting as it relates to very early-stage investment in startups
(with an emphasis on software startups).
I've been following
Y Combinator for a while now and have known people that have applied
and been accepted, applied and not been accepted or consciously chose
not to apply at all. In preparation for this article, I contacted
several of these people to get a sense of the high-level pros and cons
of joining the group. Thanks to all of those that offered their insights and
comments.
Disclaimer: I am in no way affiliated with Y
Combinator other than having followed the group for a while and having
met both Paul Graham and Jessica Livingston. As an early stage investor myself, I guess I compete at some level, but my investment activity is not that significant and my approach is very different.
So without further preamble, here are my thoughts:
Why You Should (Or Shouldn't) Apply To Y Combinator
1. Forced Focus: Lots
of early stage entrepreneurs have several ideas in their heads (and
sometimes even several semi-working projects too). One of the toughest
things to do in this situation is to actually pick one of the
ideas and dig into it a little bit deeper. Since it is unlikely that Y
Combinator will fund a "portfolio of ideas" from a single founding
team, it forces a degree of focus. This is a good thing.
2. Great Network: I
must admit that I'm a little envious of the network of exceptional
people that are involved with Y Combinator. This extends beyond just
Paul Graham and Jessica Livingston and goes to all the great people
starting companies and those that are following what Y Combinator is
doing and provide their support.
3. Instant Early Adopters: One
of the hardest things to do when getting a new project off the ground
is finding that early mass of users to actually try it and tell you why
it sucks. No doubt it sucks, because all early software projects suck
in some ways, you need to know why it sucks. Y Combinator is
exceptionally good at delivering some instant users for any
project/company that it is involved with.
4. Limited Funding: The
amount of capital invested by Y Combinator in any founding team is
limited. The amount is $5k base + $5k per founder. So, if you're a two
person team, you can expect about $15k in funding. This is not a lot of
money, but it seems to be enough for many teams of "capital efficient"
founders to get a prototype built over the summer. I think the amount
if a bit arbitrary, but I can't fault them for that as trying to make
case-specific decisions doesn't scale. As an entrepreneur (even an
early stage one), I just don't think that level of capital is
interesting enough to make it worth taking outside capital. So, if
you're applying to Y Combinator, chances are, you aren't really doing
it for the funding – but mostly the other benefits.
5. Follow-On Investments: Y
Combinator has a reasonably good reputation for producing "interesting"
companies. As such, for those startups that need funding beyond what YC
puts in, the fact that they've been one of the chosen few likely gives
them an edge over a random startup looking for angel/VC money. Paul's
network is also pretty strong and he can "draw in" outside investors. I
was invited to the last "Angel Investor Day" the company held whereby
each of the YC startups had a chance to present to a group of
interested potential investors. What I liked about this particular
forum (from the entrepreneur's perspective) is that it is held on their
"home turf" and was relatively informal and easy-going. Very different
from the unpleasantness that is usually associated with meetings with
VCs.
6. Relocation Requirement: If you're
accepted, YC requires you to relocate to one of two locations
(Cambridge for the summer program and the bay area for the winter
program). Whether you want to relocate or not is a personal decision,
but I agree with the forced relocation. There is a lot to be gained by
being in the physical proximity of both the YC network and
being in one of the major centers of startup activity here in the U.S.
I think for early-stage software entrepreneurs building web companies,
it's particularly important to be in a conducive environment.
7. Projects vs. Businesses: Personally,
I think YC is really selecting interesting teams and projects and not
really concerned with selecting what may (or may not) become "real"
companies. Though there's nothing intrinsically wrong with that – it's
simply an investment selection thesis they've formed, I'm not convinced
that it's really good for the entrepreneur. Though I like the idea of
focusing on users/customers first and letting the details work
themselves out later (i.e. projects), I think there's some value to
actually thinking about business models earlier in the process. Simply
identifying market opportunity (i.e. how do you make money) does not
necessarily reduce creativity and your ability to succeed at building a
product people will like. I think YC leans a bit too heavily towards
the "build it and they will come" model and for inexperienced
entrepreneurs (just about all of the YC founders), this can distort
reality. It's much for fun to think about the project, and I'm all for
being passionate about the right thing – but a little bit of balance is
healthy.
8. Teams vs. Individuals: YC
leans strongly towards selecting startups that two or more founders.
I'm a strong advocate of this myself as I believe that having two or
more founders in an early-stage startup significantly improves the
chances of success. By explicitly stating this requirement, YC forces
early-stage entrepreneurs to find co-founders. This is a good thing as
if there's a problem with finding a co-founder, that's an early signal
of a problem (either with the founder or the idea or both), and
everyone's better off knowing that sooner rather than later.
