20 Years Later

Twenty years later, I can’t remember what I saw and what I think I saw. I remember listening to the news with my mom, Judah, and Mimi as the anchors casually mentioned that a small plane seemed to have hit a tower. We were on I-95 - or maybe the Garden State - headed south to visit Penn ahead of applications.

I looked out the window and could see some smoke. A tree broke my sightline. And then a flash of fire and a jet of smoke. Bigger than a small plane but what did I know? Also, the small plane had already hit, right?

There was still nothing on the news. Then maybe it was another small plane but something seemed wrong. And then the reports started that a big plane had hit? Or maybe two? And then we were on campus. Mostly, there was some confusion, but the day was on a crumbling routine. We checked in at the tour area. We didn’t have smartphones. There was no information. We started the tour, and soon we started to sense that hell had broken out 80 stories above lower Manhattan.

Walking into Hillel, the TV was on. The tower fell. The towers fell. My mother started to cry. My father had been there the day the van blew up. He’d left already. I was 7 then and didn’t know what it had meant.

No one knew what was going on, but the tour was over. We wandered for a short time and then got back in the car.

I-95 was empty. Not empty, just us and humvees, olive and tan trucks. It seemed that every armory in every county in all of New Jersey was empty and on the highway. Jets were overhead. Calls started going out and in to see who wouldn’t be coming home from work. Then we saw lower Manhattan. Or maybe we saw just a plume of smoke. We prayed, but didn’t cry. It was too shocking.

My sister lived, then, not close but maybe too close? She’d heard a jet accelerate overhead, she ran outside and saw another. My brother walked to his apartment. A friend’s father missed a meeting because a broken shoelace led to a missed bus led to a missed train meant he came home that night. A friend’s brother didn’t. 

The tower of smoke was bigger than those of glass and steel. Much bigger. The flags tried to blow it away but couldn’t. It cleared itself over time.

Why Build Toys

I first wrote this essay a few years ago. A founder mentioned it to me over the weekend, and so I decided to re-publish it here. One thing that's bothered me in the time since I wrote it is the way in which toys, which are meant to be harmless and fun can become companies capable of wreaking havoc on the world. I mention Facebook below, which was quite fun when it first showed up on campus. I don't personally find Facebook fun now, and think it has caused a lot of damage in the world. Thinking through the way in which you build things, even toys, to create positive forces in the universe is hard, and maybe more important for that challenge.

Some of the biggest technology companies look like toys in the beginning.[1] From a classical business building perspective, this shouldn't happen. Toys are for fun. Businesses, especially huge ones, are for making money. Toys are small and of limited use. Large companies contain multitudes and perform a huge array of functions.

This trend does not fit with history either. Standard Oil, US Steel, and Boeing were all iconically huge companies that were built as businesses. None of them went through a phase where they looked like toys. Startups can be different, though, because of the expectations of them and the seriousness with which people approach them.

Expectations

If you give people a tool and tell them it will perfectly solve an important problem, any imperfection in the tool is going to make them angry. If you give someone a toy and say “Look what I made! Isn't it fun? It kinda does this thing.” then you've set yourself up for a positive reaction. It's much easier to beat low expectations than high ones, so you've materially increased your chances at having a happy user.

And “happiness” is an important way to think about early users. People spend more time with something that makes them happy, especially when they don't expect it. Happy users are easy to get feedback from, because they know that you can make the product better and make them happier. They're also likely to tell friends about the cool new product that they're using, which means you start to get users without having to dip into the dark arts of marketing.

When you look at something you build from the perspective of how happy it might make someone vs. how angry it could make them, it also becomes easier to experiment and put things into the wild. This isn’t just about low stakes, it’s about how seriously you take what you’re doing and how seriously other people take it, at least at first.

Seriousness

Business is about making money and working with customers. These are very serious and scary things. Toys are for playing and trying new things. This isn’t serious at all.

Maybe that seems bad if your goal is to make your toy into a startup, and your startup into a big company. That implies you have to be serious right from the start. But if you are serious right from the start, a number of things start to go wrong.

The first thing that goes wrong is you become unwilling to experiment with ideas that aren’t clearly aligned with making a big company. This means that people building serious things focus rapidly on revenue. They become risk averse and innovation averse. Companies built on new technologies have to capitalize on non-obvious ideas, ones that wouldn’t pass muster in large corporations. Otherwise, the large existing companies would do these things themselves.

