Don't Over-Optimize Fundraising
blog.ycombinator.com
blog.ycombinator.com
And, hey, that might be true.
But it also seems to me that there is a conflict of interest here in several of the main points.
> Founders who quibble over selling 18% or 20% of their company in a round have lost sight of what actually matters.
If each VC is getting that extra 2% of the company for free each round, that adds up.
So maybe we should take these points with a grain of salt. They don't seem obviously wrong to me (but I'm not an expert), but there does seem to be a conflict of interest in what they say and where it comes from.
Whenever an investor says "are you really going to quibble over 1%?" my instinctive reaction is "are you?" It goes both ways. Yes, 90% of a watermelon is better than 100% of a grape. And obviously the investor's perspective for an ROI and risk tolerance are different from the startup founder and it has to be worth it for them. But it's so insanely selfish to paint the founder as greedy when the investor is literally in the process of being a hypocrite.
I actually understand the investor's perspective and realize they have a completely different context with their own goals, risks, assessments, etcetera and it's completely valid for them to have their own terms! I just despise when they frame the argument in such a tone-deaf manner. Yes, 1% fucking matters, otherwise you wouldn't be asking for it.
This also underscores the importance of doing fundraising in parallel and lining up as many offers as you can in a short period of time. If you're negotiating 1:1 you've already lost; you can't actually get market price unless you can make a market.
Two, I don't think you will find many entrepreneurs who'd claim indifference around their investor choice. At the very least, this claim asks us to believe there aren't terrible investors who cause damage, which runs contrary to both common sense and history.
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Most early-stage raises lack the luxury of a competitive process. Bring able to trade concessions in terms for the win of a deal is a strong predictor for greater commercial sense. If someone can’t give away another point to fund their business, they may be in the wrong seat.
In areas that aren't startup hotspots I can certainly see that dynamic, but this is why people move to the Bay Area for fundraising.
The issue with founders who over-optimize in fundraising is that they are rarely working with a clear, frame worked goal in mind. It's often "I just want better!"
I understand this impulse. I've been there myself. I'm hoping to help people take a step back and consider the wider picture.
My reaction is even stronger: "Yes, I am. 1% to you is .02% of your fund--it's a rounding error. 1% to me is real money."
The VC is doing, give or take, the same deal 10-20x in a portfolio. If you talk about that 1% becoming a norm, then it really moves the dial 5-10% on the total return for the VC.
A founding team should be owning 60-80% of the company after that transaction. Meaning, the 1% ownership difference is something like 1.3% of the founders' total return.
If you're going to try to do math on it, be fair and real.
Full disclosure: VC here.
Founders are (or at least should be) optimizing for the fact that they are most likely to be a mediocre business that isn't going to cash out with a lottery ticket.
As far as what the VC is optimizing for -- fair enough, I am only pointing out that saying the 1 point difference in, say, a 10 or 11 point equity stake is somehow actually only 0.2% to the VC isn't fair. It's a 10% difference in the VC's stake.
I think the more salient point being made here is that too many founders try to over-optimize the quantitative aspects of the round. If you find yourself trying to negotiate for a 2% difference in dilution, you should probably see if there are other qualitative terms you can get instead. Use whatever negotiating leverage you have to adjust board structure/voting, founder re-vesting, and a million other less-flashy terms.
And in the scenarios, such as SAFEs, where the only real terms are $$$-related, just decide on a starting number you're comfortable with and don't stress about optimization.
VC's will often ask early on, "what are you raising at?" and just because they agree to that number, doesn't mean "oh darn, I should have asked for higher and let them negotiate me down."
As Michael Seibel said at one of our YC dinners, "during fundraising, don't try to make ninja moves because most of you are not fundraising ninjas." While yes I understand that 2% dilution every round over the lifetime of the company adds up, the advice for 98% of founders is that you will hurt your company (and therefore financial outcome) more than you will help if you try to make minor negotiations on price/dilution/valuation.
Optimizing a deal is absolutely, 100% what a startup should be doing, but you should be going for a globally optimal deal, not optimizing for just one attribute. Would you counsel a startup not to optimize for sales or user growth? Sales are literally the only other form of revenue for most startups and without users you have nothing. Just as with sales and user growth, however, juggling long-term and short-term needs is critical.
New money doesn't particularly care you raised post demo-day at $15M if they think you're worth for example, at best, $12M now. It's a difficult conversation to have with founders and it can result in completely unnecessary pain around morale and optics. The worst loss is perversely invisible, as smart money might de-prioritize pursuing these companies knowing they have to work around the earlier mis-price. This is an opportunity cost that might not be apparent to most.
This is all complicated by the fact that demo day is in fact, not the first shot investors get at the companies in a batch. You might find that some of the most exciting companies in a given batch have been almost fully subscribed by the time demo day rolls around, as top tier firms don't wait till the actual demo day. Obviously, YC can't nor should they proscribe meeting with investors ahead of demo day, but this simply means access isn't as equally distributed as the notion of demo day might suggest. It looks to some degree like a second pass for folks without the network or access of a top-tier firm.
