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.   :-)
Elad

PS You can follow me on Twitter here.

Thursday, January 27, 2011

You Don't Need A Good Idea To Start A Great Company

I met recently with a friend of mine who has been talking about leaving Google for the last 3 years.  Every time I see him he says he is just "waiting for a great idea" to leave to start his own company.  I expect him to do what a lot of people do - stick around Google for another 6-24 months, and then join someone else's company.  He is never going to start anything.

I think "waiting for a great idea" is absolutely the wrong way to "start" a company, and typically does not yield a startup.

Startups are not about working on a great idea - they are the relentless pursuit of doing stuff for customers.

  • Start a company.  Don't "start an idea".
    • As you work on your "good idea", you will quickly find that nobody wants to use it.  This means you will keep iterating on the product and potentially even the market until someone wants it.   Many "side projects" or internal tools are examples of this, as they have turned into great stand alone companies or products.  Blogger came out of Pyra Labs as an internal tool.   Github came out of an internal tool at a startup.  Yammer came out of Geni.   GroupOn came out of thePoint.
    • The key to all the examples above were that the entrepreneurs were actually *starting a company*, not *starting an idea*.  It is more important to do something, anything at all, than wait and do nothing with the hope of thinking of something great.
  • If it was that obvious, someone would have already done it.
    • There is a dearth of great ideas just sitting around without someone executing them.
  • Focus on a great market, not a great idea
    • As you iterate in a market, you will often find that the initial idea you chose is less important then the broader market you are in.  A great market will always have opportunities in it.  Even if the first idea is terrible you will get to know the market and its needs and build something great on your next try.  In contrast a great idea in a terrible market will often fail.  Don Valentine, the legendary founder of Sequoia capital (investments by him include Cisco, Apple, Atari, Oracle and EA) always says the market is the primary thing that matters to him.
    • Josh Koppelman calls great entrepreneurs "Heat seeking missiles" as they hone in on their target/market even if their initial course if off.  Startups are exactly like this. (I always wonder what would happen if Josh's "heat seeking missiles" got into a fray with Mike Maples "thunder lizards from radioactive atomic eggs" - what entrepreneur could possibly survive the resulting explosion????)
  • It is all about execution.  Even if you have a great idea - 5 other people will have it at the same time.  This is why so many similar companies get started more or less simultaneously.  See e.g. Instagr.am, PicPlz, Mopho.to, PicBounce, in the photo sharing space.
The next time you stop yourself to "wait for a good idea", don't stop yourself.  Go and build something that is a bad idea in a great market, or something small but is a product you want for yourself.  Iterate on it and keep pushing, and eventually you will find the bad idea has become a very good company indeed.

You can follow me on Twitter here.

This work is licensed under a Creative Commons Attribution 3.0 Unported License.

Monday, January 24, 2011

M&A Ladder: Position Your Startup To Sell it For More

There is a hierarchy in the value of a startup to an acquirer.  As you move up the hierarchy, potential acquirers will value you on different metrics that increase the multiple that your company is worth.

Similarly, if you can convince a company that you are at a higher value point in the hierarchy relative from their perspective, they will pay more for you.

