Entrepreneurship


Over this last year, I have been watching a whole group of startups attempt to land their series A. One aspect that has been shown to be incredibly important for sophisticated and series A investors is showing superior metrics and your knowledge surrounding them.

Why Metrics?

With internet startups, practically everything has been shown to be measurable.

Showing that you are tracking the right metrics means that you have experienced personnel in tracking the progress of your business.

Showing exponentially rising metrics means that you have found a way to grow and capture share that is grabbing customers in ever rising, large numbers, and that is hopefully growing faster than your competitors. Investors love startups that are growing exponentially in a short amount of time; for startups, time is your enemy and showing that you can get big quickly is critical.

Exhibiting metrics that are not only growing exponentially, but large in magnitude helps a great deal. But at series A level, the magnitude of the metrics may or may not be enough to land your next round.

Metrics on Demand

We have seen that investors demand that whomever is pitching should know every metric by heart and memorized. This shows that the team members are living and breathing metrics day in and day out.

If you cannot spew metrics on demand, you substantially reduce your ability to grab that series A. Investors are seeing too many pitches where the people pitching can recall detailed metrics from memory; it shows an obsession with tracking and deep knowledge of your business. If you don’t show an equivalent grasp of the metrics, then investors may get skittish and think you don’t know enough of about your business, thereby increasing the chance that something unknown might sink it.

You must also show proficiency with metrics, showing not only that you are tracking the right ones but that you are using them effectively to grow your business, and methodologies to improve and test them and also make them better over time.

Which Metrics?

As I sit down with startups, many need to track the same metrics. But different types of startups will have different metrics, and some will have different metrics they will focus on given the situation.

The topic of which metrics to track is too broad to cover in this post. Suffice to say there has been written on the topic of metrics, many of which can be found on the KISSmetrics blog. This book is about to be released: Lean Analytics by Alistair Croll and Ben Yoskovitz. You can buy the pre-release PDF at the O’Reilly site if you’re impatient to wait until March.

Some great articles and posts to read:

Single Startup Metric – this is also discussed in Lean Analytics. It is about focusing on one metric at early stage to drive the success of your business and not getting overwhelmed with too many metrics.

9 Metrics to Help You Make Wise Decisions about Your Start-Up – A great list of common metrics used to drive startups’ businesses.

Cohort Analysis – Measuring Engagement Over Time – Cohort analysis is very important. Showing increasing engagement across cohorts and over time is critical. Setting up the same graph with other metrics like LTV, which arguably is a measure of engagement, can be very valuable and worthwhile for an investor to see.

Ecommerce is a slog — what’s your angle ? – Fred Destin has an easy discussion on ecommerce metrics.

E-Commerce: What are the most important metrics for e-commerce companies? – A broader discussion on ecommerce metrics via Quora.

SaaS Metrics 2.0 – A Guide to Measuring and Improving what Matters – Written by David Skok of Matrix Partners. Great overview on metrics applied to SaaS businesses.

Many more great posts exist out there. Search on ” metrics” on Google and also in Quora.

By the way, toss Vanity Metrics. Save those for the press; don’t waste investors’ time with them. Definitely don’t use them for tracking the growth of your startup internally; they can lead you down the wrong path to death!

Are My Metrics Good Enough?

When you meet with seed investors, they may overlook the fact that you have metrics that are miniscule or non-existent. Seed investors often don’t have traction for proof and need to invest on the dream more than concrete proof.

When you get to series A, the bar gets raised significantly. Very few startups get series A on the dream today; we can always find the example startup or exception – but that’s the point – it’s the EXCEPTION not the rule. Much better to have shown that you have a good handle on metrics and the metrics themselves are great.

The elements of great metrics are easy. You need ideally all four of:

1. Show that you operationally have a great handle on metrics, tracking the right ones, showing that you are applying strategies driven by those metrics, and have on staff the right people doing the right things with the appropriate technology in place.

2. Exhibit metrics large in magnitude, ex. not 100s users, but millions of users (or maybe 10s of millions of users now).

