From A Science Experiment To A Business: Notes On How To Build A Tech Startup In 2017
These are my running notes about how to do a startup the right way, gleamed from my own mistakes + soaking up the pearls of wisdom online: from strategies, to KPIs/metrics, to which platform to choose for development, to growth hacking, to startup finance key concepts, to understanding how venture capital works and other terms like founder vesting and liquidation preferences. This is over and beyond the first, basic step: make something people want.
1. Run Market Experiments With Your Idea
SELL A PRODUCT YOU DON’T HAVE
This screen shows the number of unread notifications from potential customers reaching out via SMS to a market experiment I did — rented a Twilio phone number for $1/mo, used Smooch.io’s integration to hook up to Slack and advertised where customers were already looking for a solution. There was no capability to serve that need, but the response indicated the product was needed. To people reaching out, it resulted in minor annoyance (I am sorry OK, but you only lost a few minutes of your time while I gained valuable insight into what the market actually needs).
These are potential customers expressing a direct willingness to use a product which doesn’t exist and can’t fulfill their need, yet. Time to build it.
Before you get into coding/further vision/getting busy with even forming a startup, you need to test the waters with the idea you have. You don’t have to have a finished product to go in the market and see what potential customers think about it. You can think you do, get feedback; and then improvise. By doing this, you save yourself from going down a rabbit hole and spending time/money on chasing the wrong idea and building a product which no one wants.
For marketplace startups, connecting buyers and sellers of something, starting and growing a free Facebook group well before the product is designed, developed and launched, is free, easy and would give valuable insights into what is it that your target customers really want; apart from having an enthusiastic community when you do launch.
Arcade City, a rideshare group based in Austin did this successfully; and so did another NY-based temp summer sublet service (Skylight). They started out as Facebook groups; and once they had a critical mass of users using their service (Skylight — over 15k, and Arcade City — over 30k Facebook group users), they started moving them to their app which offered additional value-added features. They had figured out the hard part: distribution, and how to grow their communities, before spending a dime on product development. In addition, using platforms like Sharetribe you can quickly launch a marketplace with some basic features.
UN-AUTOMATE — DO IT MANUALLY FIRST
Offbeat methods like doing manually what your startup proposes to streamline with software are good starting points. This will teach you about the true pain points which your customers experience and develop processes to fulfill their need. Software is simply streamlining that established workflow, once you know for sure what it is. Product development without any of this is like throwing darts while drunk and blindfolded.
KNOW YOUR CUSTOMERS
Your key challenge is identifying your customers and figuring out your distribution strategies. Developing the product which fulfills that market need is secondary and procedural.
Key concept here is that of Customer Development (from Lean Startup): who are they, what is life like for them, what problem are you solving for them, how are they responding to your solution — if you don’t have this, you don’t have a startup, and you better stop at this stage and think of another idea as your time as a first-time entrepreneur is very limited.
FIGURE OUT HOW TO REACH THEM
Is Facebook advertising cost-effective for you (it can be highly local+demographic based) ? How about Google AdWords ? Do you have a strong social component/strategy so that you can grow more quickly by referrals ? Everybody else is doing this — what can you do differently, perhaps at the local level, offline, which sets you apart ? Who will you partner with ? Uber grew by buying out their entire network: they bought drivers and customers with referral bonuses. You can’t/won’t be able to afford to do that — you will need to come up with clever, non-paid ways to grow.
An excerpt from one of Mark Suster’s blog posts linked below:
Get customer input. This is another big mistake. People design their products in a box assuming that they’ll show customers later and get feedback. Get feedback before you start building anything — else you might be wasting your money. Interview customers to better articulate their problems. Show them multiple solutions to their problems and find out which ones resonate. Ask if they’d be willing to pay for a solution like that if it existed. Ask them how much they think such a solution would cost them.
Paul Graham’s essay on Do things that don’t scale:
..power of compound growth. We encourage every startup to measure their progress by weekly growth rate. If you have 100 users, you need to get 10 more next week to grow 10% a week. And while 110 may not seem much better than 100, if you keep growing at 10% a week you’ll be surprised how big the numbers get. After a year you’ll have 14,000 users, and after 2 years you’ll have 2 million.
