We need to rethink employee compensation

I think that the way that employees are getting compensated at startups is starting to break. The old model of relatively low salary and "high" equity only works when there's a healthy public market for that equity in the not too distant future. If IPOs are getting significantly delayed and are potentially at risk of not happening at all,[1] we need to change how compensation is structured.

Options only make sense as compensation when you can draw a clear line from the point at which you get the options to the point at which those options are equivalent to cash. This happens when two conditions are met: 1) the stock price is enough above the strike price on the options to make exercising worthwhile to the employee and 2) there is someone willing to quickly buy the stock. This tends to happen with access to liquid markets, which traditionally means public ones. That's the only place where an employee can sell whenever she wants and can know the price she'll get with a high degree of certainty. It's also the only place where an employee can really hedge out some or all of the risk of her options.[2] That hedging is important if the value of the options rise significantly and lead to an employee having 99% of her net worth in a single illiquid asset.

When shares can only be sold in private transactions on secondary markets, and, increasingly can only be sold with the consent of the company, the options are actually worth less. This is true for three reasons.

The first reason is that control is an important factor in asset pricing. Think about this in a situation where an employee would like to sell stock to fund the purchase of a home. In a public company, that employee could exercise the options, sell the stock quickly and use the cash to buy that home. If that employee instead wants to sell stock in a private company, and the company does not let the employee do so, the employee cannot get the cash to buy the house. Because that employee cannot do what they want with the equity, that employee should discount the value of the options they hold.

The second reason that options are worth less in the absence of robust public markets is that the terms of sale of stock in the future are unclear. An employee being granted options has no idea under what conditions he will be allowed to sell stock in the future. The future sale might be subject to board approval, there might be a heavily restricted set of buyers, the employee could be told that no sales are allowed whatsoever for a variety of reasons. Each of these possibilities adds uncertainty which makes the options harder to value and worth less.

Founders need to account for this change in the value of options when giving them, and employees need to account for the change when evaluating their offers and negotiating. This is, however, hard to do in the absence of information. Without a liquid public market to value stock, it's hard to say what the options are worth. The best guess an employee has in this scenario is to go by the most recent valuation given to the company during a fundraise. The further from that fundraise an employee is, the less relevant the price. Furthermore, without the ability to compare how different employers control and handle the sale of private stock, it's nearly impossible for an employee to know what is standard.

The third reason for why individual options are probably worth less now than they used to be is that both employer and employee need to account for the fact that the time until IPO or liquidity is longer than it used to be. This is a big issue. To get the true value of offered comp, employees need to add their offered salary to the present value of the options offered. When calculating that, the further out the payout, the less it is worth today.[3]

This is an especially important calculation when trying to hire employees away from larger companies who are already public or can offer larger cash packages to employees. Those offers also tend to include options or stock grants which have known price and sale terms. Because of their easy to understand high dollar value, these offers are hard to compete with. Options in early stage startups are much harder to value even without all these new factors. Given uncertainty around the final value of those options, the time until they can be exercised and sold is hugely important. As you move further out on the curve, not only does the discount factor become a larger lever, uncertainty over the final value gets more extreme. You can be pretty sure that a company currently worth $10mm won't be worth $1b in 3 months, so you have a reasonable band of expectation. Once that value calculation moves to years out, nearly anything is possible and needs to be factored into the calculation.

I'm not the only one thinking about this, and, indeed, there are instruments available that let employees take immediate advantage of long term options. Some banks or private investors will provide loans collateralized by options. This can be good, but debt is very different than having cash. Taking advantage of this kind of strategy could also lead to potentially tricky situations where, if the option value as determined by secondary transactions falls (which could happen quickly and dramatically given the lack of liquidity in the system), the creditor could claim the assets before the term is up. Even if the price then recovers, the employee is out of luck and money.

Founders need to deal with these issues, and given how fierce the competition for good employees is, I think someone will do so soon. One response would be to increase overall options packages to account for the fact that they are now less valuable.

