This post includes video, slides, and a full-text writeup. At 3,500+ words, you probably don’t want to be reading this on your phone.
Over the past two years, I’ve been lucky enough to be involved with 500 Startups as we’ve invested in 400+ companies in 20 countries. As we’ve started to ramp up operations in India, I’ve spent quite a bit of time there in 2012 and was asked to speak at the Unpluggd conference a few weeks ago. I thought I’d write up my presentation for the benefit of people that were not at the conference.
When Ashish first asked me to speak at this event, he asked me to talk about things that Indian companies could learn from American or other international startups. So, the way I’m going to structure today’s talk is that I’ll first talk about the underlying things that are changing early stage startups. Then I’ll talk about how those things are behind the underlying changes in venture capital. I’ll tie that together to talk about how fundings are changing. And, finally, I’ll leave you with a couple of crisp things you can do as founders to raise money more successfully.
First off, you’ll have to pardon the cliché, but early stage startups have already changed. The first underlying factor that drives that change is that initial startup costs continue to drop. It’s driven by the Cloud, driven by open source, driven by the online distribution platforms available to you. It no longer costs, for example, $1M, $2M or $5M dollars to start a new company like it did when founders started up ten or fifteen years ago. With that being said, though, the cost to scale a company is rising. So it is cheaper than ever to start but once you hit product market fit, the cost to scale is rising. That’s usually driven by the fact that companies that achieve that product market fit will often kick their growth into high gear by ramping up their budgets. Separately, customer acquisition channels tend to become saturated which further increases costs at that stage of the game.
The second underlying trend is that as the web gets bigger the world is getting smaller. What that means, for example, is it that if you wanted to raise money from an American investor you might try to get their attention by showing up in their backyard and you were only really competing with a few other American companies for their money. The unfortunate reality is that there are more and more entrepreneurs coming in to the market, just take a look around you in the audience today. There are more and more entrepreneurs coming online in Brazil, Mexico, Chile, Sri Lanka, China and Russia.
If you take a moment to really think about that, what I’m suggesting is that while increasing internet penetration certainly gets you more potential users for your product but it also gives me more potential companies to invest in. So it’s no longer good enough to be the best company in your neighborhood or your town or your city and frankly even your country. In fact, it’s incredibly important to be the best company an investor has seen that week. To give you some context: on average, we do probably one new investment somewhere on the planet about every three days. Roughly speaking, we do about one hundred fifty-ish new investments per year.
The third underlying trend is that tech differentiation no longer matters or, in other words, tech differentiation is not as important as it used to be. For most tech startups, if not all tech startups, traction is the only intellectual property that matters anymore. A great example of this is Facebook: they have one billion monthly active users now — that’s simply overwhelming. That’s not to say that nobody will disrupt them, they might. But the point is that it’s incredibly hard to do that. It’s much harder to beat that traction than it is to maybe, say, build a slightly better product.
The fourth underlying trend is that capital is increasingly commoditized. It certainly may not feel like this to many founders but the reality is that there is more money available to you than ever before. It doesn’t matter where you’re based. It doesn’t matter like what industry you’re in or what you do or how unique your thing is. The fact is that there’s more money available to you and it’s rapidly increasing. For example, we’ve got crowdfunding coming relatively soon. In Singapore, the NRF programs can multiply initial investments by up to five times. Then there’s Startup Chile in South America and, more recently, similar programs in St. Louis, Missouri that give startups up to $50K to relocate there.
The point is that none of these things existed a few years ago and that early stage money is increasingly becoming more available. Early stage money is becoming commoditized. In fact, I believe this decade will be remembered as the Rise of the Angels all over the world. But, perhaps more interestingly, I think it will also be remembered as the Rise of the Entrepreneur and that’s because early stage money is increasingly following you, the founders.
In fact, a subtle but very important thing to understand is that you don’t need to pitch investors. It’s our responsibility as investors to find you. Your job as the founder is to spend all of your time building your business. In doing that, you automatically make it easier for me to invest in you. Make no mistake about it, the venture capitalists in this room today (including me) want to invest in your company. And if we don’t, you should be asking yourself the hard question: is it because we weren’t able to connect the dots or because you really don’t have something we can invest in?
The fifth, and most profound, trend is that signals are available everywhere. In other words, transparency is everywhere. The best way I can make this point is to use the public markets as an example. For those of you that are new to venture capital, it’s important to understand that this industry is just one asset class in the bigger picture. Other asset classes, for example, are stocks, commodities and derivatives.
