If Einstein were alive today, what would he think of our investment markets? He is vaguely attributed to have said that compound interest is the “most powerful force in the universe” but the evidence supporting this attribution is weak.
However, he would surely find it curious that we now live in a world of negative interest rates, where more than US$2 trillion has been invested in negative bond yields and banks are charging interest rates on deposits. Although the word deflation is constantly used in the media, the reality is still inflation, so whether measured in nominal terms or real terms there is no doubt that we live in a time where a certain group of borrowers are able to get paid to borrow money.
Since the driver of these interest rates is the cost of time, the financial sector has accidentally created a way for money to reverse the effects of time.
Besides being surreal, why is this important?
The obvious answer is that no serious investor should want to invest their assets into negative return assets if there are better alternatives. It is both a pessimistic view of the world and an inefficient use of assets.
Large companies are also taking a cautious view of the world, preferring to spend on share buybacks rather than new investment, with a record US$900 billion spent on buybacks and dividends in the US alone in 2014. In this case, share buybacks create the illusion of growth by shrinking the denominator, the number of shares outstanding. At an individual firm level, this can sometimes be the right strategy but can society overall shrink its way to prosperity?
For context, it helps to look at the size of investment at the opposite end of the investment spectrum, early stage companies focused on growth. Overall venture capital investment in the US was a record US$48 billion in 2014 and a closer inspection of the data shows that early stage deals received US$1.3 billion.
In today’s world, when the opportunities to create value through innovation are more exciting than anytime in history, society is investing the largest amount of money in the most pessimistic assets with the lowest expected returns and investing the least amount of money in the assets with the largest potential to create new innovation and highest potential returns. These are symptoms of a deeper problem: failure of the imagination.
As an early stage venture investment fund, this actually works better for us because it means less competition. Ultimately, however, early stage investment is not a zero sum game and so we would rather have more people invest to create more overall value.
Finally, if the perception is that there are no assets that can generate meaningful returns given the risk, investors are better off giving their money away because there is no shortage of social issues which have not been solved by markets.
Circling back to Einstein, some people may argue that he would be in favour of the current asset allocation by society because it appears to be made by rational decision making in a scientific manner. But his comments suggest otherwise. In Einstein’s own words, “imagination is more important than knowledge.”
Being an early stage investor is now a status symbol. For individuals, funds and companies. Unfortunately, not everyone should be an early stage investor focused on the seed stage. What are the key considerations?
How much time do you really have? This is the first question for everyone, from small angel investors all the way up to large corporates. No matter how much money you have, your main constraint is actually time. The most common feedback from people who have just started to invest in early stage companies is that the time commitment was beyond their expectations.
Every single investment made takes significant time, both in terms of due diligence before the investment and, more importantly, support after the investment. To build up a successful early stage portfolio, diversification helps because of power laws and so at least 15 investments but probably closer to 30 is the right size. In addition, to even find a single investment, most investors should first look at 100 potential companies. When you multiply the time commitment through that funnel, it suddenly starts to look like a full time job for one or more people.
Where is your geography? The traditional approach to geography in early stage investing is hyperlocal. The upside of this philosophy is the close contact with the founding team. The downside of this philosophy is that your universe of opportunities has been reduced significantly and you probably lose the broader perspective of what is happening in other markets. In today’s world, not having a global perspective is a competitive disadvantage.
Some investors, including ourselves, take a cross-border approach. While this provides a significantly larger universe of opportunities and a more diverse perspective, it is extremely difficult for most people to execute in practice. You need a team that is comfortable across both physical distance and cultural nuance. Most early stage investors are actually better off partnering with someone who knows how to do this rather than trying to replicate this skill set in house because it is not easy.
Who is your network? Clearly the quality of your network will be a key driver of both your investment opportunities and the value you can provide after investment. In the past, having a network of strong connections to people in high places was the ideal. Access by itself was a key asset. As the cost of building an early stage startup has collapsed, the doors for everyone else have opened up. Knowing people in power will always be valuable, but it is not the most important feature of a network anymore.
