Nivi · May 5th, 2010
I recently got on the phone for a cross-continent conference call with Chris Dixon from Founder Collective, Mark Suster from GRP Partners, and our own Naval Ravikant. The topic was VC signaling in seed rounds — and how these signals help or hurt your ability to raise money in the next round.
The interview was inspired by Mark Suster’s (VC) and Chris Dixon’s (super-angel) discussion on whether entrepreneurs should take seed money from VCs — and Mark’s claim that “if we discussed the issue live we’d probably end up agreeing more than disagreeing.”
This is the first time we’ve interviewed so many people. The resulting interview is fun, with lots of actionable info for entrepreneurs — at one point, Naval asks if we’re getting too deep and my response was roughly hell no.
Thanks to the SlideShare team for helping us resolve a technical issue very quickly.
The interview was inspired by these posts (in chronological order):
- Venture Hacks: Keep your Series A options open if you raise debt
- Chris Dixon: The problem with taking seed money from big VCs
- Mark Suster: Understanding the Risks of VC Signaling
- VC signaling in seed rounds
- Chris Dixon bio
- Mark Suster bio
- Naval Ravikant bio
- 3 guests, 3 different types of funds
- What stages of investment does a startup go through?
- The $ amount in a round changes based on the public markets
- Seed investors make decisions quicker and ask for less control with simpler documents
- The cast of characters you run into when you’re raising money
- What is VC signaling?
- VC signaling is when insiders convey information through their actions
- Investors aren’t the only insiders who can signal
- VC signaling is the action or lack of action of people who have information you don’t have
- Investment decisions are often influenced by social proof and momentum
- Social proof short-circuits investment decisions
- Social proof is rational
- How do investors transmit signals?
- Typical investor signals
- When signaling matters
- All VCs talk to each other — you can’t keep them apart
- If you hear 5-6 people passed, you’re predisposed not to like it
- 4 types of investor signals
- In the good old days, supportive investors would always do their pro rata
- Supportive investors still tend to do their pro rata in the Series B
- Funds can establish norms and stick to them
- Does GRP have a follow-on policy?
- Do early stage funds do selective follow-on rounds?
- There’s a difference between focused seed stage investing by VCs and shotgun seed investing by VCs
- Don’t give VCs contractual options on your next round
- Taking office space can also be a signal
- If my existing investors don’t want to invest, how do I talk my way out of it?
- Does a VC work against you in the Series A if they don’t buy enough of the company in the seed round?
- What are the pros of taking seed money from a VC?
- Anything I missed that I should have brought up?
- How to take an option-style investment from a VC
- What’s your favorite blog these days?
- What’s your favorite life hack these days?
- Get intros to seed investors with AngelList
Music: The Moog Cookbook
Nivi: Hi, this is Nivi from Venture Hacks. I’m here with Chris Dixon, who I think is in New York; Mark Suster, who I think is in L.A.; and Naval Ravikant, who is in San Francisco with me. The subject today is VC signaling in seed rounds, and we’re going to use that as a jumping off point to branch into other aspects of VC involvement in seed rounds.
Before we get into it, why don’t we just go around and you guys can each give us your 140-character bio. Well start with off with Chris then Mark then Naval.
Chris Dixon: OK, sure. Way back I was a computer programmer and then I started a couple of companies. The last company was called SiteAdvisor, which was acquired by McAfee. My current company is called Hunch, which I co-founded with my SiteAdvisor co-founder Caterina Fake, from Flickr.
And then on the side, I am an angel investor. I was a personal angel investor, now I do it through a fund that I co-founded called Founder Collective.
Mark Suster: That sounded like the Facebook edition rather than the Twitter edition.
Chris: Yeah, sorry, I exceeded it.
Mark: Just teasing. This is Mark Suster. And I’ll give the Facebook edition as well. I also started as a developer, for what it’s worth. I built, founded, and was CEO of two companies, both in document management space. The first I built in Europe, and ended up selling to a French publicly-traded company called the Sword Group.
The second I built in Silicon Valley, also a document management company, called Koral. I sold that to Salesforce.com, where I became VP of product management. And for my sins, I have joined the dark side as a fulltime gig, working for GRP Partners, who funded both my companies. Based in sunny Los Angeles, we are the largest venture capital firm in Southern California.
Naval: Great. This is Naval, and I’ll give the LinkedIn edition, which will run full-on for about 10 minutes.
Naval: I’m a startup guy as well. I started out as a developer; Co-founded Epinions, where I was the founding CEO. The company went public as Shopping.com, and it was eventually acquired by eBay. I started Vast.com, which is a large classified ad network that powers Kelly Bluebook, AOL USA, and some other very large sites.
I have also started Venture Hacks with Nivi, where I’m a co-author and help create Venture Hacks and Angel List. These days I’m angel investing as well, so I was an early investor in Twitter, Social Gold, Plancast most recently, and a bunch of others.
Nivi: If I’ve got this right, we’ve got Chris Dixon, who is at what I would call a seed stage fund, or what some people would call a super angel fund, is that right, Chris?
Chris: Yeah. Just to clarify, that’s really a side thing for me. I’m full-time at Hunch.
Nivi: Right. And also a practicing entrepreneur at Hunch.
And then we’ve Mark Suster, who is a full-time VC at GRP, which is a multi-stage fund. And he’s a former serial entrepreneur. So you guys do seed rounds, A rounds, all the way through up to what?
Mark: We do B and C rounds as well.
Nivi: OK. And then Naval, who represents himself mostly as an angel investor. People know him as Naval, but he’s investing other people’s money, he has a fund, is that right, Naval?
Naval: Yeah, I’m investing my money and other people’s money out of a fund.
What stages of investment does a startup go through?
Nivi: Right. OK, great. Why don’t we start off with some definitions, if that’s cool? One thing I’d like to hear, and I’m sure our audience would like to hear, is what are the different types of funds that are doing seed investing right now? What sizes are they? What are the relevant attributes that distinguish these funds?
Maybe I’ll throw it out to Mark to start the conversation.
