Monday, January 31, 2011

Dear YC Company, How To Use Your $150K Uncapped Note To Your Advantage

Dear YC Company,
Now that you have your $150,000 uncapped convertible note in the bank, how can you best use it to your advantage?  Also, what dangers or obstacles to your business should you avoid that this money may bring?

How to use the money to your advantage: (note: *not* listed in order of importance)
1.  Use the money to fuel competition in your *real* fundraise.
To take a shot at being a long-term, sustainable you will likely need to raise more than the $150K from the note (most companies these days are raising $300K to $1.5 million for their seed, with a median of $750K to $1 million).  This mean that no matter what you may have to get on the fund raising wagon and spend a bunch of your time raising your seed.  One of the best ways to take advantage of this money is to use it as leverage.

In particular, you can use the money in the bank as a way to:
  • Increase the perception of traction / shrinking supply in your round.  E.g. if you are raising a $500K seed, this will already get you to close to 1/3 of the round committed.  By getting just $50-$100K in small time investors (see e.g. this guide to holding a party round) and you are half way done with the fund raise.  You can use this diminishing supply of available investment to push on people to close/create excitement.  E.g. "We are already 50% of the way to closing our round and are worried about getting oversubscribed.  We would love to find a way to work with you Miss Investor, so please let us know as soon as you can so we can save room for you".
    • This will create more of an auction/fast close dynamic for your round, helping you close good investors and speed time to fund raise.  Be careful not to overplay this, as it can backfire if you push an investor to close too hard.
  • Claim that you do not need any additional money right now.  "We don't really need to raise right now, but will take money on the right terms opportunistically" is a good way to put it.  This will cause investors to pay a higher valuation since you have a fallback option.
Valuations have been going up in general in the last 12-18 months, and I think the convertible note will only accelerate it for YC companies (and this valuation rise will spillover to the rest of the valley soon thereafter).

2. Use The Money to Bootstrap
Frankly, it is better to not have to raise money then to have to.  If the $150K can get you to a point where the business can grow off its own cash and is self sustaining (e.g. investing the money to buy your way into a network effect in a vertical) then by all means become independent of the throes of fundraising.  This is especially true if you are really setting up a cash, rather then an equity, business which may require less long term investment / operating at a loss for an extended period.

3. Get more in place prior to fundraising later (this strategy can also backfire, see below)
You can use the money to get farther with your prototype or idea, or substitute cash for labor (e.g. hire a UI designer part time) so you have something more compelling to show investors to raise money on.  The best possible scenario for fundraising is to have a product with hockey stick traction and spend the time that is needed to get there.  Conversely, the worst place to raise money is when you have launched a product with little traction (see "dangers" below).

4. It gives you time to try a bunch of stuff.  I know a number of YC companies that changed direction last minute or multiple times during the YC program.  This cash provides more room to try new things before you tap into savings or run out of money.

Just as the money comes with benefits, it also brings some drawbacks or things to be cautious of: (also *not* listed in order of importance)

A. Waiting too long to raise money can *hurt*, rather then help you
  • Raising on a dream vs traction.  Ironically, for a seed stage company it is often better to raise money pre-launch (or in closed beta), then post launch.  This is because pre-launch you are raising money on a vision or a dream.  Each investor will interpret the promise of the startup in their own way and imagine it growing like a weed, GroupOn-like, to a multi-billion dollar market cap within 24 months.  Unfortunately, most startups actually sputter quite a bit post-launch, and it takes unnatural acts of perseverance to get to the point where the product has real traction. 
    • If you wait to launch before you fund raise, and you don't have traction with launch, the dream is now cold reality.  Investors will value you on numbers instead of aspirations, and you may not be able to raise at all.  Using the money to wait it out and "get to traction" may backfire big time if the traction does not occur fast enough.
  • Demo day is a good forcing mechanism for investors.  Many investors now scramble to invest in the hottest companies prior to demo day, as they are worried there will be more competition on demo day when all their peers can get access to the same companies.  This creates a competitive environment startups can exploit in their fundraise.  Waiting past demo day removes this time based pressure for a deal to happen.
  • YC fatigue.  Some investors invest in multiple YC Companies in each batch.  Some of them seem to get tired of investing in "yet another" YC company shortly post demo day as they feel they have filled their quota.  This means raising early may help avoid this, or waiting for a few weeks or more post demo day when investors have had a chance to recover from YC fatigue.
B. Just because you have money, doesn't mean you should spend it.
A friend of mine's company raised a few million dollars.  One of the first things he bought for this startup was a $20,000 large circular couch that "looked cool".  I am guessing the couch didn't help much in making his startup successful and this purchase set a bad cultural tone that spending money on stupid things is OK.  Be cautious of what you spend the money on and remember that what you do now sets your culture overall.  Just because the terms were favorable, doesn't mean the money was free.

C. "Free money" is not free
Fred Wilson had a great blog post about the current funding environment and the costs of taking capital.   The costs/risks/things to be way of post-taking the $150K include:
  • Make sure you get help and value out of the money you raised.  Many of you would have been able to raise the money anyways.  You now have a chunk of money whose owner may or may not be helpful to you, which means there is less room in your eventual funding round for additional angels who can be of high impact and help.  You should be selective in choosing your angels and putting your investors to work for you.  Only time will tell how much time/help will come with money given in such a blanket manner.  That said, Ron Conway and team are amongst the best in the business.  If they provide the same level of support to you as they do their average startup, than taking their money is definitely a good thing.  I have also heard that Yuri Milner is quite smart.  So the fundamental question is how much time/access/help they will give you in exchange for the money.
  • You run the risk of inadvertently giving away future rights.  You now have an investor with potentially a sizable chunk of your company and potentially a pro-rata, which means they can avoid getting diluted down in subsequent rounds.  As a larger investor in your future round, they may end up with information or other rights you did not mean to give them as a passive (?) investor.  Make sure to write your equity financing docs carefully to block inadvertent leakage of information or other rights to this investor (unless you really want them to have it).
To sum things up, a lot of people are commenting about how these $150K convertible notes will cause angel investing to cease to exist and the world as we know it to end in a fiery ball of ruble-fueled agony.  I think this is a smart move by Milner and SVAngel.  This will cause a number of changes in the ecosystem, but I think a lot of them will be good for YC companies in the short term.  I hope this letter to you helps you take advantage of this opportunity.

Good luck with your business.  I am rooting for you.   :-)

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