Investments over dinner and board room – Angels v Seed Funds

(embarrassing picture from an old Newsweek article)

Eric Paley called me one evening to talk about an angel deal he was looking at. I was cooking dinner with my wife when he phoned. We talked about whether behavioral psychology could really work in convincing consumers to reduce their energy consumption. Eric had known the founders for years and thought the world of them, and I had gotten to know one of them, and figured the business was a bet worth taking. While still cooking, I agreed to invest with Eric and Dave Frankel. That investment, Opower, is my best to date.

It got me thinking how different angel investing is from my role as an institutional seed investor. I no longer make investing decisions while cooking, and that’s just the start.

1000s of companies vs dozens

As an angel investor, I saw a dozen or two companies per year. For the better part of my angel investing career, I was running a business so I didn’t have time to meet hundreds of start-ups. Thus, my context was very different. My first year as an angel, I looked at a med device company, a sports nutrition company, and a restaurant business. I had very little context on any of these. In some sense, ignorance was an asset and thus it was easier to make a quick decision with limited data. There was no time or means to “get smart” in a given space, so if I didn’t get the gist of the business in the initial pitch, I didn’t invest. (that year, I invested in none which was a mistake!)

Founder Collective receives thousands of opportunities per year and we take about 1000 pitches. We track our “venture” funnel in a CRM (jerry rigged Salesforce.com). The minute I see a company that’s intriguing, I can see if we’ve met them before and ask my partners what they think. Usually one of them will have knowledge about the space or related companies. Thus, the context around each deal is much more developed when we make an investment.

Angels pursue passion, invest in the network (and mostly ignore valuation)

When you’re investing your own capital, you can invest in stuff you’re passionate about. Noted angel investor Andy Palmer pays particular attention to the healthcare space, and Joanne Wilson favors women entrepreneurs in the industries she knows well. I invested primarily in my network – virtually everyone I invested in as an angel was someone I knew.

In the seed fund world, investing is our business. We can’t just invest in industries or people that we know. (If so, I would only invest in dental companies!) We make 20-30 investments per year. There simply wouldn’t be enough opportunities. That isn’t to say we don’t have high conviction and enthusiasm for the stuff we fund, its just that we need to explore a myriad of opportunities. Additionally, while some more experienced angels are price sensitive, as a fund, we are much more focused on valuation than I was as an angel. Angels don’t need to think about IRR, mainly cash on cash return, but as a fund we’re measured on it.

Follow on support

I did very little to check in on my investments. Often times, I wouldn’t even be aware of follow-on financings. These investments were for fun and hopefully a little extra “alpha” for my personal portfolio.

As a partner at Founder Collective, I’m responsible for keeping my partners up to speed on our companies. In turn, we have to keep our investors (LPs) updated on the performance of our companies. We discuss them at our annual meeting and they receive regular reports on their value. There’s a benefit here, which is our portfolio gets the benefit of help not just from me, but from the whole FC team and sometimes, even our LPs.

The increase in the universe of angels and seed funds is a good thing for entrepreneurs, but with so many options, fundraising has gotten more complicated. Entrepreneurs today can sequence their fundraising, and graduate from Angel to Seed Fund to Series A fund, etc. This provides the entrepreneur with more options along the way, even for those starting companies in the dental industry!

 

SXSW observations (party meter is at 7)

After a few days running around Austin, I jotted down a few of my observations.

International flavor
Maybe it was the fantastic mix of Korean kimchi and Mexican tacos that I ate last night, but I sensed an international vibe to SXSW. I heard numerous accents and languages spoken throughout the convention center. Prior to the conference, I received invites from dozens of groups outside the US hosting events. The Silicon Valley culture has definitely permeated the globe (nobody carries that torch better than Dave McClure). Moreover, the Whatsapp acquisition has led the generally inward focused tech community to understand the value of a global userbase.

Medtech is mainstream 
I saw connected health devices of all kinds. One example was Wello, an iPhone case that captures your vital signs. Another interesting one was Push Strength, a wearable that ensures you’re exerting the ideal amount of power when lifting weights. The R/GA accelerator in NY hosted its demo day in Austin as well, featuring a handful of intriguing connected devices. I still believe we’re in the early innings as it remains ambiguous as to how  consumers will use this information in our daily lives.

