Fundraising is one of the hardest and stressful stages of running a company. It takes time and energy away from what you really want to be doing.
We’ve pulled together some of the best resources on scaling-up, building a startup, the wonderful world of venture, and how we invest, what we invest in and how to raise money from us.
"A prudent question is one-half of wisdom."
Sir Francis Bacon
Entrepreneurship
Consumer fundraising checklist
So, you’re trying to raise money. Here’s a guide for thinking about the kind of information you’ll need to craft a narrative about your company. Depending on your stage of growth, you may want to focus on different elements of this checklist. This is meant as a general guide, not a prescriptive template.
Problem/mission/vision
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What’s the big vision?
Product
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What does your product do today?
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What is your value proposition?
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What is your unfair advantage?
Market opportunity / size
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What’s the opportunity?
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What’s the market size?
Team
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Tell us about the executive team
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Why are you uniquely qualified to solve this problem?
Proof of product / market fit
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Growth to date: sign-ups, weekly or monthly active users, paying customers (if relevant)
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To the extent it’s relevant, do you have quantitative evidence that you’re better than competition/incumbents?
User engagement + retention
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Engagement metrics for core product features
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Monthly or weekly cohort retention (depending on the kind of product/company); churn (for subscription products)
Customer acquisition
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What are your customer acquisition channels?
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How much does customer acquisition cost (per channel)?
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How will you make this money back and how long will it take?
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How scalable are these? How big can you get with your existing product + customer acquisition channels? At what point do they get saturated or become too expensive, and what do you do if/when that happens?
Business model / monetization
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Do you make money today?
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How will you make money?
Competitive landscape
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Do you have competitors? Who are they?
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If no one else is doing this, why not?
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What are others doing in adjacent spaces?
What’s next / fundraising ask
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How much money are you raising?
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Use of Proceeds: What will you do with the money you raise?
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What are the milestones you will accomplish to get to the next phase of your business?
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How does this tie into achieving your big vision?
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Are there any gaps in your team you need to fill?
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What are you looking for from an investor?
Employee equity: dilution
When you start a company, you and your founders own 100% of the company. That is usually in the form of founders stock. If you never raise any outside capital and you never give any stock away to employees or others, then you can keep all of that equity for yourself. It happens a lot in small businesses. But in high growth tech companies it is very rare to see the founders keep 100% of the business.
The typical dilution path for founders and other holders of employee equity goes like this:
1) Founders start company and own 100% of the business in founders stock
2) Founders issue 5-10% of the company to the early employees they hire. This can be done in options but is often done in the form of restricted stock. Sometimes they even use "founders stock" for these hires.
Let's use 7.5% for our rolling dilution calculation. At this point the founders own 92.5% of the company and the employees own 7.5%.
3) A seed/angel round is done. These early investors acquire 5-20% of the business in return for supplying seed capital. Let' use 10% for our rolling dilution calcuation. Now the founders own 83.25% of the company (92.5% times 90%), the employees own 6.75% (7.5% times 90%), and the investors own 10%.
4) A venture round is done. The VCs negotiate for 20% of the company and require an option pool of 10% after the investment be established and put into the "pre money valuation". That means the dilution from the option pool is taken before the VC investment. There are two diluting events going on here. Let's walk through them both.
When the 10% option pool is set up, everyone is diluted 12.5% because the option pool has to be 10% after the investment so it is 12.5% before the investment. So the founders now own 72.8% (83.25% times 87.5%), the seed investors own 8.75% (10% times 87.5%), and the employees now own 18.4% (6.8% times 87.5% plus 12.5%).
When the VC investment closes, everyone is diluted 20%. So the founders now own 58.3% (72.8% times 80%), the seed investors own 7% (8.75% times 80%), the VCs own 20%, and the employees own 14.7% (18.4% times 80%). Of that 14.7%, the new pool represents 10%.
5) Another venture round is done with an option pool refresh to keep the option pool at 10%. See the spreadsheet below to see how the dilution works in this round (and all previous rounds). By the time that the second VC round is done, the founders have been diluted from 100% to 42.1%, the early employees have been diluted from 7.5% to 3.4%, and the seed investors have been diluted from 10% to 5.1%.
Everything you want to know about advisors
1. What do advisors do?
They provide advice, introductions, investment, and social proof. Any combination of these is useful, except for an advisor who just provides social proof—savvy folks don’t take those advisors seriously.
2. Should I put together a board of advisors?
A “board” of advisors is not a formal legal entity like a board of directors, which is defined in the Constitution and shit. You don’t need a board to collect advisors.
Create a board if it makes you and your advisors happy. Perhaps some advisors feel fancy if they’re on a board. But it really doesn’t mean anything.
3. How do I get good advice?
Ask questions. I usually ask questions about my immediate goals for the next day and week. This sounds obvious but most people simply don’t know how to get good advice and apply it.
Some entrepreneurs set up quarterly advisory board meetings and that probably works well for them. But we find savvy entrepreneurs tend to be transactional—they ping their advisors as needed and skip the advisory board meetings.
4. How do I apply advice?
Don’t follow advice. Instead, learn from your advisor and apply the lessons to your company.
Your advisor isn’t you: he doesn’t have your goals, history, or strengths and weaknesses. He doesn’t know your company like you do. So take the advice and apply it to your specific situation. This is the advisor paradox: hire advisors for good advice but don’t follow it, apply it.
Even good advisors may guide you with conventional wisdom. And startups are about applying unconventional wisdom. Your task is to hire the maverick advisors in the crowd.
5. How do I find advisors?
From your network and cold calls. There is no magic solution. Hiring advisors is an ongoing effort. Start now and continue until you’re dead.
If you’re working on something interesting, smart people will offer to help you. The contrapositive is also true: if smart people don’t offer to help you, you’re probably not working on something interesting.
Personally, we are always asking people for advice. We try to turn the folks that give great answers into advisors.
What about lawyers? Every startup needs one right?
First, know that lawyers are referees, not coaches.
Second, learn that advisors are the coaches of the startup game.
Lawyers teach you the rules of the game. But they usually can’t teach you how to play it.
Lawyers say whether you can do something, within the confines of the law and your existing contracts. Lawyers will also write the contracts and do the filings. But they usually can’t tell you what to do—that’s what coaches do.
