Wade Roush at Xconomy took detailed notes on all the talks and published them here and here.

7 angel investing tips

Naval’s 7-minute talk starts at 26:00. Here are Wade’s detailed notes:

“1. Don’t move in a herd, but do be a pack animal. Not everybody has all the information. One angle might know the market, one might know the founder, one might know the customer base. Every time an angel comes into a round, they bring a piece of information. Ride on their coattails.

2. Say no early and often. You should be doing one deal for every 20 to 30 that you see. If you do more than that, you’re overinvesting.

3. You need to have a brand. The really great deals are obvious, and everybody wants in, and if you want to get in you need a brand. That could be that you have been successful with great companies in the past. And building a brand does not mean taking coffee meetings. Shallow connections do not mean much. If you have a fancy office on Sand Hill Road or Market Street, the best deals are not going to come to you. If you’re not out there running around getting to know people, then you are really just practicing the VC model.

4. Humility. When you’re sitting there all day and people are asking for money and more often than not you are saying no, it eventually goes to your head. The problem is that when a Mark Zuckerberg walks in, those guys have more offers than they have room for. If you come across as arrogant, they will drop you.

5. Your job is to be a little dispassionate. Don’t try to run the company. Don’t even take the power—if you don’t have it, you won’t be tempted to use it.

6. Filters. Every winner is unique by definition, because what they’re doing is new. But the losers tend to cluster around common mistakes, such as investing in a company with one founder. You will find you can establish filters, even one as simple as “Do what you love.”

7. There are many paths to success. You have to be very careful about taking your limited experience and trying to shoehorn your companies into it.”

I haven’t watched all the angels yet but I’m making a mental note to watch it while I brush my teeth tomorrow morning.

7-minute abs

If you’re not an angel investor, watch this instead:

This post explains how to raise a seed round with no lead, no fixed amount, and a fluid closing date. The process is called mass syndication, or a party round.

Paul proposes eliminating rounds altogether, but we’re not there yet. Mass syndication is a single continuous seed round and I think it’s the state of the art in continuous fundraising.

We originally offered this interview exclusively to AngelList applicants — now it’s available to everyone.

Another future

The future of funding is also finding the right investors for your startup, quickly. Not just picking from the investors you can get introductions to.

How? You want to get instant meetings with any investor you want. And you only want to meet investors who are genuinely interested in your startup. That’s what AngelList is for. One danger of this approach is that your round is oversubscribed.

Despite the name, you can use AngelList to request intros to any subset of investors on the list — you don’t need to send it to the whole list.

Leads aren’t going away

Fred Wilson writes “If you don’t want a lead investor, then don’t knock on my door because I don’t know any other way to be.”

This interview explains how to raise a seed round with the conservative assumption that a lead won’t step forward — but it doesn’t preclude you from changing course if a lead appears.

1. Interview

Video: Interview with chapters (for iPod, iPhone, iTunes)
Audio: Interview without chapters (MP3, works anywhere)
Transcript: Below

2. Outline

Here’s an outline and transcript:

1. You can close an angel round with ‘mass syndication’
2. Start with terms and valuation below market
3. What you want in your term sheet
4. What you don’t want in your term sheet
5. Should you have a board seat for seed investors?
6. This isn’t comprehensive term sheet advice
7. Memorize the term sheet before your first meeting
8. How do you set your valuation? Price it to move
9. How do you bring up the terms in a meeting?
10. Describe how the terms are investor-friendly
11. A preferred round is a good way to set up good initial terms
12. Does a small seed round need protective provisions? Pros and cons.
13. Get feedback on the terms in the first meeting
14. Drop names to build social proof
15. Social proof works differently in a Series A round with VCs
16. See if the “interest” includes a dollar amount, intros, and name-dropping (a.k.a. soft circled)
17. When do you need a lead?
18. Approach the financing as if you won’t find a lead
19. What’s a lead investor?
20. If they say “find a lead,” ask why
21. How to create a deadline
22. Raise the money when you don’t need it
23. Send two emails to the angels
24. Do a rolling close: the cash comes in just- in-time
25. Mass syndication can fail if a very high social proof investor drops out
26. Use AngelList and StartupList to get intros to angels
27. What do angels look for?
28. Advisors are good for getting your foot in the door, not in a pitch
29. Get advisors by going to events or talking to entrepreneurs
30. Before you raise a seed round, you need a product in the marketplace
31. Use customer development and lean startup techniques to get to market with less
32. Pitching hacks free chapter: Advice on getting investor intros
33. If you need money to get something in the marketplace, pitch idea investors
34. Pitch incubators or do your startup on the side
35. What are the different types of seed stage investors?
36. If you’re talking to a VC, make sure they really do seed stage rounds
37. Potential concerns with pitching multi-stage and seed-stage firms
38. Get intros to seed investors with AngelList/StartupList

3. Transcript

Music: Squarepusher

Nivi: Hi there, this is Nivi from Venture Hacks.

Naval: And Naval from Venture Hacks.

Nivi: And we’re going to talk about how to close an angel round, how to put together an angel round, or in other words, how to herd a motley crew of angel investors and turn those meetings that you’re getting into money in the bank.

I think we’re going to start off by talking about mass syndication, which is an approach that I think more entrepreneurs should be taking to close their angel rounds.

You can close an angel round with ‘mass syndication’

Nivi: I think entrepreneurs make two typical mistakes when they’re doing an angel round, and they come from what they’ve read online about how to close a VC round. So, there are two things.

One: they don’t name drop enough. They don’t mention who else is interested.

Two: and I guess more importantly, they’re looking for a lead, which you don’t necessarily need in an angel round.

When you put those two together and combine them with a term sheet that you essentially write yourself, you’ve got a new way to close an angel round which we call mass syndication, which I’ve done personally. And Naval, maybe you can talk about how often you see that happening, or if you don’t see that happening, or whatever.

Naval: It happens fairly often these days. Especially the Y Combinator companies, which are well trained by Paul Graham and crew, will exercise mass syndication a lot. So, they take the standard term sheet that they’ve been given and they go out and do a rolling close of various convertible notes. And it generally works pretty well.

The keys are that you have to set the terms and the valuation very, very reasonably. In fact, you have to probably price slightly below market, because otherwise the angels don’t trust you, then they want a lead who’s done the due diligence. You have to work with people that you have warm intros with, you have to name drop like crazy, and you have to create forcing functions to get the round to close. You can’t give people all the time in the world.

Start with terms and valuation below market

Nivi: Right. So let’s dig into all that stuff. First off, I think you want to start with a term sheet that you’ve generated yourself.

Naval: I think it’s even better to have a term sheet that comes with someone else’s authority attached. So, it could be one that Wilson Sonsini has put up. It could be one that Y Combinators put up or Founder Institute has put up or Founders Fund has put up, but it’s just better to start with a widely accepted circulated term sheet where you can point to it and say dozens of other startups have used this term sheet, it’s not new.

Nivi: Yeah. And then there are the new Series C documents from Andreessen Horowitz and Ted Wang and other investors, which we haven’t reviewed, by the way. At least, I haven’t.

Naval: Yeah, we’re not endorsing any particular set.

Nivi: Yeah, so I would look at the term sheet first, and I find that a lot of entrepreneurs that I talk to have not really studied the terms that they’re signing onto enough, and they end up using the authority of: it’s a Y Combinator series AA doc, so we’re going to use it because everybody else has used it.

What you want in your term sheet

Nivi: I think there’s some wisdom in that, but at the same time I really want to understand what I’m signing. The things that I look for, personally, in a seed-stage term sheet are: If you’re going to do convertible debt there’s going to be a cap on the conversion price. In the event of an early acquisition you’re probably going to use that same cap to give the investors a non-participating liquidation preference.

Naval: Yep.

Nivi: If the debt matures before the company is acquired or does another round, you want the debt to convert into common or preferred stock, and that’s at the company’s behest.

And I like to have a majority or supermajority of the investors able to amend the documents.

Naval: They have to approve any amendment of the documents.

Nivi: Yeah, they can approve an amendment of the document, so you don’t need everybody’s approval to make some change – to extend the maturity date, or whatever, or to increase the amount of debt you can raise. Off the top of my head, that’s kind of….

What you don’t want in your term sheet

Naval: Yeah, what’s equally interesting and what’s usually not in a seed or angels syndication round is that you don’t have a minimum raise requirement. You don’t have, usually, a board seat or board structure. You often have vesting, but because the company is still controlled by the founders, the vesting is more of a pre-nup agreement between the founders than it is anything to do with the investors. But generally you want to keep it very simple.

Nivi: No option pool, really.

Naval: There can be. Actually, I would say that there usually should be, because you don’t want the situation where an investor starts reading the documents, finds out there’s no option pool, and therefore doesn’t feel like your valuation is properly represented, because these days in the market, people are used to seeing an option pool.

Should you have a board seat for seed investors?

Nivi: OK. And yeah, with the board seat thing, I think too many seed stage companies probably have board seats, especially if there is a VC involved in the round. If you want some normative leverage on that you can go to Marc Andreessen’s blog where they write, essentially, that they don’t think most seed-stage companies should have investors on their board of directors. Right?