3. Exhibit exponential growth in key metrics. Linear is not good enough for most metrics – an example where linear might be still great is linearly growing LTV over time. Mostly, show a real hockey stick up and to the right!

4. Show that your metrics are greater than industry benchmarks and/or competitors.

If you don’t have all 4, series A can be a real slog, potentially unachievable in today’s Series A Crunch laden market where there are too many early stage startups coming up for their next round. Why? It’s because too many startups have a handle on all 4 items above AND have higher magnitude and exponentially growing metrics than you. You’ve got your work cut out for you!

So the overall goal would be to achieve all 4. The first goal is item 1. Build the dream team for metrics and put in place technology to surface all sorts of metrics that you need. Use awesome tools like KISSmetrics and/or build your own. If you don’t have 1., then other 3 are going to be super tough and you’ll be reliant on luck to get there. Don’t rely on luck! Throw the odds in your favor of achieving the other 3 by being deliberate with respect to metrics, not haphazard.

Once you build the dream team and have the right technology in place, then you need to find the right metrics. Read those posts above. Get the right help – talk to others in your industry who have experience in metrics like yours and get their help in developing the right metrics for you to work with. Replace vanity metrics with better ones!

Let’s jump to item 4. This one is easy. Search Google, look at annual reports of public companies operating in your or similar spaces. Look on Quora for someone who may reveal metrics that you can’t find elsewhere. Search Slideshare for an elusive presentation that may reveal industry numbers. Check industry reports for more. Now you have a target – if you can show that your metrics are better than existing companies out there, that’s impressive!

Back to the hardest of the 4: items 2 and 3. How do you achieve these, and both in magnitude and exponentially growing numbers? Ack!

No magic I can impart on you from this post for sure. I will say that if you’ve got item 1, you’re well on your way to do the right things to get there. This is where the rubber meets the road and now YOU have to make your project shine.

What If I Don’t Have All 4 Items?

If you’ve got all 4 items, then why the heck are you reading this post? Go out and raise your series A!

However, if you’ve gotten this far, you may be one of the hordes of startups which do not exhibit all 4 qualities. What do you do now?

If you still have runway, go out and improve your metrics!

If you need to raise, then here are some suggestions to increase your chances, knowing that there could be hordes of startups with unfortunately much better metrics than you:

1. You probably can’t hire since you are running low on cash and need to raise, unless you can get somebody to sign up on equity. But you should go to investors with someone who at least is tracking and implementing a metrics driven approach in your startup. That person could also be you! Bring that person to the pitch so that they can show uber-expertise in metrics at your company.

2. The most common problem I’ve encountered are items 2 and 3. You either have low magnitude numbers or slow, linear growth, or both. If you have either 2 or 3, you still have a chance to raise on the vision and team. The better one to exhibit is exponential growth, even with low magnitude numbers. If you don’t have growth but big numbers, investors might think that your growth has stalled, or you’re doing something wrong, or both.

Metrics are an important part of the startup process. Investors today demand not only great metrics, but people on the team who understand the critical metrics in the business and can use them to grow the company. Implementing technology and process for metrics in your startup will greatly increase your chances of landing that next round. Don’t wait – do it now!

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This must be the favorite sentence uttered by entrepreneurs. But who can really lay claim to this statement being true? Could someone truly have no competitors?

Usually what happens is, after the pitch I go back to our research team and after their digging, we find a mass of competitors. How could that be?

In thinking about competitors, I find there is generally a difference of opinion between me and the entrepreneur that is driven by the different types of competition, and whether the type of competitors that exist matter to us investing or not. Then add to that how market forces shape competition and this all gets pretty complex.

The Different Types of Competition

What are the different types of competitors? Looking out on the Net, I found these categories of competition:

Direct/Existing Competitors – usually the easiest to find, these are companies with products who are the same are very similar to yours, and attempt to serve the same need.

Entrenched direct/existing competitors are those who have been around for a while and have grabbed a lot of market share before you showed up.