Another path would be to create an internal liquidity pool capable of buying shares from employees at predetermined trigger points. Maybe this could be funded by existing investors, or maybe by other employees or existing shareholders. Because the sale points are predetermined and don't provide an open market, the value of options would still be discounted, but not as much as a scenario with no guaranteed access to liquidity.

It may make sense for some companies to start creating revenue share programs as standard practice - especially for companies that never plan to going public (of which there appears to be a rising number). This could be a powerful means of retention, though would only work with companies throwing off enough cash.

I think that something even more basic needs to happen first: companies need to standardize their secondary sale and options repurchase practices. We're living in the wild west right now - each company and each employee is doing things on their own. An employee that wants to sell shares on the secondary market generally starts asking friends if they know anyone who wants to buy those options. Generally, they'll find a broker who offers to matchmake and who then gets a cut of the overall sale in exchange for their work. The price that gets set isn't shared from one deal to another, and the rules around whether or not the company can block the sale aren't standardized. This isn't fair to employees, and will lead to confusion and bad outcomes.

Maybe what we need is two things. The first is a founder pledge that they will do everything in their power to let common holders sell into secondary markets above a certain valuation, say, $500mm. The second is that founders of highly valued private companies need to participate in a robust, standardized, secondary market to allow for the clearance of those shares.

My guess, though, is that there will be a number of different solutions with the market choosing the best one as evidenced by the quality of talent hired and retained by the company using them. Founders should be watching for that and be willing to adopt best practices as soon as they arise.

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[1] There have been a lot of articles and blog posts about this recently, but Andreessen Horowitz's recent "US Tech Funding - What's Going On" is the best analysis I've seen. They note that the average time to IPO is now 11 years vs. 4 in 99, and that the overall number of tech IPOs is plummeting as privately funded companies raise huge late stage private rounds instead.

[2] You can do this a number of different ways and hedge out either your exposure to the company itself or do the overall market. Hedging out this risk probably deserves an entire post as it can get complicated. And, while nearly impossible to do it perfectly, is important to significantly reduce risk.

[3] We'd do this as a lump sum calculation for simplicity. You can play with that calculation here: http://www.calculatorsoup.com/calculators/financial/present-value-investment-calculator.php

Party (round) all the time?

There are a lot of party rounds happening right now in early stage investing. Definitions vary, but calling a round with greater than 10 investors a party seems about right. My thought is that party rounds tend to leave companies without an investor who cares enough or has pockets deep enough to bridge the company when necessary. Some rounds do actually have a strong lead, along with a syndicate of smaller, useful investors. Those generally have different dynamics.

What I've been trying to figure out is whether or not party rounds are increasing in frequency or not. Anecdotally, it feels like they are. Has something changed in the valley that party rounds should become preferred? The JOBS Act made it easier for large numbers of small investors to back companies in a way that was not previously legal. Platforms like Angel List reduce the friction required to find investors by creating a central, easily accessibly clearing house for companies looking for money and investors looking to give it to them. Or maybe the growing size and frequency of Demo Day type events (YC's included) have created an environment where party rounds are the new normal.

I took a look at Crunchbase, expecting to see that the overall number of party rounds has been rising uncontrollably. Interestingly, that's not what I found.

What's actually happening is that there are more startups getting funded, and the number of party rounds going to those companies is rising roughly in tandem. What's really surprising is that party rounds as a % of overall rounds actually fell from a peak of 3.7% in 2010 to 2.2% in 2012, though it's now back up to 3.42%.

So it seems that we're not seeing a new normal when it comes to early stage investing. We're actually seeing an overall stable pattern ticking up in the last year after a drop. The real story here is the one about the overall number of startups getting funded as the economy has come out of the Financial Crisis. That number is clearly rising, though 2014 tailed off a bit[1]. More startups mean more innovation, and that's great.

The structure and composition of a single round of funding isn't the most important factor in a startup's success or failure. It's just another piece of the story, and one that doesn't seem to be changing much.[2]

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[1] Not sure why the number would have dropped in 2014. Might be a function of the data available to Crunchbase when this run of the db was pulled on April 3, 2015.

[2] I am still curious about whether or not party rounds are a positive or negative influence, but don't yet have an answer.

