Why VCs sometimes push companies to burn

Originally posted on the YC blog, here: https://blog.ycombinator.com/why-vcs-sometimes-push-companies-to-burn-too-fast/

In Investors and their incentives, I tried to give a broad breakdown of the incentives that drive the major types of startup investors. I want to dig deeper into a behavior that VCs sometimes exhibit which seems strange from the point of view of founders. Despite praising frugality, VCs sometimes push companies to spend more money, faster. Sometimes this leads to faster growth. More often it leads to empty bank accounts. I've seen a number of companies get killed by this dynamic, and it took me a long time to understand why it happens.

Misaligned Incentives

Though VC firms generally act in ways that they believe are most likely to help a company succeed, their incentives can become misaligned around questions of burn because of uncertainty and time. Since VCs know that most of their returns come from a very small number of bets, they need individual partners to spend large amounts of time with the companies that they've funded. That time is required to help (in the best scenarios) and to figure out which bet is actually worth further investment of time and capital. In an ideal world, VC firms would be able to increase partners and investing capital whenever they want to add investments. That would, however, require infinite accessible capital and ever larger partnerships. The first doesn't exist and the second would be hard to manage and support.

Funds are also under pressure to produce returns within a given timeframe in order to demonstrate quality for raising further funds. These capital raises are important because many VCs make more off of management fees than they do from investing well.[1] The most important thing for the near and medium term success of a firm is its ability to generate more fees. With an average fund life for early stage investors of 10 years - and a pattern of raising a new fund every 2-4 years - VCs must show some kind of progress. There is rarely enough time for a firm to return capital to LPs before raising a new fund, so they use private valuations to mark their portfolios up or down. If a fund can show a material markup, they have an edge in marketing for their capital raise. While funds that don't produce meaningful returns to investors generally fail after a while, it takes a really long time for that to happen.

Combining these two incentives creates a situation in which it is better for a VC firm to push a company to demonstrate success or failure quickly rather than move more slowly. Companies that succeed quickly lower the uncertainty involved in investing further in that company, and justify the amount of time spent by an individual partner on that investment. If a company is doing well it is also likely to attract new investments at higher valuations, which allows the firm to mark up its investment.

Conversely, companies that fail remove themselves as a time commitment for a partner. That's not an ideal outcome, but it means that the VC firm can refocus energy on companies that are doing well and on finding new companies to make up the valuation lost through the failure of one piece of the portfolio. The faster this happens, the better for the investor.

The worst situation for a VC is one in which the firm has made a significant investment in a company that just muddles along, constantly threatening success and failure. These companies require a lot of time and effort to figure out whether or not they can be saved. They generally generate significant team drama which investors sometimes mediate. They often present difficult bridge financing questions, and they rarely function as good marketing fodder.

How Founders Should Respond

Figuring out how to deal with these pressures is important, and varies depending on your relationship with your investor. The most important thing to remember is that the CEO controls the bank account. Investors can pressure founders to spend faster, but they cannot force them to do so. Founders need to have their own understanding of where and when to spend money, and what rate of spending makes sense.

Next, remember that promises of more funding made when things are going well aren't worth much. All that matters is the money currently in your bank account. It can be easy, during heady days of growth, to justify any and all expenditures. I've talked to founders who have done just that, saying that they need to hire more engineers to develop new features for new users or that they need to spend on advertising to ramp up acquisition. Invariably, they talk about how investor x or y told them that they're special and had promised to keep funding them no matter what. Investors will often point to the burn at successful companies like Uber to prove that spending is good. Founders will sometimes accept this logic without thinking deeply enough about whether or not the lesson applies to their own situations.[2] A company can get away with this so long as growth is working, but as soon as that company goes sideways, spending becomes problematic.[3]

The closer your company edges towards “not likely to return a meaningful part of the fund,” the faster investor capital will dry up, no matter the promises made early on. This is where investor incentives diverge from those of the company. As the investor gets surer that the company will fail, the investor usually pulls back. As the founder gets closer to failure, the founder's need for active engagement and help grows. This mismatch can kill companies and relationships.