9.
Startup Valuations: Early-stage
valuations are a black art. There's very little data to go on, so it
simply ends up being a combination of market forces (who else is
looking to invest) and prior precedence ("…most Series A VC startups
are getting between a $4MM - $6MM pre-money valuation…"). Though the
valuations that YC provides for early-stage companies is rumored to be
low (< $500k in most cases), it's not really fair to call this
valuation low. For one, they're not competing with many other
early-stage investors. This is the stage I like to invest in (i.e.
smart founding teams with a decent idea and the ability to crank out a
product people might love), but to be candid, I'm no Paul Graham. So,
in the absence ofno multiple potential buyers, there's no real "market"
so it'd be wrong to call the valuation low or high. It just is what it
is. If it were me, and all the other positive YC forces weren't in
play, I'd be bootstrapping in the early days, validating the idea as
quickly as possible and
then looking for outside investors.
That's
all I have for now. Overall, if it were me and I was just out of
undergrad and looking to build a software startup, I think I probably
would have applied to YC. I started my first company with $10k (so the
funding itself is not that important nor necessary), but the other
components are extremely helpful.
Before we get too deep into this, let me clarify two things.
When I say without a “plan”, I mean without a formally
written business plan – not that you should be clueless about what you
want to do. And, when I say startup funding, I’m talking more about
early stage seed funding via angels (though most of these tips should apply to
VCs as well).
As a member of the local Boston entrepreneurial community and a
part-time angel investor, I come into contact with lots of new startups at
various stages of the process. It continually amazes me how much time
some entrepreneurs spend time writing (and rewriting) a business plan. Though
the planning process can often be
very useful, the degree of efficiency is often very low because taking your set
of thoughts, ideas, brainstorming and research and trying to “capture”
it in an externally consumable document is really hard and takes time. For
every 10 minutes you spend “thinking” about things (and actually
planning the business), you might spend an hour trying to get it into a form
that might make sense to the reader of the document. And, the real irony
is that very few people will ever
read the full document.
One of the main reasons I’m not a big fan of business
plans is that things change. Instead
of spending time writing a business plan and continually refining it, I’d
much rather see an entrepreneur testing the
market and refining the approach. Josh Kopelman posted a great
article on his recently titled “Failing
Cheaper”. It’s worth a read.
In any case, here are some thoughts I have on how you can
increase your chances of getting funding without going through the misery of
writing a formal business plan. I’m assuming here that you have the
ability to at least get an audience with a potential investor or investor
group. If not, then you have a different problem (and a business plan is
probably not going to help with that).
Quick Tips On Raising Startup Funding
Without A Plan Or A PowerPoint
- Have A Story: People like stories. Stories are
exciting. They have characters, they have a plot (even a small one).
Your story can be about a use-case (i.e. how will your product be
used to solve a problem). The story can be a description of how you
uncovered the opportunity: “There I was sitting in my office at
a big company and we needed a way to do [X]. We were losing customers,
hiring consultants and otherwise frustrated because we just couldn’t
find a way to get [X] done. Then I thought, here’s a simple
way to solve part of the problem…”. The story can be
about some anticipated “future state”. Example: “In
2 years, we believe that those that grew up with the Internet will no
longer accept the inefficiency that exists in most doctor’s offices
today.”
- Demonstrate Leverage: Different people call this different things (a
common phrase is the “unfair advantage”). Basically,
what you need to do is communicate what kind of leverage you have (or are
likely to get). Some of my favorite points of leverage that few
early entrepreneurs talk about is their capital
efficiency. Example: “We’re two college
students that have come across this really exciting market opportunity. We
think we can get build this with less than $25,000 while living on red
beans and rice and working out of a shared apartment…” This
leverage point basically says you’re going to learn your lessons
cheaper than others that may be doing the same or similar things. [Note:
Everyone is going to have to
learn some lessons, the question is how much money are you going to spend
learning them?]. Other favorite leverage points of mine are:
access to a group of customers (from a prior job/life), access to a
potential partner or distribution channel, access to unique “talent”
that can build the product, pre-written IP (you’ve already got a lot
of the code you need from a side project you’ve been working on),
etc. Basically, the idea here is to try and explain why you will
have a disproportionate chance of not screwing this up completely.
