The robots are taking our jobs, folks.

In a previous post, I talked about some of the reasons why it might make sense for an angel-backed startup to reject venture capital money, summarizing a great article by Darian Ibrahim.

Here, I want to summarize Prof. Ibrahim’s points about why it might actually be preferable for some angel-backed startups to reject venture capital funding.

Earlier exits

It’s long been thought that entrepreneurs wanted to continue running their startups so they enjoy the benefits of running their own ship.

However, many prominent angels, including Basil Peters, have stated that both entrepreneurs and angel investors would prefer to exit earlier because that results in a greater time-adjusted return on investment.

Also, as many are aware, many entrepreneurs suffer from founder’s syndrome. By selling their companies earlier, such entrepreneurs are able to go off and start their next big idea, instead of hanging around for years pushing a startup to some exit that would appeal to VCs.

Because VCs typically invest larger amounts than angels, they require much higher valuations on exits.  When you also consider that most performers in a VC firm’s portfolio are not that great, you begin to understand why VCs are so dependent on the homerun companies that return 1000x that keep the overall portfolio performance in the black.

Related costs & geographic flexibility

While angels typically invest in equity, VCs often take preferred stock. This adds not only complexity and costs to funding, but can even lead to different incentives for VCs and entrepreneurs/angels.

Finally, Prof. Ibrahim claims that angels have more flexibility in terms of where they live because they are not constrained to stay in Silicon Valley or Boston, as many VC firms are. In fact, some angels can even afford (because they are independently wealthy) to live in places with less dealflow.

Though these two reasons may be viable, in my opinion, I’m not entirely convinced. After all, how many angels actually choose to live someplace that doesn’t have great dealflow? In my opinion, the most compelling reason to reject VC funding is simple: you can get a greater return if you don’t dilute your ownership stake. Taking VC funding means you give up a large chunk of your company (usually anywhere between 30% and 40%) and a few board seats. If you early stage with little traction or cash flow, you might give up even more.

If you’re an entrepreneur or aspiring entrepreneur, you know that customer development is crucial. You know even more that you have to validate your idea first before you start building. Who wants to build something that no one wants in the first place?
When it comes to customer development, a lot of entrepreneurs begin by asking friends in real life or on Facebook if they like their idea. They might even go further and create a survey and blast all of their friends to fill out the survey, which asks about pain points, the size of the pain points, what other solutions people have tried, and whether or not they like the proposed idea.
These are fine starts but I argue there is a first question entrepreneurs must ask. What is it?

Why won’t this idea work?

I believe if you want to get great customer feedback, you must first describe your idea in a sentence or two and then ask people why your idea won’t work. I think it’s a better way to get customer development for a couple of reasons.

More honest responses

If you ask your friends if they like your idea, they probably do not want to hurt your feelings. “Sure, it sounds like a good idea,” they might say. “OK,” you might say. “What’s so good about it?” Because they are your friends they might repeat some of the features you told them and, in an effort to at least be constructive and offer original thought, might offer up a challenge or two if you build your idea (“Pinterest is already huge so you have to think about a way to break through the clutter.”)
If you begin the conversation by asking them why the idea won’t work, customers will have to think about the problem your idea is purporting to solve and why your solution falls short. In doing so, they’ll probably give you a more honest response (“It’s a neat idea but the problem is not that big of a deal to me to warrant paying $9.95 per month”).

Partnership

A strange psychological thing begins to happen when you ask someone why your idea won’t work. They will instinctively want to help you figure out the problem. Even though it’s a hypothetical problem you posited, humans have a natural desire to fix things. As a result, your customers will likely stop and think about your one-to-two sentence summary of your concept and will apply it to their problem. They’ll think about all the dots that must be connected to go from problem to your solution and they’ll rattle off all the issues that might keep from seeing the idea as worthwhile.
For example, if your idea is to build an online classroom for small businesses, and you asked your customers why the idea won’t work, they might tell you that they don’t trust the quality of the teachers or that they don’t think that small business owners have time to go online to take a class, etc.
For that moment when your customers are telling you why your idea won’t work, they are partnering with you on your idea. They are invested, albeit for a small amount of time, in your project. They want to help you succeed.

