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Do Investors Invest in Ideas, People or Markets?

Investors often say that they invest in people first, then the market and lastly, the idea. I’d say that’s generally true, but it’s also very difficult not to triage and make judgement calls in reverse. When an investor asks for a pitch, they don’t say, “Tell me why you’ve got what it takes to be a startup founder.” Instead it’s always, “What’s your idea?” And countless entrepreneurs never get past that stage – the first elevator pitch, the first ten seconds of a meeting. Boom. Judgement made. Idea sucks. Entrepreneur out. It’s like filtering resumes based on typos; you get so many resumes you need to create easy filtering mechanisms that you can employ quickly. Investors see a lot of pitches.

It’s fair to say that super successful entrepreneurs have bad ideas. Probably just as many as unsuccessful entrepreneurs. The difference is that successful entrepreneurs somehow managed to take a bad idea and make it successful, or finally went through enough bad ideas to get to one good one. Point being, it’s hard to judge someone on ideas alone, but unless they come with a known history as an entrepreneur (successful or not), investors don’t have a lot of data points.

So I think investors put quite a bit of weight on ideas, even if they claim that they’re only (or primarily) interested in founders. I’m not saying this is a bad thing, just exploring the realities of investment.

Ideas are to some degree a reflection of the entrepreneur. You can poke holes in ideas and see how entrepreneurs respond. You can challenge them, throw out crazy ideas (or not-so-crazy ideas) and see what they say. You can probe how an entrepreneur is working to validate an idea and emphasize the importance of not believing they’re own hyperbole. Entrepreneurs that are rigid, steadfast and blind to the possibility that their idea might suck most likely don’t have Founder DNA. Entrepreneurs that take this kind of abuse (I mean … feedback) and run with it, coming back two days later with new ideas, proof points (or failure points) and an eagerness to learn, pivot and think more broadly, are demonstrating their ability to be true startup founders. All of that starts with the first idea.

This is essentially the process we go through at Year One Labs. It often starts with a quick meeting, followed by a much more intense meeting where we try and deconstruct and reconstruct ideas. Throw the proverbial shit on the wall and see what sticks. It’s not to be mean (we genuinely hope everyone – us and the entrepreneurs – in every meeting extracts some value), it’s about evaluating entrepreneurs and their potential. We’re trying to get to the true mantra of, “We invest in people.”

I know some people have found our meetings discouraging or difficult. Others have walked away revitalized and encouraged. But if we’re going to truly invest in people and not ideas, then we have to assume that every idea we see we’ll ultimately be thrown completely out the window. That’s not easy for most entrepreneurs to understand (I struggle with it myself sometimes!) Entrepreneurs are often wedded to their ideas, it’s just the way we are. It’s not natural (even though it makes logical sense) to focus on experimentation and validation (or more likely invalidation) of ideas, with the intent of killing them quickly.

Investments aren’t Structured for Killing Ideas

Most early venture or angel investments are not designed with the intent that the startup will receive funding, spend some focused time validating their market and then pivot. And potentially pivot so hugely that the startup is moving from one business to a completely new one. It’s great to see stories like this one – Pivotal Pivot – about the Instagram guys that tossed out 8 months of work to pivot completely. It does happen, but when someone invests in your startup they’re not expecting it (although they won’t be totally surprised when you pitch them on pivoting.) At Year One Labs it’s built into the plan. It’s expected that companies will pivot – possibly in drastic ways – but it’s important to do so very, very quickly. Having said that, I regularly catch myself envisioning how we’re going to work with entrepreneurs to build their products, launch, acquire customers, gain market traction, raise follow-on financing, etc. in a linear fashion. I love building products. So do most entrepreneurs. It’s natural as an entrepreneur to assume you know more than you do and build against your own “knowledge of how things should be done.” That’s why we’re committed to a process at Year One Labs to focus on early testing and validation of ideas before moving into rapid product development and beyond. And again, this comes back to investing in people and not ideas. You have to find people that are equally committed to this approach, willing to move from idea to idea as quickly as possible.

