Angels and Demons

For those that know me well, I have two passions in life: technology and building companies. Since I started Parallax a couple of months ago, a number of my readers have asked me to write a bit more about the latter. Apparently they think I've formed some opinions about raising venture capital and building venture backed startups. Well, I have. And to this end, I have decided to intersperse my normal technology related blarticles with a series of shorter posts aimed at sharing some of what I have learned. I hope you will find these interstitials interesting, and I have a feeling some of my opinions may drive some heated debate. So without further adieu, i present you with my first installment.

Angels and Demons

Recently a good friend of mine (name omitted so he can hold onto his current job) decided he wanted to start another company. While he was eventually able to take his last startup public, he unfortunately caught a bad case of LTS in the process. LTS, commonly known as Lockup-Timing Syndrome, occurs when you’re still in lockup and the decibel level of the market crashing becomes inversely proportionate to the number of Ferrari’s purchasable with your vested shares. I can’t think of anyone I know who worked harder for longer only to be outed by a triple-play in the 9th inning. No good startup deed shall go undone I suppose. Fortunately for him, and hopefully for many of us in the near future, he’s the kind of entrepreneur who has far more than one fantastic idea in his lifetime.

Having been around entrepreneurs for a while now (and in rare moments even describing myself as the same), I’ve formed some pretty strong convictions about what good entrepreneurs do and bad entrepreneurs don’t.

1) Good entrepreneurs throw away 90% of the ideas they come up with. Let’s face it; we all secretly tell ourselves we have one “brilliant” idea for a novel and two more for movie scripts. Thank your deity of choice most of us are too lazy to actually attempt to write them (well, most of us). Not surprisingly though, entrepreneurs that throw away 90% of what they come up with are many times left with a pony in the remaining 10%.

2) Good entrepreneurs talk to as many people as they can about their ideas. For many running the startup gauntlet for the first time, this seems like complete heresy. I can’t tell you how many times I have heard “I don’t want anyone to steal my idea”, “I can’t write that in email, we need to talk on the phone” or “Company X could easily just fund it themselves if they heard about it”. Well the reality is that once you get past the vanity that your idea is the best thing since sliced bread and baby carrots, the reality is that very few people in the world will just drop everything and start a company based on overhearing 15 seconds of your pitch at Starbucks. And as for your competitors, yes they can build it themselves. And even if you start the company yourself, they might just do that anyway if the idea is good enough. Get over it and get ready for it. And please, for God sake, don’t walk into a VC’s office with an NDA. In the VC community, NDA is an abbreviation of NaDA, as in “not going to happen” (definitely your NDA and most likely your deal).

3) Good entrepreneurs get the business model right before they worry about how to fund it. I added this to my good entrepreneurship punch list a few years ago after one of the most comical experiences I had as V.P. of Research at Exodus Communications. Exodus at the time was the world-wide-leader in web hosting. At the peak of our glory we looked at buying another large hosting provider. All the key executives from both companies piled into a plush legal firm’s office somewhere a few stories above the cloud-line in downtown San Francisco. We were there to talk about the merger of two giants. The providence alone was titillating. What do you think the first thing out of the other company’s mouth was? And I quote: “the first thing we need to do is talk about price”. Apparently the second thing we needed to do was get up and leave. Immediately. And that’s pretty much what we did, minus a couple hours of diplomatic executive pleasantries. You just don’t lead with price if what you’re selling is valuable. Imagine if Lincoln had quipped “Four score and seven years ago our fathers negotiated a great rate on four trans-Atlantic sailboats..”. Nuff said.

So, back to my friend for a second. Not only do I think he’s got a great idea, but I have to give him credit because unbeknownst to him, so far he’s coloring well within the lines of my entrepreneur do’s and don’t guide. On my first point, he’s done an incredibly good job of throwing away 90% of the ideas he’s had related to revenue models, the appropriate go-to-market strategy, technology stacks and product roadmap. Where he’s ended up was not exactly where he thought he would, but you know what they say “Horseshoes, hand grenades, and startup business plans”.

Confident in the remaining 10% of his ideas, he moved on to step 2. He talked to potential end users of the product, leaders in the space he’d be playing in, successful entrepreneurs he knows, possible team members, friends, and family.

After all that, then and only then, did he walk into Polaris and have a serious sit down about how to get the thing funded. After a great meeting with Bob and the gang, apparently devoid of any of the Ten Lies of Venture Capitalist, he sent me the inevitable question: Angels or Demons. You see, the fallacy of point #3 above is that, in the end, all you really do care about is how to get your baby funded. And the reality is that you don’t have many options.

If I was to do a relatively cursory survey of how you could get a zero-code, one man team, PowerPoint-only company funded, you really only have four options: fund it yourself, get a customer to fund it, raise money from Angels, or raise venture.

Self-Funding

Self-funding a company has two downsides: you get to watch your personal bank account go down and you get to watch the company’s bank account go down. Personally, I can watch only one at a time without minor heart palpitations. If that’s not caution enough, try making a rational decision about how to spend the last 30 days of cash you have knowing you’re two months late on your mortgage payments. Leave this method of financial carnage up to those going into the restaurant business (I speak from experience here on both accounts).

Funding through a Customer

The great thing about funding a company by building your v1 product for a specific paying customer is that all customers are completely representative of the general market. Any customer you pick will give you a balanced perspective of the features customer 2, 3, and 4 will need when you get around to selling to them. Expect little to no re-engineering for v2, and definitely not a complete re-write by the time you get to v3.