..In Airbnb’s case, these consisted of going door to door in New York, recruiting new users and helping existing ones improve their listings.
2. Outline A Long-Term Vision And Strategy But Pick A Niche For Now
Next step is to doodle on this further and outline a long-term vision ? Where is this headed ? What is the market opportunity ? Who are your customers and why do they need your product in their day to day life ? Can you somehow tap into a blue ocean of non-customers whom no one else has thought about instead of entering markets with pre-existing aggressive competition ? What would be the key elements of your product and where does it fit on a value curve compared to other competitor offerings ? What niche do you start with, and if all goes well, what is the eventual vision ?
Preparing a pitch deck and utilizing a business model canvas are some of the tools which will help you structure your thoughts into a plan for your startup.
Resources:
- Blue Ocean Strategy (book).
- Xtensio.com: Business Model Canvas outline, Pitch Deck template, User Personas, among other useful tools.
- Dave McClure’s passionate post on why startups should focus on a nice instead of working on a “big market” at the outset:
These pitch decks are for startups from later stages in their lifecycle — but what if you have a template like this and think backwards of how you will fill in the gaps as you go along ?
- AirBnB’s pitch deck: https://arenavc.com/wp-content/uploads/2015/07/airbnb-original-deck-2008.pdf
- Front’s visually appealing pitch deck:
And while we are at it, here is Front’s product roadmap on Trello: https://trello.com/b/kZsVVrc8/front-product-roadmap
3. Organize Your Startup
CHOOSE A COMPELLING, UNIQUE NAME
Decide on a name — Is it unique, catchy and eventually trademark-eable ? Search the free online US Trademark register — get an idea if your desired name is already registered to somebody else in your field of operation. If it is, choose a different name at the earliest! Infringing on someone else’s registered trademark is a battle you will only lose.
The most important place where your chosen name needs to be available is the Facebook page name. If your chosen name is already taken, I would suggest choose another one, instead of adding “app” or “get” or some other variation to it. facebook.com/<yourbrandname> is what you ideally want. This is also your Facebook messenger username, which makes it even more important enabling you to chat with your customers directly.
Check if the name is available on the Google Play Store and the Apple App Store ? If not, you could try a variation. Lyft’s app is not called Lyft on the app store — but has keywords indicating taxi / cab in its name, which make it more relevant from app store search perspective too. As long as there is not a directly competing app with the same name — you will be OK with a variation to the name. You can try reserving a name before you publish your app — enough material available online to guide with that.
Is a suitable domain name available ? .com most likely will not be available, but if you care about SEO (and you should), you want to choose at least a GTLD which Google considers at par with .com (such as .io and a few others). Exotic country specific TLDs are *not* considered at par with .com from SEO perspective.
ORGANIZE LEGALLY
Decide on your chosen jurisdiction and incorporate, open bank accounts, and sign co-founder agreements with your co-founders — don’t forget about founder vesting, even at this early stage.
WHERE TO BE BASED: CANADA vs US
If you are not Canadian, you can skip this section.
For Canadian tech entrepreneurs, key question to answer is where do you want to base your startup ?
Consider this: the US sees 1000x more investment at the angel/seed stage stage compared to Canada ($1.6 billion in Q1 2016 alone). Compare this to China as well, where the government has earmarked 1000x more capital for high-risk early stage startups compared to Canada ($338 billion venture capital war chest — largest pool of venture money in the world). The community is amazing, but the government of Canada has not made innovation a national + urgent priority yet; as a Canadian tech entrepreneur you are largely on your own.
Even though some Canadian tech centres like Toronto are doing great and have amongst the best YoY growth % in terms of funding across North America, getting funded in Canada requires a lot more convincing and being at a more advanced stage than comparative startups in the US. The seed capital being invested in Canada mostly sees participation from US-based investors.
