2018 YC Investor School Notes: Aaron Harris
How to Be a Good Investor
What does the word “good” mean in the context of being an investor? One obvious definition is an investor that generates returns. But, in startups there is another definition that Aaron argues is more important than just generating returns. It relates to an investor’s reputation.
Startups vs. Public Markets
In startups, reputation drives returns. In public markets, anyone can buy stock. It doesn’t matter if a hedge fund boss is an asshole. They can still make money. Aaron has personal experience with this as a former Wall Street employee. However, for startups, there isn’t an open market with an open exchange. There is no place where an investor can simply buy portions of YC startups at will. Indeed, this is changing a bit for ICOs. But, even in those cases, investors must know someone to get into a pre-presale or a pre-pre-presale. Those with good reputations get the best prices and get into the most oversubscribed deals. This also applies to the most desirable startups. And while the most desirable startup today might not be the best long term performer, investors still need to find ways to gain an advantage to get into the desirable deals. This advantage is primarily a function of reputation.
Being good is directly correlated with deal flow. For example, consider an anger investor’s first investment. What is her/his job in that case? It is, simply, to improve the likelihood of the startup’s success. If an investor can help make a company be really, really good, founders will mention the investor to other founders. The founder community is quite connected, and, so, word will get around. This will lead to more deals and more opportunities to help companies succeed. This is a recursive loop.
But, the opposite is true also. If an investor hurts companies, deal flow will dry up. Aaron faced this situation with an investor that did something bad. That investor didn’t get many invitations to Demo Day. Founders have long memories and startups are a small world. These things quickly reinforce themselves in either direction, positive or negative.
There are four opportunities for an investor to demonstrate that she/he is good to a founder: (1) sourcing deals before making an investment, (2) meeting the founder and negotiating the terms, (3) closing the deal, and (4) the ongoing relationship with the company.
To source deals well, it’s important to find good place to locate investments, like Demo Day. There about 150 companies present in one day and investors can do all of their sourcing for 6 months in 1 day. But, how can one get an edge here?
Some people email founders. But, perhaps, the founder won’t respond because she/he is busy. Here, there is a choice between (1) respecting the founder’s decision not to respond and politely email back saying, “Hey, I know you’re busy, is it okay if I keep following up and find a time when you’re not so busy to meet?” and (2) pertering the founder by showing up at places where she/he might be. Surprisingly, scenario (2) does indeed occur. It is creepy and weird. This is not the right kind of persistence.
(2) Meeting & Negotiating
When companies need capital, they tend to go looking for it. If an investor sources one of these deals, there are simple rules of etiquette for meetings. First, start with a half hour meeting. If it goes well, try something longer. When an investor goes out for coffee or a meal with a founder, the investor pays. If there are 2 investors, whichever investor has the higher AUM pays. The aim is to be good to the founder and show that the investor wants to help. The cost of the coffee/meal is irrelevant compared to the overall investment. And if you don’t do this, the founders will tell others about it.
During the conversation, it is okay if the founder says, “I don’t know.” Investors that expect the founder to know everything will be disappointed. One can ask the question a couple times in different ways to try and get the relevant information, but asking 15 times is certainly a way to annoy the founder.
Focus on the founder. This is difficult during cocktail hour after Demo Day. But, don’t start walking away as another person is talking to you just to try and talk to someone else. This is basic human conversation stuff. While you are with the person, give her/him attention. The founder will remember if the investor was a jerk.
Understand the terms when discussing the investment. Understand what’s okay to ask for at a certain stage of the life cycle. For example, recently an investor agreed to terms for a standard safe. Then, before signing the prepared documents, listed 10 demands (i.e. board seat, 2X participating preferred, drag along rights, right to block a sale). When the founder asked what should be done in this situation, Aaron said, “Walk away, there are other investors out there and this is a bad investor. Tell your friends.” This is the type of information that goes into YC’s investor database and will result in decreased deal flow.
It is natural for one side to have more leverage than the other in a negotiation, but don’t push this too far. There are always unexplored pockets of alpha that might be attainable by pushing the limits. It might appear to be the right decision in the micro, but it’s the wrong long-term decision. It is unlikely that a tiny, tiny bit more ownership in one deal, is going to be the difference between greatness and badness over the arc of a career as an angel investor.
