Paul Graham may be right, but Chris Zacharias is righter
danshapiro.com
danshapiro.com
Need to take a step back and look at the primary purpose of acquiring investors: taking capital from them now in exchange for future cash flows to them later. To maximize this in favour of our business, we need to take the most money for the minimum amount of equity sold.
Now look at the primary purpose of the management team: to use the assets and resources placed in their care to create the highest future cash flows possible. This includes the tasks that Chris is conflating with investors: secure deals, find the best lawyers and accounts, getting meetings with difficult people. The management team is then compensated directly for their efforts.
The above is how it works in traditional companies. The investors invest capital and decide on the management team. The management team actually runs all facets of the business. In the startup world this relationship is not as simple, as the founders are both the primary shareholders and the management team itself.
What Chris is proposing is not as outlandish as it sounds - he is proposing joining the investors as part of the management team by selling shares to them for cheaper. If a share is worth $10 on the open market, but we sell it at $5 in exchange for valuable help from investors, then we are doing something very simple: we are paying these investors to be part of the management team, and in this case we are paying them $5 per share. This is a good option to take if the skills they bring are worth the $5, and a very bad option if we could hire better/more skills by taking the $10/share and then directly hiring on the market.
TLDR: Nothing to see here - you can pay people in equity or in cash, and the choice is as difficult as it ever was.
However, in seed stage investing in startups, investors do not end up looking at their equity stakes when they decide to help or not help a startup.
The primary determinants of whether an investor helps you are: 1) Whether they are the type that generally want to help the companies they invest in 2) Their relationship with the founders 3) How successful they perceive the startup will be and whether they feel they can contribute to that success
The latter might be more 'expensive' but also more valuable.
I disagree with your TLDR. There's definitely something worth seeing here as Chris has just described a fundraising tactic that's useful to be aware of (it's not one I'd have thought of independently).
When you hire an engineer, you can either pay him $100 or give him $100 worth of stock. If the engineer chooses to be paid $100 in cash, you need to acquire that cash. If you have revenues, you can pass those onto the engineer. If you don't, you can sell $100 worth of stock, and pass on that $100 to the engineer.
Valuations are identical - you are selling off the stock for cash - it is identical to the case above when distilled, and the actual choices involved are the same. Example:
Option A
Investor 1 who will give $100 in exchange for $100 stock
Investor 1 will not help the company recommendations etc.
Option B
Investor 2 who will give $50 in exchange for $100 stock
Investor 2 will get you a meeting with Investor 3 (X)
Investor 2 will help you with his experience (Y)
Real value of your company
- This one can only be found by using a time machine
to jump forward and see the true cashflows.
- It is the true value that the other values try estimate.
Your estimate of the value
- You get this by being objective about your business.
- You should base all your decisions off this number.
Other people's valuations of your business
- Everybody has their own unique value
- You don't want to sell stock to people who have
a low value of your business.
The only important number is your own estimate of the value, and you should base all share decisions off that number alone. And try to get that number as close to the real value as possible.
So if there is an Option C which is just plain better than the other options, it's the obvious choice to take - but be careful of any strings that may come attached in lieu of a cash payment - he may be expecting bigger rewards in future and can cause drama in your business getting them. Not everything with no cost is free...
This is the mistake. This pool is not merely smaller (that may not even be the case), but investors in it have a lower ratio of value to cost. Which is precisely the reason someone who fishes in this pool has it all to himself.
I.e. the argument here is not akin to "Since this restaurant is too crowded, I'll go to that other equally good restaurant that's empty, but rather "Since this restaurant is crowded, I'll go to that other one that is deservedly empty."
I find it odd to be arguing this side of the case, because I'm usually the one telling founders not to chase high valuations. But these arguments are simply fallacious.
He also marveled that he closed the funding round in just a few days. I constantly read here and elsewhere that one of the huge pain points when you're looking for funding is that you spend so much time dealing with fundraising that you have to drop the ball on developing your actual product for a while. Courting quality investors that tend to be priced out by many startups with high valuations could reduce that problem's impact.
Again: I recognize that this certainly isn't a general solution that every startup can pursue. But it sounds like you're dismissing it in general.