Title inspired by: 

Things that aren't work

Recently, I've had a few conversations with founders who, after YC is over, feel a bit lost about what to do next. During YC, the answer of what to do is pretty simple - we tell them to write code and talk to users. Intellectually, they know the answer after YC is to keep building their businesses, but all of a sudden they're faced with a lot of different opportunities, needs, and demands on their time.

This is a tricky time for founders because it can be easy to confuse things that look like work with actual work. Work may mean more than just writing code and talking to users, but it should only encompass things that make your company grow and get better. It can be easy to convince yourself that doing these other types of things make your company better, but that's wrong. These things are mostly for recreation. Treat them that way if you want to, but don't confuse them with what will actually help your startup.

Things that look like work but aren't:

  • Writing blog posts about running startups - This feels good. If it gets onto Hacker News and gets a lot of views, you'll feel really flattered and proud. But don't confuse people reading your post with people knowing and caring about your company.
  • Speaking on panels at startup conferences - If your customers are other startups, and the panel is about something specific you do, great. If not, this is a waste of time.
  • Going to fancy conferences hosted by investors or media - Feels great because  you get to talk to people about how well you're doing. If you were doing that well, you'd be in your office or talking to customers. Simple test for conferences: Are your customers or users there? If yes, could be worth going, if not, then it isn't.
  • Advising other founders - If you know enough to genuinely help, this is a really nice thing to do. It's good to help other founders, but it isn't likely to help your company grow. Make sure you are careful about this and don't let it take up too much time.
  • Investing in other startups - Definitely not work, though it might make (or more likely lose) you some money. This is on personal time.
  • Being a venture partner for a VC - Opposite of work. This is probably taking time away from your startup because now you're working for someone else.
  • Attempting to fix the plumbing in your office - I've done that. Not work. Not the best way to save money. My former cofounders would probably tell me not to insulate the windows myself either.
  • Networking happy hours hosted by investors - This is an opportunity to drink free beer. Great to do in moderation.
  • Having coffee with investors - This can be confusing, because sometimes you need to meet with investors. If you're gearing up to raise money or need specific advice, this is work. Most of the time, though, this isn't work.

Things that don't look like work but are:

  • Writing updates for your investors and meeting with them one on one - I've written about investor updates. These relationships are important, and can be incredibly helpful as you grow. Maintain them.
  • Talking to your cofounders and team - Sometimes, this looks like having coffee or grabbing a beer. Invariably, you'll be talking about work and how things are going. This is work because you need to know what's going on, and need to care about how your team is feeling and doing.

Cofounder management

It turns out that before founders ever have to manage employees, they have to manage one another. In fact, at the earliest stages of a company, when it's just two or three founders, bad management generally leads to the death of the startup. This kind of management also happens to be really hard.

Despite how important and difficult managing your cofounders is, most of the management advice I've seen is about managing employees or superiors. That's useful, but not at first. What I have read about this stage of management is structured as "treat this as a relationship." That's true, but also general enough as to be only somewhat helpful.

Managing cofounders is hard for a number of reasons:

  1. Initially, there are no clear lines of direct reporting amongst cofounding teams. One cofounder may be the CEO, but that doesn't mean that that person is the best manager or the best suited to lead engineering, sales, or product.
  2. Cofounders rarely have experience managing anyone or anything. They're learning at the same time as running a startup. There are a lot of good ways to manage, but they take time to learn and practice.
  3. Cofounders often think they don't need management because they're all on the same team, working towards the same goals.
  4. Startups are high pressure, and pressure makes people make bad decisions and lose their tempers. Small mistakes get magnified 
  5. Communication is much harder than you'd expect, even when there's just two people.
  6. Deciding to start a company from scratch with the goal of building a billion dollar business takes ego. As a result, founders often have large egos. With every success or piece of publicity, egos get inflated. Failures, public and private can deflate egos, and beat people up emotionally. That roller coaster creates tension, frayed nerves, and fighting.
  7. Divisions of responsibility are often unclear. That can result in turf wars, feelings of encroachment and micromanagement.
  8. Decision making in small teams of equals can be hard, especially when there are disagreements, which are often passionate.