Naval: Yeah, and it absolutely depends on the stage the company’s at and how much money you’re raising. If you’re raising a million bucks from institutional investors, you’re actually really doing more of a mini-VC round than a seed round, so you are going to have a board seat at least, although you probably won’t give it board control.

On the other hand, if you’re raising $250,000 spread across 10 investors, then you don’t need to have a board seat, although you may want to have an external board member just to help resolve any founder issues that come up, and to get some good advice.

This isn’t comprehensive term sheet advice

Nivi: This isn’t intended to be a comprehensive discussion of term sheets for seed-stage companies, but it’s a good start.

Memorize the term sheet before your first meeting

Nivi: So I think that’s our best advice on the first step, which is generating a term sheet. And you should be able, when you go into a meeting with any of the prospective seed investors you have, to essentially rattle off the major terms in that term sheet.

How do you set your valuation? Price it to move

Nivi: I guess the only thing I would add to what Naval said earlier when he described it as maybe the price is “below market,” I sometimes describe it as “priced to move.” So you want a price where there should be no discussion around the price that you’re putting forward.

We’ve got an article, actually, that you should look up. It’s called How do we set the valuation for a seed round? Let me look it up right now.

Naval: The valuation is a very difficult topic, especially when the entrepreneur is trying to do it themselves. They invariably get it wrong, and usually it’s too high. You just want to talk to somebody who has a lot of data points in the market and can give you those data points.

Nivi: Right. So you need the market data, and then check out this article we have. It’s called How do we set the valuation for a seed round?

How do you bring up the terms in a meeting?

Nivi: OK, so at this point you’ve generated the term sheet, we’re going to assume that you’ve got some meetings lined up, and we’ll get back to this topic of how to get some meetings, but let’s assume that you’ve got some meetings lined up. You do the meeting. How do I bring up a discussion of the terms?

Naval: I think if the investor’s interested, as a final step they’re going to ask you. They’re going to ask what the terms are or who’s in the round, or they’ll ask you to give them some details about the financing. And that’s when you basically say: So-and-so is committed to invest. We have a couple of people looking at it. We’re hoping to close by such-and-such a date, or we are going to close by such-and-such a date. There are x dollars available, and it’s a convertible note and it’s capped at a valuation of x and a discount of y. So, you can just throw the terms out. You can be pretty straightforward with most angels.

If you want to be a little more subtle you can say we’re raising x, and we’re selling no more than y% of the company; but I feel that with most angels you can just be direct and say the cap is whatever it is, and just give the number.

Nivi: Yeah, if they don’t bring it up you should just have a slide that says “Financing” at the end of the presentation, [laughing] and you tell them exactly what Naval said. You drop the names, and we’ll get back into the specifics of exactly how you drop the names.

Describe how the terms are investor-friendly

And you discuss the terms, and you discuss them in a way that shows how investor friendly they are and how sane they are, and frankly, there really should be no room for discussion on them. Not that there’s no room, just that there’s no need because the valuation is priced to move and there are a lot of good investor protections – which the only ones they really care about are some kind of liquidation preference in the event of an early sale. They care about getting the same terms as the Series A investors, whenever that happens, which they’ll get through convertible debt or through one of the other types of mechanisms in a preferred financing. What kinds of mechanisms?

Naval: Essentially, if it’s convertible debt, it’ll just convert into the same security as is being sold in the next round. If, on the other hand, the convertible debt has a term sheet attached to it and has specific rights, then those rights will be negotiated, but that’s pretty unusual. With convertible debt usually you usually just get whatever security is in the next round.

Nivi: No, I meant if there’s a preferred financing in the…. I mean, here’s the question: what percentage of deals do you see being done convertible in the seed round versus preferred in the seed round these days, you personally?

Naval: It’s about half-and-half. The larger the round the closer it gets to just being a preferred round. The smaller the round the more likely it will just be debt.

A preferred round is a good way to set up good initial terms

Naval: Generally, even in the startup side, it’s probably better to do a preferred round because these are the times to set your terms very favorably for yourself, and they form a precedent for what happens when you do later rounds, whereas if you’re negotiating, if your first negotiation is with a VC you’re not going to set yourself the friendliest terms. So there’s nothing wrong with doing a preferred round, it’s just that the expense is slightly higher, but it’s not tremendously higher.

Nivi: Yeah, I guess I’m wondering if there is usually some kind of most-favored nation clause in those preferred term sheets that gets those investors the same terms that happen in the next round.

Naval: No, there almost never are except that there is one game-theory element that comes into play, which is, any subsequent round has to be approved by the current round investors. So if there is some term that the subsequent investor is getting that the current investor is not, very often they will not approve the transaction unless they get that.

Does a small seed round need protective provisions? Pros and cons.

Nivi: Yeah. Actually I haven’t looked at the Series C docs. I think they might not have that in there. My preference is that if you’re doing a small seed round, under $500K, there should really be no protective provisions like in terms of vetoing the next round, vetoing a sale of…

Naval: Well, you kind of have to have some of those because unfortunately these are minority shareholders, so you do have cases where an entrepreneur, for example, will raise money from their cousin at a low valuation, or they will sell a company to an affiliated entity. These things actually happen.

Nivi: Yeah.

Naval: And so that’s why the investors often need to assure that there aren’t linked transactions or need approval. And that’s why you’ve got to know your investors; you’ve got to trust your investors to also do the right thing. People who have a history of investing in good companies and having good exits likely aren’t the types who will block financings or block sales.

Get feedback on the terms in the first meeting

Nivi: You can ask them right at the end of the meeting, after you’ve presented the terms, what feedback they have on the terms, if any. So you could solicit some immediate feedback. My guess is if your terms are structured right you probably won’t get much, if any, but make note of any feedback they give you on the terms.

Drop names to build social proof

Nivi: Let’s talk about what kind of names you can drop at the end of the meeting.

Naval: Yeah, you definitely want to use social proof to build up momentum in closing a mass syndication round. So, every angel who signs up, you should make clear to the other angels that this angel has signed up. Now, you have to be careful about what the definition of “signed up” is. If someone says they’re interested, don’t go around representing them as committed, because angels will talk and if they find out that you’ve been exaggerating or lying it will cost you trust in the whole financing. Basically, the clear indicator is if somebody says they’re in, they negotiate an amount with you, they say they’re happy with the terms, and they shake hands on it. If you want to play it extra safe, if you don’t have a long-standing relationship with this person, then I would also suggest getting an email confirmation.

Nivi: Right. So, just going from the top of the list, if they’ve wired the money, signed the term sheet, and the money’s in your bank account, you should almost certainly use their name, unless for some reason they’ve specified that you can’t. Ok; so that’s an easy one.

Next, if you’re in the process of closing with them and you’re negotiating a term sheet, I think, again, unless they’ve said you can’t use their name, it’s extremely safe to say that you are in the process of closing with such-and-such, assuming they’re negotiating the deal with you in good faith.

Next on the list, I don’t think there’s anything wrong if the angel, at the end of the meeting after you’ve discussed the terms, has said they’re interested, for you to ask: are you interested enough for me to tell the other guys I’m talking to that you’re interested?

Naval: Yeah, that’s perfectly reasonable.

Nivi: That’s what I would do with the guys who you’re not actively negotiating the deal with. Just ask them, hey, is it OK if I use your name?

Social proof works differently in a Series A round with VCs

Naval: Social proof in a venture round works differently because in a venture round you want independent bids because you’re actively negotiating a valuation. Here, because you are setting the valuation and there’s room for multiple players, social proof is much more important than getting independent bids.

See if the “interest” includes a dollar amount, intros, and name-dropping (a.k.a. soft circled)

Nivi: Yeah, the advice for an angel round and a VC round are exactly the opposite of each other. Another way to test people’s interest or to just see how interested they are is to talk to them at the end of the meeting about a dollar amount that they would be interested in investing, and then whether they would be willing to make introductions to other angel investors.

A guy who has given you a dollar amount and is willing to make intro’s – I think that’s basically what I would call the formal definition of a soft circle in an angel round. I guess the third part of a soft circle is they’re willing to let you use their name.

So, the definition of a soft circle is:

1) There’s a dollar amount attached to it.

2) They’re willing to let you use their name with other investors.

3) They’re willing to make introductions.

If you’ve got all three, I would call that guy essentially soft circle.

When do you need a lead?

Nivi: So, we talked about mass syndicating the round, and we’re not done with that, but what are some cases where you would actually want, or let me put it another way, where the angels would actually want a lead in the round?

Naval: Angels will want a lead if they don’t know you and they don’t trust you, or if they don’t agree with the terms and they want the terms renegotiated, but their amount is too low to do it themselves; or if you have a very complex business that requires a lot of due diligence, or a very mature business that requires a lot of due diligence, so someone is going to have to go in there and investigate it; or if the price is just high enough. If you just need to raise a certain amount of money, usually beyond around $500K I would say is the upper limit, then you need an institutional investor and that person is going to be a lead.