Facebook is a great example of this. Early on, all users could do was look up people they’d met at parties on campus at Harvard from other dorms and poke them. This seems silly because it was. Very few people saw it as more than a toy, which is why they were willing to give it time. It was something to play with when not working. I don’t think we would have been willing to play with something that felt like a serious business, which would have meant that Facebook wouldn’t have gotten it’s early happy and engaged users.

The second thing that goes wrong when you take your toy too seriously is that you signal to the bigger and better funded companies already in the marketplace that you are onto something important and profitable. This is bad, because those companies will start paying attention to your toy too early and copy/buy/kill it. Airbnb looked like a doofy hipster thing to hotels for a very long time. And then, when it was too late, they realized that it wasn’t a toy at all. By that time, Airbnb had enough customers, revenue, and funding to survive the attacks of the incumbents.

The third thing that goes wrong when you take your toy too seriously is that you immediately start optimizing on the things that you believe serious businesses should - profit and margins. While these things are important in the long run, focusing on them too early injects an impossible set of things for an early startup to do.

Startups only have so much time and ability to focus. At the earliest stages, that focus needs to be on making things that users love and want to play with. A startup’s early and heavily engaged users are its only real base of strength and chance for growth. Focusing on anything else puts them at an immediate disadvantage to better funded, organized, and wide reaching companies.

When toys become companies

Not all big companies start out as toys, just as not all toys eventually become big companies.

This is just as often a question of motivation and goal for the creator as it is a question of whether or not the toy was good or bad. Most people who make things don't want those things to become companies, which is great - it would be unfortunate if every interesting thing made for the world had a commercial purpose behind it.

The founders who do turn toys into companies are generally the ones who relentlessly push what they've made to users and obsessively improve the toy in response to feedback. They then have to master a whole set of skills that are orthogonal to making things - hiring, managing, business building, fundraising, etc.

This is an atypical path, which is why it's so exciting when it happens. When we meet founders who we think are going to combine the toys they've built with the ability to build something lasting, we generally fund them whether or not we're sure the toy is actually a business.

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[1] Two examples: Facebook was a way for people to waste time while Apple helped hackers build home computers before there was any business case for it.



Asymmetries in Fundraising

Too often, founders approach fundraising as if they are supplicants to the investors. They understand that fundraising features many asymmetries, but the founders mostly see the asymmetries that are tilted towards the investors. Here’s the thing - in today’s market, the asymmetries largely favor the prepared founder.

This is a rough catalogue of the major asymmetries:[1]

  • Experience - The more fundraises someone sees, the more skilled they are in getting what they want.

  • Capital - This is what the investor has that the founder wants.

  • Ownership - This is what the founder has that the investor wants.

  • Speed - This is the pace at which the investment process moves.

  • Information - Data on how the business is faring. Particulars about the progress of the fundraise.

  • Price - How much the business is worth.

  • Emotion - A key element in any negotiation.

Near as I can tell, there is only one item on this list that is squarely in an individual investor’s column:

Experience

Simply put, it is an investor’s job to invest. This means she does it frequently, knows the language, the paths, the places to negotiate and relent. She has a better sense of where the market is and what tactics work on founders. The best investors use their experience at an intellectual level - to evaluate a deal and rapidly make a decision - and at an emotional level - to influence what deal a founder takes and when.

Even founders who have raised multiple rounds have not done as many as a good investor, or as that investor combined with her partners.[2]

Every other item on the list can be tilted to the founder’s advantage. This is what the best and most prepared founders do.

Capital/Ownership

It is true that the point of fundraising is to get capital. Investors have that capital, and founders do not. However, this does not actually mean that the investor has the advantage because the founder has something that the investor wants even more: ownership. This may seem purely psychological, but it is important.

Investors have more access to capital from LPs than they do to equity in great startups. This seems strange to most founders, because they have not internalized how abundant capital is in today’s market.

Founders who see this dynamic for what it is have a psychological advantage when pitching - they know that they are in control, which in turn creates confidence. An investor who believes that the equity she is trying to purchase will be worth 100x what it is today will move mountains of money to get that equity.