Then again, I'm just an armchair non-entrepreneur commenter who has never faced any of these problems. ;)
And lowering one's valuation is not an automatic way to make a round close faster. I've watched literally hundreds of startups both succeed and fail at raising money, and as a rule, if investors don't want to invest at a valuation of x, they don't want to invest at x/2 either.
All that's really going on here is that Chris is mistakenly generalizing from a single data point.
My assumption was that there's a group of investors that would love to invest, but just don't have sufficient capital to do so at the valuations companies are getting. But I guess that's too small a number -- especially when you consider that you want quality investors, too, which shrinks that pool -- to be a general solution, as you say.
Angel Investors are helpful for the resources the provide. One is financial and two is non financial (intellect/network connections etc) It seems like Chris has decided that the focus at YC companies has become too much on the former and not on the latter. He seems willing to reduce the amount of value he receives via the monetary piece (not less dollars, smaller valuations) in exchange for much higher value on the non monetary piece. "I'll give you a lower valuation in the hope/expectation that you'll be much more vested in our success and thus leverage your non monetary resources towards our success."
In a nice reinforcing circle: by taking a lower valuation he creates, or perhaps reinforces, the right economic incentives to do that.
On a side note I thought he was extremely brave to challenge the system with his original post.
Red investors oceans represent to all the industries in existence today – the known Investor space. In the red oceans, investors boundaries are defined and accepted, and the competitive rules of the game are known. Here start-ups try to outperform their other start-ups rivals to grab a greater share of investment demand. As the funding market space gets crowded, prospects for high valuation and rapid investments are reduced. Products become commodities or niche, and cutthroat competition turns the ocean bloody; hence, the term red oceans.
Blue investor oceans, in contrast, denote all the industries not in existence today – the unknown investor market space, untainted by start-up competition. In blue oceans, investment demand is created rather than fought over. There is ample opportunity for high valuation and rapid investment. In blue oceans, start-up competition for funding is irrelevant because the rules of the game are waiting to be set. Blue investment ocean is an analogy to describe the wider, deeper potential of investor space that is not yet explored.
(Adaptation of Wkipedia article on blue ocean strategy for investment for start-ups)
In your article the "guilder-investing angels" are the blue ocean for investment in start-ups.
On the other hand Zacharias's blog describes observing and responding to feelings that there was a disconnect between the funding features available to his YC class and his entrepreneurial gut.
As a "pre-cofounder" (I love the term) he was in a position to take a different course. He also enjoyed the advantage of friendships with potential investors.
I can't help but see what he describes as extending some of the fundamental YC processes beyond the point where YC kicks the baby birds out of the nest. YC works because of the trust founders place in the partners. It works because founders don't worry about the investor screwing them over, and it works because founders can spend more energy building rather than negotiating terms.
This appears to be what Zacharias did. He was careful about who he sold his company to and conscientious about the price of shares which are likely to be worthless.
It was a personal strategy - right for Zacharias. PG is right that it is poor as a general strategy for YC companies.
http://statspotting.com/2012/12/elon-musk-always-go-with-a-h...
I can understand the reasoning but are the 'best' of this pool as good as those from the dollar-pool? Wouldn't the really good/useful ones be trying to enter the dollar-pool anyway? (NB I'm not aware of the back-story yet)
Edit: Just read both pieces and I agree that they're both right. I see this as a difference between Angel vs VC. Angels sometimes get involved because they can imagine having a useful impact on their portfolio. If an Angel takes a tiny slice of a company which also has VCs and 'YC valuations' then they may feel they have no real 'clout' or ownership in the company (not everyone wants a board seat). Even though the economic argument may be to take-whatever-you-can-get that doesn't make it fun or worth your time.
I will say that one nice thing about pricing on the higher side is it requires more conviction on the part of your investors. Thus, it will be those that are committed to your company, despite a higher relative price. (All investors are price-sensitive, it's just to what degree.) So by pricing it higher you end up with the same result as CZ and DS are seeking, except you keep more of the company.