- Accept That Your Baby Is Ugly: Just like most parents think
they have beautiful babies, most entrepreneurs think they have beautiful
startups. In reality, just about all startups are ugly in the early
days. Don’t spend time trying to explain to others why your startup baby is beautiful. It’s
not. Instead, spend energy explaining why your baby is going to grow up into something that’s
beautiful. Describe how you’re going to tackle the problem of
building the product, finding customers, dealing with support, etc.
- Dream Big, But Plan Small: In the early stage process, entrepreneurs that
can get things done cheaply and efficiently are more likely to get funded.
The reason for this is simple. Too much cash allows you
to delude yourself into a false sense of what the market really wants and
how you might deliver it. The less cash you have, the more quickly
you have to deal with the really hard things (like figuring out a way to
get people to part with their money and buy your offering). Most
early-stage investors know this. Even though I know an idea is likely going to take
more cash than the entrepreneur things, I prefer backing people that believe they can do it with little
cash and try to do so. As Josh said, learn to fail cheaper.
If you’re new to the early-stage fund-raising game, it
is easy to fall into the trap of thinking that the only thing standing between
you and some angel funding is a pristine business plan with sparkling financial
projections and prose that is so compelling that the checkbook practically
leaps out of the investor’s pocket. I’m here to tell you that
this is simply not the case. Most startups today simply don’t know
enough about what they’re actually going to eventually become in order to
get it down in the form of a business plan.
If you’ve ever attempted to raise VC for a startup, you likely know that it is a long process that takes months. One thing I’ve found particularly intriguing is that outside of bubble-like times, the average time it takes a deal to get done (and money to exchange hands) doesn’t seem to change a lot. Though many other industry sectors have shortened the delivery time of their offering in reaction to the fact that we live in a fast-faced society where timeliness trumps other factors, the VC industry doesn’t seem to have changed a whole lot. Dell can ship you a custom computer faster, FedEx can deliver a package quicker and home loans can be approved more rapidly than what we have ever known before. But, VCs still will take months to work through a deal and write a check.
My fundamental question is this: Is the investment return a VC generates for its limited partners correlated somehow with the time spent in due diligence? The reason I find this question interesting is that there is a sneaking suspicion I have that VCs, like other people, form very quick decisions on whether a startup is or is not funding-worthy. If this is the case, and they’re forming their decisions early-on anyways, it seems inefficient to spend inordinate amounts of time on due diligence – as it likely will not change the original decision often-enough. So, I asked VC friends as to why they do this. Why spend months on due diligence if it is not likely to change the outcome?
The answer, paraphrased from VCs, goes something like this: “It takes some amount of time to get “comfortable” with a startup before we write a check. Not all of this time is spent doing deep due diligence. A lot of the time is just spent letting the deal “bake” in our (the VCs) minds. Often, it is during that “think” time that we’ll come up with insights into the business and market that we would not have otherwise. Sometimes, it’s simply a matter of getting educated on the space, educated about the founders, etc. Often, during this “due diligence” time (where often, not that much due diligence time is being spent), we’ll come up with good reasons not to do the deal. These reasons would not have occurred to us in the early conversations.”
This actually makes pretty good sense. If the VCs are not having to invest all that much time/energy in “deep” due diligence in the weeks and months that pass, and they do indeed “discover” things that cause them to filter out opportunities that are later determined not to be of sufficient value, then it seems that VCs should do exactly what they’re doing. Why close a deal in days or weeks? You sometimes have a small risk of losing the deal, but since everyone else behaves this way anyways, there’s little that an entrepreneur can do to accelerate the process.
From an entrepreneur’s perspective, the situation looks something like this: The VC will likely make a spot decision (within a day or two) as to whether you’re worth even investing the time in. But, you’re not going to get a direct “no” (I’ve written about this phenomenon before). But, from the time that they make the mental decision to invest, they are looking to leave themselves enough time to talk themselves out of the deal. If they fail to talk themselves out of the deal, they’ll close it. During this time, where there is no possible way they’re going to reach a “close”, VCs are likely to ask entrepreneurs for deeper, more exhaustive information. The frustrating part is that not all of these requests are so they can learn more about the company, which will influence their decision. . Some of it is simply to ensure there is adequate time for them to talk themselves out of it. Unfortunately, it’s hard to know the difference, you have to respond to all due diligence requests as if they are somehow going to change the outcome. Such is the life of an entrepreneur raising money.