Speed

Most founders that are new to fundraising allow investors to control their fundraising timelines. They believe the investors who say “we need to meet once a month for six months to evaluate you” or “we only have investment committee meetings on Monday mornings between 9-11am PST.” Neither of these statements are true. In fact, there is no such thing as a required timeline or minimum time spent for an investor to issue a term sheet.

Founders can largely control the pace of their own fundraises by preparing the market of investors ahead of time. This means building the right relationships over the months preceding an active fundraise and executing a tight and coordinated process when the time to raise arrives. This also means that founders should plan fundraising activities around the natural rhythms of their businesses, the calendar, and their runways.

This is even true in the case of a “pre-empted” round - a round in which the investor offers a term sheet before the founder is “ready.” Some founders believe that they need to take a pre-emptive offer, but no one will force them to do so. The most prepared founders are, however, always ready for a term sheet because they have sets of relationships which they can use to check the market at any time. These founders also know whether or not a pre-emptive offer makes sense given the path of the business.

Information

There are three types of information that influence the path of any fundraise:

  • Information about the company

  • Information about the process of the fundraise

  • Information about the market in which the fundraise occurs

I’ve written about how founders can use information to their advantage in a fundraise ( https://www.ycombinator.com/library/3N-process-and-leverage-in-fundraising), so will just summarize the major points.

Founders should assume that all information they share about their company with an investor will be public and that it will always be used to evaluate an investment in the company. With this knowledge, founders can choose who sees what information and when, creating a dynamic where investors are always pressing for more. This is a clear advantage for the founder because it allows him to control the pace of the process and manage the excitement of the investor.

Information about the process works similarly. The only person that actually knows what’s happening in a fundraise is the founder, provided the founder is paying attention. Founders should release information about meeting cadences, offers, term sheets, etc. when they choose to, and not simply when asked.[3]

The final type of information, market data, generally favors the investor. This is relevant because it informs what terms are good/bad. However, founders can significantly decrease this imbalance by talking to other good founders or to advisers who see many rounds at any given time. Price is a subset of this information set.

Emotion

There are many emotions involved in fundraising. Investors are able to approach a raise with emotional detachment since, for them, the raise is just one in a series of business transactions.[4] Founders generally experience far more emotional range and depth during a raise since their companies are extensions of themselves. While, to some extent, business is business...it isn’t.

Rather than try to balance this one, it is useful to recognize that there are emotional games played on both sides. Founders should be aware that investors work hard to get founders to “fall in love” or to believe that there are (morally) right and wrong decisions on picking a capital provider. This isn’t actually true. Investors who lose deals may be upset, but they move on. Founders who negotiate hard aren’t hurting the feelings of investors - and the same should be true in the other direction.[5]

Some of the emotions investors leverage to win deals:

  • Guilt: “Look how long we’ve known each other! Look how much I’ve done for you! Isn’t that worth something?

  • Fear: “If you don’t pick us, we will fund your competitor and grind you into dust.”

  • Greed: “Don’t you want to be rich? I’ll make you rich.”

  • Inferiority: “You’d have to be stupid not to work with us. This is an intelligence test. Don’t fail the intelligence test.”

There are more, but this is a reasonable catalogue of the ones I see most often.

The key thing to understand about asymmetries in fundraising is that they most disadvantage founders who are unprepared. I’ve always thought that Sequoia’s focus on the “prepared mind” was a useful model for approaching a consequential decision.

To the investor, a prepared mind means having the right frameworks and knowledge to evaluate an opportunity and most effectively and quickly move to take advantage of it. To the founder, a prepared mind follows the same model, but the opportunity set is different. Founders don’t need to be prepared to evaluate their business, they need to be prepared to run a fundraising process with knowledge of their strengths and weaknesses, of leverage points and norms, of asymmetries and of ways to utilize or mitigate them. There’s never going to be a perfectly even interaction between two people. That’s only a problem if you were expecting it to be.

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[1] For the purposes of this essay, I’m not going to address asymmetries of power resulting from the personal attributes of either founders or investors. These are critically important dimensions of fundraising, but are so nuanced that I only feel comfortable addressing them directly with founders vs. in this fixed essay form.

[2] This is, admittedly, not true for a brand new investor at a brand new firm putting money into a seasoned founder, but I’m going to ignore that for the sake of argument.

[3] The way in which a founder releases information - who, when, how much - is a topic for an entire tactical essay.