It may not be surprising, then, that the more money a founder has in the bank, the stronger their position when fundraising. In fact, we've seen a few YC companies raise financing rounds without having spent any of the money from a prior round. They do this because they get offered very friendly terms. They can do this because they've figured out how to grow without spending lots of money.

The Second-Worst Case

When incentives start to diverge, one of two things can happen. The first case is a bit better, though not great for the founders. There are times where the VC will see a failing company and decide that success is still possible. When this happens, the VC may invest more into the company but will only do so on terms materially more favorable to the investor than would otherwise be the case. This results in significant loss of control and equity for the founder, and may involve the founder being replaced. Whether or not this happens depends on how much leverage the founder has left, and as a bank account approaches 0, leverage decreases asymptotically.

Still, the company may survive.

The Worst Case

The company runs out of money.
__
[1] https://hbr.org/2014/08/venture-capitalists-get-paid-well-to-lose-money
[2] I addressed a bit of this here: http://www.aaronkharris.com/exceptionalism
[3] My partner, Dalton Caldwell, wrote a great post about what you should do if you find yourself in this situation: http://www.themacro.com/articles/2016/01/advice-startups-running-out-of-money/.

Thanks to Craig Cannon, Paul Buchheit and Dalton Caldwell for your edits. Thanks to Paul Graham for initially explaining this dynamic.

Fundraising isn't predictable

I recently had a conversation with a founder who'd just finished a number of unsatisfying conversations with investors. The founder's company was growing well, had crossed $1mm ARR, but still couldn't raise money. According to conventional wisdom, that should have been enough to open some checkbooks. Unfortunately, that's not how fundraising works.

This is strange because of the way we generally talk about startups. In attempting to set up the kinds of experiments on which startups are built, we tend to put precise milestones in place to gauge results. This is great when measuring progress, but it implies a false sense of precision with regard to raising money.

I've started borrowing a concept from insurance to frame this problem: Parametric triggers. Parametric triggers are a tool used by insurance companies to govern payouts from policies. These triggers remove subjectivity from the claims process by using independently verifiable, empirical evidence as the decision tree for claims.[1] Applying this concept to fundraising would mean that there is a precise set of things a startup could do to get funding. That's how we'd all like it to work, but there are no specific events that will automatically get money from an investor.

In reality, fundraising happens for companies under a ranged set of conditions. Those ranges and the accompanying outcomes are generally different for different companies, or even for the same company at different times. To make matters even trickier, those ranges are only apparent in hindsight when looking at aggregate information about a large number of deals. What those ranges don't tell you is where the actually successful companies sat in those ranges.

This dynamic is apparent in the aftermath of Demo Day at YC. If you were to isolate on a single characteristic of companies within a batch (say, revenue), you'd find companies with impressive revenue growth failing to raise capital, and ones without much revenue raising significant capital. In a parametric world, this wouldn't happen.

The reason this does happen is that parametric triggers are a great tool for deciding what to do about something that happened in the past. In insurance, parametric triggers determine a specific payout for a specific event - an earthquake of 4.7 magnitude will pay a policy, while one of 4.6 will not. Parametric insurance doesn't account for costs after the event or the payout. The system has all the information it needs to make a decision at the decision point.

Investing in startups isn't about what has happened. Investing in startups is about what will happen. Investors are trying to find small companies that will become multibillion dollar ones. They use past performance as an indication of the quality of the founders and the idea, but no metric is a perfect predictor of the future. The ranged conditions that investors often use as filters - i.e. 15-20% growth per month for SAAS companies [2] - are useful tools to use when sorting for worthwhile conversations given limited time. Those filters are never sufficient for actually making an investment, and every investor has a different framework for making that final decision.

When investors turn down a deal, the good ones will give the founders at least one reason. This may take the form of “we don't understand how you can scale,” “we think there are too many competitors,” or “we don't think you're growing fast enough.” While it is important to think about the reasons given, never assume that the only thing between you and the investment is proving that you can solve for that condition.

What you actually need to do is figure out what pieces of evidence you can use to create a future for your company that investors would be foolish to ignore. This will likely require some mix of your traction, the market you are attacking, and how impressive you and your team are. You also need to recognize that there are contra-indicators of success which investors have been trained to recognize. If they see a small ultimate market with no adjacencies, then incredible early growth has no chance of producing a big company, so they will pass.