Mark: Sure, I’ll be happy to. Listen, the definition of what a seed investment is has really blurred. Historically money was raised by what they call the “Three F’s”: friends, family, and fools. And that typically was your immediate group of people that you knew.
And then people graduated into an angel round, which might have been prominent people from the community who had built tech firms in the past. Those rounds historically were, call it 150K to 250K. A lot of professional angel groups or super angel groups have been founded, and there’s also just a lot more wealth these days from people who created and sold tech business and want to do angel investing, so they’re moving up the stack and doing 750K investments.
A traditional seed round, I would call somewhere between $500,000 to $1 million, and there are seed-stage funds that do that. And then the next thing you graduate into would be a venture capital round. Venture capital rounds tend to be – I don’t know why – but they tend to go in letters.
An A round tends to be your first round of investment. That usually is somewhere in the neighborhood – and I’m going to leave out outliers, outliers being people who are superstars and have created companies and can raise a 90-pre on their first deal – but a traditional first investment will be $2 million to $3 million from a venture capitalist, and that might creep up to $5 million if it’s a big team and a big idea, and if a lot of progress had been made previously.
A B round will typically be in the $5 million to $7 million range, but can be $8 million to $10 million. And I’ll stop talking there.
Nivi: Naval, you want to add anything to that?
The $ amount in a round changes based on the public markets
Naval: Yeah. My definition is not so much around the cash, because the amount of cash that these different funds put in is squishy, it depends on the supply of cash flowing through the system. So right now with the NASDAQ being up again, after there recently being some exits, there’s a lot more angels out there investing.
And so even the definition of a seed round, as Mark put it, has gone to 500K to a million, but even a year-and-a-half ago, seed rounds were smaller than that. They might be 250K to 750K, or even under 500K. So the cash definition moves around based on the environment.
Seed investors make decisions quicker and ask for less control with simpler documents
What doesn’t change is kind of the attitude, philosophy, and investment style. Generally out of a seed round investor, or a seed fund, you can get a decision out of one or two meetings, without extensive due diligence and that multi-months of “get to know you” process.
You also don’t get onerous control terms. Most seed investors these days don’t take a board seat. And if they do, it’ll expire at the A round. And the term sheets and the documents are usually on one of the standardized forms or are a one or two page term sheet kind of thing.
Nivi: Great. Chris?
Chris: Yeah, I’ll agree with that. What else can I say? Often the angel rounds will be…
I do a lot of convertible notes with caps on them. Should I define that, or is that something your listeners would know? The type of security will vary, often seed rounds versus proper venture rounds.
Naval: Yeah, that’s a good point, Chris. That goes hand-in-hand with the lower control issue.
Chris: Yeah, and it’s also like legal fees. A convert with a cap kind of gives the seed investors the economics of setting a valuation without the control rights, which they tend not to care as much about, but doing it in a less expensive way. So you could do that with $5,000 or something, as opposed to $20,000 for an equity financing. When you’re doing a $500,000 round, that’s meaningful.
Naval: The convertible notes type structure has an effect where it actually gives the seed entrepreneur a lot more flexibility. They can run the business however they want, they don’t have to have board meetings, they don’t have to check in. They can even add a co-founder and dilute another 20-30%. The investor’s less likely to care because they’re protected against that by the conversion cap.
Chris: Yeah, I think it’s a decent structure. Obviously as an investor I want it to have a cap that allows for some reasonable upside if things are going well, and allows you as an investor to feel an incentive to go help the entrepreneur raise the higher priced A round.
But it also, as you said, gives you flexibility, because it’s sort of baked in there. So the way it works is either investor gets the better of a 20% discount, or let’s say a $4 million valuation. So it’s like if you do the next round at $3 million, you still get a discount and it’s not sort of seen as “down round.” It’s the greatest thing optically but it’s not… So yeah, you’re right, it gives more flexibility. It defers a lot of these sorts of voting rights, and also they’re kind of stuck, which just seems excessive at this early stage, to the equity round.
The cast of characters you run into when you’re raising money
Nivi: Cool. Thanks, Chris. Let’s go on to the next question. And let me throw in what I see before we go on to the next question.
The cast of characters I see entrepreneurs running into – and tell me if I’m right or wrong – is basically they run into an angel investing his own money, or it’s an angel investing other people’s money – like Naval, who markets himself as an angel, or say Jeff Clavier. They run into seed stage fund like First Round Capital or Founder Collective. And they run into multi-stage funds like GRP. Am I missing anything in that list of folks that you’ll run into when you raise the seed round?
Chris: There are certain outliers like Beta Works, who I’m buddies with in New York. They are actually like a seed corp and they’re really funky in terms of structure. But I think that what you’ve just described is generally the case, I’d say.
What is VC signaling?
Nivi: OK, great. Next question is, what exactly is VC signaling? And I’m going throw it out to Naval, but before I do I’m going to propose a definition. I’m going to throw this out: VC signaling is when a firm that is known to a prospective investor to invest in subsequent financing and has knowledge of the company, says that they’re not going to reinvest in the next round, or says they are going to reinvest in the round, or says they’re going to do their pro rata.
But it’s basically what they say they’re going to do in the round. What do you think about that, Naval?
VC signaling is when insiders convey information through their actions
Naval: I would use actually a slightly broader definition. I would say that VC signaling is when insiders, through their actions, convey information that is more powerful than what is being conveyed through words.
Nivi: OK, so what’s in insider?
Naval: Insider is any investor who’s an insider. It’s more of an issue with VCs, because VCs have more capital, and they tend to have put in more diligence, and they tend to participate in future rounds. So their signaling effect is more powerful than angel signaling.
Investors aren’t the only insiders who can signal
Mark: I’m sorry, can I broaden the definition further?
Nivi: Yes, go ahead.
Mark: I don’t think it’s prohibited to just people who made the investment.
Naval: That’s true. It’s the actions of insiders who may have more knowledge than you.
Chris: It also can be the fact that… I think what Mark is saying, I agree with him. It can be the fact that some entrepreneur was an EIR at Sequoia and now they’re going out and raising money, everyone’s like, “Why the hell didn’t Sequoia invest?” And Sequoia might not be an investor.
