Let's not get greedy with these bubblicious seed rounds

I recently chatted with Josh Felser of Freestyle Capital.  We talked about all sorts of things going on in StartupLand.  Josh is part of a loosely connected crew of successful, serial entrepreneurs that now spends its time investing in early-stage entrepreneurs.  While Josh is now a VC who is responsible to LPs, he is still close enough to his founder days to remember how challenging the startup path is.  As a result, he is a trench warrior who works his ass off right alongside the entrepreneurs in whom he invests.

Fortunately, there are a lot of of these guys in the investment ecosystem right now.  We sometimes call them Super-Angels or Micro-VCs.  Whatever the terminology, you know them because they invest collaboratively in syndicates, are accessible to founders of all shapes and sizes, write helpful blogs, and work their asses off.  We were lucky to have several of them in FlightCaster's financing.

Compare those attributes to our perceptions of traditional VCs who are far more regimented in a process that is not easily accessible to those that haven't already been around the block.[i]  While the traditional VC may have the capital you need to scale your growing company, it's this new group of investors that many of us are choosing for large seed rounds instead of jumping straight to a traditional Series A.

During our chat, one of Josh’s comments really stood out. He expressed regret that given today's high valuations, he has had to pass on some companies that he otherwise would surely have invested in.  It's a sentiment I'm hearing more and more often from some of my favorite investors in Silicon Valley.   Josh subsequently tweeted:

@dsamuel & i have been disciplined about seed valuations in our portfolio.  we aren't the cheapest partners but we work our arses off. 

While I do love seeing these guys continue to hustle and sell themselves, I’m starting to worry about how often I’m hearing this.[ii]




So listen, my fellow founders, I think I know what's going on here:  These are the good days. We're cashing in.  Raising money has been so horrendous for so long, and the processes have always been in the investor's favor.  And now it's our time.  

In the past 18 months, the landscape has changed dramatically.  We now have widely-accepted convertible notes that reduce paperwork to almost nothing.  We can close moneywithout a lead investor.  We can change the terms by the hour, party-round style.  We can use social proof to our advantage through Angel List We can capitalize on traditional VCs who bid up valuations to price out angels.  This is all happening during an up-market or bubble, whatever you want to call it.  The bottom line is, we're fuckin' killing it. 

The problem, though, is that we are beginning to let this shift in leverage go to our heads.  It’s time for us to slow down a bit and check ourselves.  I'm starting to believe that we are more often than not failing to optimize on the right terms in our rounds. 

I know for a fact that many of our best investors are frustrated about this but have been hesitant to speak out on the subject.  Since AngelGate faded away, the seed stage investor community has remained relatively silent on this issue, even though it caused so much (inside baseball) drama in late 2010.  I have no desire to re-hash that incident, but I do think it's time for us entrepreneurs to have a frank discussion about our responsibilities in this particularly founder-friendly investment environment.

My suggestions below are not as well formulated as they are when I speak to more trivial subjects, such as emailing busy people or being in stealth mode.  This is a far more complicated subject, and I don't really have enough experience to understand the larger trends that are at play here[iii].  I'd love to hear your thoughts, pushback, suggestions, etc.—especially if you've been through several of these cycles. 

To start us off though, here are my thoughts on what we should keep in mind while raising bubblicious seed rounds:

Optimize for the right investor
You will have each of your first investors on the cap table for the life of the company. The single most important item on any term sheet is the name signed at the bottom.    You should think a lot about who you want that investor to be.  He’s going to be  present for many important moments in your professional and personal life.  You will depend on him for countless small requests.  You will need to trust him for big picture advice and mentorship.  You will want him to care about you as a person when you're down.

Stop obsessing about valuation
We are all waaaaay too wrapped up in valuation comparisons.  Seed-stage valuation is what head-count was two years ago: the worst way to boast about your company. 
Mark Suster talked recently about raising at the high end of the normal range.   The fact is, it’s often better not to have the highest possible valuation at the seed stage because it means that you don't have to stretch as far to make it to your Series A.  You need to be clear-headed about this issue and not so concerned with bragging to your founder friends about how much your startup is worth on paper.