Much has been written on how to pitch and fundraise, which is part of the problem. Founders are drowning in examples that seek to turn fundraising into a deterministic process. Accepting that it isn't is a counterintuitive and critical lesson in fundraising successfully.

Here are examples of meaningful achievements that won't automatically get you funded but will get an investor's attention and can be used as part of the story you tell:
  • $1mm ARR
  • 10% weekly growth
  • Repeat founders who were previously funded
  • 2 Fortune 500 pilots, 5 in pipeline
  • Engagement rates that are higher than Facebook

Fundraising is a frustrating process that resists well-meaning attempts to make it into a predictable science. That's actually quite fitting, though, since while much about startups can be measured, that measurement never guarantees success. Success comes from using the unique advantages you have and combining them into a coherent, self-reinforcing story and product.
__

[1] https://www.wikiwand.com/en/Parametric_insurance
[2] http://tomtunguz.com/mrr-growth/

Thanks to Craig Cannon, Dalton Caldwell, Sam Altman, and Andy Weissman for your edits.

Investors and their incentives

It is incredibly important to understand the incentives of investors when you are raising money. This used to be fairly easy - you raised money from Venture Capitalists who wanted to see a big return on their investment. The best of these investors were incredibly focused on doing the one thing they did well: investing in technology companies.

The world looks different now. There are a lot of different types of startup investors, each with a different approach to investing and different incentives for doing so. While they’d all prefer not to lose money, the differences in how their incentives and expectations are structured are critical in understanding how to decide whether or not to work with them, how to negotiate with them, and how to interact with them over the lifetime of your relationship.

Below, I've tried to highlight the key motivations and structures of each of the investors you are likely to encounter. While I haven't attempted to catalogue all the ways in which the incentives of investors influence their behavior - sometimes to the detriment of the startup founders - this should work as a starting point to think through those issues.

One big incentive difference that I've chosen not to address here is preferred vs. common shareholders. That creates a whole other set of questions that is out of scope. Assume the investors below will hold preferred shares.

VC Firm
The classic startup investor that is primarily working to achieve returns for the funds they’ve raised from a set of Limited Partners. The partners at these funds are usually paid in two ways: they earn a % of the funds that they’ve raised and they earn a % of the return they make on the total fund from which they invest in you. These firms generally raise further funds based on the performance of earlier investments.

While investors make money off their management fees (the % of what they've raised), the big pay outs only happen when they return a multiple of the total capital raised. Because of how concentrated venture returns are, VCs generally invest only in deals which they believe will return all or most of their returns.

Angel [1]
Usually a wealthy individual who invests their own money in startups. Sometimes these are people that made money through their own startups. Sometimes they are coming from different industries, and sometimes they inherited their wealth. It can be useful to know which category of angel you are talking to.

Angels have become hugely important to early stage startups as the number of companies have grown beyond the financing ability of traditional funds. More importantly, the wide distribution of Angels has materially decreased the access barrier which founders face when raising capital.

There are a lot of different incentives at play for Angels. While many of them are hoping for huge financial returns, many also want to be able to brag about having invested in a hugely successful startup. What's strange is that Angels often just want to brag about investing in startups, regardless of the success of those companies. Investing in startups has become a badge of pride in a lot of circles.

Though most angels invest as a part time activity, there is a wide range in the amount of time and effort they devote to investing. Knowing that they have other things on their minds should change how you approach and interact with them. You also need to understand how experienced they are, the size at which they invest, and how much time and energy they'll actually spend on their investing.

At one end of this spectrum, you'll find angels who are essentially small seed funds. They invest significant amounts of money in startups, and do so frequently. In the best case, these investors have a deep understanding of the companies in which they invest and can be incredibly helpful. These investors understand that they are likely to lose all their committed capital, understand the standard terms and instruments through which startups raise money, and are generally low maintenance.

At the other end of this spectrum, you'll find small, inexperienced investors who just want to invest in startups wherever they find them. These investors will put a small number of small checks into whatever company they can get into. Because they are unfamiliar with how startups work, they are often hard to deal with and incredibly focused on the risk of losing their principal. These are investors you should avoid unless you absolutely need them.