If your goal is to continue basing the startup in Canada, if you are able to, raising funds locally might be the best idea. As then, when you have grown and are looking to raise your Series A round of funding, the connections which your local Canadian investors have with US investors will prove valuable. Below two posts which I wrote previously capture this trend:
Being located in Canada, especially in a region like Toronto — has amazing benefits. The local population of about 6 million+ in the GTA region is big/diverse/mobile-connected enough to test-launch products; healthcare is taken care of by the government; and there is good talent available locally, and also immigrating here from all over the world. Uber chose to launch UberEATS in Toronto as its first-ever test market, before launching in the US cities.
But moving to the US now is easier than ever before. For example, previously Canadian tech startup Shyft moved from Toronto to Seattle to participate in the TechStars program, and after going through it, raised well over $1 million in funding in Seattle and has re-located there. There are many other Canadian startups which go through Y Combinator and 500 Startups as well and either choose to be based in the US or in Canada.
On August 26th 2016, US introduced an equivalent of a startup visa (to go into effect shortly): where if you have >15% equity in your startup as a co-founder, and have raised over $345,000 in funding from investors with a record of backing successful companies, you can get a 2 year visa to build/grow your startup in the US, with a 3 year extension possible (after which EB-2 and other visas will come into play).
This time in history is the easiest and simplest its ever been for Canadian tech entrepreneurs to incorporate in the US, setup shop there and operate as a US startup, market locally and raise funding from US-based investors to grow further, and eventually sell to a US company or go public.
Choose your location carefully — where you incorporate, market your product, and do product development. For Canadian entrepreneurs, a mix of US-Canadian presence would be most beneficial.
Most tech startups incorporate in Delaware in the US, regardless of which state you want to market your product in — why won’t you do the same ?
Use Clerky.com or get a referral to Stripe Atlas — which would setup your US corp, open up a US bank account for your startup, send forms to IRS, obtain your EIN, and set you up with Stripe US integration.
FOUNDER VESTING
Earn your equity. You will not really own 100% of your % ownership when outside investors come in (until a liquidation event happens), as they will want your shares to “vest” over a period of time to protect them in case you leave the startup sooner.
This also safeguards your interest, if a co-founder leaves shortly after the startup is founded (life happens), that equity is locked and goes with him/her, which you won’t be able to tap into in the future when you are looking to make your key hires. Investors coming on board will also insist on founder vesting as they are betting on the founding team, and without it, their investment is meaningless.
As a cheatsheet, the “normal” equity structure is:
Founder terms: 4 year vesting, 1 year cliff, for everyone, including you
Advisor terms (0.5–2.0%): 4 (or 2) year vesting, optional cliff, full acceleration on exit
Vesting means that instead of each getting our 50% immediately, it gets given to us regularly over some period — usually 4 years. So if we quit after 6 months, we’d have earned 1/8th of our total 50%, or 6.25%. If we quit after 3 years, we’d get 3/4 of our total 50%, so we’d keep 37.5%.
A problem this can lead to is that you can end up with loads of people who each own a tiny percentage of the company. That makes future legal work more painful, and it’s what cliffs are designed to solve.
Cliffs basically allow you to “trial” a hire or partnership without an immediate equity committment. You agree on the equity amount and vesting period immediately, but if you part ways (via either quitting or firing) during the cliff period, then the leaving party gets no equity. Apart from that, it acts like normal vesting.
Remember our 50/50 split, 4 year vesting? Now let’s add a 1 year cliff.
With those terms, if I quit after 6 months, I’d actually have nothing. But then at 1 year in (as soon as my cliff is over) I immediately get a full quarter of what I’m entitled to (since I’ve made it through 1 of the 4 years of vesting). And after that, I get my remaining equity dripped to me smoothly as time passes.
Once I stay for the full vesting period (in this case 4 years), I’ve paid my dues to the company, and can choose to either stay or leave. The equity I’ve earned is mine in either case.