Here’s a classic startup mistake that illuminates the difference between a coach and a referee:
You’re negotiating an investment and you’ve agreed to a board with 2 investors, 2 common, and 1 independent.
You’re almost ready to sign the term sheet when your prospective investors say, “Sorry, we forgot, one of the common board seats needs to be the CEO.”
You’re thinking, “I’m the CEO and I was going to elect myself to the board anyway, so that’s fine.” Your lawyer agrees and says, “That’s standard.”
This is a mistake. If you hire a new CEO and he’s aligned with the investors, the investors will gain control of the board. Instead, you should create a new board seat for a new CEO.
A lawyer knows that you’re not breaking any laws or contracts if you give a common board seat to a new CEO. He also knows how to write the contract. But an advisor knows the possible outcomes of that decision.
Third, startups without advisors often assume their lawyers have good business advice.
That’s a mistake. You need a coach, not a referee, to teach you how to play the game. And most referees aren’t good coaches (but some are).
Fourth, not every coach is a Phil Jackson.
Not every coach has won 9 NBA titles as a coach. The effectiveness of coaches in the NBA varies widely. Why would the effectiveness of advisors be any different? Is your advisor a Phil Jackson?
Fifth, there’s more than one way to play the game.
Phil Jackson doesn’t have a monopoly on coaching. And neither do we. Go find a coach who can teach you how to play the game. There’s only one Phil Jackson in the NBA because basketball is a zero-sum game. Fortunately, there’s more than one great startup advisor in the world—life is not a zero-sum game.
Good boards don't create good companies, but a bad board will kill a company every time
The composition of the board of directors is the most important element of the Series A investment. It is more important than the valuation of your company.
The valuation of your company won’t matter to you if the board
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Terminates you and you lose your unvested stock.
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Forces the company to raise a low-valuation Series B from existing investors by rejecting offers until the company is almost out of cash.
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Merges the company with another private company and wipes out your common stock in the process.
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If it isn’t obvious by now, a bad board can do lots of stupid or malicious things to make your stock or company worthless.
The board you create will be your new boss. But trying to please everyone on your board dooms you to managing board members and ignoring customers and employees. Great companies are rarely built by committee and a bad board will waste your time trying to run the company their way.
This hack will show you how to create a board of directors that you can trust even when you don’t agree with its decisions.
The board should reflect the ownership of the company.
The form of government in a company is dictatorship. The board represents the owners of the company and selects the dictator (CEO). The board then works to ensure the dictator is optimally benevolent towards the owners. Naturally, bad dictators get beheaded…
If the board represents the owners of the company, its composition should reflect the ownership of the company. Truly competitive and transparent markets, such as the public stock markets, have already reached this conclusion.
After the Series A investment has closed, the common stockholders are probably going to own most of the company. The common stockholders should therefore elect most of the board seats. Let’s assume the common stockholders own approximately 60% of the company after the Series A. If you’re taking money from two investors, the board should look like
3 common + 2 investors = 5 members.
And if you’re taking money from one investor, the board should look like
2 common + 1 investor = 3 members.
In either case, the common stock should elect its directors through plurality voting. Plurality voting enables the founders to elect all of the common seats if they control a majority of the common stock.
An investor-leaning board gives an equal number of seats to every class of stock, no matter how many shares that class owns. This makes no sense, but, hey! that’s venture capital! There are many future scenarios where your investors can take over this board (e.g. a down round or hiring a new CEO), but there are no realistic scenarios where the common stockholders take over this board. Hence, this board is investor-leaning.
If you end up with an investor-leaning board, get your investors to agree to create a new common seat anytime the company creates a new investor seat (e.g. for the Series B investor). This prevents the investors from taking over the board in the Series B as long as this term isn’t renegotiated.
If you have a strong BATNA, you should reject anything less than an investor-leaning board. If your prospective investors suggest anything worse, they are probably trying to take advantage of you.
Startup strategies during uncertain times
1. Design a new operating plan & cash forecast.
“Put your wartime CEO hat on and think that business as usual is likely not going to cut it,” said Marc Manara, co-founder of Farm Hill and member of the AWS Startups team.
It’s time to revisit and rework your operating plan, and monitoring cash flow should be your first priority. Knowing your bank balance at all times is a must. That includes having a constant understanding of operating costs so that you’re always aware of “cash-out date” — the specific date you’ll run out of cash.
“The worst thing you can do in this scenario is just lose track of where you are,” Manara notes.
That advice is aimed even at the startups lucky enough to provide a service or product that’s suddenly become more in demand. Business might be booming now, but be mindful that ecosystems you depend on may collapse. Anticipate and prepare for challenges like supply chain disruptions, payment delays, or decreased productivity from workers who may be dealing with health or childcare issues, and work those into your revised operating plan accordingly. Plus, rapid growth can mean rapid cash burnout. Keep a constant eye on your finances so that you’re not caught without the cash to produce the product your customers are suddenly clamoring for.
2. Take a hard look at your personnel costs.
Salaries can be a huge chunk of a startup’s budget, and it’s a natural place to look when you need to cut costs. When possible, evaluate your own income first.
“If you haven’t reduced your own salary to the bare minimum, that’s obviously a quick and easy one, barring personal financial situations,” Manara says.
You can also look at options like salary cuts (potentially with a refresh on stock options) or furloughs to minimize the number of people you’ll leave without a job. For small teams, reducing each employee’s salary by the same percentage can be a way to equitably share the sacrifice and avoid conducting layoffs.
Still, layoffs may be necessary as a last resort. If it comes to that, be mindful that while unemployment is never great, this is an especially scary time to lose a job. Try to be as transparent as possible with your employees about the state of the business and why you can’t afford to keep them on board, and act as a reference or connection for future opportunities. The best founders utilize their networks to actively seek out job opportunities for laid-off employees.
3. If you haven’t already, discuss your plans with your investors.
Your investors know there’s a disruptive pandemic happening. Don’t sugarcoat or try to convince them it’s business as usual. Have candid and frequent conversations about your revised operating plan. Be upfront with them about the challenges you may be facing since these types of honest conversations are the ones that lead to the resources and answers you need.
“The best founders are very transparent with their investors and their board. Investors expect you to discuss the challenges you’re facing openly, but also to come with proposed solutions. Be prepared to articulate the set of options you considered and the specific approach you recommend,” Manara says.
