..........and bullshit walks! Easy as that for start-ups when it comes to making up your mind about raising additional capital. Are we in a bubble? No idea but this question keeps creeping up. Those of us who went through the bubble at the turn of the century are secretly hoping we're not in another one. Those who don't remember the last one are also worried wondering whether all the old-timers are right. One way or another, it doesn't really matter.
You'll hear multiple opinions on whether to raise money at times like this. I have a very clear opinion on this. It's based on the fact that I believe the best venture backed businesses are in it for the long haul. These are companies with a real product that add value to their customers. These are businesses generating real cashflow intent on growing to significant scale. Finally, these are businesses which will use additional money to expand. Hence, here's my take on when to take money (with focus on EU based businesses):
1. Sequoia or Kleiner are on the phone. Start negotiating, get the best deal you can get and make sure to raise the money. Say what you will but Tier 1 VC's from the US will lead to a far larger exit. Specifically the top tier funds have access to management for your businesses, access to potential partners and are likely to sit on the boards of the companies that could buy you. You'd be dumb not to take money but do so wisely.
2. A tier 1 fund from Europe is interested. Find out whether there's a good fit with your businesses. I've often enough written about how to figure this out and I say to focus on the partner and not the fund when doing your due diligence. Negotiate a good deal and take the money. Tier 1 funds in Europe have learned to add value, have significantly better networks nowadays and will most likely get you bought by a US based business.
2.5. A tier 1 fund from your home country calls up. I've labeled this 2.5 because Tier 1 funds in Europe tend to only differentiate themselves based on where they are located. The rest is mostly the same. The benefit of a tier 1 locally invested in your business is the proximity. It's in your interest. You want them closer than further. If the terms are right and you have offers from abroad and locally, I'd sway towards local but the vibe has to be right. You won't be necessarily doing anything wrong taking money from a London VC verses a German VC when you are in Germany. The London VC may even be around more than the German VC. This all depends on the partner.
3. A tier 2 fund from the US calls up. Ask yourself first why they found you? Go ahead and ask. Further, research the fund and find out what they've done in the past. Have they invested in Europe before? Are they only looking to Europe because their dealflow in the US sucks? Think twice about whether they will invest the necessary time to be in Europe and invested in your business. If the deal terms are good and you are comfortable with the partner doing the deal, take the money. They can still be helpful in accessing US buyers. They are highly unlikely to open as many doors as Kleiner or Sequoia but they definitely know more people in the US than many European partners. Plus make sure you want to go to the US. They will probably eventually ask you to move the company there.
4. A tier 2 fund from outside your home region in the EU finds you. Ask yourself how the hell they found you. More importantly, if you found them, ask yourself why the Tier 1 funds from your local region aren't interested in what you are doing. Say what you will but a UK based fund prefers to invest first in the UK and then rest of Europe. A German fund in Germany and then rest of Europe, etc. Although valuations are good and the power is in your hands to some extent think twice. There are times when taking money could be detrimental to the health of your business (as well as to your equity stake). It's nice to get a higher valuation and some extra cash but make sure it doesn't ultimately cost you more than you think.
5. A tier 2 fund from your local region calls up. Again, ask yourself first why the tier 1 funds aren't interested. Don't underestimate the value of many tier 2 funds though. Maybe they aren't the best known name in the market. At the same time, maybe they are striving to become a better fund. Maybe the number two in the market will work harder than the number one for you. This may be in your interest. Maybe! Do your homework and if you are comfortable with terms, take the money. Be far more diligent in this case though. Think longer and harder about whether you really can do more with the money now or prefer to hold out a bit.
6. Some tier 3 fund you've never heard of and can't find out much about approaches you. Be really careful. There are lots of people in this business who sure won't be around in a couple years. Money from these guys can be a nightmare. At the same time, maybe your business is the nightmare and you couldn't raise money at any other time. One way or another, things aren't going right one way or another. If you need the money to survive and know you'll never get more down the road, do everything you can to raise cash now. Maybe you've just been approached by the future Kleiner or Sequoia of Europe. Maybe not.....but money talks and bullshit walks!
You'll notice a general trend from 1. through 6. above. Take the money! If you can get good terms, know how to put the money you raise to work for growth and like the partner from the funds approaching you, go for it. The getting is good right now. As a VC I'm worried about valuations and bursting bubbles, etc. but as an entrepreneur you should be optimizing for you business. Money is always good. Ignore all the crap about having too much money and being negatively swayed by this. In this post I am defaulting to the fact that I think you are a smart entrepreneur. You aren't going to raise money to get that Porsche as a company car. You're going to grow your business and become amazing. Some will say I am wrong but I'd prefer to have the cash in the bank and worry about being wrong later.
Editor’s note: Guest author Chris Yeh is an independent angel investor and VP of Marketing for PBworks, one of his investments. He has been involved with Internet startups since 1995. His Twitter handle is @chrisyeh.
Update: This post originally referred to DST as the investor in Start Fund when it actually is Yuri Milner personally investing, along with Ron Conway’s fund SV Angel.
Update II: This has been corrected below.
The big news this morning is Yuri Milner’s announcement that he and Ron Conway will be investing $150,000 in *every* Y Combinator startup on a no-discount, no-cap convertible loan.
Many people have already weighed in with instant reactions—”It’s a bubble!” “It’s the greatest thing to happen to the US economy!” As usual, these off-the-cuff reactions focus on a single part of the story, rather than looking at the big picture.
Let’s walk through the news, step-by-step, and see what it really means. Ultimately, my take is that it’s good for Y Combinator and Milner, but bad for the rest of Silicon Valley.
1) “Yuri is a fool who believes he can sell to a greater fool.”