Nivi: Do you think the majority of financings of $500K or lower are done without a lead?

Naval: They certainly can be; I wouldn’t say they are. I would say about half and half. It’s always harder to do without a lead because you’re looking for smaller angels. If you find a lead it shortcuts the whole process. You’ll close much, much more quickly, but one may not always want to find a lead, either because one doesn’t want the oversight and that institutional investor mentality that a lead generates, or one doesn’t want to negotiate the terms.

Approach the financing as if you won’t find a lead

Nivi: Yeah, and just to be clear, we’re not saying that you shouldn’t find the lead, but I think you want to approach the financing as if you’re not going to get one.

Naval: Yeah. If a lead steps forward and is willing to negotiate a term sheet and do the bulk of the round, or half the round, then yes, you should definitely entertain it. If they’re someone you like and trust they can short-circuit the whole process for you.

What’s a lead investor?

Nivi: And we’ve got a few articles, actually, on Venture Hacks you can look up, How do I find a lead investor?

What’s the definition of a lead investor? Let me throw one out: They want at least half the round, and often they want the entire thing. If they don’t want the entire round they’ll help you find the other investors. They’re essentially willing to make the decision for themselves, and in the best case they’re willing to put their money in your bank account and close the deal even if all of the money is not signed up yet.

If they say “find a lead,” ask why

Nivi: So, I would say if a sophisticated angel investor, or even an unsophisticated one, at the end of the meeting or in an email says yeah, I’m interested but I need you to find a lead, I would ask why, and why they’re not interested in participating in the mass syndications. And they may end up telling you one of the things that Naval said, for example, they like you, they like the product, it looks interesting, but they don’t know the market well enough to make the decision on their own, they don’t know enough about the terms or they don’t know enough about you to negotiate the deal with you, or they don’t care enough to negotiate the deal with you, they just want to put the money in and not worry about the deal. So just ask why. Don’t take hey, I want you to find a lead, as a great answer. It’s often a way for people to preserve the option to invest in the round, just in case Sequoia decides they want to invest in the round.

How to create a deadline

Nivi: OK, after the first meeting how do we turn all these angels interest into money in the bank?

Naval: This is a very difficult problem because you have to create a forcing function, and really there are two forcing functions that work well. There are some artificial, external ones. It could be the case that your company has some kind of a partnership coming up where you have to make a payment by a certain date or you’re going to go under, so that can create a forcing function, but that’s not necessarily the good kind because it gives people leverage over you.

There are two of the better forcing functions. One is time based where you very clearly say: We’re closing a round at such-and-such a date, the notes are all authorized to close at that date. After that date we will not be able to accept more money, we will be back to focus on our business, and if we raise less than the maximum amount that we’d authorized, that’s fine, we’ll just make do on that amount, and when we go to raise money next time it will be on different terms.

That is the lesser of the two good forcing functions, and that allows you to at least put a time limit on it. Now the problem here is you have to be credible and you have to stick to it and you have to pick good time, because if you arrive at that date with no money, or too little money, you will lose all credibility when you go back and ask for more money.

Nivi: Holidays can be good forcing functions.

Naval: That’s true. Holidays are very good that way. You can say you’re trying to get it done by Christmas or before the New Year, and so on.

Nivi: By Thanksgiving.

Naval: By Thanksgiving. You probably don’t want to use ones like: we’re trying to get it done by Boxing Day, or something like that, or more obscure. [laughs] But certainly if there are trips coming up, or if the founders have to go back to the UK for visa purposes for a month, that would be another way to do it. But the time-forcing function is the lesser of the two.

The better one is over-subscription, where you basically say: We have more people who are interested than we have room for. We like you very much, but we can’t guarantee a spot until you’re committed. Allocations will be on a first-past-the-post basis. And you basically line up more angels than you have room for.

Raise the money when you don’t need it

Nivi: And the third thing I’d add is raise the money when you don’t need it. That can be super tricky, or perhaps impossible on a seed round where you’re trying to build the product, a team, and get a little bit of traction so you can go to the angels with something other than just a product or an idea, with some traction. It’s hard to raise the cash when you don’t need it, but if it’s possible I would do it.

Naval: Absolutely.

Send two emails to the angels

Nivi: So, just very tactically, how do I get the money into my bank account? What I would do, or what I’ve done in the past is collect the names of all the people who are interested, have said yes, they’d like to participate in this round. Send an email to each one with the term sheet, with the same exact terms that you discussed previously. Tell them who else is going to be participating in this round, just as long as the guy has said that they’re interested and they’re willing to let you use their name. I would list all those people in the email. Tell them here’s the day we want to sign this term sheet by – at least put it two weeks out. Ask if they have any feedback on the terms; if not, you’re going to send them the closing documents.

Basically, do they want to invest? What’s their final decision? Do they have any feedback on the terms? If not, we’ll send you the closing docs.

Naval: It can often be a good tactic to send the closing docs through the lawyers, because the lawyers will make it very formal, and they’ll put things like: the closing date is such-and-such date, here are the wire instructions. That creates an air of authority and formality around it, which helps the closing.

Nivi: Yeah. I don’t think I would send the closing docs until they’ve agreed to the term sheet, though. Right?

Naval: Absolutely. Absolutely.

Nivi: OK. So don’t force the closing docs down their throat. See if they have any feedback on the term sheet. If not, I would just send them the final rev of the term sheet that incorporates feedback from all of the investors, as well as the closing docs and the wire instructions all in one email – so this is the second email we’re describing now – again, listing the names of all the angels who have committed to sign the term sheet now, or have seen the term sheet and have approved it.

So this is actually two emails. The first one is term sheet, and please give me feedback on it, with a list of angels who are interested in signing it. The second email is: here’s the final term sheet, the closing and wire instructions, and the final list of angels.

Again, for the first email I would set at least two weeks out for them to get back to you. Do you think two weeks is too long?

Naval: Probably. I would just give a week.

Nivi: OK. I guess I would do a week. I would expect to blow that deadline in my limited experience, though. [laughs] And you’ll have to send a few emails to these guys, just bugging them a couple of times with: hey, do you want to invest or not? kind of emails. Put it nicer than that, and also always include one sentence on something great that has happened in the meantime to the company, just so you can show momentum.

Do a rolling close: the cash comes in just- in-time

Naval: This is where the concept of a roll-in close comes in, which means that investors don’t have to put their cash in all on the same day. All of the investors don’t have to commit all at the exact same time. As they get to your email, sign the docs, get their account into the lawyer to set up the wire, the money comes in. And that money can come in over the course of, say, a week or two in practice.

And you can also set up the documents so that even when all the money’s come in, there is still room in the documents to raise another 50 or 100 or another $200K using the same, exact documents.

So you can do this first roll-in close, and then you can do a subsequent roll-in close if you find some new investors you want to bring in on these same terms.

Mass syndication can fail if a very high social proof investor drops out

Nivi: Have you ever seen this mass syndication approach blow up at the end?

Naval: Mass syndication could fail at the end. It would fail, most likely, if some very high social proof investor drops out. That’s probably the single biggest reason it could fail, but it’s pretty unlikely because here you have sort of a diffuse group, so it’s unlikely that any one person would blow up the deal.

Nivi: It’s really a question of how effectively you’ve read their interest in your round when they say they’re interested. Again, I would use those signals that we put forth before, in terms of are they a soft circle or not? Did they say you can use their name? Did they talk about a dollar amount? Did you discuss the terms with them? Are they introducing you to other investors?

Use AngelList and StartupList to get intros to angels

Nivi: OK. Let’s talk about how to get intros to angels. I’ll start off.

Naval: Angel List.

Nivi: Angel List is one thing. We’ve got a list of angel investors. It’s called Angel List. You can contact a lot of the angels directly or through referrals.

Read the free chapter from Pitching Hacks for tactical advice on getting intros

And then we’ve got something called Startup List, where you send us your pitch, and if it’s a good pitch we pass it on to the angel on Angel List.

What do angels look for?

Nivi: When we look at the applications for Startup List we look for a few things: Social proof – essentially who have you convinced to let you use their name as an advisor or investor or team member. We look for your traction.

Naval: We look at your bio – who you are, what you’ve accomplished. Plus we look at your product if it’s a web-based product. We like to see the demo or the alpha or the prototype. It’s very hard to actually send something out to Angel List without having seen some evidence of the product.

Nivi: Right. If I had to boil it down to two things, I’d say social proof and traction. And if I had to boil it down to one thing, I’d just say traction.

Naval: Yeah. I’d say in order of importance, it’s probably traction then team then social proof then product.

Advisors are good for getting your foot in the door, not in a pitch

Nivi: Right. And VCs and other folks like to make fun of people’s advisor slides that they tend to put too much emphasis on when they pitch, which I think is right, but I think advisors and social proof are a great way to get into the door. When you’re in the door I don’t think it’s important anymore, but it’s a good way to get in the door.