4. Communicate big changes to your team.
Extend that same transparency to your team. In addition to asking what they need from you, include them in meetings about budgets or cuts. That way, they can understand where change is coming from rather than be blindsided by it — in fact, they may even be the key to coming up with creative solutions.
Institute practices like weekly all-hands meetings and clear-cut plans of action so that although your company and employees may be facing mounting uncertainty in the world around them, they at least know where they stand and what they need to do in their professional life.
Startup founders will have to make a lot of tough choices in the months ahead, so remember that your reputation will be impacted if you execute those decisions in a way that maximizes the harm.
“Think about how you’re treating humans during this time. That’s going to be huge,” says Kate Edwards, co-founder of Heartbeat and member of the AWS Startups team.
5. Make cuts for expense triage.
Take a hard look at every single one of your expenses. You may be surprised how much you’re spending on things that aren’t a priority right now, like magazine subscriptions or unused software licenses. It’s also a good time to lock down corporate credit cards, or at least make it clear that each expense will be monitored closely for unnecessary spending.
Edwards suggests that if you’re debating cuts to employee perks, it can soften the blow to get them in on the decision and show how much money actually gets sunk into these costs. You might show them what it costs to buy office snacks or gym memberships, for instance, and ask them to choose between perks.
6. Tighten AR & AP to improve cash cycle.
It’s common for startups to run a slightly looser ship when it comes to receivables — maybe you’re lenient on payment deadlines with the first client that took a chance on you, or you’re working with a small team that doesn’t have time to chase down payments all day.
Now isn’t the time for that leniency. Be vocal with your clients about how important timely payments are right now. You may even offer a 5% discount for early payment, or be upfront about how critical your cash flow is.
“I found that by saying, ‘Hey, you might be a big company, but we’re a really, really small company, so one day difference could make or break our business,’ [can help]. People are being humans right now, so I think it’s helpful for you to be transparent about what the situations are and say, ‘Look, I’m just trying to make sure that I can make payroll,’” says Edwards.
7. Consider all sources of funding.
Rather than relying solely on fresh VC funding right now, think outside the box for cash you may not have known about or considered before. Look into resources such as industry-specific grants or disaster loans for small businesses. If you have a COVID-specific product or service, you might also be eligible for government research grants. It can be tricky to parse which COVID-specific loans and grants apply to your company, so Manara advised reaching out to a lawyer with startup familiarity to figure out which ones are worth your time.
If you have existing investors, you may want to have conversations with them about extending your most recent funding round or doing a bridge round to secure your cash position. No investor likes doing bridges (unless you already have a term sheet in hand for a bigger round), so if you choose to explore this option, you must come prepared with your revised operating plan, an updated pitch deck, and a tight story about what you’ll achieve with this funding. It won’t be easy to convince investors why they should make a bet on you during this time, and preparation is critical.
With any of these options, the key is planning ahead of time and securing funding while it’s available.
8. Talk to other founders.
It may feel like it, but you’re not alone. Other startup founders are facing the same tough decisions and conversations that you are, and reaching out to each other can be a great way to let off some steam, commiserate, bounce ideas off one another, and pick up a few tips that can help you.
9. Breathe. Sleep. Exercise.
“Take care of yourself so that you can bring your whole self to work,” says Manara. Your team needs a leader they can count on to make smart decisions, navigate change, and rally everyone together. That becomes impossible if you let stress deteriorate your mind and body.
Prioritize sleep, eating well, and other stress-relief measures that work for you. You can tell yourself that you don’t have time for exercise because you’re too busy, but you’ll never regret the long hike that cleared your head and allowed you to come back to your desk with a sharper mind and fresh ideas.
It may also help to remember that with massive societal change can come new opportunities. Appreciate the moments you may have now to connect in new ways with the people or the world around you, and think ahead to the ways your business can adapt and thrive in a world that will look different than the one we knew before.
On Funding
Why do investors want protective provisions?
Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. Roughly, they state that
“The Company requires the consent of the holders of at least X% of the Company’s Series A Preferred to (i) effect a sale or merger of the company, (ii) sell Series B Preferred with rights senior to or on parity with the Series A, (iii) et cetera…”
To understand why investors want protective provisions, you first need to understand how the preferred and common classes control the company.
The board mostly controls the company.
The common and preferred classes control the company through
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Board seats, which require each board member to serve the interests of the company as a whole. Board members cannot simply serve the interests of their particular class of stock.
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Shareholder votes, where the preferred vote as if they held common shares. In legal-speak, the preferred vote on an as-converted-to-common basis. The preferred usually gets one as-converted-to-common share for each of their preferred shares. The preferred and common use shareholder votes to serve their own interests.
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Class votes, which require a majority of the preferred and a majority of the common. We will cover this mind-numbing topic in a future hack. The preferred and common use class votes to serve their own interests.
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Protective provisions, which allow the preferred to veto certain actions, such as selling the company or raising capital. In some companies, each series (Series A, Series B…) has their own protective provisions. In other companies, all of the series exercise their protective provisions as a class.
After the common and preferred classes select their representatives on the board, the board takes it from there. The board, not the shareholders, usually approve management decisions.
However, some major actions require shareholder votes and class votes in addition to board votes. For example, Delaware corporations require a shareholder vote to sell the company or raise money.
Protective provisions protect the preferred minority from the common majority.
The preferred usually owns 20%-40% of the company after the Series A. If the common is united, the preferred can’t influence shareholder votes—they don’t own enough shares. Nor can they influence board votes if a united common controls the board (e.g., the board consists of two common seats, one preferred seat, and no independents).
If the common controls a Delaware corporation’s stock and board, the preferred need protective provisions to stop the common from:
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Selling the company to the founder’s cousin for $1 and wiping out the preferred stock.
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Selling $1M of the founder’s shares to the company so he can get a great haircut.
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Issuing a bazillion shares to the founders and diluting the preferred to nothingness.
Protective provisions protect the Series A minority from unfair actions by the common majority. That’s why they’re called protective provisions. In future rounds, protective provisions can also protect each series of preferred stock from the other series of preferred stock.
Investors argue that protective provisions encourage good governance.
Some investors claim that they need protective provisions because they can’t use their board seat to serve their own interests. They correctly argue that board members have to serve the interests of the company as a whole, not the interests of their class of stock.