Commoditization of hardware is fast
I was in the market for a battery recharger (juice pack) and was able to pick one up that can charge my phone 2x for $20. I was shocked how cheap it was. It was a reminder that despite barriers to entry, hardware can commoditize quickly. Larger companies or companies that know how to access Asian manufacturing can produce similar quality stuff quickly and cheaply. It’s another reminder why upstart hardware companies must leverage software as their differentiator. I wouldn’t be surprised if we see lots of low-cost wearables in coming years.

SXSW fatigue
The conference was as energizing as ever. However, I noticed that some of the entrepreneurs and VCs I would have expected to attend, did not. I  heard someone say “The valley is over SXSW.”  While that didn’t feel to be the case, we did find that within the FC portfolio, fewer founders attended than in previous years. I suppose they’re all heads-down focused on growing their businesses instead of loading up on BBQ!

Tech party meter stands at 7
When I started Handshake.com in 1999, I remember attending a party on a huge yacht that served lobster and top shelf drinks.  A well known band performed on the deck. Those types of events were the mainstream in those days. While the parties at SXSW this year were  swank, and enthusiasm ran high, it didn’t feel over-the-top like I remember from 1999. On that metric, I’d put the tech party meter at about a 7, so I suppose we’re okay … for now.

No immunity: Start-ups and litigation

I long thought that litigation was the exclusive domain of lawyers, large companies and criminals. Who would want to pick on a poor, helpless start-up? The reality is, sadly, that our litigious society has entered the domain of the early stage company.

Legal Battlefronts

The disgruntled “friend,” collaborator or employee

I sometimes call this the “Social Network effect” after the Facebook movie. Usually, the litigant feels slighted and entitled to equity or cash. These cases are especially challenging because they become personal, rather than rational. The biggest sticking issue is equity, because often the litigant is seeking equity for some early collaboration (perhaps classmates that brainstormed an idea in their dorm room). While its generally understood that equity is for one’s forward-looking contributions, this principle can be hard to establish in a jury trial. This makes these cases especially tricky even when the company is 100% in the right. This should be a reminder to all founders to get stock allocations set and locked in the beginning to avoid future disagreements.

IP litigation

Perhaps inspired by patent trolls, I’ve seen an increasing number of larger companies sue any or all upstarts that threaten its core business. Given the number of very generic patents that have been issued over the past decade (many in software), it has become increasingly easy to demonstrate some sort of violation, especially to a less-than-sophisticated judicial system.

Smaller companies generally have only one product to sell, and without the ability to sell that product, have no business. Furthermore, most start-ups cannot afford the distraction and therefore, most boards advocate settling cases sooner than later.

Innovation ahead of regulation

This type of litigation is in the press seemingly everyday. Uber, a portfolio company, and Aereo are well-documented examples where municipalities or other groups sue the company for violation of certain regulations. The reality is that most regulation hadn’t taken into account the existence of new technologies (as in Uber or Aereo). Instead, protectionist politicians that wield significant influence try to shut down these new services before regulation catches up to innovation.

Selecting Counsel

Representation selection signals to the other side a great deal about your view of the case. For example, if the start-up hires a large firm, the other party knows that high rates are being paid and thus may believe a higher settlement is likely.  That said, if the start-up is fighting “bet the company” litigation, its advisable to use a big firm despite the signaling risks.

On the other hand, if you’re fighting a lawsuit that is a nuisance but doesn’t jeopardize the very being of the company, its advisable to use a smaller, less expensive firm. Remember that investor dollars are being used to fund litigation, which is among the worst ways an investor (or an entrepreneur) can envision spending his/her company’s capital.

Budgets

I’ve seen our companies spend tens of thousands to over a million dollars in legal fees. Each case is unique, but my experience has been that the vast majority of cases settle close to the trial date. In these cases, generally hundreds of thousands have been spent. This isn’t altogether surprising given that it takes time for both parties to realign their expectations. If a case does go to trial, the costs almost certainly will be at or north of $1M for all fees leading up to and including trial.

Venture investors are increasingly familiar with litigation. The start-up founder/CEO needs to be transparent about the situation and the facts, and keep the Board closely updated on the process. Unfortunately, the wheels of justice turn slowly and often the biggest expense paid by the company is the time and distraction.