Accelerator
Accelerators are, for the most part, a subset of VC firms where there are professional investors who raise funds from outside parties to invest in startups. They usually fund more companies than classic VC firms, and do so in batches. Similarly to a VC, most accelerators need to demonstrate return to investors to continue to raise funds.

Accelerators also have a non-financial incentive - they need breakout successes to prove that they are providing operational help to companies and actually “accelerating them.”

Syndicate
Syndicates come in a number of different flavors, but are generally groups of angels who come together to invest in a single deal. Usually, these syndicates have a lead who will be your main point of contact. This lead usually puts money at risk for a return and gets some sort of performance fee for the other funds that they bring into the deal.

Watch out for syndicates where the syndicate runner is taking a management fee on funds raised and is encouraging you to raise more money than you think is wise. Also, be careful with syndicates since you don't know ahead of time who will invest in your company, and might find that one of the investors is a direct competitor who just wants some privileged information.

Crowdfunder
Any and all comers on the internet who pre-order an unbuilt item in the hopes that it will some day get built and be cool/solve a problem. They’re not expecting financial return, but do want regular updates on what’s going on with the project and when they can expect delivery. Hiding problems is a lot worse than transparently failing to deliver.

Family and Friends
While your friends and family are probably hoping to get a huge return from their investment, they’re more likely motivated by wanting you to get a chance to succeed and be happy. They are unlikely to try to negotiate terms, though in contrast you will feel the worst for losing their money. Take money from them if you need it and only after making sure they fully and completely understand that they are likely to lose anything they give you. You also need to be okay with losing all of the money someone you care about gives you. If you don’t think this is true, don’t take money from them because it will likely hurt your relationship.

Family office
These are the private investment vehicles for super high net worth individuals and families. Whereas some individuals invest their own money as angels, those that get to a certain scale often employ staffs of portfolio managers and investment professionals. There are many different structures here. Some family offices are structured like single limited parter hedge funds with a high tolerance for risk, and others are structured more conservatively. Whatever the risk tolerance, the staffs of family offices generally get carry on their investments as well as salary, which introduces some of the incentive dynamics present at VCs.

Generally, these entities are very concerned with not losing their principal. Whereas a VC fund that loses an entire fund will have a hard time raising other funds, a family office that loses all its principal has no recourse for more funds. Generally, if you get an investment from a family office, it will come from a small portion of a portion of an overall investment portfolio.

Corporate investor (direct)
There are a lot of corporations that like to talk about investing in startups. Some of them actually do this, and some do not. When an investment comes directly from the company's balance sheet at the direction of a particular business line, the corporation is usually looking for strategic value from the investment. Most of these companies know that investing in startups is unlikely to change the valuation of the investor.[2]

This means they either want an inside edge to acquire you at some point, or believe that investing in you will help improve their bottom line. They may want to prevent you from selling to competitors in the same space, and may have other confusing and onerous ideas. This is because their incentives are different that those of most startups - they are more concerned with how you can help them than with how they can help you get gigantic.

Corporate investor (venture arm)
While corporate venture arms have some of the misaligned incentives of direct corporates, they generally have a mandate to generate financial returns for the company's balance sheet. This means they act more like VCs, and are typically more conversant with how startups work.

Government
Governments have many reasons for investing in startups. There are many government grants available in various countries that are designed to promote startups as way to increase job growth. There are also government agencies with their own venture funds, generally designed to fund technology that will help the government in the long run.

University endowment
University endowments are similar to family offices, but they represent an endowment. They are designed to produce returns to fund the university over time. These entities do not generally invest in early stage companies except in conjunction with a fund with whom they have a strong relationship.

Seed fund
Seed funds are VC funds that write smaller checks at early stages of companies. They usually have the same incentives and structures.

Hedge fund
Hedge funds are largely unrestricted pools of capital. Traditionally, these were focused on public market investments, though in the last few years have started investing in startups. Generally, they invest in later stages and are looking for returns on capital as they have LPs and similar incentive structures to VC funds.