Get advisors by going to events or talking to entrepreneurs

Nivi: And by the way, how do you get advisors? Go to events. We recently talked about this thing called Startup Digest, which is the best events in 27 cities or so. It’s a curated email list. You can subscribe to that. It’s called Startup Digest.

Naval: You can ask other entrepreneurs.

Before you raise a seed round, you need a product in the marketplace

Nivi: And I think we already answered this question a little bit, but what do I need before I raise a seed round? I would say you need your product to have been prototyped in some way or another, and it needs to have been put into the marketplace in one way or another and have some traction.

Naval: Yeah, and obviously that differs on the product type. For a consumer web product you should probably have launched it or soft launched it. For an enterprise product or something that requires a lot of money and a big team to build, you may at least want to test the market demand.

I would define traction as quantitative evidence of market demand.

Use customer development and lean startup techniques to get to market with less

Nivi: Yeah, that’s good. And look up SteveBlank.com for customer development techniques. Also look up Eric Ries’ blog, StartupLessonsLearned.com for lean startup techniques. It’s basically how to get more traction with less work.

Pitching Hacks free chapter: Advice on getting investor intros

Nivi: For some really tactical advice on how to get meetings with angel investors, we’ve got a whole book on that topic called Pitching Hacks. Look it up. You can buy it for $9.00. I think it’s worth it. You can check out the testimonials from smart guys like Adam Smith, the founder of Xobni, or Aaron Iba, the founder of EtherPad. And the chapter on how to get introductions to investors is actually free online, so you can get the PDF of that chapter for free.

If you need money to get something in the marketplace, pitch idea investors

Nivi: If you need money just to get to the point where you can apply to Startup List or talk to angels, essentially to get to the point where you have some product, some team and some traction, my recommendations are friends and family investors. So those are your actual family or people who know you and are willing to essentially back you. So it might be a boss that you worked for for 10 years who has enough disposable income to write you a check for $5K or $10K or $25K. And finally I would say people who just see the same problem that you see, and they believe in the product and the market. Like, they’ve had that same idea themselves and they don’t have the time to pursue it themselves, but they’re willing to put a little bit of money behind the guy who does have the time to do it. I call those three groups of people idea investors.

Pitch incubators or do your startup on the side

Nivi: An alternative to raising that idea money is to apply to one of the Y Combinator style incubators, like Y Combinator, TechStars, DreamIt, there are a bunch of them now. Just do some web searches. They will back you on the basis of essentially an idea alone, but in general you need to have a team of people who can get things done. It can’t be all just business guys.

Another option is to keep your day job and do your startup on the side, which you can find lots of great posts on, online, if you just do some searches. We’ve got a post on it on Venture Hacks called Half-Assed Startup, written by Tony Wright from RescueTime.

What are the different types of seed stage investors?

Nivi: I guess the last topic is what are the different types of people who invest in seed rounds? You’ve got your independent angel investor who’s investing his own cash. You have angel investors, or let’s call it a seed-stage fund, which is investing an LP’s cash. They have other investor’s cash that they’re investing. And that seed-stage fund may be represented as a fund, like first round capital, or it may be represented as more of a person, like Naval, say.

Naval: Yeah, generally the way a seed-stage fund will differ from a pure venture fund is they’ll be investing smaller amounts, they will be willing to do convertible debt with a cap, and they also will not require board seats or require heavy oversight. They can also probably decide a lot more quickly. Most seed-stage funds, although not all, don’t have the concept of a partner’s meeting. Usually when you’re talking to one or two people, you’re talking to everyone.

Nivi: Right. So I guess another example of a seed-stage fund that presents as an individual is like Jeff Clavier. Is that right?

Naval: Yes.

Nivi: Seed-stage funds that present as firms are First Round Capital. Who else?

Naval: Founders Fund.

Nivi: Founders Fund are more multi-stage aren’t they?

Naval: Ah, fair enough. True Ventures.

Nivi: True, right. And now we’re getting into the topic of multi-stage funds, so now you have classic VC funds, or new ones like Founders Fund, that invest across a broad range from incubation all the way to Series E.

Naval: Right. Charles River Ventures has a very active seed program, all the way from 25,000 to a quick start of 250,000 to Series A and Series B.

Nivi: Yeah, and other firms that don’t have specific programs like Sequoia Capital, for example, do seed-stage investments all the time, although they don’t have a specific program for it.

Naval: Correct.

If you’re talking to a VC, make sure they really do seed stage rounds

Nivi: I think if you’re talking to any VC that does multi-stage investing, you really want to ask them: When was the last time you made a seed-stage investment? How many have you made in the last year, essentially, and more importantly, what did the company look like when you made that seed stage investment? Their definition of what the company looked like may be 5 million uniques a month coming to the website and they still call it a seed-stage investment, while you’re struggling to release your product. So you want to ask them what their definition is of a seed-stage investment.

Potential concerns with pitching multi-stage and seed-stage firms

Nivi: I want to talk about two things. One: what are the things to be concerned about when you start to bring seed-stage firms into your angel round, and multi-stage firms into your angel round? And two: a lot of these firms are acting more like angels these days, and let’s talk a little about that. But let’s talk about the concerns first.

Naval: The concerns are that you don’t want to have a process that’s a VC process, so you don’t want to go through too many rounds of meetings and due diligence and so forth. You don’t want to have governance that’s VC governance, so you don’t want to give up board control; you don’t want to have regular board meetings; you don’t want to have to concentrate too much on financials at this stage. And finally, you want to be careful about firms that may have negative signaling value – so, people who often do invest in subsequent rounds and sometimes don’t – because if one of those people invest in your financing and then does not follow on in the next round, it can be a signal of death, a death knell to the other prospective investors.

Nivi: Right, so the ones to worry about most on the signaling value are the multi-stage firms who are investing in seed rounds mostly to have the option to invest in the next round, and maybe a little bit about the seed-stage firms that present as firms.

Naval: Seed-stage firms generally don’t lead or invest in following rounds, so it’s less of an issue.

Nivi: Not even for pro rata? I’m talking about a First Round.

Naval: Yeah, it depends on the firm, but yes, for example First Round probably normally does pro rata so that signal is important. But someone who is investing and doesn’t seem to care about the valuation at this time, but wants a contractual option to invest in the next round, there you’d really have to worry.

Nivi: And they don’t even need a contractual option. It doesn’t matter.

Naval: Yeah, it’s just an even stronger signal with the contractual option if they don’t exercise it.

Nivi: Yeah. I guess the other thing to worry about if it’s a multi-stage firm, is if they don’t own enough in the seed-stage round.

Naval: Yes, because then they’re going to want to invest maybe more than their pro rata in the next round, and that can create strange dynamics where they’re trying to bid your valuation down.

Nivi: Yeah, and the bottom line is if they’re trying to increase their percentage ownership in a subsequent round of financing, they have an incentive to drive down your valuation in the next round. You might ask if they don’t always have that incentive. No. If you want to do your pro rata or decrease your percentage ownership in the next round, you’d no longer have that incentive. If you want to just do your pro rata, you’re indifferent on the valuation of the next round, and if you want to decrease your ownership you actually want to increase the valuation in the next round as much as possible.

What do you see when these seed-stage and multi-stage firms participate in terms of leaving room for angels, taking half the round, just participating as like 25% of the round like another angel?

Naval: The good ones will leave room, and it’s up to the entrepreneur to dictate. Probably one of the biggest mistakes you can make in doing a syndicate is where you don’t leave enough room for individual investors, and you give everything up to one or two lead investors. The amount of help you get out of a person is relatively fixed. There might be slight variations around the edges, but you’re passing up most of the advisory benefit of having angels if you don’t do a mass syndication to a large group.

Nivi: Another bit of advice I would give is if you’re going to raise money from a fund in a seed round that has signaling power in the next round, don’t raise money from just one, get a couple in there.

Naval: Yeah, it helps to diffuse that signal.

Get intros to seed investors with AngelList/StartupList

Nivi: OK, thanks for listening. Nivi and Naval are signing off.

A last plug for our products is Angel List, which is our curated list of angel investors and what they’re looking for and how to get in touch with them, and Startup List, which is where you apply to us, we look at your pitch, if we like it we pass it on to whatever angels you want us to pass it on to, or we’ll pass it on to all the angels on Angel List if you like.

The metrics on that, to date, are pretty good. The whole idea is about five weeks old. We’ve had about 25 investors ask for intros. The other cool thing about it that I like is the investors come to you and ask for an intro, but great investors like Jeff Clavier, and Ann from Mike Maples’ fund, and guys like Matt Mullenweg, and Jon Callahan from True – just a great bunch of guys – are asking for intros. About 15 startups have gotten intros and we’ve even gotten one startup funded so far, and probably more coming online pretty soon.

Naval: One that we can talk about right now.

Nivi: One that we can talk about, yeah, where Matt Mullenweg, the founder of WordPress, invested, and we hope to announce some more success stories about Startup List soon.

Thanks for listening! Bye, bye.

“Have you thought about angel investing but weren’t sure whether it was right for you or how to get started? Are you an entrepreneur who wants to learn more about working with angels and how angel investment differs from venture capital? Here’s a chance to learn from the experts.