Example template — shared by Boris Mann:
Founder Vesting: All shares held by the Founders shall be subject to vesting as follows: {INITIAL VESTING %} of the shares are vested as at {VESTING CLIFF} with the remaining {REMAINDER VESTING %} to vest monthly over the next {VESTING TERM} years. All unvested shares shall immediately vest upon a qualified IPO or deemed liquidation event at any time after the date that is twelve months from the closing date.
Provisions which I like, as a founder, are — accelerated vesting in the event of:
- Single trigger: Termination without cause OR change of control of the company. Double trigger would be something like termination without cause within 12 months of change of control. Double trigger is what is standard and what Clerky would set you up with — review if you are ok with this or not.
- Death or permanent disability: You came up with the idea; worked hard, built the team; then something bad happens to you but the startup still goes on to have an amazing result. Your beneficiaries are left depending upon your insurance and don’t get any proceeds from your startup, because your stock didn’t vest and was purchased back by the startup for the 1/1000th of the dollar which you had paid for it when it was issued to you. Yes, beneficiaries should not get control, but to get no proceeds whatsoever simply doesn’t sound fair to me. What am I missing ?
This example founders agreement captures the above terms (use at own risk):
CAP TABLE
A cap table is used to keep track of who owns what: class of shares, % ownership, etc. Maintain in a spreadsheet, or using one of the tools below:
- Captable.io: captable.io
2. Capshare.com: capshare.com
3. Eshares: https://esharesinc.com
Resources:
- Mark Suster’s blog: Both Sides Of The Table
- Clerky.com: Incorporate in the US
- Stripe: Will incorporate and open up a US bank account for you
- USPTO: US Patent and Trademark Office
- GoDaddy or Google Domains: Domain name registrar
4. Develop+Launch Your Minimum Viable Product
The most important mistake you need to avoid making here is developing a product for too long, in isolation from direct usage feedback from the intended customers. A product that “just works”, even though with some bugs, is OK to start introducing to target customers. If it really solves their problem, minor bugs/imperfections are irrelevant at this stage. Your startup is trying to SURVIVE, and interacting with customers is the oxygen it needs and needs to surface frequently for it.
Javascript is eating the software world. If you don’t know/are not using it extensively, you are literally adding months to your dev cycle. I have coded in every major programming language and framework out there — from C, C++, Java, .NET, Ruby on Rails, Swift, Python — — for web+mobile app development, for client or server side, for simple speed, agility and to tap into a massive community of coders sharing their little snippets which you can quickly plug into your program — you need to go with Javascript.
What programming language/tools/frameworks/cloud platforms you choose will be the difference whether you are a team of co-founders able to write the code themselves and launch a MVP; or being in a situation where you *have* to raise seed funding and hire developers in order to do that. This is where you will need to hustle and this is what will differentiate you. For instance, an app like Uber, containing 90% of its features can be written by a reasonably competent programmer in under 3 months (speaking from experience). Look into re-using code already written by others and available under open source licenses instead of re-inventing the wheel yourself. Choose frameworks with active community support, not just from the vendor. This goes back to the question of the tool/framework you choose when you start out and that’s what will limit your options. Again, why are you not choosing Javascript ? AngularJS, React, Node.js and several other frameworks provide a compelling enough reason.
Along with this, being able to rapidly iterate based on understanding how customers are actually using your product is fundamentally important to the success of your business. You/your co-founders need to go out and talk to your target customers and get a feel of the direction you are headed in. Don’t make something beautiful which nobody excepts the tech echo chamber wants and chats about. They are not your customers, but can throw you off track inadvertently.
Resources:
- Lean Startup (book)
5. Get To Product/Market Fit
You need to reach a stage where a good percentage of your customers are coming back to use your product, and are referring it to others they know, and will be unhappy if your product were to go away. That is the state of nirvana — also known as product/market fit, coined by Marc Andreesen. Read his post about this:
The market needs to be fulfilled and the market will be fulfilled, by the first viable product that comes along.
The product doesn’t need to be great; it just has to basically work. And, the market doesn’t care how good the team is, as long as the team can produce that viable product.