Mutual fund
These are large pools of capital run by portfolio managers. They don't have LPs, rather they have large groups of retail investors who buy shares in the funds, which capital they can then deploy. These funds only invest in late stage startups, because they need to deploy a lot of capital to have any kind of impact at the portfolio level. These managers are paid based on performance, and often have reporting requirements that cause them to publish their internal marks for private companies. This has caused a lot of consternation lately as Fidelity has been publishing widely oscillating valuations for a number of companies like Dropbox.

Sovereign wealth fund
These are the largest pools of capital in the world, and are essentially very large family offices for entire countries. These funds are large enough to invest in any and all asset classes that the managers believe will produce a return on investment. Like mutual funds, these funds rarely invest directly in startups - they are more likely to invest in funds that do.

In the last few years, however, a number of them have begun to invest directly in startups. While the managers of these funds are generally paid on a performance basis, there are a lot of other complicated incentives in place at certain funds deriving from political requirements. These are pretty hard to parse.


__
[1] I don't actually love the term Angel as it seems insufficiently precise given the wide range of investors to whom it applies. While it would probably make sense to find other terms for subgroups, the key thing to know is that. Maybe we'll try to rename them down the road.
[2] Yahoo's investment in Alibaba is a rare exception to this rule.

Thanks to Paul Buchheit, Geoff Ralston, Daniel Gackle, and Dalton Caldwell for your help writing this.

Carts without horses

Investing in emerging markets such as India, Kenya, and Nigeria isn’t quite what I naively thought it would be. Before I started, I thought that finding a good company in an emerging market would just mean copying models that worked in developed markets. All I’d have to do is figure out how the business would need to be tweaked for a lower price point, identify the best founders working on the problem in the new market, and invest in them. Any structural difference in the new market would just serve as a barrier to other companies from moving in. In the last few years, though, I’ve learned that while this is one way to invest, it’s unlikely to identify the largest companies that have yet to be built. I now think that the better way to invest in startups in the developing world is to ask “How would you solve a problem if you started fresh with today’s technology?”

This probably seems like an obvious question, and one that founders and investors should be asking themselves with any opportunity. But, one of the more surprising things that I've learned is the degree to which the sequence of technological adoption changes the opportunity set available to startups and how we think about them. This isn't something you can actually see when looking at a single market, it's similar to comparative literature where each pair of markets that you examine in tandem illustrate the differences and gaps.

Credit cards and payments are a good way to illustrate this dynamic. We'll use the US as the base case. The US has an extensive and well established financial system, from trustworthy savings banks to a wide array of credit options to standardized and reasonably secure systems for transferring money. When M-PESA, Kenya's mobile money transfer system launched in 2007, Kenya did not have many of these pieces of infrastructure. What they did have was an unmet need to quickly and safely transfer money over long distances. They also had Safaricom, the largest cellular operator in the country. Not only did Safaricom provide the phones and coverage needed to make transfers possible, their network reached more of the population than the branches of any bank. On top of that, the banks lacked the lobbying power to kill off an upstart that was actually being run by a powerful company.[1]

Contrast this situation with the one faced by companies like Venmo on launching in the US. The foundation of the market is different here, with huge amounts of regulation governing money transfer alongside a fairly sophisticated (if not perfect) system to send money. Mobile money is just a convenience in the US and also faces barriers to widespread adoption from entrenched technologies, user behaviors, and regulations. In contrast, mobile money is a solution to a deep and unmet need in Kenya with a relatively green field from competition, regulation, and behavioral norms.

M-PESA wasn’t a startup that investors had access to, but let’s pretend it was. If those investors had focused on how a payments company would ever make significant revenue given the small size of the average transfer, they would have missed the opportunity to invest in a system that was handling 25% of Kenya’s GNP in 2013!

Something similar is currently playing out in India. Imagine if the first credit cards had been created today, with ubiquitous smartphones, rather than in the late 40s. Instead of serial numbers printed on paper[2], you’d probably have an app tied to your phone and some uniquely verifiable identity token. It would be easier and more efficient to create a vertically integrated system that combined the features of multiple players within the payments stack. This is the situation in India, where there are around 20 million credit cards and 220 million smartphones. Credit and debit cards aren’t a big thing there, which is why payment is so often handled in cash. In fact, they have a Cash on Delivery (COD) rate of close to 80% for goods purchased online[3]. That means that there are opportunities to build startups in India that look like credit card processors in the developed world, but there’s an even bigger opportunity to invent a new way for people to pay, and to own all the pieces.