Chris: The basic idea is that, especially in a seed stage round, you have so little other information to go on – you don’t have revenues, you don’t have a product in the market, you don’t have all these other things. Signaling happens in every market, including the public market. The fact that some smart hedge fund took a position can have an effect on other investors.
Mark: I think signaling can be as much about what insiders do in your fund as what people did not invest in your company. The classic case that I like to give of signaling is you worked for somebody, you were VP of whatever. There was a CEO, they got a huge exit, they sold of $400 million, they put $70 million in their pocket. You have a list of angels, let’s say five prominent people from your community, and that CEO who you reported to did not invest.
And if they’re known to do angel investments, like it or not it’s a signal.
VC signaling is the action or lack of action of people who have information you don’t have
Naval: Maybe the broadest definition would just be that it is the public actions of people who have information that you do not have.
Chris: And not actually – sorry to be nit-picky.
Nivi: No, keep going.
Chris: Often it’s not even public, it’s sort of back-channel, or the lack of action, for example, as Mark just pointed out.
Naval: Yeah, the action or lack of action of people who have other information.
Investment decisions are often influenced by social proof and momentum
Chris: The reason it’s so important in seed rounds… One of the reasons I like to blog about this topic is I think it’s not at all obvious to entrepreneurs who haven’t done investing. I think when you’re an entrepreneur, you kind of think like, oh, these investors, you go in, they analyze your business, they’re really super-smart and rational. You kind of maybe give them more credit than they deserve, and I’m including myself in that, of course. [laughs]
When in fact, a lot of how you actually make decisions is: things are moving very quickly, it’s referred by a really trusted source, their boss who is great guy is investing, a bunch of other interesting people are investing, and you don’t have that much more information in a lot of these seed investments.
Mark: Nivi, I’ve read on Venture Hacks the other day, you talked about this. You called it “social proof.” And I even tried that on This Week in Venture Capital with Jason Calcanis, and he didn’t like the term. I kind of like it, social proof.
Social proof short-circuits investment decisions
If I’m looking at doing an angel deal and four people I know have already done it, there’s a certain short circuiting that happens, almost like – rightly or wrongly, by the way – but almost like if you’re hiring somebody and you know they were at Google or McKinsey or went to Harvard Business School or whatever. There’s a certain signal implied in that.
Social proof is rational
Naval: Social proof is completely rational, and it’s employed more in markets where each entity has a little piece of the information. So if you look in the public markets, there’s a form of social proof going on with the pricing. Many different people are making a decision, and all their collective information is determining the price of the security.
The difference is, in the public market is those decisions are made and everyone kind of moves at the same time. The difference in private investing is that people move in series. So I commit to the round before Chris commits and he commits before Mark commits and so on.
So, that signal propagates in a way that we can cumulatively add the information value and get the deal done. So the herd mentality is not irrational, it just emerges from the fact that private rounds close in series, whereas public rounds close in parallel.
How do investors transmit signals?
Nivi: Great. So that’s a segue into the next question, which I’ll throw out to Chris. We talked about insiders taking action, so we’re talking about a signal. How exactly is that signal transmitted? Does it go from VC to VC? VC to entrepreneur to VC? Is it over email? Do VCs call each other on the phone as soon as they see a company? Do they call the last round investors or anyone else who might have information? Should I assume every prospective investor I talk to automatically emails my existing investors?
I’ll throw it out to Chris.
Chris: The first thing is that this business of seed investing, and frankly, early-stage entrepreneurship, is so much about getting good information. And almost all that information, unfortunately, is not published.
Hence, any entrepreneur or early stage or mid-stage investor — any investor, for that matter – you’re constantly talking to people. It’s just part of your job. I’m sure Mark will say that as well. And so it happens through all different forms.
But in particular, I’ll just give you a simple example. This is what prompted me to write a post last year, I think it was titled “Don’t Take Seed Money From Big Investors,” or something.
A kid came into my office and he said, “I want to raise a follow-on round, I raised a round earlier.” And the prior round was, let’s say, $100,000 done by a big VC and $300,000 done by a bunch of angels. So it was a $400,000 round, right?
Typical investor signals
And I had seen him six months before. I knew that this big VC had invested, and he was raising more money. He’s like, “I want to raise more money.” So the first question I asked, and the first question every investor is going to ask is, “What is the big VC doing?”
So at that point the big VC has roughly three things they’ll typically do. They’ll be leading the round, meaning they’re doing $500,000 or $1 million or $2 million or $3 million. They’re doing pro rata, which says they kind of like you but they’re continuing it. Or they’re doing nothing, which says basically they hate it.
And he’s like, “Oh, they’re doing nothing. They don’t want to participate in the round.” So what do I think? I think, OK, these are smart money, professional investors, who’ve been tracking this guy very closely for the last nine months. I was very blunt with the guy. I said, “Look, it’s going to be hard for me to invest, and quite frankly I don’t think anyone’s going to invest in you now, because you’re damaged goods in the eyes of the investment community. That’s totally unfair, you may have a great company, but that’s just the way it is.”
Six months later he shut down the company and sent me an email saying, “Unfortunately you were right. No one would touch me because of the action of that big VC.” After I got that email, I wrote that blog post.
When signaling matters
The sad thing is that there’s these… let’s say that 5% or 10% of the time the company’s hitting out of the park and it doesn’t matter what the signaling is. Another 10% of the time, the company’s a disaster and should just shut down anyway. But I would say 80% of the time things are kind of going mediocre and they’re going OK, and the signaling can actually get in and kill a reasonably good company.
The big VC did it so they would get an option in a later round, so it was completely sort of self-interest on their side, and they killed a company and they didn’t think twice about it. I think it’s really, really sketchy, and that’s why wrote about it and use it consistently as one of the themes on my blog.
All VCs talk to each other — you can’t keep them apart
Nivi: Mark, do you want to follow up, but not necessarily getting into the whole “take seed cash from VCs or not” because we’ll get to that. I’d like to get into a little bit more into different types of signaling that occur in addition to the ones Chris described.