[4] This isn’t to say that all investors actually do approach fundraises with emotional detachment, just that they should be able to do so more easily than founders.

[5] Adora Cheung’s advice here is that founders should find their peak toughness while negotiating with investors. This is a perfect framing - tough doesn’t mean being a jerk or unfair or amoral, it means knowing and pressing your advantages.


Thanks to Adora Cheung and Janelle Tam for helping me write this.

Unbundled Capital

The way we talk about fundraising is wrong. Specifically, I don’t think that founders sell equity when they raise money. It’s the other way around - founders use their equity to buy capital from investors.[1]

Investors know this, which is why they spend so much time and money on marketing.  That marketing makes it clear that money isn’t enough to win deals, at least not the competitive ones. Investors make a big fuss about their ability to advise companies, their ability to help companies hire, and their ability to help companies raise future funding rounds. These capabilities can all be real, but, if a founder is valuing any of these items as worth more than 0, then each is worth some amount of equity.

Think about it this way: if all the founder needed was cash, then the smart thing to do would be to optimize for the least dilution to get the money needed. If the founder needs cash + advice, then the founder should figure how much dilution he needs for the cash, and how much dilution for the advice. The founder would keep doing this until he’d assembled all the required capital and services to grow the company.

For instance, the founder could say “In this next round, I need to buy capital, a brand, a board member, and help with the next round. I’m willing to spend 14% of my equity on the capital, 2% on the brand 2% for the board member and 1% on help with the next round. That means I’ll sell 20% of my company in this financing.” Founders are doing this implicitly when they pick a given investor over another because of “brand,” but it should be explicit.

This calculation will change for different founders at different stages. An experienced founder may not need help from a board member or care about the investor’s brand. This founder may decide she only needs capital, which is worth 12% of her company. That’s all she should sell in the round.

A less experienced founder that knows her next round is likely to be difficult may put a premium on the brand of the investor and the investor’s ability to help pull a round together. If each of these is worth 3%, and the market price of the cash is 15%, then the dilution on the round is 21%.

Once you reframe the fundraising transaction this way, the current model breaks down. The natural next question is to ask why any of these elements should be combined inside of a given investor in the first place. Founders should unbundle these items. This would have been extremely difficult in the past, but the market has evolved. There are now specialists at each of the things that the founder may need from outside parties. These specialists do not necessarily work as VCs. Founders should be able to pick and choose the best of each of these specialists at the best price, rather than averaging them out just to buy some dollars from an investor.

This is the fourth in a set of essays drawn from watching the interactions between investors and founders during several hundred Series A and B in the last few years (The first three are https://blog.aaronkharris.com/abundant-capital, https://blog.aaronkharris.com/distributed-capital and https://blog.aaronkharris.com/conflicted-capital). If you are wondering how this dynamic impacts your company, please reach out at [email protected]

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[1] All transactions are bidirectional, but founders use their abundant resource - equity - to buy scarce resources - mainly cash.


Conflicted Capital

I’ve spent a long time wrestling with how to advise founders about investors and the conflicts of interest generated by opposing incentives.[1] These considerations are especially important when a founder thinks about fundraising. The founder needs to figure out how to treat internals, how to balance the incentives of those internals with new investors, how to assess the various conflicts that might arise and the likelihood of those conflicts. This is exhausting and seemingly unavoidable.

Part of the analysis here is to figure out what to do with investor attestations to being the most “founder friendly,” as if this term is a talisman. Investors hold up their hiring prowess, willingness to grant extraordinary voting powers, secondary offers, etc to show how they are friendlier than everyone else. Unfortunately, no amount of upfront promises can make up for the fact that investors are definitionally conflicted with founders any time the financial interest of the LP diverges from the founder.

This conflict doesn’t make investors bad or immoral. In fact, the vast majority of the investors I’ve met, even those that have fired founders, are good people. It’s deeper than that, even. Investors mostly want to do the right thing for founders. There are emotional and business reasons for this impulse, but ultimately the fiduciary responsibility has to win. Founders need to understand that venture investing is a business where friendship is an input or an outcome, and not the other way around.

Rather than trying to tease apart every instance at which investors and founders might find their incentives misaligned, I think it would be helpful to focus on one particular divergence since it seems to surprise founders every time. This scenario plays out every time a company raises a round that an internal investor could lead. This means that the company has a multistage investor on the cap table which has the capital and mandate to lead the round in progress.