It probably makes sense to always try to identify the optimal solution to a problem no matter where you are investing. However, finding ideal solutions is harder to do in developed markets because there are layers and layers of infrastructure, technology, and regulation that have gradually built up around most big problems. No matter what approach you take to a problem, those factors will influence how you think about it.[4]

It seems to me that the best investors are those that can most clearly articulate this thought process and hold onto it while accommodating the particulars of a given market. This is the underlying logic for investors who talk about the importance of identifying new platforms, or of catching the next wave. The companies that fit these criteria rewrite the rules of how their markets work by building entirely new foundations of infrastructure and user expectations. By doing so, they unlock the types of huge opportunities that you'd otherwise only expect in a developing world market with a clean slate.

While some great founders may think this way, many of the best simply have a vision of the world as it should exist that’s only possible with what they are making. Rather than trying to work around barriers, these founders either ignore them or are naive about their existence. Either way, they end up building things that others would have deemed too hard or pointless because of all the things other people had done. I think that's why so many great companies start as projects without much attention to commercial relevance.[5] When you start thinking about all the million different things that an existing market imposes on a new idea, it can be enough to stop you in your tracks. That's not to say that great founders ignore the market. What they actually do is react rapidly to what their companies encounter on first contact and move quickly to adjust and get better.

Developing markets are a kind of mirror of the future, or maybe of the present if things had happened differently. As such, they're hugely instructive in understanding the types of companies that can be built, and of the founders who can build them. I think it’s clear that there will be huge startups built in the developing world. More importantly, though, thinking about how and where those startups will occur forces us to think about solving problems from first principles. Starting with a clean slate lets founders and investors think about how to change the world as quickly as possible, rather than incrementing their way forward.

__
[1] The Economist has a great analysis of M-PESA’s success here: http://www.economist.com/blogs/economist-explains/2013/05/economist-explains-18. Sorry about the paywall.
[2] I was recently in the office of a Final (https://getfinal.com/), where Aaron Frank showed me a bunch of the early charge and credit cards. They have them in lucite boxes, like really valuable baseball cards, which I thought was really cool.
[3] As crazy as it might seem to hand cash to the UPS driver when he delivers your latest Amazon order, that’s exactly what happens in India (minus UPS and probably Amazon).
[4] There’s an echo here of George Oppen’s belief that it is impossible to actually be objective when writing because of the degree to which bias is ingrained into the subconscious and influences everything we do.
[5] There are, of course, founders who started with full knowledge of the challenges of their market and built huge companies designed to capitalize on existing inefficiencies.

Thanks to Scott Bell, Garry Tan, Geoff Ralston, and Nitya Sharma for your help thinking this through.

Bad Terms

Every startup fundraising process is influenced by the balance of power between the founder and the investor. When the founder has a company that is doing incredibly well, and is being chased by lots of investors, the founder has more leverage. When the founder is inexperienced, or has a company that hasn't yet gotten a lot of traction, the investor has more leverage.

Often, the output of this shifting balance is reflected in the price agreed to by the two sides. It tends to be higher relative to progress when the founder is stronger, and lower when the investor is stronger. When the two sides are equally experienced, the negotiation is usually “fair” in that both sides know what they are agreeing to. Whether or not they are happy with that is another question.

There are, however, situations that arise in which investors take advantage of inexperienced founders and get them to sign terms that are potentially harmful to the company. Investors that do this want more economic upside and know that they can exploit the founder without the founder even knowing what's happening.

How bad terms can hurt

While I've seen a number of examples of this, there's one I saw recently that was particularly bad. An investor got a first time founder to give them a Right of First Refusal (ROFR) for 2.5x their initial investment on any fundraising that that founder subsequently raised prior to an equity financing round. There are a number of bad things there, but the part that makes this even worse is that the investor has 60 days to say yes or no to the ROFR, no matter what the company does.