Always negotiate in good faith. Investors should do what they say they’re going to do. Negotiate with the intention of actually doing a deal. YC tells founders to avoid investors that are negotiating simply to discover who else is investing. Such an investment approach is bad because (1) groupthink leads to bad decisions and (2) some of the best YC companies haven’t been the ones with the most investor interest.
If you say you’re going to do something, do it. If you are negotiating with someone, do it with the intention that you’re actually negotiating for a reason. One of the worst things that investors do, and we tell all of our founders about this, is to avoid investors who are negotiating to the point where they can find out if other people are investing. This is this weird thing, they’ll say, “Oh yeah, yeah, yeah, no, I want to invest, and this term, and this term. Oh, who else is investing? No, it’s cool. No, just tell me. Who else? Can you tell me who else invested?” They will only make a decision if they see a lot of other investors have come in. This is a terrible idea for two reasons. One, group think usually leads to bad decisions. Two, as I’ve seen again and again over the last few years, some of the best companies that have come out of YC’s Demo Day have been the ones that didn’t attract all of the investor interest. It’s the investors who think differently, go against the curve, and follow their genuine interest regardless of what other people do, that find not only companies that are going to do incredibly well. Also, they get in at better prices and get more ownership. Founders remember these sharp investors and will result in better deal flow through references that say, “Hey, you should look at this one, it’s a lot like this other deal that you did, other people are not smart enough to look at this, but you are.”
After reaching an agreement, whether verbal or written, the investor’s word is her/his bond. YC drills this into founders. Upon agreement, the deal is final. Of course, there are situations where certain information wasn’t revealed or new information may change the agreement. But, do not break a handshake. Everyone will know and it will not stay secret. People will know not to trust someone who does this.
Also, as soon as an agreement is reached, the investor should ask the grounder to send the docs. If there is a delay, follow up. It’s okay to be pushy here. As soon as you receive and sign the documents, send the wire before even getting up from your computer. Open your Goldman Sachs wealth management account and get them to wire the money to the account as soon as possible.
Next, call all your friends who are trying to figure out where to put money, and get them in on the deal. Bring a syndicate with you. Bring helpful investors. Tell the founder, “Hey, thanks for letting me put $25k in. I know you guys are trying to raise a half million more, I have five people who I know are awesome for your business for xyz reasons. They typically invest $25k or $50k a piece. Can I get them in?” If the founder says, “Yes,” immediately and bring those people in. Everyone remembers this. This is the reverse of saying, “Hey, let me invest and I’ll figure out money … I promise, I’ll find you some other people, but I’m not going to invest until they come in.” Lead by investing first and then bring the other people in. That’s a great way to start the relationship on a good foot. Then get the hell out of the way.
2 stories illustrate the polar opposites of how to behave after reaching an agreement.
First, there is an investor that meets with founders at Demo Day and does a handshake on the floor. He leaves within 5 minutes of Demo Day ending. Then, he sends wires from his jet as he flies home.
Second, is the opposite, an investor that commits to writing a roughly $500k check and goes on to sign the documents, but then doesn’t wire the money. A week signing and after multiple messages from the founder, the investor says that his fund hasn’t closed and asks for his spot to be held. The founder did not agree. The investor then offered to send a check in the mail but required that it not be cashed for a couple of weeks.
The second is terrible. Investors should never commit to invest money that isn’t available. Also, commiting to invest caused the founder to stop looking and prevented any further discussions with other angels because the documents had already been signed. This is considered a blacklist-able offense.
Another mistake that investors make after investing is feeling as they are the CEO. This is particularly acute among investors that are/were CEOs. This results in emails to the founders about details of the product and other minutia. A barrage of these emails has been referred to as a human DNS attack. The founder is trying to close a round and get back to work but are then overloaded by these emails. Don’t do this unless the founder asks for help.
(4) Ongoing Relationship
Being good to companies on an ongoing basis is like building any relationship that deepens over time. But, not every relationship will develop in this way. Chances are that an investor will not hear very much from one or more investments. Hopefully the founders will send investor updates and there will be things that the investor can help with. But, some founders won’t ask for or need help. It’s not the investor’s place to force themselves in.
Founders will ask for help. Good founders will ask for help when they need it. If a founder disappears, it’s probably not worth chasing after him/her. The founders who send regular monthly updates tend to outperform those that disappear for 6–12 months at a time. The founders that understand transparency and that relationships are a two way street will tend to create better outcomes.