More ear, less mouth

By phrasing the question as why the idea won’t work, you are forced to listen to your customer. This is crucial. Which do you think is more helpful? You telling your customers why you think your idea is awesome or your customers telling you their barriers to using your product?

Conclusion

There are lots of ways to do effective customer development. To my knowledge, there is no one right way to do it. In my opinion though, you can be far more effective if you fought your optimism and instead of focusing on why your idea is awesome, and focused on all the things standing in the way between your idea and your customer, you might just have more insights.

The traditional route to financing used to begin with bootstrapping. After bootstrapping got you so far (and assuming you were not able to fund future growth with revenue), you might turn to friends & family and/or angel investors. Then, the old story goes, you got venture capital (VC) money and you were on your way to IPO glory.

That story is not true for software startups today.

According to Darian Ibrahim, one of my favorite legal writers about startups asserts, there are at least three reasons, startups who are angel-backed might actually want to REJECT VC money.

The cost of innovation is less now than it used to be

Everyone knows that tech startups today enjoy far lower operating costs than they used to. Whereas founders might have had to actually buy Sun servers back in late ‘90s, today Amazon Web Services can pretty do much everything needed in the early stages (even Quora reportedly relies heavily on AWS). Whereas you may have needed millions in startup costs before, today you might need only $250k-500k to ramp up. Founders’ largest cost today are likely to be the cost of acquiring and keeping top engineering talent.

Professional angel groups can facilitate larger deal flow.

The traditional reason for getting venture capital funding is that VCs could inject much larger amounts of money into the startup. This is still true today. But, as discussed above, because the costs of running a tech startup, especially a web-based one, are so much lower today, professional angel groups (like Tech Coast Angels) can facilitate much larger deals and handle greater deal flow. The result could be that you could get most, or all, of the funding needed to ramp up.

Angel-backed companies may find strategic M&A easier than IPO

By comparison, the way VC funds are structured, the incentives are to go for the HUGE 1000x exit, which is most likely an IPO. However, the IPO market, especially for tech companies, is worst today than it ever was in the late ‘90s. In addition, regulatory changes, such as Sarbanes-Oxley, have made the IPO route more costly for startups. As a result, the IPO route for tech startups is a lot harder than it was back in the day. Sure, there will always be some startups that go public, but ask yourself this: if you were around in the late ‘90s, does the level of tech IPO today compare with that time?

Startups, on the other hand, might prefer a strategic sale to a larger company. Indeed, today, the big trend in exits for startups is M&A or the acqui-hire.

Some problems exist in the VC framework relative to current trends.

Lock in

One problem with VC funds was alluded to above. Simply put, VCs need a HUGE exit to be profitable. Once you take VC money, you might be “locked in” to the company for a much longer time than you might want to be. Remember that VCs will take a few board seats of your company so they run the company

Investment in preferred stock rather than common stock

VC typically invest in preferred stock, as opposed to common stock like angel investors. I will get around to posting why preferred stock is so different from common stock and how it can cripple young startups. Suffice to say that the upshot of all this is that VC’s incentives are different than the founder’s. This is something to consider.

In a future post, I’ll talk about why it might actually be preferable to get only angel funding. [Note: future post updated here]

One question that comes up a lot is what investors look for when investing in an entrepreneur or a founding team (and, mind you, for the most part investors are putting money into the team, not necessarily the product).

To help put a framework on this, below are some criteria that investors use when they evaluate YOU as a founder. So, without further ado, let’s get to them.

