Capital raises come in twos

This is another one of those ideas that seem obvious to me now, but didn't always -- and I keep hearing from entrepreneurs that it's new information to them, which tells me I should write it down.

Chris Dixon is one of the most articulate entrepreneur / investors I know of on the many risks of seed-stage fundraising. His post "Once you take money, the clock starts ticking" covers most of the ground I want to, but with one important omission: fundraises aren't actually discrete, time-separated events; instead, they behave more like, and should be actively planned, in pairs.

Every capital raise contains implicit assumptions about the next one. The more explicit you make those assumptions -- both to investors and to your team -- the more likely you are to get that next raise done.

Why is this so?

Almost by definition, venture-backed companies consume capital. The more successful they are, the more capital they consume as they rocket (hopefully) to a position of dominance in the market they're targeting.

Despite cyclical variations in pricing or deal mechanics, the steps in the fundraising process look pretty much alike from one company to the next:

If your company is on a venture path and you're raising anywhere within this trajectory (i.e,. you're consuming capital much more quickly than you're generating free cash flow), every raise comes with a set of assumptions about:

• (a) how much time you're buying until the next raise (18 months is a good rule of thumb, and 

• (b) what you expect to accomplish within that time.

In other words, no matter what you plan to do with the money you're raising today, investors in any current round *already* have a set of assumptions about what you need to achieve for the next round to happen.

If you don't understand -- and fundamentally share -- those assumptions, you and your investors are very likely to wind up at odds over your next raise.

For example, if you're raising a Seed round today and expect to raise an institutional Series A within 12-24 months, you need the current raise to buy yourself enough time + capacity to:

• build a product customers actually want, 
• figure out how to sell it to them, and 
• develop a credible hypothesis for how those product / customer pairings can be acquired at scale with positive (and ideally accelerating) margins

If you fail to do all of these things reasonably well, or at least one of these things extraordinarily well, you will probably fail to raise your Series A, at least on "market" terms.

This may not feel right or fair, but it's a fact. And the ongoing glut of seed stage company formations has only raised the competitive bar for high-quality Series A financings (the much-discussed 'Series A crunch').

The absolute best hack for this problem of step-function financing hurdles is to over-perform -- delivering extraordinary results between each planned financing event. 

But the next best strategy is to fully grok the benchmarks that both current and next-round investors are planning to use to evaluate you, and make sure you raise enough / hire enough / accomplish enough to make the cut.

Money, Power + the Culture of Innovation

The concept of acquired situational narcissism has been in my head since 2001, when the New York Times Magazine included it in their annual "Year In Ideas" issue.

The phrase describes the lack of empathy -- and resulting self-serving behavior -- that the rich and powerful tend towards when they mistakenly interpret their own success as evidence of their innate superiority, and not just a happy confluence of of birth, luck, environment, hard work and timing.

Living in Seattle, I (thankfully) don't cross paths with many investment bankers, heads of state or Hollywood celebrities, and the per-capita incidence of the condition is probably lower here than in LA, DC or New York.

But as our culture increasingly looks to technology for its heroes (think Mark Zuckerberg or Steve Jobs) this pathology is starting to seep into in the nominally egalitarian world of software innovation.

This change is already visible in the national discussion -- tech founder stories that used to be told with a light-hearted "revenge of the nerds" angle now have a darker tone, lamenting the billion-dollar valuations ascribed to "trivial" companies like Facebook, Twitter and Instagram, and claiming that the current easy-money culture of Silicon Valley signals the death of innovation.

Unsurprisingly, the attacks are most often launched from the East Coast, long the center of American money and power. 

The New Yorker recently waded into this bi-coastal culture battle with Ken Auletta's piece on Stanford's abrupt withdrawal from the New York Tech Campus project, ominously titled "Get Rich U. : There are no walls between Stanford and Silicon Valley. Should there be?"

The tone of the article veered wildly, beginning with a celebration of Stanford's remarkable success as the intellectual heart of Silicon Valley, then shifting to a vague but unmistakably critical profile of Stanford President John Hennessy and his handling of the negotiation with Mayor Bloomberg's office over the project.

