Venture Hacks

Q: Everybody is telling us to raise smart money. What’s the difference between smart money and dumb money?

“The best assumption to make is that your VC’s primary value add is the cash they are investing. Then you’ll always be surprised on the upside.”

— Marc Andreessen

Summary: Smart money is money plus the promise of help that’s worth paying for, dumb money is money plus hidden harm, and mostly money is mostly money. Weed out the dumb money with diligence. Evaluate supposedly smart money with the smart money test. Finally, assume your investors are mostly money: unbundle money and value-add to get money on the best terms possible and value-add on the best terms possible.

If smart money is money plus the promise of help that’s worth paying for, then dumb money is money plus hidden harm, and mostly money is mostly money. All three provide what entrepreneurs primarily want from investors: money.

1. Avoid dumb money: you don’t hire harmful people—so don’t marry them for the life of the company either.
2. Most investors are mostly money but very few of them act like their primary contribution is capital. They spend too much time selling you on their value-add and not enough time getting you a quick yes or no.
3. Smart money is rare—after all, would you work with most investors if they didn’t bring a piggy bank? Also, too many investors think the “smart” in smart money means “we know how to run your business better than you.”

Weed out the dumb money with diligence.

Don’t assume any investor won’t be harmful. Do the diligence to prove otherwise:

• Do you trust him?
• Will he provide his pro rata in the next round? (Not so important for seed funds and angels.)
• Will he support you if the company is going sideways?
• Does he have impeccable references?
• Does he want control?
• When it comes time to sell the company, will he let you?
• Will he let you expand the option pool to hire someone great?
• Does he want to replace you as CEO?
• Will he try to merge you with a dying company from his portfolio?
• Do you want to marry him for the life of the company?
• Is he committed to investing in startups and does he have a reputation to protect in the startup world?
• et cetera…

Evaluate supposedly smart money with the smart money test.

After you’ve weeded out the dumb money, do the smart money test on everybody else:

Would you add the investor to your board of directors (or advisors) if he didn’t come with money?

If the answer is no, he is mostly money (see below). If the answer is yes, subtract some dilution from his investment since he’s eliminating the cost of a value-add director or advisor. You’re paying for the smart money investor—with his own money!

A smart money investor can be very valuable because he is good enough to be an advisor or board member and he owns enough to really care about the company in good times and bad times. An advisor or independent director won’t own enough of the company to really care if the company is in trouble—his career isn’t on the line like an investor’s.

But! If the investor you thought was smart doesn’t add value, you can’t fire him like an advisor or director and get your money back. You can only hope to ignore him. Which is why it is safer to…

Assume your investors are mostly money.

Whether you raise smart money or mostly money, you should raise money as if your investors were mostly money. In other words, unbundle money and value-add. Get money on the best terms possible and get value-add on the best terms possible.

You can buy advice and introductions for 1/10^th of the price that most investors charge. An investor will buy 15–30% of your company. An advisor or independent director will require 0.25–2.5% of your company with a vesting schedule of 2–4 years.

An advisor or independent director will be hand-picked from the population of planet Earth. He should be more effective than someone picked from the vast pool of investors who want to invest in your company.

He will own common stock, unlike an investor who owns preferred stock with additional rights.

And he won’t have conflicting responsibilities to his venture firm, other venture firms, or limited partners.

Money-add first, value-add second.

Value-add is great but it comes after money-add. First, find a money-add investor who will make an investment decision quickly, who is humble and trustworthy, who will treat you like a peer, who shares your vision, and is betting on you, not the market.

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