The hierarchy is: (the higher the number, the more your company is typically worth, and the larger proportion you get up front rather then vest over multiple years)
  1. Team Hire ("acqua-hire")
    • Valuation: 0 to $1 million (on a multi-year vest, per founder)
    • Basis for valuation: Typically the valuation is based on team size and the retention bonuses given to the team.  The company is bought for the technical talent (or maybe even just 1 person), but the team is immediately dispersed and does not continue to work in the market or area they did before.  Often these companies don't have good alternative options (e.g. raising a round or other strong acquisition offers)  Usually founders will walk away with at most a few hundred thousand dollars each over a few years.  This is a soft landing for the founders, but often investors get at best a fraction (or none) of their money back.
    • Examples: Most people who are acqua-hired don't talk about it publicly, or it is framed as the more valuable "true" team or tech buy.
  2. Team Buy
    • Valuation: $4-$50 million
    • Basis for valuation: Usually $1 to 5 million is paid per engineer or team members.  Median is probably $1.5-2.5 million per person, but it really depends on the acquirer, how competitive the auction around the company was, or alternative options the company may have (e.g. a funding offer from a venture firm).  Usually the team has expertise in the area they will execute for the acquirer, but not substantial differentiated IP that the acquirer will use long term.
    • Examples:  DivvyShot, ShareGrove
  3. Technology Buy
    • Valuation: $10-$500 million
    • Basis for valuation: The purpose of buying a company for its technology is to integrate that technology into the core of what the company does (versus a team buy, where the focus is on the talent itself only, as all the tech gets thrown away).  The valuation for these companies are often driven in three ways: (a) A flat premium (tech value).  (b) A bump up in the value of the per-engineer multiple of a team buy  In some cases this premium can be many tens of millions of dollars.  (c) The creation of very strong auction dynamics, particularly if a company is bought either to fill a big technology/product gap for a company (that its competitors may or may not have), or alternatively to keep differentiated IP/technology out of the hands of competitors (which the company itself already has).  Usually, technology buys do not have much of a business (i.e. lots of revenue) in place when it is bought.
    • Examples:  Powerset, Applied Semantics, Kaltix
  4. Business Asset
    • Valuation: $20 million-$1 billion
    • Basis for valuation: These types of acquisitions are valued almost entirely on financial models.  This is the opposite of the technology buy in some ways.  In this case, the company is bought either for its customers/contracts, or it may be bought by another company that thinks it can increase the revenue of reduce the costs of the company being bought.  This is how a lot of "rolls ups" in private equity work - e.g. costs are reduced and revenues/distribution channes are merged or optimized.   Often the valuation is a multiple of revenue/earnings, or is based on a financial model that will show the increased profits the acquirer can optimize for if it owned the asset and ran it differently.
    • Examples: Almost any company Demand Media or Glam have bought.  Many social gaming startup acquisitions.
  5. Strategic Asset
    • Valuation: $100 million to $N billion
    • Basis for valuation:  These are uniques assets that can either alter industry structure by one player owning them versus another (e.g. Apple vs Google owning AdMob), or which multiple bidders view as truly unique/network effect based product (YouTube).  In this case,  valuations can get stratospheric as multiple companies drive an auction.
    • Examples: YouTube, AdMob, Applied Semantics
Your Goal As An Entrepreneur
  1. Convince the acquirer that you are higher up in the M&A hierarchy.  E.g. pitch a technology buy as a strategic asset, or a team buy as a technology platform.
  2. Find alternative acquirers that view you are higher up in the M&A hierarchy.  Salesforce paid up for Heroku because they viewed it not only as a technology platform, but as a broader asset with a thriving developer community which was a part of the strategic future direction of the company.   Other companies with less of a focus on developers, or with a massive developer base themselves, would probably have paid less.
Notes:
  • All valuation ranges in this post are rough estimates.  There are always outliers.
  • The line is sort of hazy for some of these - e.g. it is sometimes hard to draw the line between a team/tech buy once valuations cross a certain line.  E.g. Applied Semantics could probably be viewed as either a tech buy or a strategic buy by Google, as it kept AdSense-style technology out of the hands of other competitors such as Overture at the time.
You can follow me on Twitter here.

Wednesday, January 5, 2011

Hiring Tip: Graph Interview Performance Vs Years of Experience To Spot Outliers

When hiring your initial engineering team, the more tools you have to discern who the truly amazing engineers are the better.  One approach we took at Mixer Labs (a company I founded that Twitter bought last year) was to graph # of years of experience vs how the person did in their interviews (this was an arbitrary scale where we rated people 1-10, focused on performance on the same set of questions, rather then raw intelligence alone.)  They key is to have the same group of people on your team do the ratings, and to have the list of prior interviewees listed on the same ranking scale, so that it is easy to compare people.

To our surprise, we found that in general, the way people did on their interview roughly corresponded to the number of years of experience they had.  Indeed, when you graph things out, the graph looked roughly like this:


This graph helped us quickly hone in on anyone who was an outlier on the graph (i.e. their performance/knowledge in the interview outweighed their years of experience).  For example, from this perspective the person with 4 years experience who scored a "7" was a much better hire then the people with 7 or 8 years experience who scored a "7" or even an "8".  The interview performance outliers also tended to be amongst the most productive people on the team once they joined the company.

This also suggests that if you do not correct interview feedback for years of experience, you may hire more experienced people who are actually more "average" relative to their work experience level then you might expect (since you would normally compare them to *all* candidates in the overall hiring pool, which consists of people with less experience).

Obviously, anyone who scored close to a "10" was worth hiring irrespective of number of years of experience.  There are obviously a number of people who are both very experienced, and very very good.

Any other simple tools or tips for hiring?  Leave them in the comments section.

Other posts on hiring:

You can follow me on Twitter here.

Monday, January 3, 2011

6 Startup & Tech Trend Predictions for 2011

These are my predictions in terms for 6 big tech trends for 2011 (see also, "Companies That Will Buy Companies in 2011").