One particular pair of quotes from the article jumped out at me:

"Mayor Bloomberg, in a speech at M.I.T., in November, had said of two of the applicants, 'Stanford is desperate to do it. Cornell is desperate to do it. . . . We can go back and try to renegotiate with each' university. Out of the blue, Hennessy says, the city introduced the new demands. 

To Hennessy, these demands illustrated a shocking difference between the cultures of Silicon Valley and of the city. 'I’ve cut billion-dollar deals in the Valley with a handshake,' Hennessy says. 'It was a very different approach'—and, he says, the city was acting 'not exactly like a partner.'"

Taken together, Bloomberg's and Hennessy's comments cut to the heart of the massive cultural gap between the dominant values of the technology innovation community and those of traditional industries like financial services:

• The "heroic" cultural action in the software innovation community is creating, making something from nothing, growing the pie, and giving everyone who helps a slice of the gains. In this mode, negotiations tend to be friendly, focused on achieving mutual gain and equitable outcomes.

• By contrast, the "heroic" action in financial services (or politics, for that matter) is winning, "being on the right side of the trade". The pie is finite, the game is effectively zero sum, and each players' share of the gains tend to come at the expense of the other players.

Facebook's IPO this week offered an even starker example of this dichotomy, with commenters from the trading economy lamenting the "failure" of the offering, while those from the "maker" side celebrated the lack of trading gains delivered to Wall Street on the back of the maker's efforts.

The roots of this cultural difference aren't easy to pin down, but both the New Yorker article and a thoughtful recent book-length analysis (The Rainforest: The Secret to Building the Next Silicon Valley) see its historical antecedents in the egalitarian, cross-cultural and community-centric values of Western pioneer culture.  

But whatever its origins, the collaborative and gains-sharing ethos of the innovation community acts as critically important grease on the wheels of the system, reducing legal and deal-making overhead and fostering trust and agility among players at every layer.

From where I sit, it's not hard to read the current cultural moment as a long-cycle power shift from East to West -- from traders to makers. This is probably bad news for Wall Street, but good news for the long-term economic competitiveness of the U.S. as the driver of global technology innovation.

The single greatest risk to this this future isn't technological, but cultural -- allowing the short-term focus on wealth creation and extraction to erode the bedrock values of collaborative invention.

Steve Blank summed this up nicely with his recent (and widely-republished) article, "Why Facebook is Killing Silicon Valley":

"[W]hat’s great for making tons of money may not be the same as what’s great for innovation or for our country"

Acquired situational narcissism is the cultural cancer -- fed by wealth and power -- that kills empathy and celebrates extraction over creation.

The current frothy climate in Silicon Valley is tilting the table towards extraction once again, but I believe the culture of innovation is stronger than the culture of extraction -- and that even as the battle rages in Silicon Valley, maker culture is spreading too far and fast for the forces of extraction to catch it.

Unwritten Rules

Last week I had several different conversation with entrepreneurs who are on the verge of setting up operations for their new startup. The topics we covered included:

• Should I self-fund / bootstrap or raise angel money?
• Should I accept an EIR / incubation offer from a VC firm?
• Should I keep looking for a technical co-founder or outsource early development?
• How much of my founder's equity should I expect to share with co-founders and early hires?
• What would being accepted at a top-tier accelerator do for me that I can't do myself?

There are no "right" answers to any of these questions. Hugely successful businesses have been built at all points on the spectrum, and -- since companies are fundamentally a reflection of their founders' values -- the most important question is "what feels right to you?"

But founders also need to be aware that their answers to these (and other) questions have huge significance to prospective investors. I know I have a "right" answer to each of these, some of which I''ll outline below. That doesn't mean that I'll never invest in a company that chooses the "wrong" path, but it's a significant hurdle for me to overcome in making a decision to invest.

I'm not the only investor who rules investments in or out based on early choices made by startup founders.

I've hugely enjoyed Blake Masters notes from Peter Thiel's CS183 lectures at Stanford -- if you haven't read them I can't recommend them more highly -- and the notes for Class 6: Thiel's Law cover this topic well.