Before I go any further, let me make a blunt assertion: early stage venture capital is probably one of the only remaining asset classes that has not seen much innovation within itself. It’s not that venture capitalists are bad people, it’s just that we often don’t feel the pain enough to consider innovating within our own industry. And, as we all probably know from our personal lives, the sensation of pain tends to reduce the delta between cause and reaction. If I step on a nail, my reaction is immediate. If I eat Paula Deen’s cooking every day, checking my cholesterol will likely be the last thing on my mind. (As an aside, Paula’s advice to “just put some butter on it” may be the kind of advice that can apply to anything… including startups.)
Coming back to the point, the public markets have been using data in new and interesting ways — and they’ve been doing it for years. Consider the fact that banks like UBS are paying satellite operators to take hourly photos of every Walmart parking lot in order to make better guesses about how many people are walking through the door. They use this data to make better decisions around buying and selling Walmart stock.
Another company named Genscape is known for flying helicopters over the oil tanks in Cushing, Oklahoma twice a week to determine how much oil is in the tanks. They do this so their customers can make better decisions about buying and selling oil on the commodity markets. And, Wall Street isn’t alone.
If you’ve ever purchased home/auto insurance or taken a loan (especially for things like in-vitro fertilizaton), data was used to make better decisions about you. The point is that other industries are using data anytime it might reduce the risk. They do this because, generally speaking, the delta between when the transaction occurs and when they feel the pain/glory is very small. In other words, if I purchase a barrel of oil, I’ll often see the price change within a very short period of time.
When we used to write large initial checks to startups, it might take nearly two years (and sometimes more) before we feel the pain or the glory. If you consider all the underlying trends I’ve already explained, you’ll recognize that venture capitalists have no choice but to start innovating now — the changes in the startup world are forcing us to begin considering new ways to operate. When we write a small initial check to startups, we’ll feel that pain/glory in a much shorter time. If we’re talking about internet startups in particular, that could be in as little as a few months. That may not feel like a big change, but it’s an order of magnitude sooner than in the past.
One of the most important drivers of transparency has been AngelList. They’ve fundamentally leveled the playing field between startups and investors. (As an aside, the common argument from international startups is that AngelList doesn’t really help them yet. I call bullshit on that. If you’re not doing well on AngelList, you’re probably not communicating clearly — regardless of where you’re located.) It used to be the case that all deals would happen behind the scene but platforms like AngelList now allow you to follow investors, see who they’re following, which startups they’re interacting with and more. That’s profound.
Consider also that most founders (and, investors these days) are on other platforms such as Quora, Facebook, Twitter and LinkedIn. Not only are they on those platforms, but they’re engaged with them. There’s an incredible amount of signal within all that noise and the venture capital industry hasn’t traditionally looked to identify that signal. That’s all beginning to change now — firms like Google Ventures, Correlation Venture, Right Side Capital and many others are beginning to take a data-driven approach to early stage venture capital.
The point here is that the startup world is becoming increasingly transparent and that’s allowing founders to have easier access to investors. That transparency is allowing founders to make smarter decisions for their business and it’s allowing investors to make smarter decisions about their investments.
Now that we’ve covered all of those changes in the startup world, it’s important to understand that venture capital has already begun to change as well. As I mentioned earlier, it’s being forced to change because the startups are changing.
Let me first assert that the state of the art in venture capital is not very sophisticated at all. If you don’t agree with me, consider the number of interactions you’ve had with an investor that included the phrases “I think” or “I feel.” Venture capital has always been a little fuzzy, but that’s changing.
The first underlying change in venture capital is that there is an unbundling of advice, control and money. It used to be the case that the investor would write the check and the proceed to offer advice and take control via a Board seat. Today, they’ll often write you the first check without requiring a board seat — they do this because they realize that Boards can’t help a startup in the early days. (Once the company is clearly gaining traction, Boards can be incredibly useful to help guide the company through the later stages.) They also do this because they recognize that they don’t really need a Board seat in order to control you anyways — they know that later stage investors will look to them to re-invest in subsequent rounds and a smart founder will need to make sure they pay attention to the existing investors.
Separately, consider the number of investors today that boast about their mentor networks (including us at 500 Startups). Many of the smartest investors I know are beginning to realize that we’re not that useful to startups — we need to see ourselves as APIs to venture capital and functional expertise. We’re starting to realize that we don’t really add much value when you recognize that founders need help in the trenches. They need tactical help with data, design and distribution. We need to build mentor networks that can provide that.
The second underlying change in venture capital is that it’s no longer just about capital, dealflow and judgement. Those things certainly are important but, today, access is the most important thing. After all, it doesn’t matter if an investor is excited about a particular company — the real question is whether that particular founder will let the investor participate. In other words, you can’t be an asshole with money anymore. The paradox of investing is that while we all we want to invest in the best startups, the best startups *by definition* don’t need us — they can create a market for their fundraising and be selective about the investors they want in the deal.