My bet on NYC

I made a personal and professional bet on NYC this year. After founding a company in CA and two in Boston, I was apprehensive about moving to a city in which I had never worked, and perceived as a finance town. As I left a tech event last week, I thought to myself, this has been the best decision of my life. The NYC tech ecosystem is a work in progress, but I’m happily here for the long haul.

NYC tech is welcoming and collaborative

There is a fair amount of clique-ness to venture capital. There are times when it reminds me of my high school. Most of the time, however, I have found the atmosphere in NYC to be collegial and collaborative. Within our portfolio, I’ve been amazed to see how many founders know each other and regularly connect. We hold a number of events for our portfolio and they ask for more, often following up with each other on various topics.

Historically, the tech ecosystem was an afterthought in the broader NYC economy. The funny thing about venture capital in NY is that most folks here lump it in with Wall St (imagine that in the Valley!). The tech community still feels like it has something to prove. My favorite example is the “Made in NY” logo co-opted from the film business now imprinted on virtually every NY company’s website.

The east coast corridor is a real strength

Much is made about Boston vs NYC.  However, the ease with which you can get between the cities has made for some pretty interesting cross-pollination. Some of the best VC firms originated in Boston and have expanded to NY.  Moreover, I’ve connected NY companies with really capable engineers from Boston who have joined those companies. Similarly, we often recommend NYC PR and design agencies to our Boston companies. There’s no doubt that NYC and Boston are amazingly complementary when it comes to company building.

NY is young but lacks a deep bench

I think I’ve seen only two blue blazers since I’ve started at Founder Collective NYC! The average age of entrepreneurs I meet in NY is late 20s. My observation is that NYC lacks a “deep bench.” There are some real standout entrepreneurs, but I’ve seen a fair share of CTOs with less than 5 years of commercial experience. My view is that the VP corps of a company are often the most impactful in a venture. These are the folks whom, after an exit, go on to start the next great cohort of companies. That hasn’t quite happened yet in NYC, but it does feel like its coming.

Entrepreneur-friendly, but expensive

I can take 7 meetings a day, grab a drink with a portfolio company and be home before my kids go to sleep. This is a real structural advantage of NYC. I bump into entrepreneurs and investors in SoHo, Flatiron and even on the Upper West Side. NY lends itself to a lot of f2f which is important for a business that, at its core, is very f2f.

Many lament the cost of living and working in NYC. There’s no question that this makes it difficult to have a family and work in a start-up. That said, I’ve been amazed at how scrappy NYC entrepreneurs can be; I’ve seen companies that have a dozen employees working out of the founder’s living room. Many of our companies leverage co-working space, offshore labor and contractors while keeping their core in the city.

The NYC tech scene is evolving at a start-up pace. Like any venture, it’s iterative. The venture world is changing in many ways and this bodes well for NY. I bet we will look back in a few years and marvel at how the NY tech scene is as much a part of the NYC economy as fashion or media today. Who knows, maybe a successful entrepreneur will become mayor someday!?

Putting the “hard” in hardware

I woke up in a cold sweat. Our camera supplier filed for bankruptcy – we were single sourced and GA was only a few months away. Our Director of Hardware calmly shrugged, “hardware has the word ‘hard’ in it for a reason.” Thoughts of managing supply chains, quality issues and CoGS models still give me the chills from my experience at Brontes and Sample6. At Brontes, we built a custom 3D scanner out of 27 custom lenses,  300 LEDs, and it took 18 months.

“Guts” of a Brontes scanner

Having seen a dramatic increase in the number of new hardware start-ups, I’ve been thinking about whether its easier today to do hardware?

Here’s why it’s gotten easier …

Today’s hardware companies focus less on the hardware itself and more on wrapping a software layer on top of often off-the-shelf hardware. Arduino (open source hardware prototyping) and things like Atom’s Express (a portfolio co) allow for rapid hardware experimentation.