Interesting Idea From Left Field: What if a new VC came along that offered entrepreneurs a quicker, less painful process to raise capital for their startup? Would this VC be able to attract a better class of entrepreneur? Entrepreneurs that would rather focus on their business and customers than on raising capital? Or, would this new VC be doomed to failure because they were not allowing themselves sufficient “bake time”? Could some of the risk be mitigated by having a “probationary” period for the capital. For example, in a $4MM round, the VC has the ability to retract up to 90% of the investment within 90-120 days if the deal isn’t what they thought it was? This kind of approach will likely never occur, but if you look at entrepreneurs as the “customer”, then I’m pretty sure there are a pool of customers out there that would like more rapid “service” than they’re getting now. Will we see innovation in the VC sector anytime soon, or is it by design immune to the need for change?
If you are a VC, or play one on TV, would love to hear your thoughts on this. What am I missing?
This article is in response to an excellent article Paul Graham posted recently titled “
How To Present To Investors”. If you are the founder of an early-stage startup and expect to pitch your company to angels or VCs someday, I highly recommend the article.
Paul’s article was motivated in part by the fact that Y Combinator (the early stage investment firm in which he is a partner) is hosting an event called “Angel Day”. On Angel Day, the current crop of Y Combinator startups (companies that he and his partners have funded recently) will be pitching to a group of potential investors. I’m scheduled to attend this event, as one of those potential angel investors.
Having been on both sides of the fence (heard pitches and given pitches), I have come to realize that many articles have been written to provide advice to entrepreneurs on how to make effective pitches to investors. What hasn’t been covered much is the reverse: what investors should do to maximize the value they get from startup pitches. Hence, this article. To keep myself focused, I’ll pretend I’m writing to other attendees of the Y Combinator Angel Day presentations. However, most of these tips should apply equally well to other similar situations.
How To Watch A Startup Presentation
- If You’re There, Be There
Nothing surprises me (or irritates me) more than having people attend a startup pitch and them mentally “check out” within minutes. A popular activity is checking email on a Blackberry. Assuming that this activity is not intended to convey some sort of importance (I think most investors are not that insecure), I can only guess that this comes out of a force of habit and a short attention span. My advice: If you thought the meeting was worth your time to go, you are being inefficient if you’re not engaged. Even those with the best pattern matching algorithms in the world need
some inputs into those algorithms. If you’re there, be there. You’re wasting your time otherwise.
- Learn Something
It is entirely possible that the pitch you’re hearing is of absolutely no interest. It may be an idea that you don’t like, a category that you’re not interested in, etc. However, I think it’s important to remember that the best startup founders have spent a lot more time thinking about the problem. In the case of Y Combinator companies, they’re not only building products to solve a problem, they are likely
part of the larger target market. These are the early adopters and people keeping their pulse on technology. As such, there are lots of important things to learn about the state of the industry and where things are headed.
- Keep Things In Context
I’ve seen a number of startup pitches where someone in the audience asked one of the standard questions. The most common being: “That’s great, but how are you going to make money?”. Though business models are certainly an important factor, in the first pitch (and particularly in a format like the Y Combinator presentations) it is unlikely you’re going to get a thoughtful and productive answer. So, unless you’re there purely to rationalize why this is a terrible startup and why you’d never consider putting money in – try to remember the limitations of the format and context. If you have to ask questions, ask ones that will actually
tell you something useful.
- Focus On The Problem And The Solution
Many startup presenters have little or no formal experience pitching to anybody – let alone a group of smart but cynical investors. So, don’t judge the quality of the startup based on the polish of the presentation. In fact, at this stage in the game, if the pitch is really, really polished it could be a mild signal that one or more of the founders cares more about the pitch than they do about the problem. I tend not to penalize startups for having
good presentations, but it’s also important not to penalize them too much for having mediocre ones. Let the passion for the problem shine through.
- Give Back Something Useful
Many startup founders (particularly the Y Combinator ones) are early in their careers. They’re working hard to solve a problem they care about. The ones I have met are genuine entrepreneurs. Though you may or may not like the current idea, I think it is important to support those pursuing their dreams and taking the entrepreneurial leap. Be candid, but be constructive. These are really smart, hard-working people willing to listen and take input. Though the investment may not make sense for you, it doesn’t mean that you can’t help in some way. If you’re an angel investor, chances are that you were in their shoes once too.
- Be Courteous and Polite
This is likely going to be the most controversial item on the list. Many investors need to remind themselves that startup founders are people too. (Though in some cases, I think investors don’t discriminate – they’re equally discourteous to everyone). I’m not sure why, but I’ve found that people investing their own money (angels) are usually more courteous and polite than those investing other people’s money (VC) – but that’s a topic for another day.
I look forward to seeing the Y Combinator companies later this week. If you’re one of the startups presenting – or one of the investors attending, drop me a note.