These investors will claim that protective provisions let them serve their interests as investors, so they can serve the interests of the company through their board seat:
Say the company receives an offer to acquire the business. Management thinks it’s in the company’s interest to sell. The board defers to management since management is doing a good job running the company. But the investors think the company is the home run in their portfolio—they don’t want to sell the company now. So the investors use their board seat to vote for the sale and use their protective provisions to veto the sale.
Investors should use protective provisions to protect themselves, not to serve their interests.
We don’t agree that investors need protective provisions to serve on the board without succumbing to their own interests.
In fact, any investor who makes that argument is raising a big red flag. They’re implying that they can’t fulfill their duty as board members without additional veto powers. They’re implying that the interests of their fund can outweigh the interests of the company.
Your response to this argument goes like this:
“I don’t think you mean that you can’t serve the interests of the company without these additional protective provisions. I’m sure you will use your board seat to do the right thing for the company, always.
“You control the company through (1) board votes where you serve the interest of the company and (2) share and class votes where you serve your own interests.
“Protective provisions protect you against the common majority. But they’re not a tool to serve the interests of your fund at the expense of the company.”
We would rather have an “evil” investor who uses his board seat to serve his interests, than an investor who planned to use protective provisions to do anything other than protect himself. At least the “evil” investor’s power as a board member is in proportion to his share of board seats—his protective provisions give him a blanket veto that is wildly out of proportion with his ownership of stock and allocation of board seats!
What’s the right amount of seed money to raise?
Short answer: enough to get your startup to an accretive milestone plus some fudge factor.
“Accretive milestone” is a fancy way of saying getting your company to a point at which you can raise money at a higher valuation. As a rule of thumb, We would say a successful Series A is one where good VCs invest at a pre-money that is at least twice the post-money of the seed round. So if for your seed round you raised $1M at $2M pre ($3M post-money valuation), for the Series A you should be shooting for a minimum of $6M pre (but hopefully you’ll get significantly higher).
The worst thing a seed-stage company can do is raise too little money and only reach part way to a milestone. Pitching new investors in that case is very hard; often the only way keep the company alive is to get the existing investors to reinvest at the last round valuation (“reopen the last round”). The second worst thing you can do is raise too much money in the seed round (most likely because big funds pressure you to do so), hence taking too much dilution too soon.
How do you determine what an accretive milestone is? The answer is partly determined by market conditions and partly by the nature of your startup. Knowing market conditions means knowing which VCs are currently aggressively investing, at what valuations, in what sectors, and how various milestones are being perceived. This is where having active and connected advisors and seed investors can be extremely helpful.
Aside from market conditions, you should try to answer the question: what is the biggest risk your startup is facing in the upcoming year and how can you eliminate that risk? You should come up with your own answer but you should also talk to lots of smart people to get their take (yet another reason not to keep your idea secret).
For consumer internet companies, eliminating the biggest risk almost always means getting “traction” – user growth, engagement, etc. Traction is also what you want if you are targeting SMBs (small/medium businesses). For online advertising companies you probably want revenues. If you are selling to enterprises you probably want to have a handful of credible beta customers.
The biggest mistake founders make is thinking that building a product by itself will be perceived as an accretive milestone. Building a product is only accretive in cases where there is significant technical risk – e.g. you are building a new search engine or semiconductor.
Now to the “fudge factor.” Basically what I’d recommend here depends on what milestones you are going for and how experienced you are at developing and executing operating plans. If you are going for marketing traction, that almost always takes (a lot) longer than people expect. You should think about a fudge factor of 50% (increasing the round size by 50%).
How do we set the valuation for a seed round?
1. How much money do we need?
First, figure out how much money you need to run at least two experiments*. Then tack on 3 more months of runway so you can raise another round before you run out of money. This is the minimum amount of money you should raise. For example, let’s say you need $100K.
* Your experiments should be constructed such that a positive result will let you raise more money at a higher valuation.
2. How do we set a valuation from this budget?
Now decide what percentage of the company you will sell for $100K. Pick a number between 10% and 20% of the company’s post-money. You can go below 10% but that probably means your valuation will be too high or you will raise too little money.
For example, let’s say you’re willing to sell up to 15% of the company—that’s your bottom line dilution. This implies a bottom line post-money valuation of $666K.
3. How do we express our valuation to investors?
Finally, tell investors that,
“First, we think we can make the company significantly more valuable if we raise $100K—that’s our minimum. Second, we’re willing to sell up to 10% of the company.”
10% is your aspirational dilution. It’s the lowest dilution you can justify. It’s the lowest dilution you can say with a straight face.
Notice that you didn’t explicitly state your valuation. Combining the dilution (10%) with the minimum amount you’re raising ($100K) implies a minimum post-money valuation of $1M. But the valuation is not explicit. This gives you room to raise your valuation if you raise more than $100K (and we suggest you raise as much money as possible).
4. What’s the range for seed round valuations?
If $25K buys 1% of company, your post-money is $2.5M—that’s on the high end.
If $25K buys 5% of company, your post-money is $0.5M—that’s on the low end.
5. How low do seed round valuations go?
Y Combinator has set new lows for seed round valuations. They get away with it because they also set new highs for helping seed stage companies.
According to the YC, they buy about 6% of a company for $15K-$20K. So the post-money valuation of their investments is $250K-$333K.
But don’t fixate on valuation. Low valuations aren’t bad if you keep the dilution down too. 6% dilution is very low if the company makes a lot of progress with $15K-$20K.
6. How much money can we raise in a seed round?
If you sell 20% of your company at a $2.5M post-money, you raise $500K. That’s about the maximum for a seed round. Beyond that is Series A country.
7. How much dilution should we expect in a seed round?
Take as much money as you can while keeping dilution between 15-30% (10%-20% of the dilution goes to investors and 5%-10% goes to the option pool).
Compare this to a Series A which might have 30%-55% dilution. (20%-40% of the dilution goes to investors and 10%-15% goes to the option pool.)
A seed round can pay for itself if the quality of your investors and progress brings your eventual Series A dilution down from 55% to 30% (for the same amount of Series A cash).
Don’t over-optimize your dilution. Raising money is often harder than you expect, especially for first-time entrepreneurs.