METRICS
A key theme when it comes to metrics to measuring the growth of your startup is to choose one metric that matters. For example, for Airbnb, it is the number of rooms booked through its platform.
Below are screenshots from Version One Ventures Marketplace KPI spreadsheet referenced above (someone made a dashboard with pretty charts based on this as well — you would need to Google for it):
Liquidity
Two-sided markets are naturally dominant: unlike other models, the bigger you are, the stronger you are. Marketplaces strengthen with scale and scale comes from liquidity.
“Liquidity isn’t the most important thing. It’s the only thing.” Rothman defines liquidity as the reasonable expectation of selling something you list or finding what you are looking for. This means you actually have two different liquidity numbers: provider liquidity and customer liquidity. You need to measure both.
Uber drivers give on average 6 rides per day while customers take on average one ride every 8 days. Airbnb hosts average one stay every nine days while guests average one stay every two years. Even on eBay, sellers transact once a week while buyers transact once a month. Startups trying to attain early traction need to dedicate resources to acquiring the users that can provide more transactions in a given time frame.
There are many people/orgs with their opinions on the metrics — I will use one of the most authoritative sources here for a base understanding of these key metrics — this entire section below is from couple of a16z blog posts, linked below (a16z is Andreesen Horowitz’s blog — a leading VC firm based out of Silicon Valley):
TAM: Total Addressable Market is a way to quantify the market size/ opportunity. Preferred: bottoms-up analysis, which takes into account your target customer profile, their willingness to pay for your product or service, and how you will market and sell your product.
saying that you’re aiming for x% of a $ybn industry is unambitious — great companies change the y, not the x.
CAC: Customer acquisition cost or CAC should be the full cost of acquiring users, stated on a per user basis.
paid CAC [total acquisition cost/ new customers acquired through paid marketing].. it informs whether a company can scale up its user acquisition budget profitably
blended CAC [total acquisition cost / total new customers acquired across all channels]..includes users acquired organically
LTV: Lifetime value is the present value of the future net profit from the customer over the duration of the relationship. It helps determine the long-term value of the customer and how much net value you generate per customer after accounting for customer acquisition costs (CAC).
GMV (gross merchandise volume) is the total sales dollar volume of merchandise transacting through the marketplace in a specific period. It’s the real top line, what the consumer side of the marketplace is spending. It is a useful measure of the size of the marketplace and can be useful as a “current run rate” measure based on annualizing the most recent month or quarter.
Revenue is the portion of GMV that the marketplace “takes”. Revenue consists of the various fees that the marketplace gets for providing its services; most typically these are transaction fees based on GMV successfully transacted on the marketplace, but can also include ad revenue, sponsorships, etc. These fees are usually a fraction of GMV.
Churn:
Gross churn: MRR lost in a given month/MRR at the beginning of the month.
Monthly unit churn = lost customers/prior month total
Retention by cohort
* Month 1 = 100% of installed base
* Latest Month = % of original installed base that are still transacting
Monthly cash burn = cash balance at the beginning of the year minus cash balance end of the year / 12
Reminder, here’s a way to calculate LTV:
Revenue per customer (per month) = average order value multiplied by the number of orders.
Contribution margin per customer (per month) = revenue from customer minus variable costs associated with a customer. Variable costs include selling, administrative and any operational costs associated with serving the customer.
Avg. life span of customer (in months) = 1 / by your monthly churn.
LTV = Contribution margin from customer multiplied by the average lifespan of customer.
net promoter score is a metric (first shared in 2003) used to gauge customer satisfaction and loyalty to your offering. It is based on asking How likely is it that you would recommend our company/product/service to a friend or colleague? NPS = % of promoters minus % of detractors
Cohort analysis breaks down activities/ behavior of groups of users (“cohorts”) over a specific period of time that makes sense for your business — for example, everyone who signed up for your service in the first week of January — and then follows this group of users longer term: Who’s still using your product after 1 month, 3 months, 6 months, and so on? (tools like Mixpanel)
In social and mobile platforms, common metrics of measure for activity are MAUs (monthly active users), WAUs(weekly active users), DAUs (daily active users), and HAUs (hourly active users).