Take time to build relationships
Make sure you give your investors time to get to know you.  The new style of orchestrating a lightening-fast round is vastly superior to the “old” (i.e., 1.5 years ago) method that took several months to complete.  However, while we've made the process faster, we’ve done so at the expense of building quality relationships with our investors.  Try spending more time talking with investors before you officially begin fundraising.  Be very clear that you're not yet ready to chat about money, but that you want to chat with them anyway.  Take the time to build rapport.

Golden rule
First-time entrepreneurs have a bit of the kid-in-a-candy-store mentality right now.  Money is easy to get, so why not grab it on the best terms possible?  Whether we’re in a bubble or not, we all know that founder leverage will wane in the future.  Most of our companies will invariably experience tough times at some point.  If you're building a big company with several rounds of financing, you need to think ahead to that time when your
 traction will have stalled.  You will need that key bridge note from inside investors or a flat round that doesn't crush you.  If you have your investors feeling like you took advantage of them in 2011, what do you think is going to happen when the tables have turned?

Support hustling investors
Please realize how good we have it with our current crop of investors.  These guys are successful serial entrepreneurs who have found a business model and lifestyle that allows them to use their time, money, and connections to help us start companies.  Meanwhile, the entire VC industry is heading toward 
a major contraction.  The question is, who do you want to win when it contracts — the old school, traditional VCs with their painful, rigid processes or the uber-accessible, hustlin' smaller-scale investors?  Shop at your higher-quality, local market where they remember your name... 

Finally, to be clear, I am not saying that we should be leaving money on the table or treating our share prices as charity.  We should be 100% focused on maximizing our true value, which means optimizing on terms other than just valuation.  If we do that, we as founders will run more successful companies that will, in the long run, make us all a lot more money.

Am I off base here?  Sound off.




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I'm Jason Freedman.  I co-founded FlightCaster.  
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[i] Though, to be fair, many VCs have gotten exponentially better in the last 24 months.  I would argue they have done so in order to compete with Angels/Micro VCs.

[ii] It’s also worth mentioning that there is a surge in the number of startups seeking capital, so guys like Josh can still find opportunities to invest in which terms are, as he says, “optimized for success for both the founders and investors.”

[iii] Rare dose of humility!

12 responses
Hey Jason - this is Rafael, the party round author. Just a quick clarification that I've never advocated changing terms around by the hour. My main point in the post you link to is that post party round financing "things can quickly get out of control in a very good way or in a very bad way." It's simply ensuring a higher beta outcome for the startup.

But for a party round to happen, you actually have to price your shares to move and stay steady with how you communicate to investors regarding terms. So actually I'd argue going the no lead/mass syndication/party round approach means you have *less* flexibility on terms, in exchange for maintaining control post seed financing (among other things)

You're definitely on base. The key thing, especially at stage seed money IMO, is getting the right investors on board. These guys are going to help you all the way through and if you have to come down from a higher valuation, do it.

If you think about it for a second you'll see it makes sense too. Getting a seed round is only one of many to come. Taking an absurdly high valuation early means you better kill it or else you'll have trouble stretching that area where you need to expand faster than you collapse as a company.

You'll get your money's worth in the end if you work hard and smart. The key thing we've been told is grow the pie and execute an action plan that allows you to do that. If you, for sure, can do that with a high valuation early: go for it. But if you're unsure - take on less money (or less valuation) but the right people so you can figure it out along the way.

I would take a guess that part of the problem is the over emphasis on the pre-money valuation. For tech journalists, founders, even investors its' the only metric that's talked about.

If instead founders focused on hitting their reasonable PEG ratio, Earnings per share growth, P/E ratio, and the investors discount rate (i.e. required IRR) and NOT on their pre-money valuation we'd see a lot more balanced market.

I have been so immersed in building the software that I'm just now coming up for air. Where do I begin with raising money? I am rather clueless on this front.
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