This type of conflict used to be rare, but it seems to be popping up in every round I see. Ever larger numbers of VC funds are now multi-stage, which means they generate internal conflicts at any round they want to lead. Many angels now have sidelines in running SPVs,[2] which makes them multi-stage investors with the same type of conflict as the VC. Finally, given how closely rounds now follow one another for hot companies, the time in which an investor can think about something other than her position for the next round has shrunk. Every interaction a founder has with an investor is colored by this dynamic.

To name the incentives for the founder at fundraise:

  • Least distracting process

  • Best possible terms

  • Best possible partner for building a large company

  • Balanced cap table

  • Not piss off the internals[3]

To name the incentives for the investor at fundraise:

  • If the belief is that the company is a future $100B behemoth

    • Lead the round and build ownership

    • At lowest price possible to win

  • If the belief is that the company is good not great

    • Lead the round if the price is right

    • Maintain ownership

  • If the belief is that the company is not good

    • Help the round get done by someone else to preserve brand

    • Maintain most ownership in case the company surprises to the upside

Many founders approach internals at the very start of a new fundraise, which allows the internal investor to choose first. This gives the investor significant leverage in any resulting negotiation. The investor’s decision also sends a signal to the rest of the market about the company’s prospects, which could sour a fundraise.[4] In this scenario, the founder needs to treat the investor like Schroedinger’s cat - keep the investor in the dark about the fundraise until such time as the founder wants information to leak.

This is a tricky dynamic since the internal investor often has information rights, probably wants to be helpful, but does want an early look at the deal. However, the best thing for the company would be a clean and competitive process. The “founder friendly” move here would actually be for the conflicted internal to proactively recuse himself from the fundraising conversations until explicitly invited in by the founder. This is unlikely to happen.

Instead, a founder needs to take control of the fundraising process even before talking to internal investors.[5] I generally advise founders to do something along the following lines:

  1. In the months leading up to a fundraise, create touch points with likely future leads, i.e. coffee meetings. At the very least, this gives the founder a group of investors that can be activated when necessary. In the best case, this can lead to pre-emptive offers.

  2. When the founder determines that the company is ready to raise, the founder needs to prepare a deck, practice a pitch, and decide which funds and partners are top choices.

  3. Once the founder has that set together, start scheduling initial meetings with external investors. 

  4. Once those meetings are on the calendar, approach the internals and say “Ok, we’ve got strong interest for an A, and are going to run a process, we’d love for you to take the lead here. Can we set up a formal meeting?”

    1. If the investor declines the meeting and says “we’re not interested in investing at this time,” then the founder and investor need to figure out a narrative for the rest of the world about why the investor is passing. This is unlikely to happen without first having a meeting.

    2. If the investor is interested, she’ll often ask to meet in order to “practice the pitch.” The founder should decline a practice meeting and push for a formal partnership meeting, citing the process and desire to not waste the investor’s time with a “practice” pitch.[6]

  5. Run the process.

To be sure, there are significant nuances in running a process under these circumstances. Founders would do well to have an unconflicted third party with significant experience here to ask for advice on the evolving dynamics. Barring that, remember that an awful lot of awkwardness can be smoothed over by simply being polite.

This is the third in a set of essays drawn from watching the interactions between investors and founders during several hundred Series A and B in the last few years (The first two are https://blog.aaronkharris.com/abundant-capital and https://blog.aaronkharris.com/distributed-capital). If you are wondering how this dynamic impacts your company, please reach out at [email protected]

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[1] https://blog.aaronkharris.com/investors-and-their-incentives

[2] Special Purpose Vehicle - basically an insta-fund that has a single position.

[3] There are quite a few ways to piss off the internals. The founder could take an outside offer at the same or lower price than the insider’s offer. The founder could refuse to grant super pro rata. The founder may need to renegotiate pro rata. All of these present potential problems and are even more stressful if the internal is also a board member.

[4] https://www.ycombinator.com/library/3N-process-and-leverage-in-fundraising.

[5] This principle holds at every round, but becomes more complicated once a company has a formal board. Founders should not actively hide information from the board, but do need to hold board members at arms length when appropriate. The nuance in how this is done is tricky and varies depending on the situation.

[6]There are quite a few tactical paths at this point that can only be solved with sufficient context.