Indirect or Mindshare/Category Competitors – these are companies who provide alternatives to the need your product solves or the resources that your using your product would occupy, but it may not be obvious that they are taking away share from you.

“Just because your offering is unique, doesn’t mean it is unique in the mind of your prospects. To a prospective customer a marketing strategist, web designer, direct mail specialist, graphic designer, video producers, and print shops may all provide “marketing”.”

[sources: 4 Types of Competitors, Different Types of Competitors by Peter Halim]

Potential Competitors – these are companies who have the capability and the will to enter into the marketplace with a product and become a direct or indirect competitor to you.

Replacement Competitors

“A replacement competitor is something someone could do instead of choose your product, but they’re using the same resources they could have committed to your product.”

Budget Competitors

“Even if your products and services are truly unique, you still have to compete for the same budget dollars that other service providers are vying for.”

This also applies to the regular consumers. How hard is it to get customers to part with their money, if there are other choices possible? How many subscription services can a consumer have on their credit card before they say enough is enough? Advertising agencies have set budgets per year; if it all gets spoken for, you may not get access to valuable ad dollars simply because it’s been all committed.

Doing Nothing – In the face of certain situations, it may result in a potential customer doing nothing as a way of deciding. This may result from having too many choices, or too difficult choices, or somehow being prevented from making a decision comfortable to the customer. It is worthwhile to ask, how can you eliminate this type of competition?

What Matters to Us in Investing

You’re probably thinking – Wow, Dave, that’s a big list! Isn’t that being a bit unfair to a fledging startup? Wouldn’t the world be our competitor if we lay this kind of analysis on my startup?

You’re partially right – as investors we like to look at your project from all angles and weigh the odds. What’s the probability that a competitor, or competitors, will emerge and make life difficult or impossible for a startup we’re looking at?

So taking those categories of competition above, we try to see who is there and who is not.

Direct/existing competitors are the worst. You have to come up against them and fight head to head for market share. Some of them are entrenched and thus you could have a tough time grabbing share from them. On the other hand, if they are traditional, slow moving big corporations, you may have an advantage in being a quick moving startup entering with a significantly better product. Competing against other startups – that’s sometimes much harder.

The other categories are much harder to judge. We have to make a personal call as to whether or not we think the risk is too high or low enough to give the startup a fighting chance.

Market Forces Confound the Competition Analysis

The only problem is…there are too many internet startups now. There has been an explosion of entrepreneurism which complicates the competition problem.

Previously, we talked about Mindshare/Category Competitors. This was when your competitors could come from a broader category and those could become your competitors inadvertantly. However, with the enormous number of startups out there, the Category becomes so broad to emcompass all internet, meaning the fight for customers becomes the battle for attention where everyone is your competitor.

The Last Category: Everyone is Your Competitor

While this is probably true to some degree at any time, it jumps to the forefront in times like today. That’s what is happening now; there are too many startups for both consumers and B2B customers to process quickly. If they cannot choose you fast enough, then your growth is stalled, causing you to burn through your cash before you can get to breakeven. Time is the enemy of startups – you cannot wait for people to process too many choices; you need them to use you quickly and they simply won’t. This is why we see startups needing 24-30 months to get to someplace of stability, or to get to their next funding event.

This makes the investment decision much harder to process. What’s an investor to do?

We could wait for times to change. The world moves so fast now – it is possible that within a year or two, the battle for attention may abate. Or it could get worse.

What it does mean is that for now, as we evaluate startups, the best we can do is to acknowledge the battle for attention is very real but we are being very picky now.

At this point, we try only to pick startups that have really no direct competitors, or have only old, traditional entrenched competitors. The world of internet startups has reached to almost every corner of every major industry; however, we are still finding some unturned stones, businesses and markets that have not been touched by internet startups yet. This is where we are finding the last remaining internet startup opportunities that literally have no direct competitors, or at best, competitors that are old, traditional companies which we are betting cannot move as fast, nor have the expertise or innnovative spirit of a startup.