Additionally, incubators aren’t just for web-heads anymore. Lemnos Labs in the Bay Area, New Lab in Brooklyn and Bolt in Boston, serve as great resources. In the past, I spent months searching for lab space and buying used equipment on Overstock.com. Today’s hardware start-ups begin product development on day one. Couple this with the rise of 3D printers like MakerBot and services like Shapeways, and it has become easier than ever to create prototypes and bring them to prospective customers, partners and investors. Crowdfunding sites like Indiegogo and Kickstarter provide a forum to take pre-orders and gauge demand, while generating cash flow even before the first article is made.

But it’s still hard …

You can’t start a hardware business in a Starbucks! Hardware requires more capital and takes longer to get to market. Hardware is often evaluated as much on look and feel as functionality or value. Thus, costly services like industrial design are  needed which  forces the trade-off between design and speed-to-market. Perhaps most importantly, many consumer hardware start-ups compete against the behemoth electronics brands and thus struggle to get distribution (or give up 30-40 points of margin for it).

Go for it …

We fund a fair number of hardware start-ups at Founder Collective. I love meeting hardware companies. My view is that hardware is a field where experience matters, so I encourage hardware entrepreneurs to get someone on board in some capactity with experience sourcing and managing vendors. Also, business model creativity is really important given the risk of commoditization. Consider models like renting or pay-per-use to create recurring revenue. Finally, bake as much functionality as possible in the software and enable over-the-air updates. Tesla is a great example of this (for ex. they’re changing the software to increase the height of the car to reduce the risk of the battery catching fire on highways).

Hardware start-ups are hard. But when you get it right, there’s nothing quite like bringing a new physical product to the world.

Yes, the goal posts keep moving

 

It was one of my least favorite aspects of raising money. Time and time again I would ask VCs to articulate what metrics would be required to close funding. Inevitably I’d be left unsatisfied and wonder, “why does it feel like the goal posts keep moving?”

The answer has come into focus now that I’m on the venture side and it’s unsatisfying and simple. They are moving.

No such thing as hard metrics

Some investors might say I’d need to see “x” pre-orders for a hardware start-up, “y” downloads for a mobile app, and “z” revenue for an e-commerce company. Yet, such a formula is misleading to entrepreneurs (and bad investing). There are no precise metrics for getting funding, given how many intangibles go into building start-ups. Much like applying for college, kids with lower SAT scores get accepted to better schools and vice versa.

The venture market is more like the stock market than you think

We often think of the venture market in very different terms than the stock market. It feels like a cottage industry, more like the local real estate market than the broad securities exchange. The reality is that investor behavior is more similar than different. Macroeconomic factors impact the venture market – increasing stock values, economic data and even political conflict has an impact on capital raising for start-ups. Like the stock market, the venture market ebbs and flows.

Investors are influenced by their portfolio & deal flow

Let’s say you’re an e-commerce company doing $25K in monthly sales when you first sit down with a VC. The investor seems enthusiastic about the company. You come back a few months later doing 4x the sales looking to close the funding. Instead, the VC seems much less enthusiastic than the first meeting. What happened? It was a 4X!

Perhaps one of the e-commerce companies in the portfolio hit hard times and that colors the investor’s view. Or, maybe a new opportunity surfaced in the meantime that makes your company appear less attractive on a relative basis. None of these reasons are rational, but nonetheless impact the investment decision.

So what’s an entrepreneur to do?

One of my trusted mentors, Jeff Bussgang, said to me “VCs are in the extrapolation business.” It’s sage advice. Rather than focus on individual data points, the entrepreneur must generate data that demonstrates an upward trajectory of the business. Unfortunately, the x and y coordinates of these points are not obvious.

I discourage entrepreneurs from asking VCs to articulate metrics that will trigger funding. Instead, think about the risks of the business and identify the metrics that best address those risks. Don’t look to VCs to lay out a path for funding. Instead, knock down the risks you see and frame those metrics as the ones the prospective investor should care about.

Venture Debt: The third rail of venture financing

I’ve taken venture debt in all three of my start-ups. Additionally, many of our portfolio companies have taken some or are in the process of doing so. No doubt it’s a frothy market for debt. Nonetheless, when I polled others I respect, I heard everything from an unwillingess to comment  to outright dislike. Why is venture debt the third rail of venture financing?

A couple of years ago Fred Wilson wrote a post stating his view that debt is not appropriate for an early stage start-up. The primary argument was that venture-backed start-ups who have no current means of paying it off shouldn’t take on debt.