As part of the process, the investor will get information, like investor updates, that will be secret. Help the founder realize the difference between confidential information and proprietary information. Confidential information is information like revenue, headcount, burn, and balance. These don’t make the difference between life and death of a company. It’s okay for a founder to share this information and its okay to ask for this information. But the investor should not share it without permission. It’s not okay to ask for proprietary information like source code. If a founder declines to offer this kind of information, respect the decision.
Resist the urge to help companies in area that the investor doesn’t understand. Money and experience are not a license to advise companies on any question. If asked a question outside of your experience, it’s okay to say, “Hey, I would love to help you on this, but I can’t. I know some people who might be able to help, would it be okay if I asked them the question?” However, if the investor can help, he/she should. If the investor isn’t willing to get on the phone with the founder to help, then it’s probably a bad pick or investment.
Above all things, be honest. This is important for the entire ecosystem. A lot of founders will ask hard questions and the investor’s instinct will be to shade the truth. Founders sometimes need to hear hard truths and sometimes investors need to hear hard truths. If an investor is not honest with a founder, the founder won’t be honest with the investor. Honesty will result in the receipt of better information. For example, PG is completely honest with Aaron about where he stand, what he’s doing right, and what he’s doing wrong. Because he knows that PG is doing it in their shared interest, it never feels like an attack. It also helps to be direct and kind. Attacking a founder for doing something wrong and driving the point home just to prove how wrong the founder is and how right the investor is doesn’t help.
Also, investors should respect the limits of their rights and influence. Do not try to make decisions for the CEO as a small shareholder. Don’t try to influence the board or call them behind the founder’s back. This isn’t the investors’ place, except in extreme circumstances like fraud. But, use caution in these exceptional circumstances.
Finally, consider a point of contention around pro-rata rights for early investors and the impact on subsequent investors. These rights are one of the most valuable rights that an early stage investor can get. It allows for additional investment to prevent or limit dilution. The tension occurs at later stages when subsequent investors say that they want to provide all the capital in the round and block early investors from exercising pro rata rights. This puts the founders in a tough situation, especially if there is a prominent VC as the later stage investor. But, usually, the pressure to cut back pro rata rights comes from a person in the middle, like a lawyer, not a partner at the VC. Understand that the later investors are probably not intentionally trying to hurt earlier investors. Be reasonable but firm here. It’s okay to reiterate that the pro rata rights were negotiated for an agreed to. But, remember that every once in a while, the early investor might have to subordinate his/her financial best interest in a specific deal for the greater food of his/her investment career.
What Good Isn’t
Good doesn’t equal smart, in any way. It’s not the smartest investors that make the most returns, and it’s not the smartest investors that are helpful. Dumb money and smart money are kind of both money to founders. They make the machine go. Investors who know which camp they fall into can both be good. So called dumb money may not know much about startups or investing. But, they try to be helpful, give capital when it’s needed, are honest, and move quickly. That’s a good investor in Aaron’s book, and he would be happy to recommend that investor to any startup that asked. Smart money are investors who have built that kind of business and know how it works. They can also be really good. But, both of those investors can be bad by violating some of the rules we’ve talked about.
Good doesn’t equal big checks. Some of Aaron’s best investors as a founder were some of his smallest checks. They were the people willing to get on the phone. Some of his biggest investors, like Sequoia, were also some of the best investors. It all depends on the relationship that you build and how you go about it.
Good doesn’t equal famous. Most people have probably never heard of some of the best angels in YC companies. YC and founders know about them thought. It’s a mistake to use fame as a proxy for being a good investor. It’s about helping companies and getting into good deals. If investors do that and are in fact good, hopefully good actually yields returns. That’s YC’s hope. That’s what YC would like investors to be able to do, and YC would like to be able to help investors do that.
Q: What can investors expect in terms of governance and investor updates from a seed stage company?
On the governance side, most seed companies do not have external board members. Usually one or two of the founding team are kind of a board. They approve things like options grants, but there’s no one outside. That’s just sort of the nature of how the system works. Generally, boards at that early stage are more hindrance than a help. That starts to change when a company has raised somewhere above $4mm. That’s when it’s advisable for companies to form a board, whether or not an investor has a specific right to do so. In some of these cases, the YC partner will form an informal board with a quarterly meeting to make sure things are on track. If the investor thinks there is a bad governance problem, just bring it up and discuss it.