There are many other factors that can introduce difficulties into cofounder management. Fortunately, the set of solutions is significantly smaller than the problem set. These problems stem from root causes which can be dealt with more simply than addressing the various expressions of those causes.

Open communication is the single most important factor in creating a good working atmosphere and provides the scaffold for everything else. It's significantly more important than cofounders liking one another. It is not enough for cofounders to agree to communicate, and generally inadequate for them to talk when the need arises. Cofounders need to establish regular check ins with one another to talk about issues at the company and with one another.

It is often helpful to have these types of conversations away from the office, especially once there are employees. Moving these conversations away from the office limits interruptions and also takes a lot of the psychological tension out of the conversations, especially the difficult ones. My cofounders and I were lucky here. We had a coffeeshop next door, a restaurant downstairs, and a bar across the street. Each came in handy, depending on the intensity of the conversation. We did, however, realize (a bit later than we should have) that disappearing from a tiny office too frequently during the day was a bad idea and hurt morale for the rest of the company. If you find that you can't have these types of honest talks with your cofounders, even out of the office, you're in trouble.

At the earliest stage of a startup, when an idea is morphing into a company, you'll probably have the first of your difficult conversations: you and your cofounders need to divide responsibilities and assign ownership of goals and the tasks that need to be accomplished to achieve those goals. Final decision authority has to be established for individual areas and for company wide decisions. Some of this will rest with the CEO, some of it with the head of product, engineering, or sales. Those roles might be filled by the the same person, but the responsibility flows through the role, not the person.

Remember that this conversation can get contentious if people feel they are being cut out of decisions they believe they should own. It is really hard to cede authority, but it has to happen in order to create a manageable strucutre.

Talk about these issues early, write down your decisions, and regularly review them.

Part of the reason you need to divide ownership of responsibilities early is to set expectations for yourself and your cofounders. Managing cofounders isn't easy, and you shouldn't expect it to be. When you're fighting over who has final say on product decisions, you'll discover just how hard it can be. One of my cofounders and I used to have shouting matches when I acted unilaterally on product without informing him. While he agreed that I had final say, I had failed to convincingly communicate my reasoning to him, and failed to set the right expectation of how product decisions would be made.

The truth is, finding out just how hard managing can be is one of the biggest shocks of working with other people. Having a reasonable set of expectations about it will help. Knowing, ahead of time, that you'll fight, get pissed off, and struggle, puts each of those events in a context that makes sense. Having strategies to work through each of those events means that those events (hopefully) won't destroy your company.

While you'll find some of your own strategies, it's a waste of time to come up with them completely on your own. Management is as much a repeatable and proven process as it is an expression of personal style. The process aspects can largely be adapted from general management literature, but I've always found it more useful to engage with a trusted mentor. In the best case scenario, this mentor is trusted by all the cofounders so that they're learning the same lessons and can use the mentor as an impartial arbiter when needed.

Finding a good mentor is tricky. Doing YC will give you access to some great ones, but certainly isn't the only way. Ideally, you want to find someone who has been through the situations that you're going to experience. You should also expect to need several mentors at different points in your career. The mentor advising you at the earliest stages might not be the person you want when each founder is responsible for dozens or hundreds of employees. The challenges you'll face will be different, as will the advice.

Even with this framework in place, managing your cofounders is rarely easy and invariably gets harder as the company grows and pressures rise. The pressures get amplified even more when things start going wrong, as they always do. You'll fight about important things, and you'll fight about seemingly inconsequential things. That's all ok and quite mundane. Just make sure you keep talking about it, adapting, and moving your company forward. Your goal shouldn't be to make your relationship with your cofounders easier. Your goal is to make the relationship manageable.


Someone else had your idea first

"I liked Jimi Hendrix's record of this and ever since he died I've being doing it that way..."

- Bob Dylan, on Jimi Hendrix's cover of All Along the Watchtower

Most people are very lazy. They don't want to take the time to think through new ideas or look at them in a new light. Once they've made up their minds about something, they don't change them. That's generally why most people don't come up with ideas for new or great things.