Mark: Sure, sure. Just talking more broadly about signaling and picking up on some of the things that were said, all VCs talk to each other. And seed investors too. You can try to keep them apart, but they’re all really poorly behaved, and you just have to realize that.
I’ll give you an example. When I was fundraising for my second company, Salesforce was already a major client of mine. And I said to people during the process, “If you become interested and we’re interested in you at the right time, I’ll set you up to call whoever you want. You can validate at any level in Salesforce, please just don’t call without my consent.”
Three VCs in Silicon Valley called Mark Benioff, the CEO, and asked about us. And one called the other co-founder who was the CTO.
Nivi: Did they just call them right after the meeting, essentially?
Mark: I don’t know, within a week. And the other called Parker Harris, the CTO. I had expressly asked them not to. And each time, Mark Benioff would send it down to the head of corporate development, who was managing the relationship with me, and not in a flattering way. Like, “Why are these guys bugging me and who the hell are these Koral guys?”
If you hear 5-6 people passed, you’re predisposed not to like it
And every time, just shit rolls downhill and it would roll down to me. I found it really irritating. I wrote blog posts about this stuff publicly, why I tell people it’s not a smart idea to go out and cast a really wide net. Everybody talks to everybody. Everybody makes calls they say they’re not going to. And because it’s such an insular community, if five or six people passed, everyone will hear and venture capitalists and seed stage investors and everybody, it’s an industry filled with lemmings. So if you hear five or six people passed, you’re predisposed not to like it. It’s unfortunate, but it’s reality. So you have to be careful.
But to answer your question, Nivi, about other types of signaling…
Nivi: I actually think that was a great example. Do you mind if we pass it on to Naval?
Mark: Oh, yeah, go on.
Naval: Sorry, there’s a plane flying over, so I’m waiting for that to pass before I talk.
4 types of investor signals
I’ve got a lot of thoughts, not in any discrete order. But going back to what Chris Dixon was talking about, making some very good points. I would say that there’s basically five levels of signals that can get sent, all the way from an insider trying to do the whole round, which is something that Sequoia does very often, which sends a hugely positive signal.
Somewhere in the middle there’s doing a little bit more than the pro rata. Pro rata is a point of indifference, where the entrepreneur is indifferent to the VC, the VC is indifferent to future VCs coming in.
If you do than your pro rata, you’re signaling that the valuation is low. You want to own more, and so other investors want to come in. But now you’re at odds with the entrepreneur.
If you do less than your pro rata, you’re signaling you don’t really believe in this valuation, so new investors are less likely to come in. And of course if you pass altogether, as the example that Chris gave, you’re sending a very bad signal, saying that you don’t believe in the company at all.
In the good old days, supportive investors would always do their pro rata
Obviously this is a very old problem. The old VC community had established a method of working through this, which was that they only worked with other investors they liked, and it was considered that a supportive investor would do their pro rata, no more, no less, so that they were not at odds with the entrepreneur or with a subsequent investor.
It was expected that if a deal came to you, it would come to you through another VC, and of course that VC was doing their pro rata. And if that VC wasn’t doing their pro rata, they shouldn’t even be sending you the deal. And or course they shouldn’t be doing more than their pro rata, because they were at odds with the entrepreneur.
This was considered the definition of a supportive investor. And I think that it has broken down, and it has broken down for two reasons. One is you have a lot of players who are now getting in at the seed stage or the A stage who have no intention of following on later, or are inconsistent in their actions.
It’s also breaking down because you have VCs who are reaching down to the seed level, and they have no intention of following back up onto the A level.
So the pro rata supportive investor definition was a stable configuration that kept the VC industry past the signaling problem, or kept the signaling problem out for decades, I think it’s just broken down now because so many of the deals now are seed deals. Everybody wants a seed deal.
Supportive investors still tend to do their pro rata in the Series B
Chris: I would argue, Naval, that it still works that way series A and later on the marketing side.
Naval: You’re right, it’s a seed issue.
Chris: Right. The fundamental problem here, going backwards, is that I think that the VC… Basically you have to trace it back to the LP community. But basically the VC world got way too big. The good funds – Benchmark was $85 million in ’96, now it’s $400 million – got really big, and then a whole bunch of bad funds were created because there was excess appetite for LPs. You just had this huge…
Naval: Right. And on top of it, it became so cheap to start a company.
Chris: Exactly. Exactly. You had this divergence of trends. The thing still functions normally at the later stages when you’re still putting in $10 million, and there is this sort of collegiality or something.
But there is this sort of confusion in big VCs in how to play in the seed rounds. You’re right, that’s in total turmoil right now. There’s new people like us entering, etcetera, and I think there are good firms like Mark’s and Fred Wilson and other people who are kind of determining new norms for how VCs go into this earlier stage. I think there’s sort of emerging to be a right and wrong way.
Funds can establish norms and stick to them
Naval: OK, so the clean way out of this is if people establish a norm and stick to it. For example, a seed fund that says, “We never do any investment after the seed stage. We don’t do pro rata. We don’t follow on.”
Or it could even be a VC fund that’s investing in seed and they say, “If we invest seed, we’ve bought our fill, and we always do pro rata.” Or, “We never do pro rata.” Or, “We always do super pro rata.”
You have to establish a rule and stick to it, otherwise you’re signaling. And even the people establish… [interrupted]
Chris: The only people who really establish that rule though are smaller funds. Because bigger funds, the business isn’t to be in… [interrupted]
Naval: OK, but temptation is very strong when you see a hot company growing up, that even for a seed fund you want to put more in.
Does GRP have a follow-on policy?
Nivi: OK. That was great. And on that point, I’m going to throw the next one out to Mark. Do you guys have a policy at GRP, or do you want to talk about other folks that may or may not have a policy? And to set the stage, you guys don’t really do a lot of willy-nilly seed stage investing as options. You don’t invest 100K in 15 different companies. You guys do focused seed investing, is that right?
Mark: Yes. I think the velocity of how many deals you do matters. If you do 30 investments as an individual partner, and let’s just be honest, if you do 15 investments in a two-year period of time in seed-stage type deals at the same time while you’re doing later stage investments, it’s an option value to you. You just can’t track that many companies, and you can’t substantively help them.