Smart investors don’t over-optimize dilution either. They want to buy enough points to own a good chunk of the company. But they want to leave the founders with enough points to keep them highly motivated to build a lot of value for the founders and investors alike.
Should I raise debt or equity?
Startups often raise their seed round by selling convertible debt instead of equity because debt is simpler and cheaper. Read Yokum Taku’s excellent series on convertible debt for a primer.
Seed stage convertible debt agreements are fairly simple, especially if your investors are angels. There isn’t a lot to hack in these agreements. You should be more careful if your debt investors are VCs, but these debt financings are still much easier to negotiate than an equity financing.
Later stage convertible debt can get complicated and adversarial. We know companies that took convertible debt from a corporate investor and couldn’t pay the debt back on time—which triggered the corporate investor’s right to take over the company. Fun stuff.
If you are raising convertible debt, you should focus on negotiating simple and short documents, closing quickly and cheaply, and maintaining your options for the Series A. But first…
Determine whether you should sell debt or equity.
Let’s say your seed investors purchase debt with a 20% discount off the Series A share price. If you eventually sell shares in the Series A for $1 each, the seed investors will convert their debt to equity for $0.80/share.
Now, let’s say your seed investors are willing to buy equity for $0.90/share instead of buying debt. Should you sell debt or equity?
You should sell debt only if you can use the money to increase today’s share price by over 25% before the Series A financing. Otherwise, sell equity.
In this example, debt is worthwhile if you think you can sell Series A shares for over $0.90/share × 125% = $1.125/share.
Let’s say you decide to sell debt in your seed round and you raise a Series A at $2/share. After applying a 20% discount, your debt investors pay $1.60/share for their Series A shares. You were wise to sell debt to your seed investors in the seed round instead of selling them equity for $0.90/share.
But if you raise a Series A at $1/share, your debt investors pay $0.80/share for their Series A shares. You should have taken their offer to buy equity at $0.90/share in the seed round.
In general, you should sell debt only if you think it will increase your share price over today’s market price for your shares ÷ (1 – discount).
Selling debt is usually better than selling equity in a typical seed round.
If you are raising a typical seed round, say $50K-$500K, you probably want to sell debt instead of equity. If you raise enough seed debt to last 6-12 months, you should have enough time to increase your valuation by the 25%-100% required to overcome typical discounts of 20%-50%.
For example, if you raise $250K in a seed round in return for 15% of your equity, your seed round pre-money valuation will be $1.42M. You should raise debt instead if you expect your Series A pre-money valuation to be at least
$1.42M ÷ (1 – .2) = $1.77M (in the case of a 20% discount)
or
$1.42M ÷ (1 – .5) = $2.83M (in the case of a 50% discount).
In general, if you don’t think you can increase your share price and valuation by 2 to 3 times in every round of financing from Series A to Series C, you should probably pack up and go home. In fact, the company’s share price typically increases the most from the seed round to the Series A as the business goes from nothingness to product, users, or revenue.
Selling lots of debt may be worse than selling equity.
If you are raising a large seed round, say $1M, you may want to sell equity instead of debt.
For example, if you raise $1M in a seed round in return for 15% of your equity, your seed round pre-money valuation will be $5.67M. But if you raise $1M in return for debt at a 25% discount, your Series A pre-money will have to be at least
$5.67M ÷ (1 – .25) = $7.56M
for the debt to be worthwhile. $1M of seed financing may not take your Series A valuation above $7.56M—you may want to sell equity instead of debt in the seed round.
Make your debt attractive to investors
Although convertible debt is often the best choice for a seed round, investors often argue that debt does not incent them to contribute to the business:
Debt holders are incented to help the business.
Your response to an investor’s claim that “(1) debt doesn’t incent me to help the business”:
“If you buy $100K of debt, you get $100K worth of shares in the Series A, plus some shares for your discount. You’re not losing money by contributing to the business—the Series A share price may go up but your share value remains $100K, plus a discount.
“And… as you contribute to the business, the company’s risk goes down, opportunity goes up, and the net present value of your debt goes up. You’re still incented to help the business when you buy debt.”
That said, equity incents an investor even more. If an investor buys $100K of equity in the seed round and locks in his share price, he makes a paper profit if the share price increases in the Series A.
Note to entrepreneur: You don’t need to make this argument on your investor’s behalf.
Equity holders are also incented to decrease the Series A valuation.
Your response to an investor’s claim that “(2) debt doesn’t incent me to increase the eventual share price of the Series A”.
Rational investors are:
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Insensitive to the next round’s price if they plan to maintain their percent ownership,
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Incented to increase the next round’s price if they plan to decrease their percent ownership, and
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Incented to decrease the next round’s price if they plan to increase their percent ownership.
Some seed stage funds maintain or decrease their percent ownership in the Series A. These funds tend to focus on seed stage companies.
Other seed investors try to increase their percent ownership in the Series A—if the company is doing well. These funds tend to invest in most stages of a company’s growth.
Ask your investors about their track record and strategy for follow-on investments. If they like to increase their percent ownership in their best investments, they have an incentive to drive down your Series A valuation whether they buy debt or equity in the seed round.
Make your debt attractive to investors.
Rather than debating the finer points of your investor’s incentives, you can make your debt much more attractive to investors with a few concessions (ordered from small to large):
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Don’t let the company pre-pay the debt. Your investors don’t want you to repay the debt just before you raise a Series A or sell the company.
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Anticipate a potential sale before the Series A and negotiate your investor’s share of the sale price. Your debt investors want to make money if you sell the company before the Series A.
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Increase the discount by a fixed amount and/or 2.5% per month, up to a maximum that can range from 20% to 40%. A higher discount yields a higher return for your investors. For example, a 40% discount guarantees your investors a 1.7x return on paper when the Series A closes.
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Set a maximum conversion price for the debt.
The debt could convert at the lesser of (1) $X/share and (2) the actual Series A share price. This cap effectively sets a maximum valuation for your debt investors and protects them from a high Series A share price. This is a great way to maintain the benefits of convertible debt while rewarding your debt investors for investing early. The maximum conversion price can be significantly higher than any valuation you could negotiate easily.