Imagine the company were to raise $50k on a 4mm cap safe today, and then 500k on an 8mm cap safe in 55 days - which can be a very long time in the life of a startup - the investor could put in 250k at 4mm! This means that the founders of the company cannot adequately plan out their allocations to new investors, figure out how much dilution they'd be taking, or even know how much money they'd raised until 60 days after the last financing. This kind of uncertainty is terrible for founders and for companies. It is a major distraction and complication at a time when the founder really needs to focus and know what's going on.

This isn't just true about early stage rounds. Founders who are really successful at early stages may find themselves raising late stage rounds where they are again inexperienced. This can lead to founders signing terms that seem good or inconsequential at signing, but lead to really bad things down the road. For instance, a number of founders agreed to ratchets as a trade off against higher valuations in late stage rounds. This is fine if everything goes better than planned, but can hurt the company, founders, and earlier shareholders if things don't go as well as hoped.[1]

Some terms to watch out for

It would be hard to make a comprehensive list of all the bad terms out there, but here are some to watch out for: How to avoid bad terms

There's no way to list out all of the bad terms that investors can put into term sheets. There are, however, things that founders can do to stop this badness from hurting them:
  1. Read every word of every financing that you sign. Make sure you understand each clause, and what that clause will do in the future in different scenarios. If there's anything a doc that you don't understand, don't sign the doc until you do understand those things.
  2. Get a lawyer that understands startups. It's important to find someone with experience. Not only can a good lawyer explain what's going on with terms of your agreement, he/she can tell you if those terms are standard. Lawyers can also help you negotiate, though this is usually more relevant in priced rounds.
  3. Be really careful of side letters. If you're using a standard doc, like the YC safe, it's probably already well balanced and understood. When an investor wants a side letter, they want something non-standard. This isn't necessarily bad, but it should make you extra cautious.
  4. Get help from more experienced founders, particularly ones that have seen multiple financings. They'll be able to give you perspective on what makes sense and what you should push on. They may also be able to help you negotiate.
  5. Know that, ultimately, if you are desperate for financing, you may have to accept bad terms. While that's suboptimal, it is ok if you understand what you are agreeing to. It's rare that a single bad term you understand will kill your company, though the aggregate impact of terms you don't understand can materially change your outcome.
Mitigating bad terms

While these steps can help with future fundraising, there are many founders who have already agreed to bad terms (either through necessity or ignorance), and aren't sure what to do about it. This is tough, because it will depend on whether or not the investor inserted the bad term knowing it was bad for the company, or if they thought it wasn't so bad. As a founder, you should find out, and try to remove it. There's no perfect way to do this, but the first step is to ask the investor to get rid of the term. Say that you were talking to your lawyer or friend and that they pointed out that you signed a term you didn't understand. Ask the investor if you can remove it so that you don't have to worry about it. This will get rid of some portion of these bad terms.[2]

If the investor refuses, your options are more limited. If you have a strong network of other investors or advisers, you can ask them to pressure the investor to change. We've done this a number of times for our companies at YC. Remember that startups, and investing in them, is a long term bet. Reputation matters and smart investors - whether or not they are “good” - will know that screwing a company will end up hurting them down the road. You can make clear that you'll let other founders know about the bad terms you signed. An investor can probably sustain this happening once, but if that investor acted badly towards you, they've likely done it to a lot of companies. If many companies start talking about how bad that investor is, the investor will cease to be able to invest in companies and will have to find a new profession.

The investors that force these terms on unsuspecting founders fail to realize that the big outcomes in investing don't come from clever terms, they come from outliers. Even more than that, asking for these terms is a direct signal that the investors isn't a good investor. I'd avoid those investors asking for these terms, and I tell founders to do the same. In fact, inserting bad terms into funding documents is a good way to limit the number of chances investors have to invest in those black swans because adding those terms will destroy their reputations - it's just a question of how long it will take.
__
[1] Here's a good explanation of how this has actually played out recently: https://www.cooley.com/files/TechIPOsTriggeringMore'Ratchets'InShakyMarket.pdf
[2] This will probably only work for early stage rounds and investors. Later stage investors are more hard nosed, and will hew tightly to caveat emptor.

Thanks Geoff Ralston, Andy Weissman, Dalton Caldwell, and David Tisch for your help on this.