In the old days, investors picked startups who had no competitors. The internet wasn’t around back then and competition was different in other industries. With the internet, competition pops up with great ease and speed. We now look for those rare, few startups that have still no direct competitors and advise them to stay stealth, just like in the old days, to avoid other internet entrepreneurs from creating competitors literally out of thin air.

A few weeks back I met with an entrepreneur who had recently closed a round with a large VC. We got to talking about what it was like to work with that VC, and he mentioned that it was a little strange because the VC was pushing for these really bizarre terms. After he described them to me, I too agreed they were bizarre, but then I said I’m pretty sure I knew why he was pushing for them, which was I bet he had gotten burned on them in the past. The entrepreneur’s eyes lit up and said that was right! Eventually, the VC admitted this to him, talked it through, and they came to agreement on terms.

I can sympathize with that VC. Since 2006 when I started investing in startups, I’ve gotten caught by a lot of unexpected traps and rookie mistakes. These have definitely driven my current thinking on how I like to pick startups and their teams, finance them, and what terms are important to me. I would definitely admit that this was the most expensive education in any subject I’ve ever learned. Where else can you piss away 10s, if not 100s of thousands of dollars on situations that you may have avoided through better experience or forethought? Or maybe lady luck just decided to slap you down this time out of nowhere?

It was one of the reasons why I wrote this post a few years back: More Reasons Not to Invest in Notes. In the notes that I’ve done, I’ve seen many unexpected things happen. And this is why my boilerplate note has grown to include many things beyond the vanilla convertible note that someone might use.

But then, there are investors I’ve met out there who have never had anything bad or weird happen to them. This fact still amazes me that there are those out there like this. Still, it is my belief that the more you invest, the more likely something bad will eventually happen. You can’t avoid everything bad that can happen to you; you can only do so much to protect yourself.

In our attempts to protect ourselves, the entrepreneurs we meet often suffer from our past. We argue for certain agreements and terms, some of which seem downright strange and we can be pretty adamant about those terms. We may even get emotional about them and refuse to back down on them as negotiable items.

Sorry about that. The more we invest, the more we are scarred. The best thing you can do is to be like a good therapist; sit and listen to us rant and rave. Nod with sympathy in your eyes. Let us know you understand. Pat us on the back. And when we calm down, we may actually give…or not. Like traditional therapy, some things can be cured and others…well…probably never…

Back in 2009, shortly after the 2008 crash, I wrote The Importance of Revenue at Early Stage, Now More Than Ever. Up to that time, we had been on a roll – startup investing was growing well and we had bought into building traffic which allowed us to get to our next funding event. Then, the crash killed all that. Money was hard to come by, and investing in “momentum” or traffic only startups without much revenue was nearly dead. Only revenue generating startups were attractive to investors and a boatload of non-revenue startups died simply because they had none.

Then the startup funding environment came roaring back, we had our Instagram moment, and investing on momentum was in vogue again.

But times have shifted again. What has changed?

1. Tracking M&A values, they hang slightly above $20M . This is pretty low in general, and pretty unattractive from an investors’ standpoint when…

2. …Valuations for startups still hang around $6-10M cap or pre-money at early stage for the hotter deals, sometimes even higher. Remember that if you are to exit at the median, you must be doing pretty darn good and be above average. If you are not gaining traction, acquihires are happening at much, much lower values, definitely well below $10M.

Now to be perfectly clear, there are those out there investing on strategies that take into account 2-5X return on money. But our economics don’t allow us to do that – we need much more return.

3. Customers, whether consumers or B2B, are deluged by the exponential growth of startups and growth is harder to come by. In the near past, we used to tell startups that they needed 12-18 months to get to decent traction metrics; that quickly moved to 18-24 months, and now we think it’s 24-30 months. Wow! 24-30 months – this is a direct result of our observations on how startups are growing in the competitive marketplace, the battle for customers’ attention. When we saw them funded with runways of ~18 months or so, many needed more runway and so went to look for bridges, if they could not get series A – so we’re now at 24-30 months!