I, however, frequently encourage debt despite that most venture folks share Fred’s view. Some VCs argue that the start-up is riding on the VC as the financial backstop. This is true. In fact, most debt funds are only willing to finance companies backed by top tier, well-known funds. For the entrepreneur, this is another good reason for the start-up founder to get capital from such a fund! Secondly, the price of debt, often over 10%, takes into account this default risk. If the company defaults, ultimately the company reverts to the debt holders. These investors know what they’re getting into and have generally shown decent returns because most of their portfolio gets further equity capital.

Another counterargument to venture debt is that it can spook prospective investors in future rounds. There’s certainly merit to this argument. However, what the argument fails to consider is that founders need runway above all else. In my experience, the debt enabled my team to achieve the milestones we needed to raise more capital.

Investors are either buyers or sellers. Most investors put in equity dollars and want to see meaningful traction before further investment. When companies are going sideways or the trajectory isn’t obvious, debt is often the lowest cost way to extend runway. When I was a CEO/founder, I would ask my investors, will you put in money at the debt terms? The answer was always “no” and investors acquiesced.

Venture debt does have a dark side. When things start to go wrong, as one CEO said to me, debt can exacerbate decline. Servicing the debt can be costly to the burn and may make it harder to exit (typically on “soft landings”) because prospective acquirers don’t want to pay off the loan. That said, I’m a believer that the entrepreneur needs to “play to win” and as a result it’s beneficial for the CEO to get debt early, when it’s still possible to get it.

Venture debt is a case by case decision. By no means would I advocate it in all cases. The amount of debt borrowed, whether it’s drawn down immediately or not, and the terms are extremely important to consider when deciding to take it on.

 

The accelerator dilemma

Accelerators have become an amazing asset for the tech ecosystem. For start-up founders, however, picking an accelerator is like deciding to go to grad school. First you have to decide if its right for you, and then make sure you’ve picked to the right one. Just like grad school, attendance is not a guaranteed ticket to success. 

At Founder Collective we have invested in some really exciting companies that have gone through these programs. SeatGeek (DreamIt) and Contently (TechStars) are great examples. I expect us to continue to invest in accelerator graduates.

That said, prospective companies should be aware of the realities facing accelerator companies and how to maximize their likelihood for success. These include:

Investor fatigue

Recently, I’ve noticed fewer and fewer investors in attendance at Demo Days. Personally, I’ve found it difficult to attend many of them due to conflicts and the long time commitment (usually most of a day). Instead, I swing by the accelerator during the class “semester” to give a talk or hold office hours. I’ve heard some investors say they’re not stopping by a given accelerator, instead hoping to hear about buzzy companies through their network. Start-ups seeking capital should work pre-demo day to warm investors to the team and opportunity.

Challenging mentor recruitment

It’s getting harder for companies to sign-up great investor mentors. Investor fatigue is one reason, but also many investors have never invested in a company they’ve mentored. In the early days of TechStars, I mentored one company per class (e.g. StepOut and ThinkNear). These days I tell accelerator companies that I’m available to help out, but won’t mentor a single company. Industry or entrepreneur mentors are generally more valuable for companies at the early stage and thus, start-ups should focus their recruitment there.

Post Demo Day Thaw

Companies underestimate the pressure to raise capital before or immediately after Demo Day. There’s about a 60-day halo. Once the halo is gone, investors grow weary of companies that haven’t raised capital. There’s a negative signal that forms if a company is more than two months from a given Demo Day and has not secured capital. Early conversations with investors represent one hedge against this. More importantly, before applying to an accelerator founders should think hard about whether they expect to accomplish the requisite milestones during class to secure funding.

A positive sign for accelerator graduates

A growing number of investors are revisiting companies two or three classes removed from graduation.  Investors (and hopefully accelerator organizers) have realized that not all companies mature at the same pace. Some of the real gems, in fact, may have been out of the accelerator for a year or two. So, even for companies that don’t get funded right out of the gate, the future remains bright.  