The Importance of Markets

A note about markets – they’re critically important. Go after a market that’s too small and you don’t have an investable business. Go after a market that you don’t know well enough and you could get eaten alive. For founders, you need to target investors that have some knowledge and experience in your market of choice. That’s ideal. If they have portfolio companies in your space that’s a bonus. We know what we know, and although investors have to have broad knowledge on many things and work very hard to get quickly educated on markets they don’t know well, generally they’re going to stick with what they know.

People -> Markets -> Ideas.

That’s the way most (if not all) investors should (and do) look at things. But the idea itself, your understanding of the market, competitors, monetization strategies, and existing idea validation that you’ve done , are all very beneficial when it comes to getting through early investor screens. You can’t get an investor’s attention without an idea that stands out in some way, or an angle on an idea that’s going to get them interested.

Shrinking the Table – How Investors and Startups Are Getting Closer

giant boardroom table

Too often, investors and entrepreneurs think of themselves as being, “on opposites sides of the table.” Raising capital is a negotiation that regularly pits investors against entrepreneurs (and vice versa). This adversarial relationship is quite common, and the relationship between investors and entrepreneurs (many people describe it as a marriage) regularly falls apart. Sure, when money is raised and publicly announced everyone (for the most part) is exuberant, and press releases contain wonderful quotes from the entrepreneurs and investors. It’s the beginning of the honeymoon. But getting to that stage can be extremely difficult, and for inexperienced entrepreneurs it can be somewhat shocking. When it comes time to negotiate terms, investors are looking for the best deal. And the same holds true for entrepreneurs. Tempers flare, demands are made and the process can be challenging, stressful and drawn out.

Entrepreneurs and investors are on opposites sides of the table.

But that’s starting to change. The advent of super angels and micro-VC is pushing deals to happen more quickly with better terms (for entrepreneurs.) We’re seeing a better alignment of interests between entrepreneurs and investors and that’s going right up the food chain from bootstrapped startups raising a couple thousand dollars to later stage VC deals. The table is shrinking.

I don’t think it’s possible to get rid of the table completely; and in fact there are very good reasons not to do so. Investors need control over certain things and have to be able to exercise their rights from time to time. They are providing much-needed capital after all, and they deserve rights along with that. So there will always be points of negotiation in any investment agreement, even as funding documents become more public and/or go open source. But the table is shrinking.

This is one of the reasons I wanted to start Year One Labs along with Raymond Luk, Alistair Croll and Ian Rae – to further shrink the table. We’re all entrepreneurs, we’ve all raised money. Raymond and Ian also have experience as angel investors. We’ve collectively sat on “both sides of the table” and seen the struggles and frustrations firsthand. Raising money shouldn’t be easy or automatic (money doesn’t grow on trees, let’s be realistic, even as frothy as the market may seem of late), but the process should be done as quickly as possible, transparently and honestly. Bickering over terms that will more than likely be meaningless doesn’t move the process forward. Having founders spend the bulk of their time raising capital to the detriment of growing their business doesn’t help either. And having investors that write checks but do little else is also very clearly breaking down. The value proposition just isn’t there.

For me, shrinking the table means moving more quickly, being transparent, helping entrepreneurs through the financing process and then rolling up my sleeves, post-financing, to add as much value as I possibly can. At Year One Labs we think of the entire process as “co-creation” where we’ll be sitting right next to the entrepreneurs making things happen. I know a lot of angels, super angels, micro-VCs and venture capital firms that are doing much of the same (although not likely to the extent that we’re planning.) You can clearly see the direction things are going.

The table is shrinking, and that’s a good thing.

Originally posted on http://www.yearonelabs.com/shrinking-the-table/.

Image courtesy of shutterstock.

Raising Financing: Convertible Debt vs. Equity

Seth Levine from Foundry Group touched off a debate on which is the best way to raise startup financing: convertible debt or equity. Paul Graham (intentionally or not) actually started things with a tweet, “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

Fred Wilson joined the conversation, as did Mark Suster. All prominent and successful investors. And generally, they’re not fans of convertible debt. But oftentimes, entrepreneurs are attracted to convertible debt, and clearly with Y Combinator, the trend is moving strongly in that direction.

The two main reasons why entrepreneurs are attracted to convertible debt are:

  • It’s supposed to be easier; and,
  • It delays pricing the round.