Perspectives
One last chance to fix capitalism
By: Scott La Pierre - Harvard Business Review
Roughly two-thirds of the way through Reimagining Capitalism in a World on Fire, Rebecca Henderson’s prescription for reversing some of the damage business has done in the past half-century, the Harvard Business School professor rates the chances that environmentally iffy industries might effectively self-regulate. “This is a story of hope followed by despair,” she says, “followed by the glimmerings of renewed hope.”
That pretty much sums up the sweep of emotion I felt recently as I curled up with some sobering, often damning nonfiction on the current state of capitalism and finance. In my head, the working title of this article went from the chirpy “Fixing Capitalism” to the slightly panicked “Can Capitalism Be Fixed?” to the downright baroque “Capitalism Sure as Heck Better Fix Itself, Because No One Else Can, So Here Are Some Last-Ditch Ideas.”
For anyone still unsure that big, important things are now broken, several new titles paint a convincing portrait of grossly unsustainable inequality, corrupt political processes, and a looming crisis—much of it stemming from a financial system that for 40 years or so has prioritized short-term profit over all else and systematically removed any checks on its own worst impulses in pursuit of that goal.
How Money Became Dangerous reminds us that the financial sector was once a quaint service industry, humbly facilitating the greater economy’s stability and growth. The banker Christopher Varelas, who began a long career at Salomon Brothers as a summer intern in 1989, takes us on an autobiographical, picaresque tour of modern finance’s original sins (written with Dan Stone), showing, for example, how the shift from private partnerships to public corporations irresistibly tempted banks to make bigger and bigger bets with what was now other people’s money. “Should we be expected to be good,” Varelas asks early on, “if no longer constrained by the threat of losing one’s own capital?” His answer is yes, but he and his fellow bankers wrestle with exactly how to be good in a system that incentivizes greed.
After all, in less-scrupulous hands this dynamic has led directly, if unsurprisingly, to some very bad behavior. In Sabotage: The Hidden Nature of Finance, the political economists Anastasia Nesvetailova and Ronen Palan of City, University of London point out that a truly efficient, fair, and competitive market would provide little opportunity for profits beyond operating costs; therefore companies—or, more precisely, their leaders—strive to win by bending, breaking, or changing the rules. These authors offer some delectably vile case studies, from the Royal Bank of Scotland’s swindling of its own customers to Bear Stearns’s demise at the hands of unethical rivals, to illustrate the point: “[I]f you want to make money—real money—in finance, you need to find ways of sabotaging either your clients, your competitors or the government.” The highest achievers here manage to sabotage all three of them at once.
To return to Varelas’s adjective, this type of market manipulation is dangerous, and most immediately so to the people it exploits. While those at the very top of the finance superstructure have enjoyed huge gains, inordinate amounts of risk and loss have been offloaded onto middle- and lower-class workers.
High-interest credit cards, mortgages, and car loans are the least-exotic examples of how finance, in the words of the sociologists Ken-Hou Lin and Megan Tobias Neely, “nips income away from consumers and revenue away from the producers and merchants.” In Divested: Inequality in the Age of Finance, Lin and Neely argue that today “the sole purpose of money is to make more money,” as opposed to creating something of value. Meanwhile, “spider webs” of personal debt have replaced the social safety net, leaving a great many of us in a more-precarious financial position. Outsize profits, salaries, and bonuses “are not driven by this sector’s contributions to the economy,” the authors add, “but by the concentration of market power, political entanglement, and the private intermediation of public policies.” So the average consumers of financial products are, in effect, paying a lot more for a lot less—the exact opposite of what free markets are thought to deliver.
The overall picture that emerges is one in which wealth is being redistributed—from the poor and the middle class to corporations and the superrich, who use the spoils to further cement their advantage. Historically, this process has not reversed on its own. Looking to the past for guidance, we can find good news and bad news. The good news: Throughout history, inequality and economic dysfunction have swelled to crisis points, and we’ve usually managed to reform. The bad news: That has generally happened after a violent rupture.
In Capital and Ideology, Thomas Piketty’s magisterial survey of the central role that ideas and discourse have played in alternately justifying and questioning societies’ inequities, we are reminded that political uprisings, financial collapses, and wars—think the French Revolution, the Great Depression, and World War II—are what drive change. To address extreme inequality, Piketty says, “societies need institutions capable of periodically redefining and redistributing property rights.” If those are lacking, or fail, it “only increases the likelihood of more violent but less effective remedies.”
So, about those glimmerings of renewed hope? All the economists and historians mentioned here agree that the single most important step is re-empowering governments, though they diverge on whether that means more-effective regulation, progressive taxation, wealth taxes, or other measures. “In a nutshell, markets require adult supervision,” Henderson writes.
But unless political paralysis and regulatory capture somehow magically disappear, it will be up to future-minded business leaders to start putting out the inferno. Henderson offers inspiring case studies (counterpoints to those in Sabotage) of purpose-driven executives who manage to create value for multiple stakeholders (including, yes, shareholders) without rapacious extraction, exploitation, or environmental damage.
And this is the heart of her fix for capitalism. She wants managers to have better tools for measuring businesses’ true (too often hidden) costs and more-nuanced, inclusive metrics for describing success. The message is clear: It will take good, determined individuals to force the system to recalibrate before an upheaval. Private-sector leaders—especially those who have profited from the market’s decades of inefficient value creation and wealth distribution—should be leading the charge.
Why do investors want protective provisions?
By: Tristan Greene - TheNextWeb
There can be no doubt that automation is the future of work. There’s plenty of debate as to what extent AI will displace workers in the near and far future, but the general consensus is that blue collar work is an endangered species. It’s only a matter of time before robots can perform skilled human labor better and cheaper than we can. What happens then?
Companies will embrace automation
The past is prescient here. In the early 1900s the onset of US factories provided an employment boom for blue collar workers. As the decades wore on, US prosperity became the envy of the world. By the mid-1950s, the American dream had been born.
A family of four could thrive on the average median blue collar salary. Compensation at the time, even at the minimum wage, allowed most workers to purchase a home, a car, and to save up for retirement.
By the end of the 1970s, however, that dream was dead for millions. Cities that had spent decades experiencing total economic prosperity suddenly became wastelands full of impoverished, unemployed people as domestic factories shuttered.
Yet, astonishingly, the US economy itself was steadily rising. This phenomenon was referred to as “regional depressions.”