“Why do angel investing? How do you find and evaluate potential investments? What’s the right amount of money to invest? How do you set terms? How do you work with other angels, entrepreneurs and VCs? What are the legal issues?”

The speakers, presented in a 4×4 array, look great:

If you’re a Boston angel, check out the Boot Camp. Startups are invited too. And when you’re done, join AngelList.

Boot Camp: Stay-at-Home Edition

Angel Boot Camp is modeled after Y Combinator’s AngelConf. Angels who want to learn more about angel investing should read this excellent essay by Y Combinator’s Paul Graham: How to Be an Angel Investor. And this semi-excellent interview with me and Naval: How to be an angel investor, Part 2.

Without angel investing, there would be no VC investing. Fred Wilson writes, “The angel funding mechanism is potentially the single most important funding mechanism in startup land.” I couldn’t agree more.

Me

If this is your 1st time raising money…

1. It takes way longer than you think.
2. You’ll assume you’re much further along than you really are.
3. It’s not about optimizing the round, it’s about whether you can raise the round at all.

Naval (@naval)

If this is your 1st time raising money…

1. If you’ve launched and have traction but you’re not getting funded, your team is likely the problem. Look in the mirror.
2. Your financing usually goes nowhere until you’re suddenly oversubscribed.
3. Launch first, raise later.

Chris Dixon (@cdixon)

If this is your 1st time raising money…

1. Make sure the valuation is one that you can get a 2-3x step up on if you hit your milestones.
2. The earlier the investment stage the more you should think of them as partner versus buyers of stock.
3. After 3 months of pitching, you risk being perceived as damaged goods.

Mark Suster (@msuster)

If this is your 1st time raising money…

1. The biggest problem is “anchor tenants.” Once you get them, the lemmings will follow.
2. Everyone wants a “deal.” Even rich people. Get the highest profile anchor tenants and give them a deal. My commentary is specifically related angel investing.
3. Everyone obsesses with dilution from investors. The biggest dilution comes from co-founders. If you have 2 co-founders, you’ve diluted 66% before doing any of the hard work. Start by yourself and bring in co-founders for smaller stakes once you’ve got initial momentum. Unconventional wisdom, but the most economically practical advice you’ll ever get.

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.

SlideShare: VC signaling in seed rounds
Audio: Interview with chapters (for iPod, iPhone, iTunes)
Audio: Interview without chapters (MP3, works anywhere)
Outline and transcript: Below

Thanks to the SlideShare team for helping us resolve a technical issue very quickly.

Prerequisites

The interview was inspired by these posts (in chronological order):

1. Venture Hacks: Keep your Series A options open if you raise debt
2. Chris Dixon: The problem with taking seed money from big VCs
3. Mark Suster: Understanding the Risks of VC Signaling

Outline

1. VC signaling in seed rounds
2. Chris Dixon bio
3. Mark Suster bio
4. Naval Ravikant bio
5. 3 guests, 3 different types of funds
6. What stages of investment does a startup go through?
7. The $ amount in a round changes based on the public markets
8. Seed investors make decisions quicker and ask for less control with simpler documents
9. The cast of characters you run into when you’re raising money
10. What is VC signaling?
11. VC signaling is when insiders convey information through their actions
12. Investors aren’t the only insiders who can signal
13. VC signaling is the action or lack of action of people who have information you don’t have
14. Investment decisions are often influenced by social proof and momentum
15. Social proof short-circuits investment decisions
16. Social proof is rational
17. How do investors transmit signals?
18. Typical investor signals
19. When signaling matters
20. All VCs talk to each other — you can’t keep them apart
21. If you hear 5-6 people passed, you’re predisposed not to like it
22. 4 types of investor signals
23. In the good old days, supportive investors would always do their pro rata
24. Supportive investors still tend to do their pro rata in the Series B
25. Funds can establish norms and stick to them
26. Does GRP have a follow-on policy?
27. Do early stage funds do selective follow-on rounds?
28. There’s a difference between focused seed stage investing by VCs and shotgun seed investing by VCs
29. Don’t give VCs contractual options on your next round
30. Taking office space can also be a signal
31. If my existing investors don’t want to invest, how do I talk my way out of it?
32. Does a VC work against you in the Series A if they don’t buy enough of the company in the seed round?
33. What are the pros of taking seed money from a VC?
34. Anything I missed that I should have brought up?
35. How to take an option-style investment from a VC
36. What’s your favorite blog these days?
37. What’s your favorite life hack these days?
38. Get intros to seed investors with AngelList

Transcript

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.

[laughter]

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.

[laughter]

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.

Mark: Exactly.

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.

Mark: Yes.
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.

Nivi: Mark?

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.

Chris: Exactly.

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.

Nivi: Chris?

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.

Mark: Good.

Naval: Thanks.

Chris: Good. I enjoyed it. Thanks for setting that up, Nivi, it was fun.

Trent: If you’ve got a startup company hungry for seed money and you’re looking for intros, or if you’re an angel investor and you’re looking for an easier way to have hot prospects dropped into your lap, then you’ll want to subscribe to AngelList. It’s Venture Hack’s curated list of angel investors, and you can check it out at venturehacks.com/angellist.

Plenty of other valuable news, interviews, and general advice to help your startup succeed at Venture Hacks, so be sure to poke around. Check us out on Twitter as well. Until next time, from everyone at Venture Hacks, thanks for listening.

Howard Greenstein: How does a start-up know when it is ready for Angel funding?

Venture Hacks: If you’ve just got an idea, check out incubators like Y Combinator and TechStars. Or you might be able to convince someone who knows you well (a former boss or family member) to invest. Or you might be able to convince someone who knows the market really well  (they’ve had the same idea as you) to invest if they believe in the team.

If you’ve got amazing pedigree and connections (your last company was acquired and the investors made money) you might be able to raise money on just that alone. If investors are clamoring to invest before you start raising money, you can take this route, otherwise, you can’t.

Otherwise, build something (anything), put it in the hands of customers and get some traction before raising money. Any hardware/software/whatever startup can do this thanks to lean startup and customer development techniques and the decreasing costs of doing *everything* — the exception is startups with predominantly technical risk. Also get some social proof (brand name advisors) before contacting angels. Social proof lubricates getting in the door.

Read the rest of the interview for our answers to 4 more questions, including our thoughts on what to look for in an angel and trade-offs between raising money vs. boot-strapping. I think the interview turned out well. Thanks for pulling it together Howard.

“Angel investors are becoming the dominant force in Consumer Internet Venture capital. The vacuum created by the withdrawal of VCs from traditional Seed and Series A opportunities in the Consumer Internet space has been filled by a motley collection of angel investors. It is angel investors, not VCs, that are writing checks based on good ideas, business plans, and “alpha sites”; not VCs. The importance of angel investors is such that it is not unusual these days to see an internet startup publicly announce its round of angel funding, when in the past such events did merit a public mention. Yes, angel investors have always provided seed money, but today they typically provide 100% of what was once considered Series A money as well.”

(If only there was a list of angel investors…)

There’s also a good discussion in the comments. Bill says:

“My take on most seed/ super-angel funds is surprise, a fairly cynical one. I think if you offered $1BN to the managers at these seed stage funds they would go from Seed focused to multi-stage in a remorseless heartbeat.”

Dave McClure replies:

“no, i wouldn’t trade my model for that bowl of bullshit, even for the bigger paycheck in the short-term. it’s just not sustainable.”

Read Bill’s full post.

I would like to hear from VCs who are co-investing and competing with these angels. What seed stage companies are you investing in? What were the company’s metrics like when you invested? Are you seed stage (plus follow-on investments) or truly multi-stage?

“Investing in startups seems mysterious and difficult. How much are you supposed to invest? What legal agreements do you need? Where do you find startups to invest in? How do you pick winners?”

People liked Naval’s presentation — Dave McClure called it an “awesome fucking talk,” and other tweets seemed to agree. So we thought you might like it too — it’s good advice for investors and entrepreneurs alike.

Paul Graham from Y Combinator wrote up his talk in a wonderful essay called How to Be an Angel Investor. So we’re calling our presentation “How to be an angel investor, Part 2”.

Slides: How to be an angel investor (pdf)

Audio: How to be an angel investor (mp3)

Transcript

Here’s a transcript of the conversation. I’ve highlighted some of my favorite bits.

Nivi: Hi, this is Nivi from Venture Hacks.

Naval: And this is Naval from Venture Hacks.

Nivi: Naval recently gave a talk at Y Combinator’s AngelConf on how to be an angel investor and we thought we would record it — people liked the talk — and we thought we would record a slightly longer version and put it online.

Naval’s going to do most of the talking and I’m going to jump in with a question or a comment.

Naval Ravikant

Naval: So, I’ve been in this business for a little while now, been involved with starting about seven companies, been an investor as an angel or a VC in well over 30 companies and been an advisor to over a dozen companies, and of course co-author Venture Hacks with Nivi.

After a while, you do enough of this and you start pattern matching — you notice a few things — and so I’ve put those together here and I’m using those to help out people who may want to get into the angel investment or even early stage venture business.