Intangibles

Investors, first and foremost, look at your intangibles. If you’re a football fan, you know that beyond raw athletic power and positional skill, many coaches and scouts look for the “intangibles.” A similar happens when investors are deciding whether or not you are someone they want to invest in. The criteria vary by investor, so it’s hard to pin down exactly what they’re looking for.  I think a fair representation of the intangibles includes (1) business savvy, (2) ability to keep your ego in check, and (3) your appearance.

By business savvy, investors want to see that you are deeply knowledgable about your target market, beyond mere internet research. Do you have a list of contacts in your industry who could be customers, evangelists, or ambassadors? Do you have deep and well-reasoned insights into the future of the market?  If you have previously spoken to an investor about your idea, have you made progress since then? Better yet, have you been able to generate revenue?

Business savvy also includes a certain amount of leadership skills. Investors want to see that you can partner and delegate effectively. After all, n people can get more done than 1 person. Also, are you able to lead and work well with others?*

The next general intangible that investors look for are your ability to keep your ego in check. Regardless of how brilliant you are, you don’t know everything. More likely, you probably do not experience managing and leading a team as your revenues grow exponentially. That’s when you’ll get a lot of “coaching” from your investors. You’ll get straight up criticism about your business, revenues, and management skills. Don’t take it personally.

Finally, this is admittedly somewhat wishy-washy, but investors want to believe that you can look professional. What does this mean? Well, it means different things to different people, but at the end of the day, you need to look appropriately professional for your business and you need to speak and communicate your concept in a way that inspires business confidence.  It’s unfortunate, but in some way you need to fit your potential investor’s stereotypical picture of a successful entrepreneur. That’s one reason, among many, why you need to strategically choose your investors.

* n > 1, obviously.

Traction

The next big intangible is traction.  One thing traction refers to is your ability to take the concept out of your head and into a product or prototype. It also refers to your ability to attract talent to take your product to the next level. Obviously, it also refers to your product’s traction with consumers or customers.

But traction also refers to whether or not you got traction other investors. On a certain level, investors are timid. They want to know that you passed someone else’s gut check. If other investors have invested in you, this mitigates their risk.

Execution

The third intangible is execution. This is a malleable concept but it basically refers to your ability as a business manager to effectively use money. Obviously, one reason you are going to investors is for money. They want to know what you will do with it. They want to know how you manage your priorities and delegate your time and efforts.

But it also runs deeper than just what you will do with money. Investors want to also know if you externally driven. That is, would you still push your product and company forward even in the absence of money? Obviously, if you are the type of person who can only envision moving forward if you had money, then some red flags might be raised.

Concept

Last, but not least, we have the concept as the final criteria by which an entrepreneur can be judged. Obviously, if the concept viability (ie. Market opportunity) is not strong, then there are questions as to your business savvy and thinking process.

Investors also want to see that you are actually talking to customers and capturing market demand. The best measure of concept viability is whether customers are actually buying your product or have signed letters of intent saying they will buy your product. At the end of the day, investors are money people and they understand the language of money. No one can argue with actual revenues coming in.

If you outsource blog content development (or any content development for that point), you have a variety of options from Fiverr to oDesk to Craiglist and everything in between. Often, these arrangements are pretty simple and it’s very unlikely anything will ever happen that would cause you or the contractor to litigate.

If you run a business that has a good amount of revenue and you outsource content development, you might need to enter into longer-term arrangements with your blog contractors. In that case, here are some things you should consider in order to minizethe chances of litigation.

Ownership of content

Ideally, when negotiating a contract for outsourced content, to make sure the contract states that you own the intellectual property behind it. This includes not only the content itself but any related code and designs. If this provision is missing in the contract, your contractor has a good argument that she owns the content.

Sometimes, you might not get this in a contract. Instead, the contract might state that you have a license to use the content for the purpose it was created. In that case, make it clear who owns certain rights to the content. For your purposes, make it clear that you own all the rights necessary to use the content in any way that is necessary.