For those unfamiliar with sarcasm, that last paragraph was a weak, but well intended attempt at it. I have two opinions on funding through a customer. First, don’t. Second, don’t. This strategy should really be called the “Throw the first one away” strategy because you will. I promise. When it comes to building specific features for customers after you have your general product released and accepted in the market, I have a pot-limit betting sort of philosophy about making these decisions. If the customer is willing to pay you a price equivalent to the revenue you expect from all non-customized sales during the time it takes you to develop the customizations, consider the deal. Anything under that will be a distraction you’ll pay for in every subsequent release of your product.

Venture

Let me go a little bit out of order here. First off, I’m being glib about Demons (I just liked the title). I’m pro-Venture backed startup all the way. Its how I have always done it and how I will always do it (if given the continued chance). Part of this opinion results from the utter lucky fortune I had during my first VC backed startup, working with some of the best VCs in the industry. I would consider Brad Feld (Mobius) my first professional mentor, Pat Kenealy (IDG) taught me more about business model integrity (more on this in another post in the thread) than anyone ever has, and Anne Mitchell (Fidelity) solidified for me that good VCs get your back and don’t stab it. But there is a understandable anxiety of many first time entrepreneurs around the VC community. Much like NDAs though, you just have to get over it.

To start, let me spell out what you can expect in a pre-revenue Series A conversation. With the caveat that yes, there are exceptions, your Series A will be 3 on 3, 4 on 4, or 5 on 5. For those unfamiliar with the abbreviated terminology, this means 3M cash put into a 3M pre-money valuation. To figure out how much of your baby you’ll give away, you do the simple math “cash divided by (cash + pre-money)”. In other words, if you can convince someone that your idea is worth 3M dollars purely as an idea (hence the name “pre money”), and you tack on 3M in cold hard cash, the total kit and caboodle is worth 6M dollars (referred to often as “post money”). But the VCs just gave you 3M of that 6M so you’re gonna have to give them 50% of your company in return. You’ll notice that I said there were basically three Series A outcomes: 3 on 3, 4 on 4, 5 on 5. Oddly enough they all work out to the same percentage of your company: 50%. In reality with the options pool and some other wrangling, you will end up giving away 45-55% of your cap table in any serious venture-backed A round. But how could that be? There must be a difference between getting 3 on 3 and 5 on 5. Well, sort of. It’s complicated. I’ll attempt to explain it (and what control you have over it), in another post in this thread.

The key to understanding the trade off between Angels and Series A Venture is what I affectionately called “The Series B Pole Vault”. Anything under the Series B hurdle is as good a nothing. I expect people to disagree with me on this one, but I strongly believe it from my experiences. Ask a number of VC firms what metrics they consider when differentiating Series A deals from Series B. You’ll hear things like “1M in revenue”, “5 marquee customers”, “completed product”, “complete executive team”, etc.. Understand though that this is a step function analysis. There is no Series A½ in between Series A and Series B. If you’ve got some prototype code, something in the pipeline, 100K in sales, a provisional patent, and some of your executive team filled out, for all intensive purposes you might as well have PowerPoint and be looking for office space.

Angels

The word Angels sounds so great, doesn’t it? Fiscal saviors reigning cash from the heavens. Angels are always a tempting option. But there are some major problems with raising money from Angels. First, Venture investors generally don’t like messy capitalization structures. If you can do it all with 2 or 3 Angels then great, but in reality most entrepreneurs scrape together 10 Angels at 50K a piece. That’s messy when it comes to your first real venture round. Lots of voices, lots of signatures, who’s gonna do their pro rata, who ended up with a board seat, who’s mother has her pension on the line. It’s just messy. No other way to describe it.

Second, Angel rounds are usually too small to get you past the Series B pole vault. This is the fundamental Achilles heel of the Angel strategy. When you’ve been out of work for 6 months, consumed by your devotion to your idea, eating ramen for the 10th straight night in a row, 500K sounds like a hell of a lot of money. And in general it is. But you have to look at the complete timeline to the next round. How far will this money really take you? How many months of cash does this provide you given the size of the team you’ll need to get the job done? Now remove 4-6 months of that runway because you’ll be spending it running around Sand Hill and Winter Street talking to VCs about your Series A. By the start of that 4-6 months, what will you have been able to accomplish? Remember it’s a pole vault. You get no points for going under the bar, even if you’re only a few inches away. And you are going to get graded based upon what you walk in the door with. Day one. This is the hell that most Angel funded startups find themselves in. You have 10 investors, you’ve spent 500K of their money, you’ve almost got a customer, the pipeline is growing, you have some good leads on executives who will join if you get “real” funding and you walk into a VC office and what do you hear? “This looks like a Series A deal, how about 4 on 4”. Doh! This has happened to so many Angel funded companies that I don’t care to count them.

So what’s the moral of this story? Well, my friend is in this dilemma now. I think he’s starting to realize the Angels or Demons dynamic and embrace the realities of today’s venture model. Because he’s gone through it before, he knows that you have to step back and think through all the rounds of funding you’ll do. Series A is a small step on a long journey. Embrace your demons and repeat after me “smaller piece of a bigger pie”.

Comments

[Knox Massey]

Good comments on angel investing. If an angel round (messy or not) gets you to Series B--that's half the ball game. Most angel groups are thrilled to play that part for the entrepreneur. Yes, some may ask what weighted average is and some may be Nervous Nellies, but you'll also find committed and experienced angels that will help guide and push you until Series B (or A-1!) is reached.

[Daniel Nerezov]

Niel, I think that's a great blarthicle you've written.

Not sure, how practical it is to tell the average founder to go and raise venture capital - but, nonetheless - a great post.

Perspective opposite to yours: www.antiventurecapital.com

[Niel Robertson]

For a VCs perspective on this (especially the Angels section), Will Price (Hummer Winblad) wrote a good blog entry at:

http://willprice.blogspot.com/2005/12/cap-table-hygiene.html