Seed Startups & Fundraising
Thesis: the most successful investors will be seed stage leads excited about ideas and finding founders that don’t quit
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You want to find leads, even at the seed stage.
Initially, I resisted the idea that seed rounds even need leads. If you’re raising less than $1 million, I thought the syndicate model would be best. But if you’re just collecting checks, you might as well go to a seed stage VC and spend more time convincing one person than going around to 20 different individuals. Ironically, it may be easier to collect money from a larger fund that has a greater tolerance for risk, since seed stage startups are by definition risky.
Some people will ask: won’t angels help you out more than VCs? Who knows. Maybe the good angels will, if they’re excited and they actually add value. Which means they might as well act as leads.
The paradox of seed investing
There’s an interesting paradox that plagues seed stage angels. All of them are looking for the Black Swan that’s going to win, and they want the best deal with the most growth. But a Black Swan by definition doesn’t look like the Next Big Thing when it’s starting out. There are interesting parallels to optimal stopping theory.
The problem is: when a founder has traction, they can now talk to the best angels or VCs, and those deals will never be within grasp of the obscure angels. The real question is: why is an angel playing the angel game when they should be playing the less risky and more comfortable LP game?
On one hand, if your startup has no traction, you’re the ugly girl at the bar that nobody wants to talk to. Every guy wants the hot girl, but she knows she’s hot, and she’ll get to pick who she wants to take home. You’ll have your pick of who you work with if you have strong traction, and how you price the round, so traction will make your life a lot easier. As a seed investor, you can’t both be an ugly girl and want the hot guys.
Generally, founders on a strong trajectory will work with the name brand VCs, and the obscure angels are the ones left out of the deal. In the past, I’ve heard of angels complaining of prices being too high, but that seems like a petty complaint. There’s some interesting debate there where some people say you need more active angels involved, and you should lower your valuation for them. Paul Graham says that the valuation for the most part doesn’t matter; just try to find Black Swans. When you find a Black Swan, the difference between a $4 million cap and a $8 million cap is negligible because you’ll still score a homerun.
Nobody will know who the Black Swans are—not even the founders. So why is fundraising so difficult?
It’s unintuitive because any regular person would say “you have to find the Facebook before it’s Facebook.” That’s a truism, but it’s also an unsolvable problem. Y Combinator to date still can’t determine who will be successful, even after they’ve completed a batch. Paul Graham says he’s always surprised by the winners and you can’t predict them. I found myself just as surprised that Stripe emerged from my batch as one of the big winners. I remember the Stripe guys so vividly as a terrible idea with a terrible name. They were just the /dev/payments guys.
The challenge for founders comes down to quickly figuring out if an investor is excited or not. This is not as straightforward as it sounds, and it complicates the entire fundraising processs unnecessarily.
An example of “no” that looks like a legitimate question
Most investors are really good at finding long and convoluted ways of saying “no” or delaying, and those two are often indistinguishable. They do this for their own benefit, but the smart founders know what’s going on because they’ve identified this pattern of bad behavior.
One example is “how does this scale?” It’s deceptive because it sounds like an honest question. At the seed round, scale shouldn’t come up in any conversation, and even if it does, it’s sort of like the question “how big will this be?” You can quote Gartner market size reports, but nobody actually knows and until then the founders are just going to give arbitrary projections. Especially in newer markets. How big was couch-surfing back when Airbnb came along and legitimized the whole thing? Probably not big enough; people were couch-surfing for free.
The answer of how to scale anything is by adding people, software, or equipment. Often times, it’s just people. Neither the problem nor solution are interesting or worth talking about at this stage, so why does it come up? An investor who isn’t actually interested in investing would much rather focus on the problems in your plan, even if you acknowledge them. They do this because it makes them feel better. Investors want to feel okay about saying no to you because of cognitive dissonance. If they thought about how you could solve the problem, then that might create some discomfort for them because not only are they stupid for walking away from a good deal, but they also realized they were doing it which is worse.
Don’t focus on scale too soon
When I was at Bloc, we initially focused on scale by making the product something that is done without any human interaction. We built code editors in the browser, and we even deployed the apps for the user. But nobody liked it, and nobody used it. And investors still asked: “How do you scale this? You have to create the content manually.”
The investor was asking the wrong question the whole time. This is a pattern that occurs in investors that aren’t actually interested, at least not in the idea or team. They focus on problems, rather than possible solutions. Instead, they could have said: “You’re writing the courses manually, let’s try to brainstorm the ways that this could be done automatically, or if it would make sense to do it a completely different way.” There’s a subtle difference here: one approach focuses on a problem and is overly critical, the other tries to constructively find potential solutions if the existing one doesn’t seem ideal.
Eventually, we broke out of the browser and involved humans in the process, which was a much better outcome for the user and the business. We completely changed focus to the mentorship model and had cohorts. Revenue went through the roof, we started teaching people how to program, and investor interest grew after seeing how profitable the company was. Scale was the last question to be asking; the real questions to ask were: should this product really exist? Is it generating revenue? Do the customers enjoy it? Is it better than anything else out there?
Why does the scale question come up so much?
For one, startups are expected to grow quickly. Scale is arguably the easiest cop out, but it’s now common knowledge: don’t worry about scale early on. This is the same advice Paul Graham gave often to our Y Combinator class in 2009.
Back in 2009, Stripe was in my batch. They were called /dev/payments back then. Nobody knew who they were and I bet they would have had a lot of trouble raising money or getting meetings, even with obscure angels. Maybe I should interview them for Startups Open Sourced 2 and find out.