However, practically NO startup I know raises for 24-30 months at the seed stage – well, practically none. If you go to Techcrunch and other online publications that follow startups, you’ll see a ton of early stage raises at $1.5M-2.0M – what happened? This is smart. These founders, and their investors, have realized that they need more runway and have funded them for that. Startups who raise less than 24 months runway have a higher probabiility, now more than ever, that they will need additional runway to extend them to 24-30 months within a year.

But if you aren’t one of the startup darlings to get $1.5-2.0M at seed, what then?

4. Last, we’ve been in contact with some prominent financial guys who follow the economy like hawks. They process every bit of information that is out there, stuff we all can get and a ton of stuff that we can’t. (If there is anything I’ve learned about the financial industry, it’s this – there are those with the information and those without – those without basically include everybody else including you and me – and yes, the world will continue to have unfair information advantage no matter what we do with regulations). They are fearful that another 2008 is coming. We’ve been digging into this and have found evidence in a potential earnings cliff, and we are concerned as well.

All this means that we think the importance of revenue at early stage is back – one could argue that it never left, but what I mean is that it has risen to the top of the stack.

The world isn’t looking optimal for internet startup investing. That doesn’t mean there aren’t opportunities out there that can fit within the world we see right now – generating revenue is one of those key characteristics that can ensure some longevity even when the world is so uncertain. Once again, we look for that to bolster a startup’s chance for survival and give them maximal runway to achieve their next funding event.

Lately, I’ve been doing meetings with young startups in recent accelerator batches and meeting them for the first time. It’s been great to hear that they’ve bought into the iterative method of customer development and most of them have found their Minimum Viable Product or MVP, or they are well on their way to finding MVP.

This is awesome but in today’s world, you can’t raise money on achieving an MVP. Investors demand more than that.

As Steve Blank likes to say:

A Startup Is a Temporary Organization Designed to Search
for A Repeatable and Scalable Business Model

The unfortunate reality is – an MVP is not the above! Yet most of the newly minted entrepreneurs I’ve met think their job is nearly done when they’ve found MVP – they think they can go build a pitch off their early MVP and raise money!

A startup does require MVP but it is much more than just MVP. The problem is that MVP means early adoption of product and its features, maybe even some who will pay. But it doesn’t tell you how many people will do it in the long term and whether this can support the company (the people and operations within) that is behind it.

So startups are much more than MVP and requires thinking beyond just the product. This is where I’d like to coin a new acronym, which is Minimum Viable Company or MVC.

What is a MVC?

First, I would say MVCs only apply to early stage startups – you can’t really talk about achieving MVC status for a company that’s been around for a longer period of time. To be minimally viable as a company, I would say:

1. It has achieved breakeven or profitability, or has a believable and achievable plan to get there.

OR

2. It has achieved enough metrics to reach its next funding event. This includes the first funding event.

Or ideally both.

The Fundable MVC

An MVC must have achieved some sort of MVP, but having MVP doesn’t mean you have achieved MVC automatically. Nor does it mean you’ve achieved the next level of MVC which is a FMVC or Fundable MVC.

Remember that many MVCs can generate cash, but how much exactly? If you reach small or medium business status, that is great; it takes no little effort to make $500K, $1M, or several tens of millions of dollars per year. It is a notable achievement to employ a building full of workers, insuring them pay and livelihood, and providing or shipping product and services to customers. This is a win by many measures.

However, many companies like these, while there is every reason in the world for them to exist, unfortunately are not attractive to investors. This is because while they are doing great work, the likelihood of investors getting their money back and then some is very low or zero. This is the difference between an MVC and a FMVC.

We have not, as an startup/investor community, figured out how to invest in those companies whose trajectory is heading towards small or medium business status. Right now, all startups are being funded as if they are going to exit like any high growth startup. Anybody on a lesser trajectory simply won’t attract the funding it needs unless more effort is done with other funding sources or structures.