What do you need to be an Angel?

Naval: Basically, to be in the angel business you absolutely have to have three things — to be in the business and to do well. First of course, is access to capital: either you own or you manage to raise the funds or somebody just gives you money.

You need good dealflow and by good dealflow, I mean, proprietary or a high-quality dealflow that not everybody has seen or you have some unique ability to get in to. There has to be some reason why people will take your money instead of somebody else’s. Otherwise at the end of the day, you are commoditized and you get bid out of the game.

Finally, you need good judgment. Access to capital you either have or you don’t. If you don’t have it, then you probably shouldn’t be in the angel business, you’re just wasting people’s time. If you have good judgment, everybody thinks they have, and it takes about 10 years to figure that out so I can’t really help you there.

Dealflow

Naval: So, what I’m mostly going to focus on is dealflow, which is how do you find good dealflow, how do you process it efficiently, how do you get into good deals, how do you evaluate them? When it comes to dealflow, there are a lot of bad kinds of dealflow and there’s some good dealflow. Early on, you will be seeing very few deals and you’ll just be trying to get in the dealflow.

After you’ve made a few investments, you’ve got a few entrepreneurs who know what you’re doing, you have built a bit of a brand, you’ve connected to the other angels you will have too much dealflow, and you will quickly have the opposite problem. If you raise your hand and you say to the world, “I can write a check”, the world will beat a path to your door.

I’m going to help you with an odd problem, which is helping you filter the bad dealflow as well. So, you’re going to get a lot from your social friends, these are the people whose kid goes to school with your kid or someone you just hang out with.

Most of this dealflow, although you should be polite and you should see it, you’re going to have learn how to say no without taking a meeting, otherwise you’re going to find your time chewed up very quickly because these people are not in the business, they don’t have the same filters that you do, and they will pass along anything that looks like a company that’s raising money.

You, yourself, are going to be tempted to do the same thing and forward deals to other angels. Don’t ever forward a deal you wouldn’t do yourself.

Nivi: Or you’re not seriously considering.

Naval: Yes. It’s going to hurt your credibility, and it’s also going to also waste the entrepreneur’s time. The first thing any serious investor will ask you if you, yourself, are an investor and you forward a deal and say ‘”Are you investing?” You don’t want to hem and haw at that point.

You either want to say “Yes, I’m seriously considering it and I’m in the middle of my evaluation process” and you should mean it or you should actually be doing it. Those are kind of the only two legitimate answers.

If an entrepreneur asks you to forward a deal that you have passed on, your best approach is to politely explain to them that, it does not make sense for you to do so as it would send a very negative signal.

Nivi: Yeah, and if you’re an entrepreneur in that situation, I would actually ask for some names of potential investors and tell the angel that just turned you down that you’re not going to use their name to reach out to these people, but you just want to get a list of names to find some other prospective angels to reach.

Naval: Yeah, that’s a very good point. A lot of angels know a lot of other angels, you get a list of names then you have to sift through your own resources and frankly, you browse through your LinkedIn and your Facebook networks. If you’ve been around in Silicon Valleyfor a little while, you can usually find someone who knows someone.

Finally, one issue that crops up a lot when people first get in to investing is, they think they’re going to add their value in some unique process-oriented way, and so they come up with non-standard models. One could be incubation; another one could be acting CEO or so on.

They kind of say, “OK, I’ll put in some money and then I’m going to be super-active, and I want this and that and I’m going to take more stock into that.” I would suggest not doing that. Certainly you can offer it to people you know well, and certainly people can ask you for additional help or these kinds of non-standard deals, but they have two problems.

One is if you end up taking too much equity early on. It makes the company difficult to fund by VCs down the line. Secondly, it will lead to an adverse selection case, where if you’re putting out your services as a rent-a-chairman or a rent-a-CEO, you’re going to see the companies that are so desperate raising financing where they won’t entertain that notion.

Most really great entrepreneurs, yes they could use some advice and they’ll listen to it, but they don’t need you to run their company for them. So be careful about that adverse selection trap and be prepared that with some of the very, very best companies, your only value-add is essentially will be your money plus a few connections and a little bit of advice here and there.

What’s good? Deals that come from other angels who are doing them are usually very good. You build these up by quid pro quo. If they send you deals, you send them deals back and vice versa.

Branding your advisory services is very good. So if you have particular domain expertise, you are the founder of a company that was successful in a certain space, then you should be able to brand yourself in such a way that you will see the companies in your space.

Another way to brand yourself would be through some kind of a horizontal play. If you’re a marketing genius for consumer web companies, then people may come to you for help on that.

Nivi: Yeah. So, here are a few examples of that. The way that Naval put it at AngelConf was Paul Buchheit is the Gmail guy; Naval, himself, is the Venture Hacks guy and he’s also an expert on viral marketing and Facebook, and Paul Graham is Paul Graham. Those are the kind of examples you want to try to follow.

Pitches

Naval: So, let’s assume you’ve worked out this incredible dealflow pipeline and you’re getting a lot of companies that are coming to you. You want to get through them relatively efficiently. What you will find very quickly is that most business plans, executive summaries are a waste of time.

You can’t sign NDA’s, because doing so exposes you to far too much down the road. So what you really need is very high concept pitch where somebody explains to you, “we are this for that” like an analogy…

Nivi: Friendster for dogs.

Naval: Exactly. Dogster. Maybe a short 10 slide deck. If somebody comes to pitch you, don’t schedule hour-long meetings, you don’t need an hour to figure it out.

Usually within 20 minutes, is enough for the company to get their points across and you should not be pitching yourself at this point. First, you should just be listening; you can always pitch yourself a little bit later.

Nivi: I would say a high-concept pitch, like Friendster for dogs is great. One paragraph, or a couple paragraphs elevator pitch in email form is great, and if the company has it, a 10 slide deck. Of course, more important than any of that is a working demo or screen cast or mock-ups or some realized version of the product.

Naval: Generally, it’s a poor sign if a start-up comes to you, especially if they’re on the web, or consumer web, or iPhone, or one of these spaces where it’s pretty easy to hack something out and they haven’t put together a prototype or they haven’t, as Nivi would point out, made early and meaningful contact with the customer.

Nivi: Which can be done through things like surveys, as well, right? If its offline and it involves hardware or whatever, they could have gone out and talked to the customer via surveys or interviews, or they could have spent the last 10 years of their life working with that exact customer and know them inside out.

Evaluating Startups: Team

Naval: So, now when it comes to a valuable startup, you’ve got the short pitch, you’ve taken the half-hour meeting. There are times when you can eliminate the startup on the basis of team; this is not, obviously, fool-proof. Investing is not a science, it’s an art.

But here are some general rules of thumb I’ve developed over the years, which helped me, filter dealflow. One of those is that usually the optimal configuration for a company, in terms of the founder basis, two to three founders and three is the max.

Five is a very unstable configuration, eventually it will fall apart. You cannot have five cooks in the kitchen.

One is too difficult. The person gets too lonely and it gets too difficult to continue on, because they don’t have a thought partner. So two to three turns out to be ideal.

If you look at the very, very successful companies in the Valley, Apple had Steve Jobs and Steve Wozniak; Microsoft up in Seattle had Bill Gates and Paul Allen and later on Paul Allen dropped out, they had Steve Ballmer and of course, Google had Larry Page and Sergey Brin; even Oracle had Larry Ellison and quickly thereafter had Ray Lane.

So generally, you need teams of two founders at least. You want someone in the company who can build and someone who can sell and if there’s going to be an imbalance; it should, probably, be in favor of the builder.

Of course, it depends on the exact company, but you would rather be investing in a startup that has two builders and one salesperson, rather than have two sales people and one builder.

Generally, you want to say no to companies where the founders are all lawyers or all business guys and they don’t have the product development expertise to back them up or where they are outsourcing the product development completely.

Companies that outsource product development completely, generally have a hard time iterating and keeping up with the changes in the market and the competitors.

One learning that I’ve found the hard way is that is that, especially in consumer web deals, traction matters more than anything. It’s very hard to predict mass consumer behavior. It’s a very efficient market out there.

So, it’s good to find real customer adoption before you put too much money to work, whereas in enterprise deals, where you are selling to a small number of large customers, the team can make a meaningful difference.

Nivi: One thing on the topic of a guy that can sell; it doesn’t have to be your conception of a prototypical salesman or a car salesman or whatever. If you are in a one-on-one meeting with Bill Gates, even though he is a complete nerd, you would be extremely compelled by whatever he has to say to you.

So in that sense he is a salesman, right? A lot of nerds in their nerdiness can actually be extremely compelling in the proposition that they are trying to put in front of you.

Naval: Yes, by salesman, I don’t mean the bag-carrying enterprise sales quota matching guy. It’s exactly as Nivi said, people who are compelling and who can convince early customers to sign up, through whatever means possible. They can convince early employees to sign up when the company has very little cash. They can convince early investors to sign up.