This is also true for many venture capitalists. In fact, it's at the root of a very common question that founders get asked: "Well, isn't so and so doing this?" To be fair, this question isn't necessarily sparked by laziness. It's also sparked by ego - the VC wants to show how familiar they are with the market. They say "Look! I know about things and there's someone else who had the same idea you had." The implicit criticism here is that, because someone else had the idea first, your idea is somehow worse.

I think part of the reason that people ask this question as a way of putting founders down is that they assume that startups are zero sum. That's an assumption born in certain models of markets, but it's completely wrong when looking at startups. Because startups create new value, the idea that someone else has done or is doing something similar to what you're doing often acts to broaden or prove the market you're attacking.

That's not to say that directly cloning another company is a great idea. If you have no differentiation and no original thinking on a problem, then you have to fall to one of two arguments: a) the market for a given idea is so large that there's room for multiple players executing well or b) the other company is so bad at executing that they'll self destruct. They're both potentially valid, but they're hard cases to make - especially at the early stages of a company.

Even though the question might seem dumb, it's one of my favorites. It's also a great question to get as a founder. I ask it of almost every founder I meet, because it's very rare to find a truly new idea. The answer I'm looking for is nearly always "of course someone else has tried this before." But that's not enough. The question begs for a deeper answer, one that talks about why, even though other people have tried the same idea, they're still leaving billions of dollars on the table. It's an opportunity to demonstrate depth of thought and originality. It's that framework of thinking and level of insight that makes greatness.

We're all communication hoarders

In April of 2004, Google announced that its Gmail product would give users 1 gigabyte of free storage. At the time, Hotmail offered users 2 megabytes and Yahoo offered 4 megabytes. I'm guessing I initially accessed my invite via PINE, and found the idea of using a full gig of storage for email to be crazy. Unsure what I'd ever do with all that space, I initially used it as a remote backup for my thesis.[1]

Ten years later, I have nearly 12 gigs of saved email - and I delete quite a lot. Like a family in a too large home, I hold on to messages I'll never need again for two reasons: 1) the cognitive energy to decide to destroy something forever is greater than the energy needed to put it out of sight for the time being and 2) Gmail's UX actively pushes me to archive rather than to delete. This principle extends across nearly all the communication mediums with which I interact. It is more difficult to delete pictures than to upgrade storage, more difficult to delete texts rather than keep them, and to accept social connections than deny them. In each case, my desire to save against the future wins out against the knowledge that, in all likelihood, the vast majority of what I save will never be useful to me.

This is a strange place in which to find myself. I don't like keeping extraneous items around. To be sure, part of that is a function of living in a NYC apartment with little room to spare. As opposed to my apartment, though, I can assume that my storage space is effectively infinite. Yahoo already offers infinite storage to its mail customers, and it's likely that the other players will follow suit over time. This makes sense when you consider two factors. First: how cheap storage space has actually become.[2]

Second: the data contained in my communication is more valuable to my email provider than what I'd pay for the space.[3] It is unsurprising that I'm given an ever larger shoebox to fill. With no obvious cost to keeping everything around, that's exactly what I start to do.

And that leads to a paradox. The more of my communication I keep, the less each piece means to me. It feels like I'm losing something as a result, even as I gain a trove with massive potential meaning. My wife's grandfather was in Paris during WWII with the US Army. In the two years he was away, his wife had their first child - an event he only discovered weeks later via mail. The letters they wrote one another are unbelievable historical artifacts that shape their and our understanding of them and the world.[4] Of all the things they could have saved throughout 73 years of marriage (and counting), they made the conscious decision to save these items. That decision is a key part of how we know their importance.

My kids and grandkids won't have the experience of reading letters that my wife and I have saved in the same way, because we save everything by default. It's entirely possible they'll have nothing since my email account will most likely be locked when I die. That doesn't mean that all this communication I generate has no value or meaning. It is hugely valuable, in aggregate, to Google and Apple and Facebook. They'll continue to have access to my information long after I die, and it will continue to feed their algorithms.

I don't properly know what I'm losing by gaining so many individual pieces of communication. I do know, however, that the pace at which we communicate continues to accelerate, and that the forms through which we communicate continue to evolve.[5] The ways that expanding body of communication gets mined for information are proliferating at the same pace, but so far, they're almost entirely geared towards the companies that make money off our data.