The country was doing fine, and US citizens were benefiting. The federal minimum wage nearly doubled between 1964 and 1977 and, at the time, it appeared as though US prosperity would be every citizen’s birthright.
And then companies figured out they could outsource production and manufacturing to countries where workers had no wage protections. Instead of paying a single US factory worker a living wage, companies could afford to pay dozens of overseas workers for the same amount.
Fast forward to 2021 and it’s clear: when automation technologies become robust enough to replace blue collar workers, they will. This is the logical evolution of labor outsourcing.
But what about customer service?
The first argument experts tend to throw out when the idea of ubiquitous automation comes up is that good, old-fashioned human customer service will never go out of style.
To those experts, I ask: what percentage of US citizens pump their own gas, pay their bills online, or shop on Amazon? Customer service with a real human face isn’t all it’s cracked up to be.
The myth that only certain jobs are at risk is becoming harder to peddle each year. AI technology is poised to replace humans in almost every blue collar domain within a matter of decades. White collar domains aren’t necessarily safe either, but the people who run the companies deploying the automation are ultimately the deciding factor in which workers are displaced, not the technology itself.
You won’t see many unskilled managers replacing themselves with AI for the same reason factory CEOs didn’t outsource their leadership positions along with all their floor workers’ jobs.
This isn’t good for capitalism
In the 1970s, when factory workers were displaced to the degree that entire cities were ravaged by poverty and unemployment, the US economy managed to keep on trucking because corporate America figured out a way to squeeze money out of the unemployed: credit.
By 1989 the US credit scoring system had been established and consumers who’d traditionally supported themselves with full time work were able to spend money they didn’t have.
Worse, people who didn’t participate in the credit system – that is, those who didn’t take out loans or finance products or services – were given poor credit scores. This often meant they weren’t able to obtain housing or purchase a vehicle and, thus, made it even more difficult to secure employment.
Luckily for the US economy, plenty of people accepted the banking system’s faux bailouts. Displaced workers invested their borrowed money in the economy to sustain themselves and their families while they searched for work, relocated, or attended college in order to re-enter the jobs market.
The present is prescient
In 2021 we have the benefit of viewing the future through the lens of the past, but we can also take a look at what’s happening right now to see where things are going. COVID-19 has been a sort of dry-run for the automation economy.
We’re not currently seeing the benefits of having robots do all of our work, but we do live in an economy where millions of workers were displaced in a very short period of time. As a response, the US sent thousands of dollars to most citizens in the form of three separate stimulus payments.
Research shows that people put that money back into the economy immediately. They paid bills, purchased services, and bought goods.
But businesses haven’t self-regulated. Hundreds of corporations accepted bailout money from the government while simultaneously laying workers off, freezing promotions, and halting all hiring. Many businesses, especially those in the technology sector, actually increased profits during the pandemic.
This demonstrates that capitalism can thrive even when employment and economic confidence are disrupted. But what happens when there isn’t a bailout, loan, or stimulus to allow consumers to continue spending?
If US companies shift to automation with the same abrupt callousness as their predecessors chose to outsource American labor, the banks won’t be able to save the economy by loaning us all money like they did in the 1970s. The average American already carries about $90K in debt.
And that just leaves the government. Whether you’re for or against a universal basic income, if businesses outsource human labor again, many of us will need one just to survive.
Meet the new boss: corporate-friendly socialism
That’s why the future of capitalism is socialism. It’s the government taxing businesses based on the amount of worker displacement their automation solutions cause, and then using that money to create a universal basic income for all citizens.
In such a case a UBI wouldn’t save people from working. If your biggest gripe with UBI is a misguided belief that people won’t want to work if they get “free” money, perhaps you’ll be more sensitive to the pitiful plight of big businesses.
Forcing companies to employ humans, when it could be much cheaper to automate, would hurt profits for billionaires and trillion-dollar corporations. Human labor is bad for profits.
When given the opportunity to slash costs and maximize profits using automation, businesses are much more likely to support a paradigm where the government gives consumers money to spend on their products than one where they’re forced to eschew cheap labor.
Half of all VCs beat the stock market
By: Fred Wilson - AVC
There has been this narrative about investing in VC funds that you have to get into the top quartile (25%) or possibly the top decile (10%) in order to generate good returns. I have heard that for as long as I have been in VC and probably have written it here a few times.
Well, it turns out that is not right. Half of all venture funds outperform the stock market which is the benchmark most institutions measure VC funds against.
My friend Dan Malven wrote about this on his blog yesterday:
A working paper published by the National Bureau of Economic Research (NBER) in November 2020 contradicts that notion, showing that half of all VC fund managers outperform the public markets, and are therefore worthy of institutional investment.
This study was based on a large sample of VC fund level returns from 2009 to 2017 and does not include the last few years which have been particularly strong for the VC sector.
Manager selection remains an important part of VC investing because the lower half of VC funds do not outperform the stock market. An interesting data point from this study is the VC “fund of funds” mostly outperform the stock market so a portfolio of VC funds will generally give you enough diversification that you can meet your performance objectives.
The best way to know what managers to pick is to be in the startup business in some way. All you need to do is watch how people behave to know who is good and who is not. The Gotham Gal and I have been investing in the VC funds of managers we know well and have worked with closely on boards of startups for about fifteen years now.
These are the gross return multiples of all of the funds that are “mature” meaning the returns are pretty clear now:
Multiple Year Of Initial Investment
8.66 2006
3.65 2007
5.29 2007
3.31 2010
10.38 2010
7.63 2010
4.71 2010
2.01 2010
2.29 2012
8.58 2012
3.97 2012
I am not going to do the work of calculating performance against the stock market for these funds, but I suspect all buy maybe two of those eleven funds have outperformed the public markets.
As you can see, investing in VC funds can be very profitable. And I suspect it is getting more profitable, not less, as the capital markets and M&A markets are providing robust liquidity options for managers.
Sadly the VC market remains largely out of reach of many “main street” investors as the SEC limits these fund investments to qualified and accredited investors. That has never made sense to me and is yet another example of the “well meaning” rules resulting in the wealthy getting wealthier and everyone else missing out.
Why institutional investors should double down on VC
By: Dan Malven
Most institutional investors have some exposure to the venture capital asset class, but conventional wisdom has been that only a small handful of marquee VC managers are worthy of investment.