ARR: when software businesses use ARR, they mean annual recurring revenue, NOT annual run rate. It’s a mistake to multiply the recognized bookings — and in some cases revenue — in a given month by 12 (thus “annualizing it”) and call that number ARR. In marketplace businesses — which are more transaction-based and typically do not have contracts — we look at current revenue run rates, by annualizing the GMV or revenue metric for the most recent month or quarter.
One mistake we frequently see is marketplace GMV being referred to as “revenue”, which can overstate the size of the business meaningfully. GMV typically reflects what consumers are spending on the site, whereas revenue is the portion of GMV that the marketplace takes (“the take”) for providing their service.
ARPU is defined as total revenue divided by the number of users for a specific time period, typically over a month, quarter, or year. This is a meaningful metric as it demonstrates the value of users on your platform
Gross margin — which is a company’s total sales revenue minus cost of goods sold. most marketplaces (note here the distinction between e-commerce) and software companies should be high gross-margin businesses.
Sell-through rate is typically calculated in one way — number of units sold in a period divided by the number of items at the beginning of the period. In marketplace businesses, sell-through rate can also go by “close rate”, “conversion rate”, and “success rate”. Regardless of what it’s called, sell-through rate is one of the single most important metrics in a marketplace business. As investors, we like to see a relatively high rate so that suppliers are seeing good returns on the effort they put into posting listings on the marketplace.
Network effect: a product or service has a network effect when it becomes more valuable as more people use it/ devices join it (think of examples like the telephone network, Ethernet, eBay, and Facebook). By increasing engagement and higher margins, network effects are key in helping software companies build a durable moat that insulates them from competition.
Virality: virality is the speed at which a product spreads from one user to another. Virality is often measured by the viral coefficient or k-value — how much users of a product get other people to use the product [average number of invitations sent by each existing user * conversion rate of invitation to new user]. The bigger the k-value, the more this spread is happening.
Resources:
- Scaling Lean (book)
6. Fundraise: Learn, Network & Get Funded
To state the obvious, to grow your venture you will need capital to pay your salaries and those of other key hires and for other expenses.
To raise funds, you will need to have a good story, a refined pitch deck, understand key startup finance concepts, have a good network to tap into for introductions to investors, and have a good lawyer to help you navigate through the fine print.
And you need to understand the funding landscape. The below puts it together including references to more authoritative sources when appropriate.
Re-jiggering of deal stages and sizes
Two years ago, a seed round used to be $500K, now it is $2M+. A Series A round used to be $3M — $4M, now it’s $6M — $15M. A Series B round used to be $10M-$15M, now it’s… well, you get the picture. The deal stage and sizes have changed dramatically.Seed is not the first round of financing any more. In fact after noticing this trend last year, I have transitioned to calling most of my initial investments “pre-seed” rounds, where the company raises close to $500K, before raising a full seed round. The Seed round is larger — closer to and sometimes upwards of $2M. The Series A is now the fourth round of funding for a company — the first is usually friends and family, or an incubator (~$50K), then pre-seed (~$500K), then seed (~$2M), then Series A (~$6M-$15M).
Pre-Seed is the new Seed. (~$500K used for building team and initial product/prototype)
Seed is the new Series A. (~$2M used get for building product, establishing product-market fit and early revenue)
Series A is the new Series B. (~6M-$15M used to scale customer acquisition and revenue)
Series B is the new Series C.
Series C/D is the new Mezzanine
FRIENDS & FAMILY / ACCELERATOR
Don’t burn your friends and family money — you will end up with feeling an inherent obligation to return it someday in case the startup doesn’t work out (which is the fate of most startups). People investing even a penny in startups need to understand they can lose it all, with NO obligation that it be returned if the startup fails. Try explaining that to Uncle Joe! (“But you told me you were working on the next Uber..I could have gone to Vegas and gambled it away”). Yes, please Uncle Joe, go to Vegas and by all means gamble if that makes you happy.
