A couple of postings back, I noted on how web startups could get going on much less invested capital, and how startup investing had to adapt. Well here’s another way of looking at it, that isn’t so sanguine.
I’m stimulated by a posting I read recently by Paul Graham of y-Combinator fame (http://www.paulgraham.com/webstartups.html). He is hitting on many of the same points, i.e. that startups can be launched much more efficiently now, that capital needs are lower and time to market is shorter. I couldn’t agree more. He also makes a number of sweeping generalizations that my 7th grade teacher would have nailed me for. I don’t buy the whole message.
But my point here is to say it isn’t all good. Along with a blossoming of inexpensive web startups, there are also a lot of cool apps with hopelessly non-existent business models … if we build it they will come. There seems to be a growing divide between things you can do that will have a big impact on the world, and things you can do that will have a large economic return on investment. I often find myself in a presentation on a new startup idea, where I could definitely use the product, but can’t figure out how they will make a business out of it. I can see clear value in it, but no way to extract that value.
It feels like we are in an Oklahoma Land Rush world. A couple of major paradigm-shifting changes have occurred (the Internet, the cellphone, ubiquitous computers, mapping the Human Genome…), and now we have this whole generation of bright people rushing across the newly opened landscape, seeking homesteading sites to stake a claim on. Some people are doing a good job finding economically valuable homestead sites. Others are just trying to sell wagons and provisions to the incoming flood of homesteaders. Yet others are trying to stake out beautiful view lots that won’t be economically valuable but give a great view (and someday may therefore become valuable). And others are simply enjoying the run in the countryside, and are admiring their beautiful running form.
Many startups I see today are simply not venture investible. That doesn’t make them bad, just not good vehicles for VCs to invest in and get a return from. VCs have to return money to their investors. Hence they can only invest in a subset of the new ideas brewing out there, i.e. the ones that have the potential for a steep increase in economic value over a short period of time. And not likely to help the entrepreneur put food on the table.
But what happens if you can start a company with practically no money and no hassle pitching angels. My fear is that entrepreneurs will expend an enormous amount of effort launching a startup that can never become self sustaining. They have become enamored with their own idea and it’s novelty, and haven’t tested it outside of their narrow circle. And because they haven’t had to go out there and convince others that it’s a good idea --- and pitch the idea over and over again to investors --- adapt the idea to what seems to stick to the wall --- they will ultimately be wasting their time. It may be very worthwhile meaningful work, which makes a difference and draws huge traffic and changes the flow of homesteaders across the prairie, but doesn’t end up making the entrepreneur or their investors any return. In the end, it’s possible the entrepreneur will look back on these years as wasted --- benefiting others but not themselves.
What’s happening on the web is frequently cultural, and not necessarily economic. Great revolutionary businesses are being created, and great cultural changes are happening, but they don’t always overlap. And the test of a good idea is not that it is neat, or that it can be implemented simply and elegantly, or that it can draw many other’s curiosity and interest. The test of a good idea is the value others will place on it, and a good proxy for that value is the money they will pay for it. A good predictor of that value is whether others find it investible, be they angels or VCs.
So I think it is a good thing for entrepreneurs to have to pitch their ideas and convince others to put a value on it. I found in my own entrepreneurial career that my business models and even my technical ideas benefited from being pitched and explained to others. They became more focused and distinct. I recall A-HA moments that happened in front of prospective investors.
I worry about a world where doing things, making a big impact, affecting our culture in a big way, has such a very low cost of implementation. And even pitching some small investors isn’t necessary. I think it is bad even for the entrepreneurs who might seemingly benefit from it.
Tuesday, October 30, 2007
Sunday, October 14, 2007
Angel Valuations on Seed Rounds
In a recent IBF Panel on the topic of Angel and VC cooperation, I made the observation that I believe Angels should avoid valuing startups in priced rounds, and rather should invest using a convertible note. I said that nothing could screw up a follow-on VC investment more than an unrealistic early angel valuation.
I want to elaborate on that observation. First, I want to divide the startup world into two general categories: 1) startups that can reach their goals with a small infusion of seed capital within the reach of angel financing (i.e. less than $1M), and 2) startups that will ultimately require VC scale financing and are raising angel capital to eliminate some risk factor and improve their ultimate VC valuation. Frankly, this is an easy way to divide startups coming to angels. Is this deal a nearly self-sufficient business, or is it seeking seed capital before later going to the venture capital community.