In fact, usually if someone can sell you in an investment meeting really well, and you walk out dizzy, saying I don’t really get the product or this space, but this guy almost sold me. That’s a good sign.

Nivi: Yes, that in and of itself is an asset in terms of being able to sign on customers, employees, other investors, and so on.

Naval: One other thing to think about is when you are evaluating companies at an early stage, the appropriate title for the people in the company is usually founder, or engineer, or things of those sort.

If you see a company that’s very top-heavy, has its CEO, its CFO, VP of this, SVP of that, then it’s usually a bad sign. It means that the people involved are more interested in building up impressive titles for themselves or building a large organization than they are in having a successful product and a good financial outcome.

Nivi: Yes, we want builders.

Naval: In evaluating entrepreneurs, Warren Buffett often says that when he looks at the company he buys, and very often these are multi-billion dollar companies, he’s looking for intelligence, energy, and integrity. I find that the same criteria works extremely well in evaluating start-up founders also.

Intelligence for obvious reasons.

Energy because drive and passion are the number one predictor of an entrepreneur’s success, and it’s not actually intelligence in that case.

And integrity is paramount, because if you have someone with high intelligence and high energy, but they don’t have high integrity, you’ve basically got a hard-working crook. You don’t want to be associated with that. In fact, you prefer lazy, dumb crooks to hard-working smart crooks.

Nivi: Yes. They will have many opportunities to screw you, if they don’t have any integrity.

Evaluating Startups: Customers et al

Naval: So, intelligence and integrity I would not compromise on any of the three.

Similarly, we talked a little bit about teams. Let’s talk about the customers. As we talked about earlier, you don’t want to invest in companies that have made no contact with the customer yet whatsoever.

For an enterprise software company, it might be surveys; it might be a few big customers’ meetings references. For a web company, it usually means the product has been released or some facsimile of it has been released and tried out.

You definitely want to look at a lot of companies, before you make early investments. The usual failure mode for individual angel investors is that they invest too early and too quickly. Part of this is you don’t have a partner who can veto you.

Venture funds are deliberately organized, in such a way that there are a lot of experienced people saying no to the new guy’s urge to go invest in the first hot thing he finds.

In angel fund, I would suggest that you be disciplined either by numbers, so say to yourself, I’m not going to make an investment until I see at least twenty companies. One hundred might not be a bad number. In a busy year, I’ll easily see four, five, six hundred companies.

An even better approach might be to find some experienced angels that you team up with and give them an effective veto. No matter how much you like the deal, if you can’t talk them into it, don’t do it.

Nivi: Yes, and along those lines, you could just say, I’m not going to invest in any deals that these five notable angels are not also investing in for my first couple of companies.

Saying No

Naval: So, saying no is something that you are going to be doing far more often than saying yes. So, let’s get that out of the way. You have to learn how to say no, you have to learn how to turn down people.

It’s uncomfortable, but usually people appreciate a quick and up-front and reasoned no, with some good advice and hopefully a little bit of help attached to it, than they do a dragged out long process where at the end then you hem and haw and have to say no.

So, the best time to say no is before you take a meeting. If some of these deals fail your filters, or if you just can’t see yourself getting excited about the company or the business, say no over email before you meet.

If you hear the pitch, and it is not compelling, take five minutes out after the pitch, talk about it, think about it, and then say no to the entrepreneur before they even leave.

Since angel deals tend to be pretty small, you are investing tens or hundreds of thousands of dollars, you don’t want to drag it out over months. You don’t want to take weeks of the entrepreneur’s time. You don’t want to cause them to generate additional documents or write code just for you.

So try and be efficient about it. Don’t spend more than a couple of hours of their time, or if you had to noodle on it yourself for more than a few weeks, then it probably isn’t right for you.

Warren Buffett makes two really good points. Actually, Ron Conway lists one of them at the angel conference, which was don’t invest in people that you really aren’t excited about working with, because at the end of the day, the business model will change. The details will change. The company’s progress will change.

The only constant will be the person you invested in. If you don’t like to take their phone calls, if you don’t like to sit down there and talk to them all the time, then eventually you are going to see the deal as a burden.

You will eventually run out of time. So, it’s very important that you only pick the people that you want to work with. I just can’t emphasize that enough. It sounds like an easy thing to say, and hard to follow, but in reality, you will find that it will make all the difference in the long term.

The other thing that Buffett points out is that this is a game where the swings that you don’t make are not counted against you. You just have to find a few hits, and if you let a lot of hits go by while you are waiting for the perfect pitch, that’s absolutely fine. So, when in doubt, just say no.

Since the angel community is very small, the entrepreneur community is very small, your reputation is everything. So, it’s very important that you try and add value to every company whether you invest in them or not.

If they took the time to present to you, and they paid you that honor, then you should take the time to maybe make an introduction or two for them, or give them some useful, honest advice. Generally, it’s not a good idea to try and withhold your capability to help them too much, just because you did not make an investment.

Navi: Yes, and that is where you area of expertise, whether it is raising money or marketing or Facebook or whatever, can really shine right at the end of a meeting.

Saying Yes: Terms

Naval: So, let’s talk about the terms for a moment. So, let’s say you’ve processed a huge amount of deals, you’ve found a company that you want. You’ve said no to the ones that you don’t want. You want to make an investment. Some things to keep in mind is that one of the biggest risks of angel investing is the downstream financing risk.

You may look at a company and say, I could see this being a small but highly likely exit. That’s not initially a great company for you to invest in. The danger there is that a lot of companies use up cash very quickly, they run out of cash. You don’t want to put money after your own investments, because you are obviously now a biased investor.

And VCs always evaluate things in terms of their huge market potential, as VCs have very large funds. It ends up being a little bit of what the economists call the Keynesian beauty contest, which is you pick a winner based on who you think the judges are going to pick to win in the next round.

So, you are not initially picking the most beautiful start-up, you are picking the start-up the judges are most likely to pick. So, it is a dead-end trap to finance too many companies that don’t have the possibility of turning into something huge somewhere down the line.

One way to mitigate that is to co-invest with other venture capitalists. This is where you’re an angel, you’re putting a small amount of money and the VCs are putting in most of the money.

The issue there is that VCs are ownership sensitive. They want to own a lot of the company, but they tend not to be as price sensitive as angels because they have lot of money to throw around. So, one way to mitigate that is to give the VC some different rights that you don’t care about, such as the ability to invest more money the next round, and in exchange keep the valuation lower for you as the angel of this round.

Another opportunity for some superstar angels, or if you are taking a very active role in the company, is you might be able to get a little additional advisory stock, relative to the amount you invested.

Nivi: Just to be clear on Naval’s concern, his concern is that the seed round — that VCs get involved — ends up being for a lot of cash coming in at the high valuation. That makes it economically uninteresting for you as an angel investor, because you will end up owning a very small slice of the company because the valuation will be high.

So his suggestion, if I understand it right, is you basically give the investors — you do the round at a low valuation, you have a reasonable amount of cash coming in, the VCs co-invest, and what you give them is basically an option to invest in the next round. Is that right?

Naval: That’s correct. And in fact, another point of the economics is a lot of first-time angels, especially when investing their own money, tend to invest in what are called “uncapped debt.” So they’re put in a convertible note at a 20% discount to whatever the next round is going to be.

That’s an extremely uneconomic proposition. The odds of a startup going out of business are far greater than 20%, or the 16% that would be required to cover your investment. In fact, there are corporate bonds trading in the public markets today that are yielding 15-16%. So they are far more liquid with companies that are far better capitalized.

Generally, you’re looking for a 3X, 4X, 5X increase in valuation between rounds, which means you are price sensitive. So it’s OK to do a convertible note because that’s often simpler for everybody involved, from a legal perspective. But you generally want to establish a conversion price cap, which pays you back for the risk that you’re taking at this stage.

Nivi: One thing, just going back to the VC thing, from the perspective of an entrepreneur, if I have VCs investing in the seed round, the issue that it creates for me is that if those VCs don’t want to invest in the series A, it makes it very difficult to do the series A, because the inside investors who knows the company best are basically saying the company is not a venture investment.

Naval: One other point about investing with groups. A good reason to invest with other angels, no matter how much you like the company, is that stuff always goes wrong with a startup. And when stuff goes wrong, very often the entrepreneur can make the choice to walk away, especially if the company has a very small amount of money invested.

Or the entrepreneur can choose to do something that would be adverse to you, because you’re a minority shareholder without a lot of the protections that VCs often have. If you’re in a group of angels, you are much more likely to have a good outcome in that situation.

An entrepreneur is much less likely to walk away, if there are five good angels as investors than if there’s only one. An entrepreneur is less likely to change the terms that are adverse to you, if you’re with four other angel investors rather than if you’re alone.

One way in which, if you’re an angel investor, you can squander a lot of time is if you’re board seats. Essentially if you’re taking board seats, you’re going to be limiting yourself to only being able to handle five, six, seven investments, which may not be enough for you to achieve the portfolio affect that you need for the economics to work.