There are people who do high volume and have set up different kinds of VC models to handle that kind of volume, but the traditional VC cannot. And so we do a low volume of seed stage. For me, it’s often because the entrepreneur doesn’t want to raise as much capital, and it’s an earlier stage business that hasn’t yet determined product market fit. We’re willing to take that risk for the right investor.
I think the world breaks down into three buckets, and I’ve talked to Fred and Brad and everybody about this. I think everyone – the good guys, as I call them – sort of all agree. And Chris already went through these.
But A is the company that just isn’t performing. It’s not doing well and no investor, whether it’s an angel, a seed, an A round, anyone, if you’re not doing well, no one’s going to guarantee your next round. So there are some that, if you end up doing 10 seed-stage deals, there could be two of those that you just shut down and that don’t even get another penny.
The opposite case is the ones that are doing tremendously well. I tell these seed companies the same thing. Number one, if you want GRP to price the round and lead the round, I am as Brad Feld calls it, “syndicate agnostic.” I am willing to write the next check and I’m willing to set price and I’m willing to take the whole thing if you want. I’m willing to take half of it if you want.
If you prefer to shop the deal and you’re doing well and you want to go to Silicon Valley and see the highest price you can get, you can tell them I’ll take half the round. And if they won’t let me take half the round, I guess I’ll be forced to take pro rata.
But it’s my job to convince the entrepreneur that A) I add enough value to want me to either lead the round or do half; and B) that I’ve offered a fair price, that it’s not worth both the time investment and all the information leak and signaling that happens with the fundraising. And I have actually done that before.
But the more troubling scenario is scenario B. Unfortunately that happened, and my percentage was 70% at the time – Chris said 80%. But let’s call it between 65% and 80% of the time where you’re doing OK, it’s not clear that you’re going to be amazing, but you’re not underperforming. It’s just OK.
And that’s the overwhelming majority of companies. And what we said at GRP when we set up this fund, we set up $7.5 million, $5 million is for primary investment, and that’s just our seed program, $2.5 million is for follow-ons for these B scenarios.
Because if it’s a good scenario and it’s doing well, that comes from the bigger fund where we’re leading the round. And what’s important is there are times where you just have to do an extra $500,000 that’ll buy them an extra 9-12 months to get more proof points.
But when we write that check we will say – and we haven’t had to write one yet – but when we write that check we will say, “Listen, this may be the last you check you get from us unless we see positive performance. And we’re hoping we will.”
So you either are going to want to perform better, or you might start trying to think over the next 18 months about parking this asset somewhere. Or about getting the ramen profitability to you preserve your options.
But as a VC fund, you can’t guarantee that you’re going to follow every single investment.
Naval: Right. But the problem emerges, Mark, because you are funding the winners with insider rounds, you’re making them those big offers. So all the guys who are doing OK that you’re not making those offers to, they suddenly have this little bit of a stench of failure about them.
Mark: I accept your argument in theory, but then there’s life. And the reality is that these are real markets. Just because they’re private doesn’t mean they’re not real markets. These are real markets. And I can’t imagine any fund is going to set up and say, “We’re going to have a 100% rule; no way, no how, are we ever going to lead and pick winners.” It just isn’t going to happen.
Do early stage funds do selective follow-on rounds?
So let’s take some of the early stage funds that usually didn’t do follow-on rounds. Well, you know, I heard through the grapevine that out of their 40 investments, they did do two or three follow-on rounds. So either you’re absolutely, 100% religiously, in your conviction never going to do it, or even if you do one or two it’s a signal.
We tell people up front, before we do the investment, our kind of A-B-C mentality. And by the way, just because you’re a B does not mean that you’re not going to succeed. What it means is you might need an extra year to be able to get to that point. And because we write the check internally and we give you that extra year, it just may there is no signal in the market.
Nobody every knows that, because a year from now, either you sold the company, you got the ramen profitability, or now you’re ready to do a proper round and now we’re really excited and ready to invest. Or you shut down.
There’s a difference between focused seed stage investing by VCs and shotgun seed investing by VCs
Nivi: OK. Thanks, Mark; that was great. I’ll go to Naval and Chris to get a quick reply to anything Mark said and then we’ll go on to the next question. Naval?
Naval: I think there is a signal buried in that whole transaction, and Mark argues it very eloquently. But if he’s funding two out of ten companies in an insider round and then he’s bridging a bunch and he’s passing a bunch, he’s sending signals.
And I don’t disagree that other people don’t send signals either. It’s at varying degrees. If Ron Conway doesn’t invest in your follow-on round, it doesn’t mean anything, right? Whereas if Sequoia did your seed deal and then they have an option on your follow-on round and they decline that option, that signals something.
Mark: But hold on, Naval. Everyone knows that Ron has an A list and a B list, right? Everybody knows that.
Chris: If I could just defend Mark here for a minute. Every action has signaling, there’s no question, but there’s a massive, massive difference between a big fund like Mark’s doing real diligence, putting in meaningful money like $500,000 or $2 million or something, and having a true intention to create a great company and follow on and help them and work with them, versus people, who we all know of, going around and literally after a 20-minute conversation at a conference who will write a $50,000 check, never speak to the entrepreneur again until they are raising more money, and then try to exercise an option.
There’s just a massive, massive difference between the two. And we have acknowledge that. And it’s important, because I think what Mark’s fund is doing is a very sort of ethical and proper response. There’s always some signaling and etcetera, but it’s an attempt for a big firm to move down market.
And I always judge these things, and at then end of the day I’m saying, is this person at the end of day creating more great companies or are they just sort of trying to steal great pieces of existing companies? And I think that practice is the former and the better practice, and actually programs like Y Combinator sort of increase net innovation in the world, and that’s a good thing, versus these kind of bad guys who are just trying to go around a steal a piece of another person’s innovation.
So I think that is a big difference, and maybe when I blog about this sometimes, sometimes the message is taken to be all big firms shouldn’t do seed investment…
Naval: I think we could divide the world into good and evil, and coincidentally the evil guys always happen to be the ones who aren’t on the line, right? [laughs]
Chris: Like how much time they spend is a critical thing. Did they do due diligence? Are they continuing to follow up? If a guy meets you at a conferences – this literally happened last week. I met these guys and they met somebody at a conference from a big VC, and in 20 minutes he said, “I’ll write a $50,000 check.”