A few examples of Peter Thiel's investment heuristics (from that same lecture) are:

• Founders should be full-time / all-in
• Never hire consultants or contractors for important work
• No startup CEO should ever make more than $150K a year
• Every startup should be a Delaware C-corp

Again, many successful businesses have been built that violate some or all of these rules, but in Peter Thiel's estimation, every decision you make that runs counter to this framework is a signal that your thinking and his are at odds. If you want his money, that should matter to you.

I'm sure there are skilled investors who disagree with Peter Thiel, but you can be sure that every investor has a set of heuristics and biases that she uses to filter investment opportunities, even if she's not entirely aware of or explicit about them. 

If you're out looking for capital for your startup, you need to be aware of these biases and make decisions that are congruent with the kind of capital you hope to raise.

If you want to raise money from Founders Co-op, here are some of our biases that you should be aware of before you come in to pitch:

• We're "maker-centric" -- we're heavily biased toward founding teams that are more engineers + designers than businesspeople, with a track record of building beautiful, useful software both within and outside their day jobs.

• We're wary of solo founders -- the atomic founding team is at least two people, ideally a hacker and a hustler. Both can be devs, and three or more is OK, but one is a worrying number.

• We don't believe winning products get built by outsourcing / offshoring -- makers who listen to customers and improve at lightning speed will always beat spec-driven development, and all the selling in the world can't fix a shit product.

• We like founders with huge dreams + the skills to back them up -- building any company is brutally hard work, so pick a fight worth winning and build the best team you can -- investors included -- to play in the big game.
• We view attending a tier-one accelerator as a no-brainer based on signaling value alone -- even before you get to the mentorship, the alumni network or the investor intros, being selected by Y Combinator or TechStars is such a powerful positive signal to the market that you'd be crazy not to take it, especially in a world of near-perfect competition for software ideas.

These aren't rules, they're biases -- we always reserve the right to break them if we find something else about the deal to love -- but they're a hurdle to jump over. And there are plenty of other things we take into consideration when we're evaluating a company for investment.

But for founders with an interest in raising money -- never forget that *everything* you do has signal in it for investors. In the investing world the default answer is always "no", so try not to make choice that will get you a "no" before you've even opened your mouth.

Don't be a grinder

Lots of chatter lately about how Seattle investors aren't stepping up to back promising local entrepreneurs, which in turn is driving the best + most ambitious teams to decamp for Silicon Valley (e.g., GeekWire on Tony Wright's departure, or Trevor Gilbert's PandoDaily piece on local funding weakness).

This is a big and complex topic that I won't attempt to unwind in a single post, but I had a couple of different exchanges with local investors and entrepreneurs just today that drove home just how real and how damaging this problem is.

Here's a quick rant on just one of the many issues in play here:

The behavior that triggered my frustration today is what I call "grinding" -- when an early-stage investor spends little to no time on team and opportunity, but centers the conversation around price. 

Don't get me wrong -- purchase price has a direct bearing on expected return, and is a very real consideration in any deal. I've passed on plenty of opportunities because I felt the price was out of whack with the returns profile of the investment (and the current Bay Area fashion of uncapped notes or double-digit caps for "companies" that barely exist strikes me as absolute lunacy from an investor perspective).

But all too often an investor conversation that pivots around price instead of the intrinsic merits of the opportunity leads quickly to the next ask, the "special" price this investor believes they should receive because they're... umm... special.

This is what I call "grinding", and it's one of the most short-sighted and damaging behaviors an investor can engage in if they want to build trust with entrepreneurs -- and help those entrepreneurs maximize long-term value for founders and investors alike.

When good entrepreneurs ask for money, they aren't *just* asking for money. They're inviting you into their extended family and asking you to join them on a long and difficult journey into the future. 

Your investment will be highly illiquid, so you'll be stuck with them -- and they with you -- for as long as it takes to succeed or fail. Every investor that comes along for that ride is now a partner in the business -- for better and for worse.

Entrepreneurs are at their most vulnerable when they need money, and "grinding" -- taking advantage of that vulnerability to try to eke out a little more return for yourself -- is the worst kind of relationship-poisoning, short-sighted behavior you can engage in -- if you believe that the really big gains in enterprise value are still ahead of you (and if you don't believe that, why the fuck are you investing at all?!).

I know, because I have been guilty of this myself.

