“You cannot clear the market in series.”
– Office Hours
“Investors move in herds that are steered by scarcity and social proof.”
– Office Hours
Summary: This article includes audio and notes from our first office hours. Topics include selling 51% of the company, dead equity, and setting good terms with angels.
Yesterday, we held our first office hours via teleconference. Office hours are an opportunity to ask questions and discuss raising capital.
Here is an edited MP3 of the discussion:
Venture Hacks Office Hours, June 7 2007 (mp3) (length: 18:43)
The questions and discussion were great. We had to stop early due to technical difficulties. Next time, we will do it via Skypecast which I hope will be flawless. We will post the time, date, and link for the next meeting soon. Please submit any ideas for office hours in the comments.
Finally, here are some edited highlights of the discussion. Please excuse any bad grammar, these are rough notes.
Control
Entrepreneur: We have an offer of $1M for 51% of the company. What do you think?
Venture Hacks: I wouldn’t take the 51% deal. At that point it is no longer your company. You are an employee. And you are no longer doing a startup. And you killed the entrepreneurial drive.
Investors who would like to buy 51% of your company don’t know how to invest. Especially if it is early stage. They think they are buying an asset that someone is going to run for them. But what they have done is killed the entrepreneurial drive.
Reject that deal out of hand. I would rather go back to eating Ramen noodles and working out of my parent’s basement. It is equivalent to selling your company for a little bit of money and going to work for your investors. Continue looking for another deal.
Don’t even talk to these 51% guys if they come back with a better offer. They have already made their intent to own 51% of the company clear.
Valuation
We want to raise $1M for 20% of the company or raise $2.5M for 30%-40%. How do we do it?
I don’t know what your company is worth. That is driven by the market. There is no right or wrong valuation. It is driven by your team, product, market, salesmanship, etc.
If you’ve hit 10 investors who make it a habit to invest and you haven’t gotten good responses and you can’t get a term sheet or verbal terms, you aren’t likely to get a term sheet if you talk to 20 more people. There is probably something wrong with the company and you should take a look in the mirror.
The #1 reason people are not able to raise money at the valuation they want is because the team is incomplete or does not appear up to the task. And that is tough feedback for a prospective investor to give. And if it isn’t the team, it is the product or traction.
How do I get a market clearing price?
You cannot clear the market in series. You have to do it in parallel. Set up 10 meetings to all happen in the same week. Some of them will flake out and you will end up meeting with 4-6 of them. Tell them all that you plan to sign a term sheet in 6 weeks and if don’t have an offer by that time, we are going to go back to the drawing board and using sweat equity to build the company.
You have to create that time limit.
If you go to market, go to market. The only way to get a market clearing price is to talk to a lot of people at once. I often see people go down the path with one or two investors. That is a mistake. Focus on the fund raising and get it done or go back and fix what is wrong with the company.
Don’t use the word “auction” with your investors but you need to run an auction. An auction is a double win for you. First, you focus your fund raising on a short period of time so you can get back to your customers. Second, it creates a positive feedback loop of scarcity and social proof. Those are the things that close deals.
Check out a book called Influence. Scarcity means “Hurry up or the deal is going to disappear.” Social proof means “Other people want to invest, don’t you?” Investors tend to move in herds that are steered by scarcity and social proof: “Sequoia is investing? I’m in.”
Dead Equity
If one founder has a (non-patented) idea and doesn’t add much value beyond the idea and the other founder does all the work, how do you split the founder’s equity?
It ranges from 1% – 10% of the founder’s equity. If someone has the idea, follow the Einstein maxim that “Genius is 1% inspiration and 99% perspiration” and give them 1% of the equity. If someone is active and helps you get started and has industry connections and stays active over time, you can give them closer to 10%.
Ideas are a dime a dozen. There are more good ideas than time. Ideas constantly change and you almost never end up doing what you started doing.
50-50 splits are unstable and the company falls apart. 2 years after the founding, one guy is still in the garage and says “Oh my God I’ve put in all this work, the idea has changed 5 times, and this other guy who is doing nothing has 50% of the company.” It is dead equity.
The percentages we are talking about here are the split between the founders.
Angels
I probably need $.5M to get my company off the ground. How do I set my terms with angels so it doesn’t screw me up down the road?
First, don’t give a huge discount if you expect to raise your Series A soon after the seed round. VCs don’t want to pay a big markup between the seed and the Series A unless time has passed (say 6 months) and traction has occurred. Typical discounts are between 20%-40%. Put time and traction between your financings.
Second, if you raise equity from angels they will probably have to approve the Series A. If you have a nasty angel, a “fallen” angel, who is trying to make money on just this one deal and doesn’t have a reputation to protect, he can try to hold you hostage on the Series A and veto your Series A until you give him some kind of good deal such as letting him put more money in at a good price. That’s a rare scenario but it does happen and the only way around it is to pick your angels carefully. If you raise debt, don’t give debt holders veto rights on the next financing.
Third, don’t give your angels perpetual warrants that don’t expire. If the company is a big hit, you don’t want your angel to come in right before the IPO and dilute everybody 10% at a very low cost. Avoid warrants in general, but if you do use them, set a short expiration.
A really clean debt agreement between you and experienced angels is the best way to get the company going. It leaves you with a ton of control. Check out Yokum Taku’s debt term sheet.
Approaching Investors
How do I approach VCs and angels?
You approach investors through people who know them. The best approach is through an entrepreneur whom they have backed and been successful with. Next best is probably someone who works with them such as an angel, or someone who sends deal to them, or someone who is associated with the industry. Third is probably your accountant or lawyer.
Fund-Raising Schedule
How do I time the fund raising?
In short, focus. Hit all the contacts at once. In your head, declare a start to the fund raising. Set up all your first meetings to happen in the first week.
If some investors are being slow while others are moving along, tell the slow people, “By the way, we are on second meetings with three funds.”
In a tight process, there are three meetings. One with the original guy you made contact with at the firm. Second, you meet the original guy and some of his partners. Third, there will be a partner’s meeting. There may be an intermediate session where some of them come to your office.
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