That is clearly an option, right? And that’s just ridiculous, because it’s just going to screw up the company. And Mark knows what I’m talking about. We all know what I’m talking about.
Mark: I’m with you 100%.
Nivi: Hey, next question, next question.
Don’t give VCs contractual options on your next round
Naval: I was going to say one last thing, and that leads to at least one distinction, which is: don’t give somebody a contractual option to… [interrupted]
Chris: That’s the thing I’m saying, though. Of course you don’t give them contractual options, but I’m saying that some of these firms, just even writing a $50,000 check sort of gives them an effective option. Not completely effective, but it’s somewhat of an effective option just through signaling value.
Nivi: OK. Thank you Chris and Naval and Mark. Next question. Let’s say I have actually taken VC cash in my seed round and…. [interrupted]
Taking office space can also be a signal
Chris: Can I say one other thing? It’s not just cash. I think if you take office space, I think if you take anything that sort of sticks yourself with a VC – and even if it’s called something like “Candylandville” or something and it’s not called “Big VC” or whatever, it still has that effect.
Because what happens with the VCs, every time people like us call them out, they come up with another new, more obfuscated way to do the same thing. And we’re seeing another round of that right now, I think. And it’s just the same thing.
Mark: And it is the same….
Nivi: Hey, OK, come on. I’m going to cut all you guys off. No more. We’ll get back to that point, Chris, obfuscation.
If my existing investors don’t want to invest, how do I talk my way out of it?
Let’s talk abut the case where I’ve taken cash from a VC. We don’t have to talk about whether I was an EIR there or took office space there. But let’s talk about the case where I took cash from a VC and I’m the middling case where maybe they’re not being too helpful with the financing. Or I’m in the bad case where they’re not interesting in investing at all.
What do I do other than shut down the company? What’s my way out of it? How do I talk my way out of it, for example, when I’m talking to new prospective investors? And I think it’s Naval’s turn to start.
Naval: Sure. That’s a really tough situation, where your VC is not willing to do their pro rata. And it’s a fund that has a habit and a history and a size commensurate with their normally doing pro ratas.
In that case, if it truly is an exceptional case, for example they’ve decided to exit this section of the market or they’re shutting down the fund or the partner who sponsored the deal is gone, then you want to be very up front about that with prospective investors. And you want to have that check out in the reference if they call your original investor.
The second case is you could have such a hot deal that it doesn’t matter. You could just have so much traction that people will overlook that. But if you don’t have the incredible traction, or if you don’t have a really good and exceptional reason that can be checked out with your investor, then I think you have the stench of death about you and you’re going to have a very hard time raising money.
It is the exact situation that Chris described at the opening of this conversation.
Nivi: But still, how can I talk my way out of it?
Naval: An example would be the partner’s gone, they’re no longer in the space, their fund is shutting down, they’re low on cash, we didn’t get along. You could even try and say stuff like, “We pissed them off. We got into a fight. They just didn’t like us. But here, look at our great product and look at our great traction.”
But these are difficult situations. There’s no magic bullet answer. They’re highly contextual, difficult situations.
Nivi: Got it. Chris?
Chris: Yeah. It’s really, really tough. But I think you try to do things that send opposite signals. Obviously making progress in the core business is the number one thing. But aside from that, let’s say you’re a security company, like a technology information security company, you go and find five luminaries in the business who say you’ve done the most amazing thing in the world, and maybe that’ll counteract the VC’s negativity.
There’s other things you can do to kind of build up the story so that it outweighs this sort of strong negative thing. Obviously the best thing of all is revenues and profits and things, but I’m assuming you’re at too early a stage.
I’ve seen it be only fatal so far in my experience pretty much. [laughs]
Nivi: OK. Mark?
Mark: I want to disagree with your definition, because you said the middling case or the case that they’re not going to support you at all. In the middling case, I’ll make the very clear argument that I think better VCs will bridge you.
So if I’ve written a $500,000 check and I think you’re doing OK tracking, but not killing it, I might do another $500,000 investment in your company to give you equally as long as the first time to prove yourself. And nobody knows about that. I just want to make that clear.
What I think I’m talking about is a case where the VC doesn’t support you at all. And my view – and I always tell this to people – deal with the elephant in the room. Don’t try to pretend like it isn’t there.
There’s L.A.-based company that raised money from very prominent VC, and those guys got into a drag-out fight. I talked to the VC, and the VC doesn’t say good things about the entrepreneurs. But the entrepreneurs got to me first and they said, “We took money from this VC, here’s the partner we dealt with, he’s a complete dick. Here’s what he did, here’s why we were unhappy, here’s why they don’t like us.”
And they were also very honest. “Here are the mistakes we made in the last year and why we haven’t performed. Here’s what our new strategy is,” etcetera. And I just think you’ve got to deal with the elephant in the room. It’s better than hiding it, because I think the information will come out anyway.
Does a VC work against you in the Series A if they don’t buy enough of the company in the seed round?
Nivi: OK, great. The next question is going to be what if a VC invests in your seed round? Let’s say they don’t do it as an option but like it’s a focused investment in your seed round, but they don’t own much of your company. Let’s call it under 15% and maybe closer to 10%.
Does that matter, and do they end up fighting against your valuation in the next round? Or as some people argue, can they actually afford to pay more in the next round because they can dollar-cost average their purchase in the new round? I think we’re up for Chris to start, is that right?
Chris: Yeah. I’m sorry, you’re saying if they have under their target percentage?
Nivi: Yeah. The question wasn’t very clear. Let’s say a VC does a focused investment in your seed round, they own 10% to 15% of the company, but not 20% to 30%. Do they end up fighting against your valuation in the next round because they’re trying to increase their percentage ownership? Or as like some folks argue, can they actually afford to pay more than outside investors in the next round because they can dollar-cost average their investment?