Instead, the ideal network is diverse and connects small worlds with loose ties. This means spending time with different kinds of people across demographics and skill sets. Unfortunately, most investors are simply not experienced with diversity. If you do not have a diverse network, find someone who does and partner with them.
What is your value add beyond money? Ultimately, money by itself is a commodity. At the early stage especially, where the capital requirements are smaller, having more money is not by itself a competitive advantage. In fact, the pressure of having large amounts of money to invest is actually counterproductive at the early stage.
Therefore, all early stage investors need to bring additional value beyond money. As discussed above, network diversity is a key point of differentiation. Domain expertise is another helpful factor and is fantastic when it works well. The challenge with domain expertise is ensuring that the investor is not trying to be an operator and run the business for the entrepreneur. It is important to ensure that investors understand the reality of what hands-on vs. hands-off really means. Ultimately, most investor value add is useful when it is complementary to the skills of the founding team, filling a gap. By definition, this is unique for each company.
Why are you investing? If your motivation is to find a status hobby, you will be in for an expensive lesson. When it comes to hobbies, collecting classic cars would be cheaper and cooler. While this goes for individuals, the same logic applies for more sophisticated investors. Family offices who want to dabble in angel investing because of the fun factor may be attracted by the hype but ultimately will find it both less profitable and less enjoyable than expected. Even corporate investors, who have jumped in aggressively into venture capital, need to have a clear strategy. In all the cases, from individual angels through to the largest companies, it is important to have a deeper motivation than simply because of the excitement.
Some people invest simply to learn while of course many also want to make money. In both cases, you may actually be better off by investing in a fund or syndicate because having a more experienced investor will most likely result in stronger learning and higher returns as compared to simply making your own basic mistakes. The data shows that early stage investors fall into two categories: those who know what they are doing and those who don’t.
There is no question that we need more early stage investors. But before jumping in, ask yourself the above questions. If the answers still convince you to jump in, then go for it. If the answers create some hesitation, then find more experienced investors and partner with them so that you can still get the benefits without creating new headaches for yourself.
Everyone is talking about replicating and building the “next Silicon Valley” with the rise of Silicon “roundabouts” and Silicon “beaches” in several locations around the world. While this is going on very few people are talking about how Silicon Valley is evolving: specifically that Sand Hill Road is now the Wall Street of the West Coast.
The rise of the “Uber” Round
More and more tech startups are raising hundreds of millions or even billions of dollars in later stage “uber” rounds. (I call these the “uber” rounds as a play on the German for “super” or after the company Uber that has raised well over $4 billion in Venture Capital.) As of this writing, Lyft has just closed a $680 Series E. According to Crunchbase, Lyft is one of 20 startups that have raised $1B or more in venture funding in the past 5 years.
Companies are going public later and later, a trend started by Facebook; instead of rushing to an IPO, companies are staying private longer and are taking more and more uber rounds. (Some people think that these companies should be going public as the investing public can’t participate in the later stage growth, allowing the rich to get richer.) The average amount of money that companies have raised before going public has been going up, more than double since the 2008 downturn.
What is Going On?
Most pundits think that companies are staying private longer to avoid the hassle and expense of going public as well as regulations like Sarbanes-Oxley. While those are all reasons to stay private, the real reason is that Silicon Valley VCs on Sand Hill Road have evolved to grow larger and focus on late stage massive growth.
Typically an IPO is for massive growth. A company will get to a certain stage of maturity and then raise anywhere from $300m to over a $100b at an IPO. The IPO accomplishes a few things: allows early investors and employees to “cash out” and sell their shares to the public as well as provide much needed capital for massive growth.
Today companies are delaying the IPO and raising the growth capital with their uber rounds. On the surface this looks crazy. But in reality, it is genius.
Lean Startup and Uber Rounds
Let’s take a made up startup LeanCo as an example. Assume LeanCo already took a Series A ($8m) and Series B ($30m). Now they are kicking butt and are growing at the same rate as the other high performing startups. Say they have well over $250m in sales, expanding market share, healthy margins, and are expanding internationally. This is the textbook case for an IPO.