Let me know in the comments what you think the most exciting trends/markets/technologies will be in 2011! :)

1. Mobile photos is sooooo 2010; 2011 is the year of mobile communication apps (VoIP, contacts, SMS)
  • One of the big themes of 2010 was the launch of multiple mobile photo apps that each grew to hundreds of thousands to millions of users (e.g. mopho.to, picplz, picbounce, instagr.am, path).  It looks like instagr.am is the early winner in the mobile photo wars within the hipster set, while picbounce has seen strong growth in other areas.  Competition will continue amongst photo apps in 2011.
  • Just as 2010 saw the launch of multiple photo apps, 2011 will see the evolution of mobile communications (e.g. SMS, VoIP, video chat etc.).  Kik, Viber, and Tango are all examples of apps that grew to >1 million users fast.  In 2011, I think we will see some additional apps launch and a winner in this area start to emerge (keep an eye out for new startups like Camino Real)

2. Beyond checkins: cool new types of location apps 
  • 2010 was the year of the "geolocation wars", with a lot of hype and user growth for apps like Foursquare and Gowalla and checkin style behavior added to Facebook, Yelp, and Loopt.
  • 2011 will see the rise to prominence of a new set of location enabled apps, that don't depend on "location broadcast to your friends" as their primary drivers.  Apps like likealittle and Qrank are already innovating in interesting and cool ways in these areas.

3. Big data and object classification will be a big meme
  • 2010 saw the funding of a number of companies setting out to classify and aggregate structured data about the world (ThingdFactual), sites that let you collect and name items (Pinterest, Thefancy), as well as companies that provide hosted services to store and crunch large amounts of data (MongoDBAster DataRiptano).
  • In 2011 the interest in big data and classification companies will increase (especially in the press) and continue to grow as a meme.  I am guessing at least one of these will be acquired for an unnaturally high valuation by the end of 2011 / early 2012.   

Three Massive, Fundamental Market Shifts
I think user behavior, or key aspects of the following three markets have shifted fundamentally, creating big opportunities for entrepreneurs.

4. MEGATREND: eCommerce renaissance
  • In 2010 a new suite of ecommerce companies emerged, while category leads of the new old school were acquired (e.g. Zappos, Diapers.com) while new ones were funded (BirchBox, ModClothBaubleBar, etc.)  In parallel, recent online retailers (Gilt, ShoeDazzle, RueLaLa etc.) have ramped revenue very fast, proving that building an ecommerce company fast is now possible.
  • What has changed?:  Buying behavior has fundamentally changed - there is a massive pool of consumers finally truly comfortable with buying goods online, and with free returns, cheap shipping, and fast delivery people are voting for ecommerce with their wallets.  In addition, new models of eCommerce (flash sales, subscriptions, etc.) have been adopted rapidly, providing users with additional incentives to shop online.
  • In 2011 the pace of innovation and funding in ecommerce will accelerate dramatically, with craploads of companies getting funded.
  • New models will continue to be pioneered in ecommerce, for example subscription based bundles for monthly goods (see e.g. ShoeDazzle, BirchBox, and Foodzie).
  • I am personally super excited about this area

    5. MEGATREND: Huge mobile user bases
    • Smartphones have hit critical mass with >300,000 android activated a day (this is equivalent to 100,000,000 a year!).  By the end of 2011,  low hundreds of millions of users will have highly functional mobile devices.  This means services can now explode on mobile like never before.  
    • Prediction: At least 5 new, non-gaming, mobile applications launched in 2011 will reach a multi-million person user base before the end of the year.
    • In parallel, desktop web services will also see the fastest growth ever as new apps have the potential to come out of nowhere and grow to a massive user base or revenue run rate like never before (see e.g. GroupOn).

    6. MEGATREND: The Shift of The Enterprise to the Cloud Will Continue
    • In a recent talk, Don Valentine (founder of Sequoia Capital) mentioned that in the 1980s, he knew the computer revolution was happening so Sequoia Capital invested in a dozen or so companies (with great success) to capitalize on it.  Right now, a similar trend is happening in that big components of IT services are all shifting to become cloud based services (e.g. Workday for HR management, ZenDesk for customer support, PagerDuty for IT operations, etc.)
    • This massive trend will continue and multiple companies worth hundreds of millions, or billions of dollars, will emerge.

    Basically, 2011 will see a massive wave of innovation.  eCommerce, mobile, and SaaS are 3 areas where fundmental market shifts are happening.   Some exciting companies will emerge and scale fast, while new location services will wow users in unexpected ways.  "Big data" will continue to be a meme, and companies in this category will likely get high valuations.

    Any areas I did not mention that you think will take off?  Add them in the comments section.

    You can follow me on Twitter here.