Chris: I think these decisions vary so much. I’m watching a case right now where the VC put in less than his target amount. Every VC seems to have these different magic amounts they want to own, 15%, 20%. But in reality if it’s a hot company they’ll own far less.
I don’t believe in the ladder thing. The insider is probably not going to, if it’s a good company, have the highest willingness to pay in terms of valuation. I don’t know. This is really hard one; it just varies so much.
If they love the company, they’ll probably want to pay up and do a preemptive round. And then the company has to decide do they want to go out and spend the time and spread all this information about the company around, and try to get a market price.
I often counsel that they should talk to one or two people, not 20, and get some sense of the market. And then give their favorite one a 25% discount or something.
Nivi: Great. Mark?
Mark: I don’t think that investment is that rational. I don’t think people sit around and say: What price will we pay? Will we cost average up? Will we do this, or will we do that? It’s very emotional. It shouldn’t be, maybe.
It has some amount of rationality in terms of what we think the exit price is, our investment price, whether think we’re going to get a good multiple on our investment. But the reality is that an investor, whether they own 8% of your company now and they’re trying to decide if they want to re-up in the next round and what price they’ll pay, they’ll pay what the market will bear if they feel you’re a hot company.
Chris: Yeah, but will they signal against you if they’re trying to own more than they own right now?
Naval: That’s a signal in your favor.
Mark: I don’t believe so. I don’t believe…
Naval: Oh, you’re saying… yeah. OK.
Mark: I don’t believe an inside investor will work hard to stop you from raising at a higher price if you can.
Chris: It’s hard to get. I’ve had the situation many times as an entrepreneur where you go out and everyone’s like, “Am I a stalking horse? Why are you talking to me when you have Bessemer, this billion dollar fund, as a seed investor? Am I just being used as a stalking horse to set the price?” And then you get in this really weird situation, right?
Mark: I completely agree with you. And I tell it to people all the time. I even say the same about strategic investors because if they’re used and you try to sell to one of their competitors, it’s the same signal, right?
That why for me, when I make the investment, I’ve said to my companies, “If you want to go shop at a higher price, when you’re shopping tell them I’ll take half the round.”
Chris: What I do is I actually force my investors to kind of give me a decision ahead of time and then like a no-action letter so I can – not literally – but so I can know if I’m going out and telling someone they’re not a stalking horse, that they’re really not a stalking horse. Otherwise I’ll look like a total jerk.
Nivi: OK. Naval?
Naval: By the way, this is a thought, we might want to go back up to a level of greater simplicity, because we are talking about things that are very sophisticated and very advanced, and we understand them because we’re all entrepreneurs and we’re investors.
But I would guess that to the average Venture Hacks reader, this is going straight over their heads.
Nivi: Maybe. Maybe not. I’m glad to talk about some simple issues if there are some that you think that we’re missing?
Naval: I don’t have any offhand.
Nivi: OK, that’s fine.
Naval: But we’re getting very detailed.
Nivi: Very detailed is the name of the game at Venture Hacks, so I don’t care. [laughs] All right. Naval, did you have anything to say about VCs not owning enough in the seed round?
Naval: Yeah. I think if you have a very large fund and they bought a very small percentage of the seed round, then you can expect that they are going to try and up their ownership next round. They’re not going to do it by sending negative signals out into the marketplace to try to keep your valuation down or anything.
Usually the tactic is that they’ll propose an insider round. They’ll say, “Hey, this is preemptive. Before you go talking to everybody else why don’t you take this?” And these days the savvy entrepreneur will figure out what the right answer for preemptive is.
They’ll talk to a few friends, they’ll read up on TechCrunch and they’ll make their decision about what’s truly preemptive or not. I’ve seen some preemptive financing done recently by VCs who put up a little bit in the seed round and then they want to do the whole series A. And generally I’d say they’re at about market, or maybe even higher.
What are the pros of taking seed money from a VC?
Nivi: Got it. OK, good. I think we have time for two more questions.
The first one is going to be what are the benefits of taking VC cash in the seed round? And at the same time, let’s talk about why maybe this is more about the integrity and the policies of the firm than taking seed cash from a VC firm, yes or no. Did that make sense?
Naval: No, it didn’t make sense.
Nivi: Mark understands it and I’m going to throw it out to him anyway.
Mark: OK. Listen, I think, and I’ve tried to argue, that the most important decision when you’re raising money is the people you’re raising money from, knowing their background, doing your due diligence, talking to everybody who’s ever taken money form them – not everybody, but enough from the sample pool of people who’ve taken money from them. Find out about their reputation.
And whether you’re raising money from angel seed, VCs, that matters to me more than signaling. I think the world is a signal. Everything that happens is a signal. You’re an EIR, it’s a signal. Your boss, who you reported to at Yahoo is now a VC and isn’t investing, that’s a signal. It shouldn’t be, but it is.
The world is a signal. So knowing from whom you take money is really important. And by the way, I think very few venture capitalist make good seed investors, very, very few. I would include True Ventures, First Round Capital, Founder Group, Union Square. I think I do a reasonable job of it at GRP. But very few actually do.
But the benefit if you do, is if you raise $750,000 and you end up in the 70% case, which is you’re doing OK but not amazing, it is far easier to get a $500,000 extension or a $750,000 extension with relatively painless work, to get a bridge note from that VC investor, than it is to go out to eight different angels and try to get checks for $70,000 each.
The reason is, a lot of the signal for angel investors on whether or not they should continue funding you, I think, is if you’ve gone out and done all the VC rounds and no one was interested, then that’s a signal to them that it’s going to be hard to get financed through to the next round.
So I think there are some positives, there are some negatives. It all comes down to the individual.
Nivi: Thanks. Naval?
Naval: Yeah, I think Mark made a really good point at the beginning of that, that I would accentuate, which is: You can always break up with your co-founder if they’re not working out. You can fire your customer if they’re a pain. You can break off a deal with a partner. You can get rid of an employee. But you can’t divorce your investor. You’re stuck.
And I’ve seen companies show up that hate their investor and say, “Can you buy my investor out?” And it’s such a huge disaster that those companies never make it. So that is paramount. It’s job one.