As an aside here, my theory on why most investors are perceived negatively is that the person that writes the founder a check is usually not the same person that raised money for the fund. They can’t (or won’t) empathize with the founder. What founders and investors should understand is that our worlds aren’t so different. Startups sit between their customers and their investors. Venture capitalists sit between their customers (the startups) and their investors. In any case, the point is that *access* has become one of the most important things in venture capital.
The third underlying change is that transparency is finally hitting our side of the transactions as well. At 500 Startups, we’ve openly published a checklist of the things we look for in startups. Other investors are blogging and tweeting actively. It’s easier than ever for founders to get to know investors from a distance now. What this means for founders is that you have fewer excuses when you pitch the wrong thing to the wrong investor — for example, pitching your service business to me at 500 Startups shows me that you have done absolutely nothing to learn about what we do and what we’re interested in. You’ve made yourself look like a fool before you even started.
Now that we’ve talked about startups and venture capital, it’s important to understand how all of those changes are being reflected in the terms of early stage fundraises.
Financing terms are increasingly being standardized. Founders are getting more comfortable with things such as Series Seed and similar documents. It keeps legal fees low on both sides of the transaction and, more importantly, it allows the founders to get back to work sooner rather than later (which is especially important in the early days). I should mention, by the way, that I’m not suggesting that the terms are exactly the same for everyone — only that the material terms within the documents are all in place and you can just tweak the numbers as needed.
Convertible notes are becoming the norm at the early stage. That’s not to say that equity deals are bad, it’s just that convertible notes (especially when they’re capped) functionally provide the same thing as equity while allowing the founder to get back to work quickly. Legal fees tend to be lower on convertible notes (usually by an one or two orders of magnitude) which can be especially important when an investor might be writing a smaller initial check anyways.
Fundraising rounds are trending to continuous, rather than discrete, rounds. Rather than closing a specific amount of money on a certain date, founders raising on convertible notes are able to quickly close smaller chunks of money as soon as individual investors give the OK. Paul Graham wrote a fantastic piece explaining this, he calls it high resolution fundraising.
Also, prices are beginning to float. It used to be that everybody in that round would get the same price and the same terms. However, especially for the hottest deals, convertible notes also allow founders to tweak the terms a bit for individual investors that might have specific needs or that can provide a specific type of value-add that is important to the company.
As I mentioned earlier, we’re seeing fewer Board seats in early stage deals. That’s not to say that investors shouldn’t provide governance but, rather, that Boards don’t provide much for the startup when they’ve raised less than $1M, are still looking for product-market fit and are testing customer acquisition channels. Smart investors are recognizing that implicit control is still there in early stage deals, even without the Board seat — after all, outside investors in subsequent rounds will be looking to the existing investors to determine whether to invest.
Finally, and this one is probably the most controversial because we investors hate to admit it, the herd mentality is stronger than ever in early stage rounds today. Founders shouldn’t complain about this, they should seek to take advantage of it instead. What I mean to say is that founders should be strategic about how they approach the market when they begin to raise money for their company.
For example, let’s say you’re raising $250,000. I’d suggest that you identify 5-6 investors on AngelList and then look for warm introductions to them one by one. Get them to invest and incrementally widen the circle to other investors — use their names to excite other investors to join the round. The important point I’m trying to make here is that founders should use herd mentality to their advantage and recognize that platforms like AngelList can help you do that to a broader set of investors than ever.
As another aside for founders, if you’re not sure what to pitch about when you’re talking to an investor, you need to understand that there are only two things that make an investor write a check quickly:
1. fear of missing out
That’s it. Don’t tell me that you want to change the world, show me the traction. I’d like to change the world too, but I have a duty to make money for my investors. I would love for me and you to make a lot of money at the intersection of social good – love it – but let’s focus on the greed first.
If you asked me to roll everything up and just share the single most important change in the startup ecosystem, I’d tell you that it’s transparency between founders and investors. On the one hand, it gives founders access to more investors. On the other hand, it also makes it harder for founders to raise money because investors can now know more than ever about your industry too. In other words, the increasing transparency between founders and investors raises the bar for everyone involved.
A couple of resources I recommend for anyone involved in early stage startups:
The fact of the matter is that there’s more information than ever available to you founders today. You should take advantage of it, use it all for your own good. You no longer have any excuses for bad pitches, lack of funding or anything else in between. The point here is that power is shifting to founders, especially the ones that take in all this information and use it to their advantage.
If you remember nothing else, I only have two tactical suggestions for you:
The first one is something you’ve probably heard but it’s still the #1 issue I see with founders all over the world — they either don’t have it or they don’t make it clear. The second one is something that isn’t suggested often enough: many founders actually do have something interesting but they bury that information behind fear, uncertainty or far too many words. Instead of spending your time worrying about your slides, practice your delivery. Traction combined with a great storyteller is a very, very powerful combination.
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