Looking at Stripe’s investors, I don’t see a single obscure angel involved in any of their rounds. They’ve had their pick of investors: Peter Thiel, Elon Musk, Sequoia, A16Z, SV Angel, General Catalyst, and a few brand name angels. Y Combinator took that risk early on back in 2009 when they were attracted to a certain type of founder that wouldn’t quit.
As Brian Chesky put it, they were looking for cockroaches. Certainly, you have to be crazy to drop out of college in a recession to join this uncertain and unproven thing called Y Combinator. I think Y Combinator liked that about us.
While Y Combinator’s investment thesis continues to evolve, it’ll be interesting to see how it plays out. The pattern today seems to be that they’re looking at companies that are further along in terms of growth. This may actually present an opportunity for angels to make a name—and probably a lot of money—for themselves by identifying ideas that excite them and founders that won’t quit. That’s what Y Combinator was doing back in 2009.
Scale comes later at the growth stage, not the seed stage
You deal with scale once you’ve figured out exactly what the solution looks like and you can optimize without losing anything, whether it’s quality, customers, revenue, or anything else valuable to your startup. The solution may not be fully discovered for another year, give or take. All startups seem to live in obscurity for 3-4 years, and that’s where they seem to hit their true scale. Everything before that was primarily hustle.
This should drive the thought process of an investment in any seed company: there’s this thing, it needs to exist because there’s clearly a problem. We don’t know exactly what the solution looks like, although there is a clear thesis right now. It could be wrong, but the certainty right now is this team will figure it out.
This is what separates a good seed investor from a bad one. The good seed investors recognize this, accept the risk, and focus on the next 4 or 5 major hops to being more successful. The bad ones dwell on what could go wrong. If a founder allowed himself to dwell on the things that could go wrong, they’d be paralyzed and simultaneously demoralized. PayPal had no idea what chargebacks were until it was too late.
Remember that scale is a float, not a boolean. For a scale ratio, you could calculate the number of customers or revenue, and divide by number of engineers, or number of code commits. It would be really interesting to know the scale ratios of the most successful companies in the early days. It varies from company to company and at what stage the company is in. It’s a spectrum, and it’s one you can easily say “sorry, doesn’t scale well enough for us” or “how does this scale?” But, it’s still a cop out.
More like dating, less like sales
You’ll get a lot of passes, as a rule. Unless you’re an outlier.
Passes are forced to become this logical reason, and they’re rarely logical if you think about it. It’s kind of like a girl saying “I had a great time” and then you guys never hang out or talk again—or vice versa. If you had a great time, why not hang out again or be responsive? Well, you already know the answer. They’re just being nice to you, but in reality, you’ve been rejected.
Investors passing usually comes down to them not being excited about the product or team. It’s generally easier to focus on arbitrary reasons not to invest rather than directly saying to you: this doesn’t excite me. It’s kind of like going on a date with a girl who isn’t attracted to you, and trying to logically understand what went wrong. There’s probably no answer that you’ll get, and if you could, do you really want to hear them tell you that you’re just not attractive to them? If you poke them, they’ll probably say “you were nice, but I just don’t see it working in the long term.”
In that sense, seed investing is more like dating and courtship, and less like sales. You can usually control the outcome in sales, but you can’t force someone to love you. That should be reassuring to you. The the #1 mistake founders make when fundraising is having high expectations. Don’t look at “no’s” as something wrong with you; if you honestly believe you’re building something people want and you see validation, you’ll probably find someone else who feels the same way.
The most successful angels in the future will be seed leads in spaces they’re excited about
Occasionally, you’re going to be lucky enough to find one that will lead your round and is excited about what you’re doing. The smart founders are going to identify these investors quickly by how excited they get and how decisive they are. Being more decisive will be a key indicator of how valuable an investor will be at the seed stage—even if it’s a quick pass. When I wrote my comment in response to Do things That Don’t Scale, I mentioned that I always refer my friends to investors who are decisive, even if they passed on me. But I never refer my friends to indecisive investors. That’s an interesting pattern.
If an investor passes or wants you to find a lead, but they won’t lead, they’re usually dumb, scared, or confused. If they’re dumb, you can try to appeal to their logic and educate them about your space. After all, you should be an expert in your space. In some cases, emotion will appeal more and they’ll need to have first hand experience on how bad something is. Or they’ll hear it from a bunch of their friends.
Logic won’t always win the feeble mind driven by herd mentality. A vast majority will be scared, so learn to recognize the patterns that indicate fear and try to move on if they won’t act as leads. If they’re confused, it’s possible that your pitch isn’t clear enough or their legitimate questions aren’t being answered.
You have two options at this point if they still insist on you finding a lead, but not acting as leads themselves:
- You can insist that they lead, or politely tell them that the lead investors will get to choose who is in the round and they probably won’t be able to invest.
- You can use them for their money and make them compete with other sideline followers. Shop your terms and make them bid for the highest cap.
Some people say “if you have the opportunity, go with good investors instead of a higher cap.” That’s what they mean. You either use the investor to boost your cap and shop your terms around, or you take the leads who are excited about your idea and will help you out. You could get both, but why raise money from some guy that needs the signal of an actual investor to be interested in your product? That’s the textbook definition of dumb money.
This would be an interesting experiment when you try to raise your next seed round: tell every investor that you’d prefer to only have leads participating. Don’t tell them who else is in the round. Don’t tell them that you have other investors, even if you’ve got A16Z. Only tell them how much money you’d like them to invest. If they’re excited, get them to invest and work with them on terms. See if they want to get anyone else involved.