Find investors who understand the risk involved and can afford to take it; who can afford to both go to Vegas and gamble and lose their “fun $$”, *and* lose the startup $$ invested and not care enough about it.
Tapping into a local accelerator could get you $$ as well as getting plugged into a network which can open up new opportunities. Highly recommend looking into accelerators like Y Combinator, 500 Startups, TechStars, Amplify.LA, Expa Labs, etc. It’s not just the money, but the network, connections and stuff you will learn which will drive you forward significantly faster.
PRE-SEED
What used to be seed funding, is now called pre-seed. This is where investors are willing to make bets on the team + the market opportunity. There are quite a few pre-seed investors out there — you need to search and find them, but they are there, and if you have a strong founding team, this is worth trying.
SEED ROUND
The next stage of fundraising is known as the “seed round” where typically $500k — $1.5 million is raised for around 20% of the startup. Investors at this stage include angel investors (high-net worth accerdited investors who can afford to lose the risk capital), and some VCs who invest at this stage. To simplify the fundraising process — one of the more popular instruments nowadays is what is called a SAFE, which has key features of a convertible note except that it is not a debt instrument, thus reducing legal and financial complexities. The startup doesn’t have to be valued — the amount invested and the valuation cap (apart from the discount) are the only items negotiated here between the founders and the investors.
The goal of this round is to give you enough runaway to be able to establish a growth pattern which will help you raise your next round of funding, the Series A, from professional venture capitalists.
You will have a wider network of advisors, investors and lawyer to help you guide through a Series A when that time comes — you don’t need to read the below section unless for pure fun/if you find it interesting. I do, so here goes:
VENTURE CAPITAL BUSINESS MODEL
- VCs are essentially asset allocators (what differentiates them is their experience + network + ability and willingness to help). Their funds are funded by LPs (Limited Partners), with public pension funds comprising the primary source of that capital.
- To these LPs (institutional investors), the allocation to venture capital is so little that they are able to accommodate even if that capital sinks. LPs are predominantly invested in the public equity markets, with private equity comprising 10% of their portfolio, and VC comprising 1%. The LP — VC model is broken according to a paper by the Kauffman foundation, but that is not your concern dear entrepreneur. There *is* sufficient capital in the market for you to tap into.
- VCs primarily make money by around 2% fixed-fee charged on the size of the fund, with 20% of the profits (if it happens). Bigger the size of the fund, and more the number of funds, more money the VC partners make.
- 99% of the capital invested in a VC fund gets investment from these LPs, with 1% invested by the VC itself, which is often not from the VCs personal assets, but covered by the fee itself.
- Typical lifespan of a VC fund is 10 yrs, with the first 3–4 for active investment. VCs make money from the 2% fee charged on the amount of capital in the fund regardless of activity or outcome.
- VC model’s primary incentive is unicorn-ish, $3 billion+ returns — which enables them to raise more and bigger funds, apart from the carry.
- VCs typically come in to a startup after the founders and early angel investors. Liquidity preferences, anti-dilution provisions like full ratchet are covered further below. Key thing to remember is VCs share in the upside; and have no personal loss feasible in the downside.
- A crude example — it is a horse race, your startup is the horse and you are the jockey. VC is the one betting on you with someone else’s money which doesn’t have to be returned but would be nice if it is, especially with a multiple return. But the VC is also betting on other horses in the race. The losing horses in the race get sent to the never-never land. The investors bet on the next set of horses and the race goes on, the search for that horse which runs so fast it grows a horn on its head and becomes a unicorn (valued by other speculators to be worth more than a $1 billion). As a jockey, you will get the chance to race again as well — you don’t lose from having founded a startup. That experience is golden and valued by the industry. This horse race is a good thing for the community at large: new ideas, new products, more experience for market participants, maybe a few wins which go on to define the local ecosystem and contribute back in taxes, innovation, etc.