Many people mocked DST when it began investing in companies like Facebook at “outlandish” valuations. DST invested in Facebook at a $10 billion valuation; with the valuation now above $50 billion, I’d say Yuri is having the last laugh (for now).
If Milner is investing in YC companies on these terms, it’s because Milner believes it can make money on these terms (more on this later).
2) “I can’t believe all the money going into YC’s dipshit companies.”
Once upon a time, Y Combinator’s companies were features masquerading as companies. But anyone who still thinks that isn’t paying attention. The quality of YC companies has risen considerably; the companies graduating from YC these days are much more polished and accomplished. And with monster successes like Dropbox and AirBnB (along with Heroku’s exit), YC’s company quality is looking better and better.
3) “Finally, someone who’s willing to take risks, unlike today’s pantywaist angels and VCs!”
Now we’re getting to something more substantive. There seems to be a feeling among entrepreneurs that investors are no longer willing to take risks, and that no one is willing to invest in ideas any more. My response to that is simple—if startups are really so low-risk, why is it that only a tiny fraction of the companies that do get funded (which are presumably “no-brainer” investments for all the cautious VCs) actually return any money to investors?
Of course I try to invest in companies that I expect to be “sure things,” but I also know that history predicts that at least 60% of my investments are going to be complete financial failures. The reason Milner is willing to take on such risk is simple—in addition to the actual investment, it’s also buying option value.
Option value is what makes the VC system work—by investing in stages, investors are able to abandon companies that don’t look likely to succeed. This is why startups are so much more effective than big companies at innovation—a big company’s internal politics make it difficult to try lots of things that will probably fail. Milner has additional option value available to them that traditional angels do not because of its ability to invest at later stages. By investing in the seed round, Yuri – and DST – gets the inside track on any future financings.
Let’s say that I was lucky enough to invest in Facebook’s seed round (I wasn’t). As the company raised further rounds of funding at $100 million and $10 billion valuations, I would have to come up with increasingly large checks to maintain my ownership position. Buying 0.1% of the company is pretty easy at a $5 million valuation (that’s just $5,000). It gets harder at $100 million ($100,000) and $10 billion ($10,000,000).
For Milner, however, investing a few million in YC companies is well worth it if it gives him the inside track to do a $100 million expansion round in the future. Moreover, is Milner really making it easier for entrepreneurs to raise money? I was not under the impression that YC grads were having difficulties raising money. It’s not like Milner is giving $150K to anyone who asks—the investment is reserved for companies which pass YC’s rigorous screening process.
4) Okay, Mr. Smarty-Pants, why is this bad for Silicon Valley then?
In the TechCrunch comments, Ted Rheingold of Dogster fame says simply, “This is not going to be healthy for the ecosystem.” I think he’s right, but the reasons he’s right are subtle. Allow me to explain.
a) Independent angel investors need to be able to invest at reasonable valuations.
As I explained in (3) above, folks like me need to be able to invest at reasonable valuations. That means either priced rounds or convertibles with valuation caps, and seed round valuations of $1-3 million. We don’t have the money to stay in the game with the VCs and DSTs of the world, so if seed funding shifted to a model of no-cap convertibles, we would be priced out of the ecosystem.
In today’s environment, many companies skip straight from a seed round to $20 million+ valuations, and angels simply won’t get rewarded for the extra risk they assume without priced rounds or caps.
b) The Milner/YC partnership could end up upsetting this delicate balance
As I’ve argued in the past, angel investing is a fragmented game. No one has enough power to collude on valuations. However, someone who is influential enough can influence what is and isn’t considered “standard.”
Once upon a time, there was no such thing as a convertible note with a cap. There were convertible notes, and there were priced rounds, and nothing in between. Then a few years ago, a number of prominent players in the ecosystem (YC included) began pushing the concept of a capped convertible. Today, even though there are plenty of angels who despise any kind of convertible note, capped or not, the capped convertible is pretty much the standard seed financing instrument.
Now imagine the impact of YC, the most influential incubator, standardizing on uncapped, no-discount convertibles. It’s not difficult to envision a scenario in which the entire industry moves in this direction. The problem is that this shift eliminates the incentive for independent angels to participate in the ecosystem.
Angels play an important part in the ecosystem because we are willing to take on more risk than the VCs. Some of that is non-economic behavior, but some of that is also due to the fact that we get compensated for that risk-taking with much lower valuations. Eliminating that compensation will surely reduce the number of independent angel investments.
The irony is that the Milner/YC deal didn’t have to cause problems for independent angel investors. If Milner committed to providing $150K to every YC company, at whatever terms were determined by the lead investor in the syndicate, he wouldn’t be pricing the angels out of the ecosystem.
c) Removing independent angel investors from the ecosystem is a bad idea
Naturally, angels like me will be upset about getting shut out of the ecosystem, but why is that bad for Silicon Valley? After all, between YC, TechStars, the Founders Institute, and all the other incubators and quasi-incubators, who needs us? Let the incubators pick the winners, and let the DSTs fund them.
The problem is that the chaotic, fragmented, Darwinian nature of Silicon Valley is an integral part of what makes it great. We need those random mutations to generate innovation, especially breakthrough innovation.
If we concentrate the decision-making on who does and doesn’t get funding in the hands of a small number of institutions, we hurt Silicon Valley as a whole, no matter how smart those institutions are.
I tell many people that Paul Graham is a genius. He saw the opportunity to start YC, and he’s done the Valley a huge favor by broadening the pool of company founders. But I don’t want Paul to be one of a small group of people who decides which companies get funding—not because he isn’t smart (he is) or a great guy (he is). When it comes to innovation, central decision-making is bad, no matter how good the decision-makers are.
For all our flaws, independent angels serve the important role of enabling the “genetic diversity” of the startup population. That diversity is at the heart of Silicon Valley’s success, and that’s something we don’t want to lose.
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