Essays

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If you take VC money, you have to mean it, because the structure of VC deals prevents early acquisitions. If you take VC money, they won't let you sell early.

7. VCs want to invest large amounts.

The fact that they're running investment funds makes VCs want to invest large amounts. A typical VC fund is now hundreds of millions of dollars. If $400 million has to be invested by 10 partners, they have to invest $40 million each. VCs usually sit on the boards of companies they fund. If the average deal size was $1 million, each partner would have to sit on 40 boards, which would not be fun. So they prefer bigger deals, where they can put a lot of money to work at once.

VCs don't regard you as a bargain if you don't need a lot of money. That may even make you less attractive, because it means their investment creates less of a barrier to entry for competitors.

Angels are in a different position because they're investing their own money. They're happy to invest small amounts—sometimes as little as $20,000—as long as the potential returns look good enough. So if you're doing something inexpensive, go to angels.

8. Valuations are fiction.

VCs admit that valuations are an artifact. They decide how much money you need and how much of the company they want, and those two constraints yield a valuation.

Valuations increase as the size of the investment does. A company that an angel is willing to put $50,000 into at a valuation of a million can't take $6 million from VCs at that valuation. That would leave the founders less than a seventh of the company between them (since the option pool would also come out of that seventh). Most VCs wouldn't want that, which is why you never hear of deals where a VC invests $6 million at a premoney valuation of $1 million.

If valuations change depending on the amount invested, that shows how far they are from reflecting any kind of value of the company.

Since valuations are made up, founders shouldn't care too much about them. That's not the part to focus on. In fact, a high valuation can be a bad thing. If you take funding at a premoney valuation of $10 million, you won't be selling the company for 20. You'll have to sell for over 50 for the VCs to get even a 5x return, which is low to them. More likely they'll want you to hold out for 100. But needing to get a high price decreases the chance of getting bought at all; many companies can buy you for $10 million, but only a handful for 100. And since a startup is like a pass/fail course for the founders, what you want to optimize is your chance of a good outcome, not the percentage of the company you keep.

So why do founders chase high valuations? They're tricked by misplaced ambition. They feel they've achieved more if they get a higher valuation. They usually know other founders, and if they get a higher valuation they can say "mine is bigger than yours." But funding is not the real test. The real test is the final outcome for the founder, and getting too high a valuation may just make a good outcome less likely.

The one advantage of a high valuation is that you get less dilution. But there is another less sexy way to achieve that: just take less money.

9. Investors look for founders like the current stars.

Ten years ago investors were looking for the next Bill Gates. This was a mistake, because Microsoft was a very anomalous startup. They started almost as a contract programming operation, and the reason they became huge was that IBM happened to drop the PC standard in their lap.

Now all the VCs are looking for the next Larry and Sergey. This is a good trend, because Larry and Sergey are closer to the ideal startup founders.

Historically investors thought it was important for a founder to be an expert in business. So they were willing to fund teams of MBAs who planned to use the money to pay programmers to build their product for them. This is like funding Steve Ballmer in the hope that the programmer he'll hire is Bill Gates—kind of backward, as the events of the Bubble showed. Now most VCs know they should be funding technical guys. This is more pronounced among the very top funds; the lamer ones still want to fund MBAs.

If you're a hacker, it's good news that investors are looking for Larry and Sergey. The bad news is, the only investors who can do it right are the ones who knew them when they were a couple of CS grad students, not the confident media stars they are today. What investors still don't get is how clueless and tentative great founders can seem at the very beginning.


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