For information on investor updates, look at Aaron Harris’ blog post on how to write a good one. It should take about 15 minutes/month, if the company knows what it’s doing. It’s a little different if it’s a pre-product versus post-product, but basically the update should include revenue, growth, burn, cash balance, what the company needs, what’s going well, and what the company is struggling with. If a seed stage company is not sending it that often, it probably means they’re not making that much progress. Not sending updates also increases the chances that investors will forget about the company.
Q: What are the weaknesses in the investor reputation system? There are examples of investors treating companies badly but still seem to have a good public reputation.
No reputation system is perfect. But, the field is fairly small, and word usually gets around. There will always be a few bad apples that will probably continue to squeeze into deals. It’s also tricky because it’s not always clear from the outside what kind of allocation someone actually got. So, Twitter bios, Linkedin profiles, and Angel List may say that someone invested in some wildly successful company even if the invest just bought a couple thousand dollars of secondary at a massive round. Yet, they hold themselves out as some brilliant angel investor.
Geoff Ralston Comment: There is a power asymmetry and it’s difficult for a founder to try to take on a much more powerful investor, even when the investor is being an asshole. An advantage of being a YC company is the ability to limit this type of bad behavior. Also, the information asymmetry that used to exist between founders and investors doesn’t really exist anymore.
Q: What happens when pro rata rights are taken away?
It’s a pretty bad thing when companies go back and reduce or remove pro rata rights from investors that ben on the company early. Investors should fight it to the degree that they can, but should know their strengths in any of those situations. Know how to fight and how far to fight on it. At the end of the day, early investors might get screwed here and there. Hopefully, that is not the end of the story.
Also, YC helps all series A companies model out pro rata and dilution in different situation to help them plan ahead.
Geoff Ralston Comment: Don’t be penny wise and pound foolish. If an investor is in a fantastic startup, most of the money you make will be off the original investment, even without pro rata. It’s not worth ruining a reputation for this. However, it sucks. If a founder takes away pro rata from the investor that believed in the startup early, it merits a conversation at least. But, most of the time this happens, the founder doesn’t even know about it. If the founder did know, the would have put their foot down, because it’s the founders decision.
Q: Is it reasonable to ask for things like pro rata in a side letter when the deal is not using the standard safe? Or, when using the standard safe, which does not give you pro rata in the converting round, what’s reasonable to ask for?
As mentioned in the presentation’s meeting and negotiation section, the investor should know the terms, what is standard, and what leverage the investor has. Aaron is of the negotiating school that it never hurts to asks for things that the investor thinks they want them and they are deserved, if those things are standard or within the realm of expectation. Pro rata is a pretty standard thing and it’s normal to ask for it. This isn’t true for 2x participating preferred. Some angels will push their leverage as far as possible because the know a company is desperate. They might win the skirmish, but they lose the overall war.
Q: There are 2 sides to the investor reputation market, the side with founders and the side with fellow investors. How should investors think about situations when these are in conflict?
Aaron thinks there aren’t many situations where those two are in conflict. On situation would could be a conflict is where a founder asks for a recommendation to another investor but you don’t feel comfortable with it.
In a situation where you’re not an investor in the company, you can say, “I really only feel comfortable recommending companies that I haven’t invested in.” If there’s a situation where a founder asks you for a recommendation to a company and you don’t feel comfortable with it, try to be honest. Tell the founder, “Hey, while I would love to be able to recommend you, I don’t think this is the right fit for this and this reason.” If they’re super, super, super persistent, there are different types of introductions, and there are recommendations. Make sure the founder knows the kind of recommendation or introduction he/she is getting. Be honest with them about it.
Q: How should founders communicate what their cap table looks like to investors? What about founder agreements?
It’s normal for an investor to ask for a cap table and it’s find for founders to show them the cap table. It’s pertinent information.
Geoff Ralston Comment: On the question of agreements, this gets into the issue of early investors’ due diligence. It’s fair to ask about those things, but it would almost never have an impact on whether the investor writes a check or not. It’s not a good sign when companies have wildly strange equity splits. YC asks about this, but not about founder agreements. Would you not invest in Dropbox or Airbnb because of a suboptimal founder agreement? Once the investor does put it money, it may be appropriate to offer advice about what sort of founder agreements might make sense in the future. In general, due diligence as an early stage investor is pretty limited. In fact, it’s easy to tell bad early stage investors because they ask for too much (i.e. pro forma income statements over the next three years). This is an example of asking for the wrong information that will not help the investor make a decision.