Therefore, it is the FMVC that every startup needs to achieve. What are the characteristics of a FMVC? Everything that a seasoned, high growth investor looks for: big market, big vision, lots of revenue potential, world domination plan, etc. This is what will increase the likelihood of funding, not presenting your MVP at a demo day, or even a plan for a MVC, but your plan for a FMVC.

How do you turn your MVP into a FMVC?

First, you must realize that not all MVPs yield a FMVC. MVPs could yield a MVC but not FMVC. Many MVPs have potential to attract some customers, but not enough to create a company and an opportunity large and tasty enough for investors to want to put money in. This is also dependent on the market in general, meaning that 5+ years ago when there weren’t so many startups sprouting up all over the place, you could have achieved an FMVC with your project; however, in today’s crowded startup world, you cannot.

While every project is different, I point you to some suggestions on examining what you are doing now in hopes of turning it into a FMVC:

1. Iterating on MVCs is a good thing to do; keep trying out business models and plans until a FMVC shows up. It may mean giving up on your current MVP and looking for another one. Do not be afraid of going back to the drawing board if you find your MVP does not yield a satisfactory FMVC!

However, your time limit is your bank account. Never forget that. So working rapidly and lean is key.

2. Do you have a World Domination Plan? Is it believable? If you can envision a world where your MVP dominates whatever market and customers it is pursuing, is that big enough?

3. Are you too focused on the solution and not on the problem? Becoming too myopic about their product and forgetting about how this turns into a big company is something that I find happens with many entrepreneurs. They get caught up in the success of finding a MVP, but don’t realize that they not only need a MVP but need to achieve MVC and hopefully FMVC.

4. Following on 3., it would probably be a good idea to pick up some MBA skills and start running models and scenarios to see where a given MVP can become a MVC, or potentially a FMVC.

5. A good measuring stick I use with startups is to ask what the $100M/year revenue scenario looks like. Generating $100M in business per year is no small feat – you get there and you’re well on your way to becoming a big business. So can we imagine a world where your startup is making that much and believe it?

6. The weird thing about some startups is, that some break into such new territory that it is very hard to model or you can’t model anything. New industries, new markets, or products and services that customers cannot imagine having or using are like that. So the FMVC you could create is purely via pitch, arrogance, confidence, etc. – whatever it takes to woo an investor to write a big enough check on what you plan whether you have product or not. In order to accomplish this kind of FMVC, your credentials must be unique: you must be well-known to the investor, you must be trusted. Ideally, you would have had an exit or more for that investor. You must show “extreme” entrepreneurial traits: be able to employ persuasive language, compelling/grand planning, superb salesmanship skills and technical skills, among others. These are the people who can get funding on a powerpoint when others flounder even with revenue.

This can be enough to win you funding and survivability.

In short:

1. An MVP is great but not enough in today’s market to win funding.

2. An MVC generally means you have MVP, but an MVP does not guarantee MVC.

3. An MVC can yield a small to medium business, or a big world dominating one. There is nothing wrong with building any of those types of businesses and the world is big enough for all kinds.

4. However, we do not know how to properly invest in small to medium businesses. Our money may not be returnable from such businesses using the current equity structure of our investing. Thus, we want to invest in FMVCs.

5. As someone who is trying to build a real high-growth startup, therefore, MVPs or MVCs are not enough. You must search for a FMVC.

So you have just closed on your $1m seed round.  You’re excited and ready to get to work.  The first thing you do is contact TechCrunch and PandoDaily to get some PR, hire a few engineers, a marketing person and begin paying yourself.  Your burn moves from $15k per month to $75k per month overnight.  You are driving traffic to your site, building product and showing early signs of execution.  You were invited to sit on a panel; you’re mentoring some young teams; all in all, you’re feeling pretty good about yourself.

But, you can’t help beginning to think that the clock has started ticking – 12months and counting to get to that elusive Series A.