In the first category, angels setting valuations are probably taking a defendable position. But frequently it isn’t clear at the outset whether the angel raise will be all the money the startup raises. So I think the convertible debt approach is still a good way to go. The note should have an automatic conversion privilege after a reasonable period of time, at a clear valuation.
However, more often it is better to assume the seed angel round is a precursor to a later VC round. In this case I strongly suggest that a convertible debt approach is the right way to go. Let me explain why, by showing the pitfalls of angels valuing a deal. Again there are two possible cases: A) setting the valuation too low, or B) setting the valuation too high.
Suppose the angel (or angel group) succeeds in convincing the entrepreneur to accept a lower valuation than a VC would demand, i.e. case A. Frankly, in my experience over the past few decades, this is very rare. Valuations tend to be set by the golden rule --- whoever has the gold sets the rules. VCs have more money in play, with the potential for multiple subsequent rounds, and will therefore be most likely to get a lower valuation. But for the sake of argument, assume that a low initial valuation is successfully negotiated by the angels. In that case, a follow-on VC round will likely see this as an invitation to lower their valuation proposal below what they might have otherwise offered. This will hurt the entrepreneur and the angel prorata. Even if the follow-on VC chooses a more “fair market” valuation, the entrepreneur will still be getting a worse deal. Either way you end up with a less happy entrepreneur, and maybe the angel is unhappy as well.
Now suppose the opposite happens, i.e. the entrepreneur manages to convince the angels to give him a high valuation, higher than he might get from a VC. In my experience, this is actually a fairly common experience. Seed rounds are often made by Friends and Family, and they are emotionally involved with the entrepreneur. They will accept a valuation set by their friend or “son” because “he knows more about this”. But again, for the sake of this analysis, assume the entrepreneur gets a higher than “fair market” valuation. When the follow-on VC comes to see the deal, they will quickly come to understand the valuations previously set and the expectations of the entrepreneur to up that valuation. They know to get this outon the table early. I can say that my VC fund sees this case a lot and it often stops a deal cold. Frequently, the entrepreneur has taken the high seed valuation to heart, and is insulted by a VC opinion that it is excessive. For the VC to proceed, they will have to offer a down round deal. Remember that VCs often are investing to a formula promised to their LPs, that mandates their seeking a certain percentage of ownership. An overly optimistic valuation in the seed round directly hurts both the entrepreneur and the seed angels.
So in summary, if there is even a chance that follow-on VC money will need to be raised, in my opinion, an angel-priced seed round is a lose-lose situation. The best outcome is the angels set a valuation very close to what the VC expects --- and that is exactly what a properly constructed convertible debt deal will deliver automatically.
In essence, a convertible debt deal is saying that the angels want to be in the same boat as follow-on investors, rather than starting out in opposition to, or second guessing them. I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.
But a priced angel seed round is at best a breakeven exercise. Much of the time it will be to the disadvantage of the angel and it will almost always be to the disadvantage of the entrepreneur.
Convertible debt seed financing can be done with a timeout conversion at the angel’s option, with a time matched escalation of reward, and with interest and dividend privileges. In the end, the seed round is very exposed, and angels are investing monies they should never expect to get back. The lack of security for the loan is therefore relatively unimportant. And the conversion will be to a preferred round with all its carefully constructed advantages crafted by the VCs. In contrast, I often see priced seed rounds where the angels bought common stock. That opens the door to the VC constructing preferred terms that put the common stock class at a major disadvantage.
I will acknowledge that this advice is Bay Area centric, where there are many many venture capital funds. When the angel investment is coming in geographic areas with limited local VC financing, the value of this advice is lower.
As a general rule, ANY investment in a startup should be made so that follow-on financing is not inhibited. Valuation can be a big inhibitor to venture capitalists. And VCs will usually craft the best terms to protect their investment. It is better for angels to try to be under that same umbrella.
I want to elaborate on that observation. First, I want to divide the startup world into two general categories: 1) startups that can reach their goals with a small infusion of seed capital within the reach of angel financing (i.e. less than $1M), and 2) startups that will ultimately require VC scale financing and are raising angel capital to eliminate some risk factor and improve their ultimate VC valuation. Frankly, this is an easy way to divide startups coming to angels. Is this deal a nearly self-sufficient business, or is it seeking seed capital before later going to the venture capital community.