- VCs are valuable partners who can be the difference whether your startup survives or thrives, not just with the capital they can bring to you, but with their past experience, connections and advice. The entire Internet economy has been enabled by venture capitalists taking a bet on budding startups and entrepreneurs.
- Raise the right amount, when you need it. Too much VC funding at early stages would imply a need to demonstrate even higher growth rate in order to be able to raise the next round of funding.
STARTUP FINANCE 101
Key concepts:
- Liquidation preference: Normally 1x, the investor will get back its capital invested in the case of a liquidity event, and/or the % ownership of the investor (depending upon the terms agreed).
- How does the cap table work: When new investors come in, founders will dilute. Option pools are required by Series A investors but the earlier shareholders dilute for it, in addition to the dilution required to bring in the Series A investor.
Here is a great post from a16z (Andreesen-Horowitz) explaining some of these concepts:
My key take-away from this post — for VCs reputation is not the only thing, it is everything: built on how fairly they treat entrepreneurs. In the case of the startup not having a spectacularly high exit compared to its prior valuation, the provisions which are baked in for “investor protection” could lead to the entrepreneurs walking away with little to nothing, with the VC’s “effective ownership %” being much higher than their actual % ownership of the startup. Couple of provisions to consider:
Liquidation preference: Money-back guarantee for the investors with the following flavors:
- A 1x non-participating liquidation preference would give the investor its money back if that amount is higher than what the investor will get from its % ownership of the startup.
- A 1x participating liquidation preference would give the investor both its money back + its % share of the rest of the pool of capital left, leaving less for the other shareholders.
- A 2x (or higher multiple) liquidation preference could result in no money being left on the table at all for other shareholders even if the startup sells for a marginally higher valuation than the valuation at which the last investor invested at. This article explains this nicely with examples.
Full ratchet/anti-dilution provisions: If in a subsequent financing round/exit, the startup’s valuation is less than the prior round at which the VC came in at, this provision would re-price 100% of the shares purchased by the VC in the prior round, at the new lower price, resulting in a double whammy for the other shareholders, who now are diluted further and have to contend with a lower valuation.
From an entrepreneur’s perspective, understanding these terms, along with other concepts like founder vesting (when the investor comes in, you will own your share of the startup which you already had if you stay with the startup for X period) are important prior to fundraising. Reputation of the VC + access to a good lawyer is critically important. What’s the point in pouring your heart and soul doing a startup only to be hoodwinked by clever provisions/or provisions which are standard but you didn’t really understand because you were too busy.
Financial instruments/financing
- SAFE: Like convertible notes, but without the complexity. Increasingly used and advocated by organizations such as Y Combinator for seed rounds.
- Convertible note: No need to price the round, but by definition it requires legal legwork to extend it as it is a debt instrument. Discount or Cap (normally preferred).
- Standard equity financing round: Agreeing on a valuation and co-ordinating across multiple investors to close at the same time is challenging+expensive.
- Equity Crowdfunding: Could raise $$ from regular non-accredited investors based on the US JOBS Act III and enabled by platforms such as Republic.co, but no connections+network gained from this kind of capital raise. Also requires upfront cost to prepare materials.
Model SAFE/Convertible Note conversion
Sample documents:
Resources:
Suggest reading Paul Graham’s Essays and TheMacro Y Combinator, Mark Suster Both Sides of The Table — Upfront Ventures, jason Jason Calacanis, Andreessen Horowitz Marc Andreessen Marc Andreesen/a16z, Sam Altman/YC, Dave McClure 500 Startups, Fred Wilson, Brad Feld, Boris Wertz Version One Ventures, Christoph Janz Point Nine Capital, Shervin Pishevar/Sherpa Ventures, among others. Medium currently has the best collection of startup advice for entrepreneurs ever assembled — from leading VCs, successful and failed entrepreneurs and what not — suggest to not waste more time than is needed on getting advice, talk to your customers and then build something great.
https://500startups.app.box.com/s/8ybxx9y3bhk4mte50v7k
http://venturehacks.wpengine.com/wp-content/uploads/2010/11/Venture-Hacks-Bible1.pdf