And in terms of what Mark was saying with a bridge. I had a real-life experience with that recently, where a company that was going OK ran out of cash, and there were two of us who had seed funds, so we had quite a bit of money relative to the other 10 investors who were all individuals.
The company needed a bridge, and the other seed fund guy and I had to step up and do it. Luckily the company is doing well now, but none of the individuals could or wanted to or felt the need to step up. They’re good guys, but it’s just not their model.
So if you feel like your company may need a bridge in order to continue onward, that’s a good reason to get a larger fund involved. Even in my case, a small seed fund. It was a tough decision for me, whereas I think a fund like Mark’s, if they like the company they might just write a 200K extension check without thinking twice.
Nivi: Thanks. And, Chris, can you do me a favor and just move a little closer to the polycom or whatever you’re using?
Chris: Sure. Can you hear me now?
Nivi: And it’s your turn.
Chris: I completely agree with Mark. It’s all about people. I guess just what concerns me right now is I see a lot of these Internet 24-year-old types and I don’t know if they have the network yet to truly assess who they’re dealing with. That, I guess.
I completely agree with Mark. It’s a different world when you have sort of third-time entrepreneurs in the ecosystem and everyone knows. What you’re seeing more and more is kind of these people with really good product skills, etcetera, who don’t really understand the funding landscape.
I think there’s going to be, in five years, a lot of bodies on the field and people are going to realize this stuff the hard way.
Anything I missed that I should have brought up?
Nivi: OK, so the last few things – anything that I missed that you wanted to talk about? And I’ll start with Naval.
Naval: Anything you missed? Come back to me. I’ve got to parse that. I’ve got to think about it.
Nivi: OK. We’ll move on to Chris and then come back to you.
Chris: No, I don’t think so. [laughs] I think I’m OK.
Mark: I’ll do a good summary, which is just what Chris said. It is hard for 24-year-olds with no network to know, so we’ve talked about some of the funds: True, First Round, Union Square, Foundry, GRP. There probably are others, but those are the ones that come to mind. Everyone who’s worked with Founder Collective that I know has said great things about them.
So you can get a lot of signals from a lot of people out there in the market. And what you should really be careful of is a wolf in sheep’s clothing. Look out for people who do a high volume of deals. And look out for people who look at this as purely an option. That’s probably a pretty good signal that it’s purely an option.
Nivi: Got it. Naval?
Naval: Yeah. I think one thing that we didn’t talk about that’s screwy and out there and I’m seeing quite a bit is when the VC fund doesn’t invest in a company but an individual partner from the fund invests in a company. I never quite know what to make of that when one of those companies show up.
They’ll say, “Oh, the senior partner invested in the company, but his fund wouldn’t let him invest it in.” And I’m never quite sure how to parse that one.
How to take an option-style investment from a VC
Nivi: Got it. And I’ll throw one thing in here, and maybe you guys’ll shit on my head. But as long as the entrepreneur knows what he’s getting into – and maybe that’s next to impossible, especially for first-timers – I don’t think it’s that big a deal to take an option-style investment from a VC.
And what I would suggest that they do – and I see this happening more and more – is take that option-style investment from two, three, four, even five VCs, so the signaling value goes down tremendously.
Naval: Well, the signaling value gets diversified, if all five of them pass in your next round, you’re screwed.
Nivi: True. And like I said, as long as you know what you’re getting into. Anyone want to take a shit on my head?
Chris: A lot of times I get responses to my blog posts like, “Well, that was my only choice.” And if it’s your only choice, it’s your only choice. What can I say? But I see a lot of cases where people actually do have choices and they make this choice, and I think it’s a mistake.
What’s your favorite blog these days?
Nivi: Great. OK. Fun question to wrap things up. What’s your favorite blog these days on any topic? We’ll start with Mark.
Mark: Crap, you’re going to start with me? Listen, the truth is I don’t read 50 blogs. I don’t have time. When you’re a person who contributes a lot of content, it’s harder to…
Nivi: What do you read? What’s the one you like?
Mark: I read Chris Dixon’s blog. I read Venture Hacks. I read Brad Feld. I read Fred Wilson. And I read every post of every one of those people. I’m a parallel consumer so I tend to, on the weekend, read four posts rather than necessarily read them as they come out.
I sometimes like the snarky reporting at Silicon Alley Insider. Nick Carlson makes me laugh. I regret that Valley Wag went away, not matter how many people hated it. I kind of like a little bit of snarky reporting about what’s going on in the industry. It’s a bit of fun.
Nivi: Yeah, me too. Naval?
Naval: A little not related to the industry, but right now I like reading Paleo New, which is about the biochemistry behind evolutionary fitness. I like reading the Rawness, which is about sexual and social psychology. And I like reading the Angry Economist, it’s Austrian economics in short little sentences.
Nivi: Got it. Chris Dixon?
Chris: It’s funny, my behavior has totally shifted now where I get everything from Twitter. So I just constantly prune my Twitter list. But I do read Mark. I think Mark’s blog is phenomenal. I read Fred’s of course. TechCrunch, Business Insider. But I’m getting so much more from Twitter and people re-Tweeting stuff.
Naval: I agree with that, Chris. I’ve noticed the same behavior pattern in myself.
Chris: I spend most of my time, frankly, pruning the people I follow or whatever.
Mark: That’s exactly it. So the behavior that’s different is RSS. I don’t subscribe to as many things on RSS because I figure I’ll see it on Twitter.
What’s your favorite life hack these days?
Nivi: Honest to goodness last question. We’ll start with Naval. What’s your favorite life hack these days?
Naval: Low carb. [laughs] Changed my life.
Chris: God, I don’t now, life hack? I’m trying to not have meetings, the maker’s schedule, or whatever.
Nivi: Ah, that’s a good one. Mark?
Mark: For me it was getting rid of voicemail. I went over to PhoneTag where everything gets transcribed and I read all my voicemails. It’s saved me an immeasurable amount of time.
Nivi: Great. OK, I think we’re good. I think that was a lot of fun.
Chris: Good. I enjoyed it. Thanks for setting that up, Nivi, it was fun.
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