In the first category, angels setting valuations are probably taking a defendable position. But frequently it isn’t clear at the outset whether the angel raise will be all the money the startup raises. So I think the convertible debt approach is still a good way to go. The note should have an automatic conversion privilege after a reasonable period of time, at a clear valuation.
However, more often it is better to assume the seed angel round is a precursor to a later VC round. In this case I strongly suggest that a convertible debt approach is the right way to go. Let me explain why, by showing the pitfalls of angels valuing a deal. Again there are two possible cases: A) setting the valuation too low, or B) setting the valuation too high.
Suppose the angel (or angel group) succeeds in convincing the entrepreneur to accept a lower valuation than a VC would demand, i.e. case A. Frankly, in my experience over the past few decades, this is very rare. Valuations tend to be set by the golden rule --- whoever has the gold sets the rules. VCs have more money in play, with the potential for multiple subsequent rounds, and will therefore be most likely to get a lower valuation. But for the sake of argument, assume that a low initial valuation is successfully negotiated by the angels. In that case, a follow-on VC round will likely see this as an invitation to lower their valuation proposal below what they might have otherwise offered. This will hurt the entrepreneur and the angel prorata. Even if the follow-on VC chooses a more “fair market” valuation, the entrepreneur will still be getting a worse deal. Either way you end up with a less happy entrepreneur, and maybe the angel is unhappy as well.
Now suppose the opposite happens, i.e. the entrepreneur manages to convince the angels to give him a high valuation, higher than he might get from a VC. In my experience, this is actually a fairly common experience. Seed rounds are often made by Friends and Family, and they are emotionally involved with the entrepreneur. They will accept a valuation set by their friend or “son” because “he knows more about this”. But again, for the sake of this analysis, assume the entrepreneur gets a higher than “fair market” valuation. When the follow-on VC comes to see the deal, they will quickly come to understand the valuations previously set and the expectations of the entrepreneur to up that valuation. They know to get this outon the table early. I can say that my VC fund sees this case a lot and it often stops a deal cold. Frequently, the entrepreneur has taken the high seed valuation to heart, and is insulted by a VC opinion that it is excessive. For the VC to proceed, they will have to offer a down round deal. Remember that VCs often are investing to a formula promised to their LPs, that mandates their seeking a certain percentage of ownership. An overly optimistic valuation in the seed round directly hurts both the entrepreneur and the seed angels.
So in summary, if there is even a chance that follow-on VC money will need to be raised, in my opinion, an angel-priced seed round is a lose-lose situation. The best outcome is the angels set a valuation very close to what the VC expects --- and that is exactly what a properly constructed convertible debt deal will deliver automatically.
In essence, a convertible debt deal is saying that the angels want to be in the same boat as follow-on investors, rather than starting out in opposition to, or second guessing them. I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.
But a priced angel seed round is at best a breakeven exercise. Much of the time it will be to the disadvantage of the angel and it will almost always be to the disadvantage of the entrepreneur.
Convertible debt seed financing can be done with a timeout conversion at the angel’s option, with a time matched escalation of reward, and with interest and dividend privileges. In the end, the seed round is very exposed, and angels are investing monies they should never expect to get back. The lack of security for the loan is therefore relatively unimportant. And the conversion will be to a preferred round with all its carefully constructed advantages crafted by the VCs. In contrast, I often see priced seed rounds where the angels bought common stock. That opens the door to the VC constructing preferred terms that put the common stock class at a major disadvantage.
I will acknowledge that this advice is Bay Area centric, where there are many many venture capital funds. When the angel investment is coming in geographic areas with limited local VC financing, the value of this advice is lower.
As a general rule, ANY investment in a startup should be made so that follow-on financing is not inhibited. Valuation can be a big inhibitor to venture capitalists. And VCs will usually craft the best terms to protect their investment. It is better for angels to try to be under that same umbrella.
Tuesday, October 2, 2007
How close is Too Close?
A common axiom is “Invest in what you know.” I want to amend it. “Invest in what you know enough about… but not too much about.”
I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.
You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.
In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.
So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.
The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.
I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.
You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.
In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.
So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.
The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.
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