I am still learning how to be a good investor, and when I started this journey I was under the mistaken impression that money mattered more than talent, and that the terms under which I invested were a private matter between me and the entrepreneur.

Both of those assumptions turned out to be badly, dangerously wrong.

When I approached an investment with a "grinder" mentality, one of two bad things happened: either I lost the deal and permanently damaged my relationship with a quality entrepreneur, or I won the deal and entered into a long-term relationship with an underperforming team and company, with strained relations between myself, the other investors and the company founders -- all based on a lack of trust.

So grinders have not one but two different ways to fail. They lose in both cases, but at least in the first one they don't also saddle good founders with bad investors.

I still have a ton to learn as an investor, but I'm trying hard not to keep on making the same mistakes. At this point, the only optimizing behavior that makes sense to me in early-stage investing is around two things:

• Team -- are these the most talented, relentless, creative and ambitious people I've ever come across?

• Opportunity -- is this team's vision so valuable and so exciting that if they pull it off it will be a massive win for everyone involved?

If the answer to both questions is yes then price is just a binary:

• If the price offered is fair given the stage and goals for the raise, I invest as much as I can.

• If I have conviction in the team and their vision but don't believe the price is fair, I offer that feedback respectfully and decline to invest -- or better yet, let them know at what price I would invest, alongside others on the same terms, and leave it up to them do with that information what they will.

• If I don't believe in the entrepreneur or the opportunity they've chosen to pursue, price and terms are irrelevant -- the answer is always no.

Putting an end to grinding won't fix all the problems with the Seattle startup scene, but it will go a long way towards focusing the conversation on the right questions:

• Are we fielding increasing numbers of amazing teams with huge visions? 

• Are we doing everything in our power as a community to help those teams win?

Only when the answer to those questions is an unqualified 'YES!' will Seattle have a shot at the big leagues. Until then, it's chop wood, carry water.

More Turtles: "Freemium" Investing

I've written before about the fractal relationship between running a startup and running a venture fund -- here's another example:

Freemium pricing is one of the most powerful customer acquisition strategies in the software business. Many billion-dollar businesses have been built (think Dropbox or Evernote) by giving away a significant chunk of their overall value proposition completely free, no strings attached.

This model has more or less won the day in mobile app marketing as well -- most top-grossing apps are "free to play", relying on in-app transactions for premium services to drive lifetime value.

I've been reflecting lately on what I've learned over the past four years as a "professional" venture investor, and the freemium parallel strikes me as pretty accurate description of how VCs invest their most precious resource -- their time.

Most of my calendar slots are filled by people I've never met -- first-time meetings with entrepreneurs, co-investors, or other folks (academics, enterprise leaders, city and state government officials) who share my passion for early-stage innovation and community development. Most of these meetings don't "go anywhere" -- meaning they don't lead to investments, close working relationships or other obvious outcomes -- at least not in the short-term.

But every one of these meetings is an opportunity to forge a connection that may lead to a positive outcome in the future. And nearly every meeting results in additional connections -- each of us acting as a "human switch" and offering introductions from within our networks that might help the other along their journey.

This kind of no-strings-attached relationship-building and connection-sharing is the "freemium" part of my working life. And it's a very big part of what I do. The benefits of it aren't always obvious in the short term, but it's easy to look back over the past four years and see how powerfully this investment in people and relationships has become the foundation of my ability to create value as an investor.

Last night I was honored to receive the "Investor of the Year" award at the annual Seattle Startup Awards (created by Marcelo Calbucci and now hosted by the amazing team at GeekWire). It's definitely not awarded based on financial success -- I still have much to prove on that front -- but as Rebecca Lovell said in her introduction of the award, it's really for being the "believer of the year."

I *do* believe -- with all my heart --in founders, in entrepreneurship, and in the capacity of digital innovation to make a better life for people in our community and around the world. And if that's what the award is really for I'm even more grateful to receive it.

Don't get me wrong: "Freemium" investing is still investing -- it serves the the capitalist master of turning money into money. But the more I learn about my journey as an investor, the more I appreciate the wisdom of Yvon Choiunard's parable about Zen archery -- hitting the target is just a by-product, not the work itself.