And as far as the price-sensitive, there are many reasons, aside from them just being "smart": a) they're trying to raise a fund and need lower valuations, "better" numbers, for potential LPs (since LPs are usually investors with a more traditional mindset on finance, and thus more price-sensitive), b) their existing investors want to see lower valuations, "better" numbers, c) they're able to get "good deals" (I'm not mocking this, I'm just noting it's a value judgement, not something concrete) at lower valuations, d) they care more about potential multiples on their own fund(s) more than investing in the outright best companies, and any number of other reasons.
Hunting for the cheapest relative startup isn't necessarily "smart" (nor is investing in say uncapped notes), and investing in "expensive" startups isn't necessarily dumb (nor is haggling over price).
Suggesting pricing is not a rational factor in investment decisions is exactly the sort of irrational statement that indicates the peek of a bubble.
Furthermore, if you pay double, that means you've already lost 50% of your money. Valuation is essentially potential upside discounted by risk. If risk is not factored in properly, investors lose money and nobody wins. Investors expect most of their bets to lose, and winning bets to provide a significant return. That return may average out to around 20% annually for a very good investor. If that investor is paying double, that goes down to 10%, hardly worth the risk of angel investment.
A) 50K at 5M valuation is 1%
B) 100K at 10M valuation is 1%
If the company sells for $1B, the first investor gets 200X, the first investor gets 100X. The first investor can also invest 50K in another promising startup, increasing the likelihood of them making money with their 100K capital. Given that any individual company has a low chance of a $1B exit (if it had a high one, the valuation would and should be much higher,) diversification is important to investors.
Alternatively assuming a fixed investment amount:
A) 50K at 5M valuation is 1%
B) 50K at 10M valuation is 0.5%
If the company sells for $1B, the first investor gets 200X, the first investor gets 100X, and made a drastically different amount of money - $10M vs $5M (less investment). If the investor has a large number of investments, a 200X vs 100X can significantly change the overall outcome of the portfolio. This is less so when we are dealing with these ridiculously high numbers (very few startups exit with this kind of return), but with more typical $20-100M exits, the valuations of the investments makes even more difference.
The key point here is that the startup's likelihood of being a winner is a key component of the valuation. If a startup had a very high chance of exiting for $1B, then a $100M valuation may be perfectly reasonable. YC startups, on average, do not have a high chance of a $1B exit.
When a startup raises at $15M instead of a more reasonable $5M, it is riskier to invest because the upside, and therefore the expected value, is much smaller.
The idea of getting a piece of something no matter how small at any price is just bad investing and bubble mania.
This sort of unsustainable logic is what leads to boom busts cycles. It's important for everyone involved to maintain rational pricing in a market, because volatility breeds fear is ultimately damaging to the startup ecosystem.
I, and any other investor, would have gladly bought Google stock at any valuation before its IPO, whether at $5MM, $15MM or $100MM. Whereas it doesn't matter how great your terms are if the startup you invest in fails.
You said "there are a segment of investors who use valuation to drive their decisions, even if its irrational to do so".
It is not irrational to use valuation to drive decisions, though it is obviously stupid to have that be the only factor. It is however, a major one.
Of course if success is highly probably, one should not be deterred by valuation, and in fact valuation should be higher. These days, many companies are not risk discounted enough, making many investments a bad deal for investors. Companies raise at $10M valuations and go out of business 6 months later. This is not healthy.
Even at 1/100, a single $1B exit only breaks an investor even by expected value at a $10M valuation, but is quite profitable at a $5M valuation.
Of course, investing is more than probability, but probability is a significant factor.
One is a smaller angel, but a pretty good guy. We stopped before getting to the actual terms (since we decided not to do a big raise at the time, but rather to do low burn and launch first), but he has a reputation for being cheap about valuation to the extent that it kept him out of some deals.
The second was IMO the best investor I've talked to to date. his super angel fund wasn't valuation sensitive except that they had a thing against uncapped notes, having done precisely one before and gotten fucked on it. We were trying to defer any talk of valuation by using terms copied from the START note. I kind of regret not just naming a number right then (really, anything in a 2x range would have been adequate), since this investor essentially no longer exists.
This can be a difference between Angels and VC. Take my comment with a grain of salt, since I have always been self-funded.