All this works great for YC, which, like every other fund in this world, makes money off power law returns, but it comes at a cost.
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What should you over-optimize for? Flexibility. Over-optimize for the ability for your business to become a cashflow positive lifestyle business that is not a 100M+ exit. That's actually what many many startups become.
YC won't tell you that because they over-optimize for world-changing binary results.
YC does indeed optimize for power law outcomes, but then again so does every venture investor (or at least, so should every venture investor).
99% (schematically) of new businesses should indeed optimize for flexibility.
But, if you judge yourself to have a real shot at the >> $100M exit, then optimize for that path and foreclose the flexibility.
There's a real truth to the idea that you will be putting your all into any business, so if you have one that really can create an entire career's worth of wealth at once for you and your whole team, you should optimize for that.
If on the other hand your business doesn't have a realistic shot at that, stay the hell away from VC. Waste of time and cash is king anyhow.
That's the "truth" convenient for VCs. Even if a startup has a realistic shot at >> $100M exit, it doesn't automatically mean that the founders should go that route. It depends on their risk tolerance and particular circumstances. If a startup could exit at $200M with a much lower risk than them exiting at $600M, some/many founders might prefer the former route. And that still would be "an entire career's worth of wealth at once" for them and the whole team (if the team is small enough), or pretty close to that, or simply just a very very good outcome.
I think the specific numbers you're providing are tricky, because generally, getting to $200 M exit within, say, a decade, involves institutional funding (VC, PE, "growth", whatever).
(As a relatively small non-Valley funder, I would generally also prefer to be an investor in a company that exits at $200 M with a much lower risk than a $600 M exit, given that getting to $600 M might mean another $50-100 M in late-stage, first-money-out, preference overhang capital.)
I think the real question usually has orders of magnitude difference here. Internally-fundable businesses tend to opt for business models like services, consulting, etc., since they can scale without a lot of invested equity. Hence a lot of times you wind up growing a business semi-organically and end up getting a 1-2x revenue multiple for a modest growth, modest gross-margin, consulting type business. Or, if you do get a good SaaS operation going and grow it organcially, you might find yourself faced with the late-arriving roll-up play heavily funded by private equity, who will buy you at a 3-5x in an attempt to consolidate the market and float it at a 6-10x.
And yes, if you as a founder have a 90% shot at $10 M in 10 years, vs. a 9% shot at $100 M or a 0.9% shot at $1 B, most rational founders should and do take the safe road. Stipulated :)
But in my experience and observation, getting over the hurdle of product-market fit and a repeatable go to market strategy is what tends to kill startups. If you get that PMF and GTM working, it often makes sense to fund hypergrowth. If you don't, the company is walking dead anyway.
https://www.youtube.com/watch?v=pbFkw_roJqI
This is not a perfect analogy for investors and founders, but it is an example where supposedly incentives are aligned but in reality they might not be. What's best for the investor is not necessarily what's best for the founder.
But again, in this case I do agree that YC is providing useful advice.
Pro-rata is in theory the right (but not the obligation) to buy back in, at the new price, to get back to your prior ownership level.
In practice however, pro-rata is a firmly stated polite request to the next round lead investor to let you do so. The real determinant of whether you get to use the pro-rata right is whether your next round lead investor is OK with it (and whether you want to try to block that next round).
As a VC and an entrepreneur, various times over the last 19 years, I will say this to entrepreneurs in good faith:
1. Your core competency is company building, not fundraising. (There are exceptions, but you're not one of them.) Just get enough money to company-build for the next 18-24 months on plan.
2. The primary (only?) thing to optimize for in valuation is "monotonically increasing over time." All of the pain (for founders, early investors, et al.) is when you have flat-to-down rounds. That's when you REALLY get diluted, and I don't mean like "geez 30% sucks" I mean like "let's build in a new 20% option pool because then founders are now down to 5% each" kind of dilution.
3. The other thing to optimize for is keep your overhang (liquidation preferences) manageable. The bigger the prefs, and the bigger the post, the worse your options are for an earlier founder-friendly exit.
4. Finally, as a sandpaper-the-edges kind of thing, remember that terms tend to get more investor-friendly over time, even for good (but not phenomenal) performers. So all in all, choose smaller rounds and lower valuations provided you get vanilla terms (meaning no multiple prefs or strange dividends etc.) because subsequent investors will insist on same-or-better sweeteners, which can bite everyone down the stack.
5. Really finally -- remember that for all of the seeming insider sharkiness of VCs, they all have to see each other in polite company again. Meaning, they're the devil you know. The real rapacious problem terms come from non-VC participants who don't mind slashing and burning -- be most cautious of those.