Eyes way up in the sky, feet firmly planted on the ground

One of the hardest things for me as a start-up CEO was striking the balance between “selling” the big vision while remaining maniacally focused on the details. Sometimes it seemed as though everyone wanted to hear a different story – customers, employees, candidates, investors (especially those on opposite coasts!). My partner Eric put it best when he said, “keep your eyes way up to the sky, and your feet firmly planted on the ground.”  My colleague Gaurav points out that most founders give the “big picture” vision to external parties but do much less so internally. Founders often forget that teams need to be reminded of the broad company vision to keep morale high and turnover low.

Eyes way up in the sky

The startup CEO has to capture the imagination. I have found that most start-up meetings require “up in the sky” messaging. Like the coming attraction to a movie, the entrepreneur should confidently state a bold (but believable) statement of the future. The vision should be a couple of years out, not one, but not ten. Every employee or prospective investor should leave a meeting able to articulate the vision of the company.

When it comes to customer presentations and tradeshows, the same rules apply with a slight tweak in messaging to reflect their market knowledge. At Brontes, we started sales pitches by saying “imagine a day when dentistry is digitized like music or photography.” Potential customers (dentists) would nod in agreement. It was a hard vision to deny and we would spend the rest of the pitch addressing why we’d be the ones to do it.

Feet firmly planted on the ground

The details support the overall vision. Once you’ve compelled the audience by describing a future state, the key is to convince that you have the plan and ability to get there.  Those of us that have started ventures know how hard it is and that most businesses are built brick by brick.

Early stage company CEOs have to shown deep comprehension and appreciation of the product and tech. CEOs should be conversant on what technology platform a given product is built on, aware of the development schedule (and how far ahead/behind the project is) and he/she must be able to demo the product. At Sample6, I spent time in the lab trying to learn how a competitive product worked. I spent time at customer sites. I’d come back with real-world anecdotes about why the product needed to be made easier to use or ideas on how to pitch it differently. Most importantly, the quickest way to lose credibility with an engineering team is to seem removed from details or unappreciative of the complexity of their work. This is heightened when times are tough.

The start-up CEO is both a general and field marshall. The challenge is balancing these two roles – internally and externally.

Handshake.com meets 2013

In 1998, I co-founded Handshake.com, a marketplace that connected buyers and sellers for all sorts of services – from carpet cleaners to auto repair shops. Since Handshake came and went with the go-go days of the late 90s, I’ve spent a lot of time thinking about the mechanics of such marketplaces. Today’s online service marketplaces have been generally more successful than our foray. Recently, I tried a few to help with the construction of Founder Collective’s new office at 27^th St in NYC.

Original handshake team going live in Dec, 1999

First, I used TheSweeten, a site that matches projects with contractors/architects.  I posted images of our current space and a crude mock-up of the build-out I envisioned. I received 3 bids from vetted contractors and ultimately selected one of them. We then needed furniture moved from our Cambridge office, so I hired a Taskrabbit to bring it to NYC. Once the build-out was complete, I used Handybook to schedule and coordinate a plumber to fix an old water purifier and a handyman to assemble IKEA furniture. And last and most importantly, we hosted our kick-off party with catering from Kitchensurfing (a portfolio company). These services aren’t yet one-click and done, but they have come a long way in making it easier to coordinate moves, construction, catering and transportation.

Last week, at an ERA event, I was asked to share my lessons learned about these types of marketplaces. Here’s what I said:

1)   Pick a vertical, not many – One of the mistakes we made at Handshake was that we offered every service we could find in the yellow pages. However, we spent way too much time and money marketing the idea of an online service marketplace. If you’re trying to create a national brand, it’s hard enough to get consumers to keep you in mind for a particular service, let alone many.

2)   Control the money flow Much of the frustration around hiring service providers stems from challenges making payments(many want cash or don’t accept credit cards), whether to pay a deposit, and how much to tip. Additionally, if the marketplace doesn’t hold the money, it is far too easy for the service provider and customer to work around the system, and avoid fees or commission. If the marketplace isn’t stepping into the money flow, it’s likely because it’s not creating enough value for both customer and supplier.

3)   Delight both customer and supplier (but hold each accountable). Uber (also a portfolio company) does a fantastic job of this. The app knows where I am and where the cars are. Its just two clicks to call a car, my credit card is on file and there’s no tipping. But I’m most impressed (and surprised) by the driver’s reactions. They love the fact that they can rate me (1 to 5 stars) … the customer!

For the full Handshake story, click here.