What would happen is that LeanCo would go to a big Wall Street bank and raise approximately $5-$10+ billion in an IPO. After all the costs and fees and the Wall Street bank’s cut, the company would have a lump sum of money, let’s just say $5b. Now the company has the war chest it needs in order to grow. Typically LeanCo will acquire smaller rivals, enter new markets, and build out new products and services.
Instead, the LeanCos are choosing to raise billions for growth before an IPO. Instead of raising $5b in an early IPO, they are raising $2-5b privately before a much later IPO (at a much higher valuation.) They are raising the money $400 or more at a time. Here lies the genius of this approach: LeanCo only raises what it needs, when it needs it in a private (closed) market that will provide a higher valuation than a public one. There are also other benefits to staying private during the growth stage, like not disclosing your financial health and spending to competitors.
For the investors, this is actually a much more conservative approach. By only giving LeanCo the money when it is needed and doing it incrementally, LeanCo has to operate in iterative cycles similar to the Lean Startup and Agile Development. For example, if investors provided LeanCo with $5b in one lump sum, LeanCo may spend it unwisely feeling that they have a lot of capital on hand. If investors give LeanCo $400m or so at a time, LeanCo will have to take an incremental approach. If LeanCo were to go under after an IPO, investors would lose all of the $5b. If LeanCo were to fail after raising “only” $2b, investors lose far less money.
The Post-IPO World
The VCs on Sand Hill Road in Menlo Park have changed the game. I remember in the .com bubble, the largest Venture Fund was $1b and the largest deal was around $75m. Now the VC funds on Sand Hill Road are all well over a few billon each and think nothing of leading a $500m round.
Eventually the startup companies are going public, however, that is only because at some point they have to in order for the VC investors to sell their positions and the employees to cash in their stock options. I’m sure that over time, Sand Hill Road will evolve past the IPO, where companies stay private forever and large East Coast financial institutions buy back those positions from the VCs and earn returns via dividends, etc. You are already starting to see the signs of this when large pension and investment banks such as Fidelity, T. Rowe Price, and Goldman Sachs are part of the last round of financing for companies like Lyft, Box, and Uber. In the future, you won’t be able to buy shares in a Facebook individually, but you will buy shares in a Fidelity “Silicon Valley” Mutual Fund. Silicon Valley is disrupting Wall Street.
What Does this Mean for Startups in Silicon Valley
We all know that New York City and Wall Street is the IPO center of the world. Did a startup have a competitive advantage by being located in New York? As a native New Yorker who built three startups in New York City, I can confidently say no. Mark Zuckerberg proved that when he showed up to his Wall Street pre-IPO meetings in his hoodie. When your company is ready and has the right numbers, the Wall Street Investment Banks will work with you, no matter where you are.
What about tech startups located in Menlo Park, Palo Alto, or Mountain View, close to Sand Hill Road? (Sticking to the geographical description of Silicon Valley.) Same thing, when your company is large enough to take the uber rounds, it does’t matter if you live in Menlo Park or Montana, or Mongolia, the VCs on Sand Hill Road in Menlo Park will work with you. You are already seeing this with startups being located in the City of San Francisco and not down south in Silicon Valley. The larger established companies such as Facebook (Menlo Park), Tesla (Palo Alto), Google (Mountain View), etc are down in Silicon Valley, but the young, early stage startups are up in San Francisco. This means San Fransisco is about the startups and Silicon Valley is about the money.
San Francisco is the new Silicon Valley. Silicon Valley is the new Wall Street.
In my role at Fresco Capital and as an advisor to several startups, I’ve seen it all with founders: disputes over shares, disputes over money, disputes over a new laptop, founders break up, a founder falling ill, founders get married, founders get divorced, founders get into physical arguments. Often this leads to one founder completely disengaged from the business and still holding a significant amount of equity or even a board seat. We’ve seen this at large companies such as Microsoft and more recently at ZipCar. Typically you need this equity to hire executives or attract investors. Worse, if the company is being acquired, you now have one founder who can hold up the deal if they are on the board and disengaged. That of course is a problem, but one that can be solved with a dynamic founder agreement.