Pricing a round and the value of a startup is hard. It can be an uncomfortable conversation to have with investors, and it can turn into a bit of a stand-off, where no one wants to be the first one to name a price. So I understand why delaying it sounds appealing. But the truth is that a convertible debenture doesn’t really delay pricing, especially when you set a cap on the conversion in the next round.

Let’s say I’m going to raise $500,000. And I’d like the pre-money value to be $1.5M. The post money-value would be $2M and the $500k is worth 25% of the company. That’s the way you would price it for equity. When you raise the next round, they would of course get diluted.

With a convertible debenture you’ll get $500,000 (and there’s interest payments to be made too.) When you raise the next round, the initial investors convert their debt into equity, but typically at a discount. Let’s say 20%. So in the Series A, when you now want to raise $2M and the pre-money valuation is $6M, the $500k is measured against a pre-money valuation of $4.8M. They would own 10.4% instead of 6.25%. (Not including interest in the calculation.)

But there’s also the issue of a cap. The cap is put in place by investors with a convertible debenture to peg the value of their debt (with the discount), regardless of what you raise the Series A at. So, let’s say the cap is $5M. Now when you apply the 20% discount, the first investors’ money converts in at $4M. They now own 12.5% instead of 10.4%.

Investors will peg the cap amount at what they think you’ll raise the Series A value at. If you raise a lower Series A they still have the discount and own a bigger piece of the company. If you raise a killer Series A at an astronomical value, the cap protects them.

When raising financing with a cap, you’re basically negotiating the price of the deal, it’s just the mechanisms you’re using (% discount and cap) are different than company valuation.

I’ve raised money as convertible debt. And I’ve spoken to others that have done so (and others that have raised money through equity.)

In my experience, it wasn’t any easier to raise financing through convertible debt. It didn’t take any less time, and it wasn’t that much less expensive. It might seem easier because it avoids the big question about “the price of your startup”, but it’s really not doing that. Remember: Investors know how much of your company they want to own, and whether they price the deal upfront or delay it through convertible debt, they’re likely (and you’re likely) going to end up pretty much in the same place.

Generally, I expect (and have seen) fairly common standards for early stage companies. So I would bet that most convertible debt deals are being done around the same % discount and cap numbers. The same is true when pricing deals (angels and investors have told me, “When we see an early stage deal, it’s always in this range…”) That might be less true these days with the market being as frothy as it would appear to be (in Silicon Valley) but I don’t think there’s a whole lot of mystery around the value of early stage companies. Assume that’s true, and the stress of “pricing a deal” is lowered.

For entrepreneurs, here are the important things to ask yourself:

  • How can I get a deal done as quickly as possible?
  • But without sacrificing value-add for speed (Yes, I do believe in “smart money”)?
  • How can I make sure interests are truly aligned (as best as possible!) between me and investors?
  • Being more blunt, can I stomach working with these investors for the next 3-10 years of my life?
  • What deal is the least likely to bite me in the ass later and make my life miserable?
  • Do I really understand all the math at play and the various scenarios (not just the good ones!)?
  • How does taking this money really impact the strategy and focus of my startup?

Where a convertible debenture can be very valuable to entrepreneurs is for early exits that don’t require follow-on financing. If that’s the case, when a company is acquired (let’s say for $10M), it’s likely the debt will convert at the same price as was agreed upon if the company was to raise a Series A. So the initial investors get a smaller piece of the pie and the founders get more (compare 12.5% to 25%, because there’s no further dilution.) For a lot of web startups and founders, this is appealing. Raise a bit of money and see if you can exit before raising too much. And I think that’s a perfectly legitimate strategy.

Overall, the debate is an interesting one, especially because it helps shed light on how investors are thinking and educates entrepreneurs on the different investment mechanisms and strategies that exist. But I certainly don’t believe that a convertible debt structure is a slam dunk win for entrepreneurs when raising early stage financing.

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About Ben Yoskovitz
I recently joined GoInstant as VP Product. GoInstant changes how we use the web, making it shareable like never before.

I'm also a Founding Partner at Year One Labs, an early stage accelerator in Montreal. Previously I founded Standout Jobs (and sold it). I'm a hands-on startup guy, helping companies grow successfully from the idea forward. You can reach me at byosko at gmail dot com.

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