If the contract contains a “residual clause,” try to negotiate to remove it. A “residual clause” gives the contractor the right to resuse her content. Obviously, if this happens, this might divert traffic from your site or otherwise be detrimental to your business. Instead, try to negotiate for a provision where the contractor assigns your company the copyright in the content created. This means the contractor gives you her copyright for the content. You can negotiate creatively for how the rights are assigned. For example, you might negotiate for a temporary grant of copyright or within a certain geographic area or use.

Sign up for my newsletter

Warranties

Get warranties that, among other things, assures you that the contractor is responsible for getting copyright licenses for any third-party works she uses. Also include a warranty that the contractor will indemnify you if another party brings a claim against you.

Trade Secrets

Include a provision that states the contractor will keep any trade secrets confidential.

Right to Terminate Agreement

Include a provision that states you have the right to terminate the contract at any time.

Scope

Make sure you define the scope of the contractor’s work and what happens in case the work goes out of scope.

Every venture financing has to involve lawyers. But not every lawyer is suited for your venture financing.  Here’s the deal with lawyers and what they can (and should) do for your for your venture financing.

Education and Negotiation – An experienced startup lawyer should have lots of VC financing experience. Your VC obviously should have lots of VC financing experience. You know who doesn’t have a lot of VC financing experience? You. That’s where a good startup lawyer can be helpful. If nothing else, she can educate you on the stuff that matters and does not matter. She’ll be able to negotiate  more effectively than a lawyer who has no deal experience. She’ll likely have a good reputation and your choosing her will reflect excellently on you.

Focus – When you get that term sheet or definitive financing agreement (subject of a future post), you’re going to have a million questions. You’re going to (and you should) ask above every word in that document. Some of it will seem like Greek. Honestly, most of it should. A good startup lawyer is going to guide you and get your attention on the stuff that matters.

Sign up for my newsletter

Capped Fees – A good and experienced startup lawyer is going to cap her fees. If a lawyer doesn’t agree to do this, then you have to question how experienced she is in the startup space. Pre-funding, a startup lawyer may even defer fees until you get funding or waive payment, preferring to get warrants or some other equity compensation.

So you know about the structure of venture capital firms. Truth is, though, your first funding source (besides friends & family or
bootstrapping) will probably be an Angel investor.

Angels usually invest in the very early stages of a startup (also called the seed stage). A little different from venture capitalists, Angels have a more diverse background. Some are professional investors, some successful entrepreneurs, others are well-to-do techies, and some are just rich people with money to burn (kidding, they would never burn that money by investing in you!). They fit the definition of an accredited individual.

Individual Angel investors usually make smaller investment amounts. It varies, but $25,000 isn’t unusual.

Recently, the rise of the Super Angels has been well-documented. These Super Angels are sort of like mini-venture capital funds. Super Angels are very experienced and well-known entrepreneurs who invest larger amounts than traditional Angel investors. Their experience, money, and connections can really help startup companies.

What You Need to Know

Sign up for my newsletter

Angel investors are as diverse as founders. Some are active, while others are passive (the difference between “smart” money and “dumb” money, which is the subject of a future post). If your Angel group is a small group of friends, you should consider setting up a limited partnership as a vehicle for them to invest. Make sure it’s controlled by one of them. This way, they can invest together and you don’t have to chase down 20 people for signatures.

The best time to form relationships with Angels is before you need money. Here in Southern California, Tech Coast Angels is active in the startup community, so it’s pretty easy to meet Angels. As you get to know them, you will develop relationships with Angel investors, making it easier to raise money down the line.

I went to the first LA Demo Day today in Santa Monica, sponsored by just about every top VC firm in SoCal. First impression is that it was really cool. Free admission to give everyone a chance to come, especially those can’t afford inflated ticket costs.

Here are some thoughts.

The Good

Free to attend – As mentioned above, it was free to attend, which was just absolutely crucial to ensure a great launch event.

Great location – The Miramar hotel in Santa Monica is awesome. Great old hotel next to the beach!