A working paper published by the National Bureau of Economic Research (NBER) in November 2020 contradicts that notion, showing that half of all VC fund managers outperform the public markets, and are therefore worthy of institutional investment.
This is still an NBER “working paper”, meaning it has not yet been peer-reviewed, but the authors — led by Steven Kaplan of Booth School of Business at the University of Chicago — are highly experienced researchers and are unlikely to have made any egregious errors. Thus, this work will likely survive the peer review process.
They found, using a data source that was previously unavailable to researchers, that VC firms’ outperformance is much more broadly distributed than previously understood. The decades-long belief has been that only top-quartile VC funds outperform public equities.
Anecdotal belief among the LPs in VC funds is that the top quartile performance is actually driven by only the top 5 percent of funds within the quartile. Nobody really knows for sure because the underlying fund-level data had not been available for analysis, until now.
This new analysis shows half of all VC funds launched between 2009 and 2017 generated returns to investors, net of all management and performance fees, that outperformed the public market equivalents (PME) of both the S&P 500 and Russell 2000.
PME is important because it is a relative measurement to what investors would have gotten had they invested their cash into those public market indexes, net of fees, and with the same timing of specific cash inflows and outflows, including dividends paid by public companies.
It’s also important to note that VC industry returns for the 2009 to 2017 vintage years are likely to only get stronger as all of the IPO and SPAC exits occurring after the dataset cutoff date of June 30, 2020 push the numbers up, possibly pushing 75 percent of all VC funds above PME.
The conventional wisdom of only 5 percent of VC funds each year being good investments is off by an order of magnitude. At least 50 percent of all VC funds are good investments.
This new data set comes from the accounting back-office systems of thousands of institutional LPs (primarily pension funds, endowments and foundations), so while it is a highly accurate and unbiased data set, the most accurate statement is that half of VC funds that have institutional LPs have outperformed PME.
The 20–80 rule
The paper confirms one important point of conventional wisdom, in that company-level returns within a specific VC fund follow Pareto’s Principle: 20 percent of the companies within a fund generate 80 percent of returns. It also shows that 40 percent of companies within a fund become worthless. So at the company level, VC investing is risky, but at the portfolio level it is lucrative.
The study found that VC fund managers who outperformed in the past are highly likely to outperform in the future. While many believe that public company investing is a game of chance, as popularized by monkeys throwing darts and A Random Walk Down Wall Street, VC investing is a game of skill, with the most skillful practitioners consistently outperforming their peers.
The analysis shows that the average VC fund of funds, or investment vehicles that only invest in VC funds, generate net returns that also outperformed the S&P 500 and Russell 2000 PMEs over the same period. They more than make up for their fees by picking better VC fund managers than the average institutional LP can do on their own.
All this data leads to the conclusion that the VC industry has generated better returns than public markets. The question is: how much better?
The answer depends on the specific vintages you invested in.
Experienced LPs and GPs will tell you to never try to time the VC market; just invest consistently across vintage years, and ideally in the best firms. Ignoring your ability to pick the best firms, and just looking at your portfolio diversified by vintage year with equal diversification across firms that performed in the first, second, third, and fourth quartiles of performance of all post-2000 vintages, you would have outperformed public equities by 10% over that period.
If you could have picked first and second quartile funds, and then first quartile funds only, you would have outperformed by 60 percent and 110 percent, respectively.
While this data, is backward-looking by nature, the authors use prior data to indicate potential future VC industry returns. The authors debunk the old chestnut that there is “too much money out there chasing too few deals” by showing that VC industry capitalization remains at relatively low to medium historical levels of 0.10 to 0.15 percent of total stock market capitalization. When VC industry capitalization is at low to medium levels, the next five to 10 years of VC industry returns are expected to be strong.
The take-away is that even while the VC asset class has been very good to institutional investors over the years, they should double-down and accelerate their allocations, and do it to a much broader set of VC fund managers than they historically have done.
Is 'data' the next oil? or is it the next sand?
"Data is the new oil" became widely used starting in 2006 and Clive Humby is usually credited coining/popularizing the phrase. Many have repeated it or even gone further calling it the next natural resource. Unfortunately, it's usually difficult to use available data to power AI as it needs lots of processing and refinement. That makes me think of data rather being the new "tar sand" where you first need to extract the "oil" before you can process it in the analogy to oil.
Others have already outlined the flaws in this analogy, e.g. Bernard Marr on Forbes. Data is not really like other natural resources. There's no limited supply, it's not "used up" in the same way, data per-se is also becoming more and more available - quite unlike oil. Data is effectively a new digital resource.
Data is different from oil in many other ways. A few key aspects to keep in mind:
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Data for AI needs be diverse & balanced. This is e.g. outlined by Forbes. You need to know what data you are using and what you ask the AI algorithm to give you. Even more importantly you need to understand what you didn't ask for. E.g. Did you ask for diverse data across all user/customer segments? If not, you are almost certain to get implicit bias from data as a result of your AI algorithm. Finally, you need to understand what you didn't give the algorithm as a goal - often accuracy is the main goal and fairness gets forgotten. While it's a trade-off between fairness and accuracy - in technical terms this could be made transparent as an efficient frontier to make the best decision on how much accuracy to sacrifice for more fairness.
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Huge amounts of data are also not valuable by themselves - i.e. TechTalks. The more data you have the more effort you'll likely have to use it. Synthetic data and transfer learning can help lower the effort for labeling the data. Accepting a somewhat lower accuracy though. And you'll need to have great understanding if your synthetic data is representative.
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Having the right data can be extremely powerful. Just having data and getting more of it might not be too important though - see e.g. Andreessen Horrowitz. It's key to understand what effects regular scale effects vs. true effects of having lots of (the right) data. I like that the article also covers what's well known in conversational AI, you have a long tail and it's hard to get the data for the long tail. Getting in more data also has diminishing returns after you've succeeded with the initial value delivery. Even worse, data becomes stale and useless over time. Leading to expensive cleanup - with more data being more expensive to keep fresh. In short there's a clear trade-off between quality and quantity.
Overall, data is something very different than oil. It is very diverse to start with. And having more of it is not always a good thing. Make sure you understand your data, what of it is useful, what is giving you a competitive edge. Your team, your understanding of the relevant business and having the right data is a powerful combination. Just having lots of data is not.