If 1-out-of-20 to 1-out-of-30 angel investments work, and you can only make five because you’ve taken board seats and your time is full, then your economic model is in trouble, and you would have to augment it by sprinkling around a lot of companies where you almost spend no time with them.

Board seats are really only worthwhile taking if you’re getting paid for it, if you have some unique and proprietary insight to the company and it’s market — maybe you started a company in a similar space that did really well — or in that unique case where the company is just someone who is very, very close to you.

Otherwise, realize that boards spend a lot of time on corporate governance issues, which often isn’t the best use of your time.

Nivi: Yeah, I mean, you can simply advise the company. You don’t have to be on the board to advise the company. The other downside is if you’re not willing to leave the board whenever the company asks you to, you can screw up their series A investment, because VCs don’t want to come into a company, which has a random guy who was one of the angels on the board of directors.

Naval: Yeah. It depends on who the angel is, of course.

Nivi: It depends, yeah.

In terms of how much of the company you want to buy, you’re not going to end up with 40% or 50% of the company after an angel or seed round.

You should be thinking more in terms of 5%, 10%, 20%. Capital that is coming into the company is $25K, $50K, $100K, up to $250K, the valuations that you’re looking at are going to be in the $0.5 million to $2 million dollar post-money valuations.

The way you justify the company’s valuation isn’t on the basis that the company is actually worth that much money, in the sense that somebody would buy the company for that price today. The way you justify it and the way entrepreneurs justify it, is through dilution.

You need to leave enough of the company in the hands of the entrepreneurs who are the guys who are creating value for you and for themselves alike, to be incented to create value for the two of you.

If after the first round they own less than half the company, and there are three more rounds of financing coming along over the next five years, they’re not incented to create value for you or for themselves.

So that’s where you end up with the angels or the seed investors owning somewhere between 5% and up to 20% of the company after a seed round.

The other way entrepreneurs justify the valuation is just through a market clearing price. Things are worth what people pay for them, and as long as someone is willing to pay $2 million post money for a company, you have to pay the same price, either if you want to invest alongside them or you want to outbid them.

Economics

Naval: So let’s talk about the economics a little bit. Think of yourself as a patron of the arts. If you were in 16th or 17th century Italy, you would be investing in paintings and sculptures. You’re doing the same sort of thing now. You’re not really in this so much to make money, as you are to help the next batch of entrepreneurs get to where you got to.

It’s unlikely that most of us as entrepreneurs would have been successful and gone up in value, without angels as investors, and now you’re giving that opportunity to the next young batch. And I say that because it’s very difficult to make money in this business.

The hit rate is extremely low; the economics are tough because on the really interesting companies it gets bid up by the venture capitalists.

And very often even if you find a hit company and you manage to get a piece of it early on by making and investment, very often you can get wiped out if there’s a bump in the road down the line and you don’t have the capital to pony up.

So think of yourself as a patron of innovation. You’ll sleep a lot better at night, if you assume your investments are lost on the day that you make them. And I’m not the only one to say that. At AngelConf, I think most of the professional angels, including the ones who had been in it for a long time like Ron Conway, made that point.

And your personal portfolio, outside of your angel investments, should be balanced with ultra-safe investments. Nassim Taleb, the author of “Fooled by Randomness” and “The Black Swan,” advocates having a 10% ultra-risky portfolio, in other words, looking for a positive “black swan.” And the other 90% being in T-bills and cash and equivalent safe investments.

But it’s an extremely rewarding business in the sense that you get to work with very, very bright people who are young, full of energy and fire. They show up and they tell you everything they’ve learned about a topic, that they’re deeply passionate about, in a short period of time. So the learning curve is high.

It’s extremely fun, but if you’re not careful you can lose a lot of money and annoy people.

Nivi: I don’t think that I’ve been involved in a company that somewhere along the way was not catalyzed by an angel investor or a seed stage investor. I don’t know if that’s the case for Naval or not.

Naval: I have, but usually the ones that had good angel investors worked out much better. In the angel case, as an entrepreneur, you can get the advice and help and connections that you look for out of a VC but you can get it with much less dilution and much less capital and, most importantly, much less control over your company.

If you’re really looking for good advisors, it’s usually a much better idea to go and get a couple of angels than it is to raise a big VC round. If you need a lot of capital, because you have something that you’ve figured out is working and you want to scale it, that’s when venture investment makes sense.

Nivi: Yeah. One way to think of yourself as an angel is, as basically an advisor that pays for the privilege of advising a company, and in the process gets a little chip in the business, in the case that the company happens to be a Google or a sub-Google like exit, Skype, MySpace or whatever.

Naval: And to echo a point that Paul Graham made a long time ago, the best, highest quality people that you want involved in your startup are usually already pretty successful. You’re not going to be able to recruit them as employees, you probably won’t even be able to bring them on as advisors for small amounts of equity.

The only way that those people will participate in your businesses is, if they have a meaningful stake.

And you don’t want to give huge stakes to a person just for a few words here or there where you don’t know what the value will be down the line, no matter how famous or how successful they are. So the way the market clears is they get to invest in your company.

Venture Hacks

Naval: If you have any questions about this or if you would like to talk more about it, feel free to contact us at founders@venturehacks.com. We’d also like to know if you’re an angel investor who’s available to invest capital and what your profile is.

So feel free to email us with that and we will try to show you interesting companies. What we would ask is that you tell us how much capital you have to invest, how much you’re looking to put to work, and what your particular areas of expertise are.

“I’m an entrepreneur looking for seed investment. All I have right now is an idea and a pitch. I’m presently pitching friends and family and it has been very positive. Do you know any other idea investors I should approach?”

Larry and Sergey had a product and traction before they got their first check from an angel. Investors want to see products and preferably traction unless you already have a significant track record. But,

If you only have an idea.

If you have no traction, track record, or product—if you have nothing but an idea for a product in a large market, the only people who will meet you are:

1. Family and Relationship Investors: People who already know you and are willing to bet on you, based on your history together. They’re not betting on the company, they’re betting on you. They wouldn’t invest in the company if you were replaced by someone who was equally effective. Todd Vernon calls these people family and relationship investors.
2. Idea Investors: People who believe there’s a big opportunity to serve the customer because they understand the customer as well as you do. Perhaps they’ve noticed the same opportunity as you but they haven’t done anything about it.
   
3. Once Removed Investors: These investors trust or regularly co-invest with one of your family, relationship, or idea investors.

These investors sometimes have little to no experience investing in companies, but that is not an insurmountable hurdle. You will need traction, a track record, or a product to get meetings with other traditional seed stage investors.

In general, the more you need money, the less likely you are to get it. But making something out of nothing is what entrepreneurs do.

Another option: Cold call funds.

There are a few funds like Y Combinator, Seedcamp, and TechStars who will look at applications from anybody doing anything. But you will probably need traction, a track record, or a compelling product to capture their interest—ideas need not apply.

Salesmen are an exception.

Salesmen are good at getting people to comply with their wishes. That’s what it means to be a salesman. Great salesmen can get meetings and raise money with just a large market and an idea (and maybe a sprinkling of track record).

Also read the exceptional comments to this post: Ideas need not apply.

“The Family Investor: The Family Investor is likely not really a classic Angel Investor at all but rather a supportive family member that “knows you”. Their motivation is likely out of support (sometimes guilt), but their basic investment thesis is they trust you. For me these are the worst type of investor because you likely have intimate knowledge of their financial situation and whether or not they ‘should’ be investing. Likely, they have no inherent feel if your idea is good or not, but may have changed your diaper at one time or another and have overcome that experience to hand you a check for $25K or $50K. Personally, I like this category of investor the least because the investment is totally emotional and personal – and that sucks in business. But based on the financial situation of the individuals involved and the relationships this can work ok if everyone comes into the situation with their eyes open, but go out of your way to make sure.

“The Relationship Investor: The Relationship Investor is probably one or more co-workers from a previous gig or business friends you have known for a while. They may or may not understand what your new company is doing but they have had a track record working with you. They want to be supportive, but are looking for a return. You won’t lose them as friends if things go bad, but the investment for them is likely not ‘trivial’. In my experience these are good Angels to have, again as long as their eyes are open going in. These people can also be wildly supportive of you in terms of finding employees and other resources.

“The Idea Investor: The Idea Investor is probably very familiar with the space your company is targeting. These are in some ways the very best types of Angels because to some degree they validate your idea. There investment is based on the Idea and there is little emotion around the table (always good). If you can get them onboard they can open doors into partner relationships and just generally good advice. You will spend most of your time convincing the Idea Investor that you and team are the right people to attack this problem (as they likely don’t have a strong relationship with you or the team). Often an influential Idea Investor makes a good early board member for the company.

“The Once Removed Investor: The Once Removed Investor is likely connected through a personal or professional relationship with either the Relationship Investor or the Idea Investor. They likely don’t know you, and they likely don’t have a clue if your idea is good or bad but they have translated the trust in the investment to the person they know. This is a great way to get additional Angel Investors onboard, but without a solid Relationship Investor or Idea Investor it just isn’t going to happen.”

Read the rest of Todd’s article, it’s great.

Via: Ask the VC.