Variety of companies – We saw companies that aim to disrupt air travel (SurfAir) to companies that help find you a puppy sitter (DogVacay). Really highlights the diversity of talent and vision in LA.

Well-organized – From the pitch room to the check-in, logistics were great. The AV was working (mostly) flawlessly. And the air conditioning didn’t fail us.

Energy – Such great energy from all those in attendance. LA is on the rise. Enough said.

Jason Nazar – Jason, CEO of Docstoc, is emerging as the face of the LA startup scene. He’s smart, engaging, and (as Mark Suster puts it) svelte! Obviously, he will have an amazing career. Let’s hope he stays in LA.

Spots for improvement

No food – The event ran from 1p – 5p and no food was provided. Again, this was free, but come on. People gotta eat. And would it hurt to have soda?

LA referenced in terms of Silicon Valley – At one of the judges’ panel, one of the judges (I think it was Mark Suster) said that one of LA’s strengths is that it’s not Silicon Valley, in the sense that people in LA think about creating a business that makes money (agree with this). There were a lot of other comparisons to the Valley throughout the day that I can’t quite remember at this moment. LA pride is great but I’m not sure why it’s necessary to define oneself in reference to another. LA should develop its own identity without having to compare itself, implicitly, to Silicon Valley.

Jason Calacanis – Jason was a panel judge. He’s entertaining and funny. But he’s also abrasive, condescending at times, overconfident. Is he really the best ambassador the LA tech scene? Actually, given those qualities, he might just be.

Conclusion

Overall, this was a great event. Can’t wait for the next one. And I hope OC has its own demo day so I don’t have to drive up to LA.

VC kitty

Your friend might tell you he has a connection to a venture capitalist. Great, you think, now I have connection with someone who can get me money. Before you get too excited, understand the hierarchy of a venture capital firm and what that means for you. Not everyone at a venture capital firm has the authority to pull the trigger on your startup.

Let’s go through the totem pole of a venture capital firm.

Managing Directors or General Partners

At the top of the pyramid are the managing directors or general partners. Venture capital firms are structured as general partnerships and the managing directors or general partners take home the most pay. The buck stops with these folks. They make the investment decisions and will sit on the board of the companies in which they invest.

Directors or Principals

Below them are the directors or principals. Directors or principals often have significant deal experience and responsibility. They will, however, require the pull of the managing directors or general partners to get a deal all the way to funding.

Associates

Below the directors or principals are the associates. These are usually post-MBA hires. Sometimes, they have worked their way up through the ranks without getting an MBA. Associates typically work for a director or principal and do a whole lot. Sometimes, they get involved in sourcing deals, due diligence, or writing reports. They spend a lot of time also making capitalization tables (cap tables are pretty techy and will be the subject of a future post).

Analysts

Below the associates are the analysts. These are the bottom of the totem pole. Analysis are the most junior people and are usually newly-minted college grads (though from the best schools for tier one VC firms). Analysts will play with Excel and Powerpoint all day. Sometimes, superstar analysts will be promoted to associates. The usual track, however, is that analysts are on board for a couple of years and then move to something else, usually business school. At some firms, analysts take on some of the responsibility of associates.

Other Members of Venture Capital Firms

It depends on the firm, but some venture capital firms have Entrepreneurs in Residence (EIR). They might have the coolest job on earth. They are usually smart and experiences techies or entrepreneurs while playing with ideas and/or technologies that could be a fast-growth business. EIRs are usually on board for on a temporary basis, anywhere between one and three years. Sometimes they get paid. Sometimes, they just get office space.

What You Should Know

Obviously, if you know a managing director or general partner, you truly have an “in.” More likely, your friend (or you) might know an analyst or associate or director/principal. Make sure you develop and grow your relationship with them but also make sure you can get opportunities to develop a relationship with the managing directors or general partners. These people make the investment decisions, sit on your board, and have the real clout at the venture capital firm. You deserve an opportunity to see if their will align with your vision for your startup.