Most founders settle the division of equity question with a static founders agreement. It usually goes something like this:
Founder 1: 50%, vested over 4 years, 1 year cliff
Founder 2: 50%, vested over 4 years, 1 year cliff
This solves a lot of problems, such as if a founder leaves after two years, they will still have 25% of the company but give up the second half of their equity. What happens if one founder is not “pulling their own weight” or contributing enough to earn the vesting (in the other founder’s eyes) but did not leave the company? What happens if they have to leave due to illness or personal emergency? What happens if there is misaligned expectations as what skills a founder brings and what role a founder will play?
I’ve seen this happen at one of my own startups. One of our founders was a lawyer and at the time we sold the company, he could not represent us due to it being a clear conflict of interest. While the legal fees were not all that bad (maybe $50k), to this day, almost ten years later, my other co-founders are still mad at the lawyer co-founder. This was clearly misaligned expectations.
This is what Norm Wasserman calls the Founder’s Dilemma, or the unexpected consequences of not spelling out the roles and expectations of the founders early on combined with the unintended complications of a founder leaving early or disengaging. He suggests a dynamic founders agreement.
The Dynamic Founders Agreement
The dynamic founders agreement is a way to mitigate the risk of an underperforming founder by changing the equity based on pre-set parameters. For example say I am starting a company with my friend Sam. Sam and I agree to a 50-50 split with Sam being the “business guy” and me being the “tech guy”. The assumption is that I will be the coder of V1 and lead the development team after we get funding. But what if I need to leave the company due to family emergency? What about if I decide that I don’t want to code anymore, before we can afford to hire a developer? What if I only give 30 hours a week and consult on the side?
A dynamic founders agreement is a big IF THEN ELSE statement that spells all of this out. IF Steve works as expected, his equity is 50%, if Steve has to leave the company, if he becomes disengaged, here is the pre-negotiated equity and if we have to buy Steve out, here are the terms. For example:
Steve works full time as CTO performing all the coding and technical duties of V1, his equity is 50%, vested over 4 years, 1 year cliff.
Steve works part time, is disengaged, or we need to hire developers sooner than expected, his vested equity is reduced by half and he forfeits his unvested equity. Loses board seat.
If Steve has to leave the company because he needs a job or a family emergency: if Steve built V1 then the buyout is a one time payout of $50,000 USD cash or 2% vested equity, if Steve did not build V1, the buyout is 0.5% vested equity. Loses board seat.
Having a dynamic founders agreement won’t solve all of your problems, however, it will make the the process of removing a founder much less stressful. Sure some of the language in the dynamic founders agreement will be subject to interpretation, but the “spirit of the agreement” is much easier to follow or even if you have to litigate, more robust. If you never need to use the dynamic founders agreement, but built one anyway, it will force a frank and open conversation about roles and commitment among the founders. This only strengthens the relationship between founders, increasing the chances of success.
If you have ever seen me speak at an Accelerator or startup event, I usually refer back to my experiences fundraising for my past startups. I’ve had experience raising venture capital in four distinct eras: the “dot com era” circa 1999, the post dot com crash circa 2002, the post Google IPO-pre-Lehman collapse era (2006-2008), and the more current (post-Lehman) environment. While many of the rules of fundraising are the same, the stages, amounts, and terms have drastically changed over the years. Living and investing in Silicon Valley, I have observed the new pattern of fundraising, which I have broken down to four stages.
The four stages are:
Acceerator Round/Initial Capital
While there are all kinds of startups out there from pure software to BioTech to hardware, I’ll use the example of a typical software startup in the example below. The rounds and rules hold true in broad strokes for most startups, but the dollars, metrics, and sources may very.
Accelerator Round/Initial Capital/Friends and Family ~$100,000 USD
This is the round where you move from idea to prototype, possibly to a first version you let people play with. Lots of experimentation, MVPs, and customer discovery. You use this round to get a sense of a “product-market fit” but not necessarily a business model. Typically you have two or three founders working on sweat equity and some money borrowed from friends and family. This is the stage to go through an accelerator or have a single angel investor. The average size of this round is about $100,000 USD, excluding the value of the sweat equity. Once you have demonstrated the ability to execute and launch a functional prototype and can extrapolate the results, you are ready for a seed round.