So, you begin to scour the blogs, absorb everything that other successful start-ups have done and decide that with 12 months of cash on hand, its time to double down on the business model that you got funded and crack the formula for a scalable user base and show “Fab-esque” growth.  You throw out the idea of the lean model and say “fuck it” time to take control of my own destiny!

Sound familiar?

In the age of Lean Lean Lean, it never ceases to amaze me how many companies at the seed stage fall into the trap.  They mistake maniacal focus on growth for “fire in the belly”.

And, at month 10 or 11, the entrepreneur begins to complain to his investor base that despite all of these great metrics of growth, the company is falling victim to the Series A crunch.

When, in reality, the Series A crunch was a proxy for focusing on the wrong things at the seed stage…

In our portfolio, we believe that exceptional entrepreneurs tend to have very similar characteristics regardless of their customer/market/product differences.  We believe that they have a genetic make-up different then regular entrepreneurs.  I like to call the super entrepreneur gene that distinguishes the winners from the losers, “The Random Walk Gene”.

This gene is displayed by founders who, at the seed stage, realize that they are embarking on a 10000 mile foot race.  They realize that momentum early on does not dictate success. They recognize that a random walk down a lot of different avenues will ultimately help them in the long run.  They realize that learning from mistakes at the seed stage is usually more important then continuing to pile on to the early successes that they have had (think about this for a second, imagine if you knew all of the customer acquisition strategies that don’t work and why… as a nascent business, that information is incredibly powerful – maybe more powerful then knowing one strategy that does work since you don’t have enough $$ to milk that strategy to get you to scale).

The other unique characteristic of this gene is that these entrepreneurs are always ok sacrificing short-term gains in exchange for long term goals – and they NEVER lose sight of this.  If that means that they sacrifice revenue opportunities to continue to build on a more lucrative business model, then they build for the long-term.  If it means giving up a little more equity to bring on the right partners (employees, advisors and investors) then they swallow the dilution.   These entrepreneurs don’t calculate their personal net worth based on the last round of their valuation – they calculate the value that their customers get everyday from using their products.

As a result, super-gene entrepreneurs become pillars of stability in their company and in their community’s – they stay calm, consistent and emotionally stable.

I can name these entrepreneurs and examples off how the gene has displayed itself off the top of my head.  Not because I talk with these guys everyday, or brag about their success, but because I truly admire their ability to prioritize what is important.  Amazingly, and without fail, each of these companies ALWAYS figures out a way to pull off a fundraise, or convince another recruit to come on board or get multiple acquisition offers at every stage of their development.

Building a great business takes a long time.  Slow and steady at the seed stage may mean that you sacrifice the sexiness of running a hyper-growth opportunity, but in exchange, you will have a much more stable business on your hands.  Oh yeah, and the chances that you will stumble on the sexy business model of the moment is like 1 in a 100,000…so at the least, play the game where the odds are more in your favor.

I had a great lunch with a VC in NYC who I have known for a number of years.  He and I were involved in a fantastic company that went on to be one of the biggest wins in both of our careers.  During the lunch, we spent a lot of time discussing the current venture market conditions – trying to better understand each other’s take.  It got me thinking about the roles of term sheet structures and financial engineering in start-up funding:

I have spoken many times to other investors (angels and VCs), about that fact that I do not believe that at the seed stage, investors can financially engineer a win.  Basically, I do not think that the extraneous terms that can be put on a relatively clean deal (rachet clauses, multiple liquidation preferences, etc) can materially impact your outcome if the start-up you are investing in is successful.

However, I firmly believe that you can financially engineer a loss at the seed stage. Here are three common ways that this happens:

1)   Too complicated of a term sheet for the size of the round:

Explanation: This was something that we saw a lot of in 2008 and 2009 when the seed funding environment was 1/50th of the size and raising $500k was incredibly challenging for even the most promising start-ups (yes there was a time when not all YC companies got funded within weeks after demo day).  Many seed investors – and we were guilty too – thought that they could pile on protective provisions, etc. into companies in the hopes that financing risk would be mitigated.