*Note that if you are a hardware startup, your Kickstarter campaign, would typically come into play here.
Seed Round ~$1-1.5m USD
This is the round where you obtain “product-market fit” and find your business model. You develop and release your product and start to measure the results. Your customers may not pay you a lot at this point, but you have built an audience or customer base. This is the round where you bring on your first non-founder hire and move out of the garage, typically to a co-work space. The range of this round is between $1m to $1.5 USD structured as a convertible note. The typical scenario is that you have 3-4 investors, one lead at half the round at $750k and the other 3 investors in at $200k – $300k each. It is important to have a lead that is capable of investing in your next round, possibly leading that round as well. As general advice, beware of an AngelList Syndicate as your lead during this round, a lot of the time that syndicate is only good for the amount of the syndicate in your seed round and not capable to lead the Series A. Syndicates are good to round out the round, but not to lead-unless the Syndicate head has the ability to lead your Series A.
Series A ~$3-7m USD
This is the round where you execute on your business plan and scale. You have paying customers, you know where to find them, and you just need to accelerate the process of onboarding them. Typically with a Series A, you don’t need the money as you can grow organically, however, you raise a Series A in order to grow faster. Typically you use a portion of the funds raised for customer acquisition as well as some new hires in both sales and marketing roles. The range of this round is typically between $3m-$8m USD with some if not all of your seed investors participating. Sometime about now you think about moving out of that co-work space and into your own office.
Series N… $25m-$1b USD
After a Series A, typically the later rounds (Series B, C, n…) are for massive growth. I like to use the analogy for a Series B as “rocket fuel.” For example, you found your product market fit in your seed round, you developed and executed on your business plan in your A, and you have a repeatable business that scales. You’re making money and have a great team. You know where your customers are and how to get them to give you money. If you grow out of revenues, you are going to get to the target (say 30% market share or $150m in revenues), but it will take you a long time organically, say 3-5 years. This is the airplane taking off and going fast, but hovering above the tree line. With a Series B, it is like pouring afterburner rocket fuel on to your airplane and the goal is to get to the target in 1-2 years, not 3-5. Later rounds continue this trend and are also used for acquisitions to speed up the process as well as provide some capital to enter foreign markets.
While this is not the exact path that your startup will take, it is the “textbook” course a startup will take. Use this information as a guide and as with everything in this business, your milage may vary.
One of the worst parts of investing in early stage companies is saying no. A lot. We say no more than 100 times for every 1 yes.
Since our investment philosophy is people first, some assume that people are our only filter. They believe yes means we like the team and no means we don’t like the team. But that’s not the case. We also need to have conviction about the business and market plus of course need to be comfortable with the deal structure. As a result, there are many times when we say no even though we like the team a lot. That’s not fun for the team, or for us.
So why do we bother to give a clear no? Why not simply hang around on the sidelines with a maybe? Especially since it’s probably better for us, just in case the deal becomes hot and we can jump in at the last second.
Because that’s not fair to the team. We hear too many stories of investors playing games with entrepreneurs, resulting in wasted time. In addition to being fair with time allocation, we also try to be clear with feedback and give specifics of why we are saying no. If we have done serious work on the opportunity, by definition it means that we have been impressed by the team, and so we try to make this feedback useful for them. Once again, too many investors give a one line no, without any context for the decision.
Although there are no short term benefits for saying no clearly, we strongly believe that there are long term benefits for us by taking this approach. Great teams appreciate clear feedback, good or bad. When teams are doing due diligence on us, they inevitably speak to others who have received a no from us and how we act in these situations is a reflection of our overall approach. Great teams are smart enough to appreciate the connection.
So, even though it’s no fun for anyone, we will continue to say no a lot. Even to teams we like. Knowing that it’s the right thing to do for them and for us.