Result: Companies who would close small rounds of financing ended up with enormous legal bills that they were then forced to pay.  In the most extreme case, I was on the board of a company that raised $400k and ended up with a $100k legal bill (for the record, this was a friends company, and I invested on a straight convertible note with no discount or cap).  By the time the legal bill was paid, and the company was ready to start building, cash had run out and the CEOs attention went off the business and back to fundraising.  The spiral never ended and the difficult term sheet resulted in a further incurrence of crazy legal bills every time a round was raised.

2)   Entrepreneurs who don’t fully understand their economics or don’t like their economics

Explanation:  At times, the terms of a deal can be clear as day for the lawyers and investors, but the entrepreneurs don’t quite understand them.  Or worse, the entrepreneur understands the terms, but had no other option and took a deal he didn’t want.  Either way, this will generally result in an entrepreneur who feels “taken to the mat”.

Result:  This can be a tricky situation, because I know that as a seed investor, I am trying to align incentives as best as possible with an entrepreneur while getting the best deal that I can (within reason).  There are three things that I due before I finalize a term sheet or an investment that I lead: 1) I send the entrepreneur a waterfall analysis of the deal or an email that says “Hey man, this is a great deal for both of us – if we can get to the next inflection point, I think that you can retain XX% of your business”.  We now both have an aligned goal on the financing front to strive towards.  2) I make sure that the entrepreneur is represented by a good group of lawyers who understand venture financings and can coach the entrepreneur on what is a “market” rate deal.  While Uncle Morton the tax attorney might be the cheaper option, he probably isn’t going to understand the nuance of the venture industry.  3) Make sure that the entrepreneur understands that if they hit the ball out of the park with this investment round, one of two things can happen: they can raise additional capital at a substantial uptick limiting dilution or they can come to the board and ask for an option grant as part of a new compensation package.  I have seen and been involved with both (and in the best scenario, both for the same company!).

3)   Cluttering the cap table with pile-on rounds of financing or crazy note structure

Explanation: This is something that you will begin to see a lot more of as bridge financing begins to intensify alongside the Series A squeeze.  Basically, this occurs when entrepreneurs are in need of interim investment rounds because they cannot raise the next round of investment. Investors want more compensation then a simple convertible note with discount, while entrepreneurs believe that they have built enterprise value above the last round of financing.  Thus, the Series A-2 (then the A-3, A-4…), which has a different price but a similar structure to the previous round.  A similar situation can come up in/around an M&A transaction when investors want to be compensated for risk, but entrepreneurs don’t want to give up equity.  You end up with crazy note structures where there are 2x or even 3x liquidation preferences on the notes.

Result: Trust me on this one – I know is from experience and it SUCKS! – these types of financings can bite you just when you don’t want/need any problems.  Take for instance, an M&A transaction.  Most due diligence is around market, technology, team, etc and is done early in the process.  Business leaders buy off on an acquisition and it goes to the CFO or corp dev.  Then the cap table comes out… now, you have the business team excited about your company, but a CFO who needs a PhD in Applied Mathmatics to unwind your financing.  It can take days/weeks of time. At best, the CFO understands what is going on and accepts the companies financing structure for what it is – at worst, the CFO sees this as a red flag and the deal falls apart.  For investors, I would urge you to move to a note with cap structure for bridge-like financing.  For entrepreneurs, it is important to take stock in where you really are as a business and figure out if it makes more sense just opening up the last round of financing – realizing that new investors are getting a great deal.  By the way, when investors feel like they are getting in on a great deal, they tend to be more excited about the investment, willing to make connections, do heavy lifting and tell their friends!

Overall, I prefer very clean and simple deal terms that have alignment throughout the process.  In every case, the investor has to give a little and the entrepreneur has to give a little.  And, hopefully, in the end, you build a company with immense market and enterprise value, you sell or IPO for something in the $B range and the difference between participation and non-participation on your $3m Series A is completely meaningless!

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