I think that leaves something on the table. There's a class of product yet to be successfully created that can sift through all of my communication, across all platforms, that finds what is actually meaningful. I don't just want the first message that said "I love you" to my wife, I want the letter or email that led to that conversation. I want to be able to find the text which, on the surface, was meaningless, but in another time I would have set aside as an important life marker. While I can manipulate my inbox search to find some of these things, I can't really find the meaningful things. Maybe Google already does this to serve me ads, but that doesn't really help me.

Then again, maybe I'm thinking about communication all wrong. Maybe it should only have meaning in the instant it is made because that's a better fit for our brains. Or maybe we haven't figured it out yet. That feels more accurate to me, and I'm looking forward to seeing what comes next.

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[1] Pretty sure I wasn't thinking of "cloud storage" at the time.

[2] Chart courtesy of ZDNent. "Thailand Hard Drive Crisis" is my new favorite chart annotation.

[3] I've talked about this cost/persona data trade off before: http://www.aaronkharris.com/tanstaafl

[4] We're lucky enough to still have Pops and Grandma Lil telling us stories. Grandma Lil also still has some of the perfume Pops bought her with bartered champagne and cigarettes.

[5] I recall being in Scotland in 2005 and being confused at the popularity of texting. It seemed so strange and foreign at the time. Considering the average American 18-24 was sending 3200 texts a month in 2011, I think I got that one really wrong.

TANSTAAFL

At some point the internet tricked us into thinking we could get something for nothing.

More than any other company, Google is responsible for fooling us. It was the first free and legal service to gain ubiquity.[1] Google told us that we didn't have to pay anything for amazing services. It seemed to good to be true. It was and is, in fact, too good to be true.

What Google doesn't come out and say is that you're paying, a lot, just not with cash. Your data is valuable. Apparently, it's more valuable than charging you for services because you cannot choose to pay for personal Google services and avoid the sale of your data.

This means data, at least what we contribute when properly sifted, aggregated, and analyzed, is more valuable than the cash we'd be willing to pay for access to the same services. When the world is based on networks, as ours increasingly is, then the greatest network is the most valuable asset there is. By making network access look free, Google managed to capture a huge user base. Once it had the network, it started to charge. It cleverly adapted an existing model - advertising - but did it by selling data + access, rather than just access (which is the best radio and tv and newspaper essentially could really do).

If that's true, we need to ask if we're getting a fair deal. But most of us won't ask that question[2], and if we do, we have no alternatives of the same quality. The deal also keeps getting re-traded, without our truly informed consent.[3] Every time Google offers a new service, it collects more data about it's users. That data is valuable on it's own, and makes existing data more profitable. Users could get some sense of the data collected and how it will be used by scrutinizing ever longer legal documents - but that's hugely unlikely. And, again, even if users did just that and found the trade wanting, there's not much recourse.

And if we did want to pay? Mary Meeker's 2014 Internet Trends Report tells us how much our favorite services should cost. Google revenues wouldn't change if we each paid $45 for all of our free services.[4] To grow revenue, Google would have to release new services and charge for them.

That probably sounds crazy, but it isn't - it's roughly how Apple works.[5]

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[1] Napster is another important player in this story. It largely convinced a huge portion of internet users that piracy was ok because it was so easy.

[2] There are a lot of causes: laziness, ignorance, fear of complexity or awareness.

[3] Clicking "yes" on new terms and conditions hardly seems to suffice.

[4] This number is broadly indicative though likely skewed by the differences in data value between spenders with different geographies, socio-economic brackets, and histories.

[5] I've been thinking a lot about the way these two businesses work at the opposite ends of this spectrum. It's a fascinating dichotomy.

Pet Theories

All investors have pet theories. They may call these theories "theses" or "themes," but they boil down to the same thing - closely grouped sets of ideas which the investors want to be true. Investors will usually fund companies that seem to stand a chance of making these ideas real. At YC, we have quite a lot of pet theories, which end up getting expressed through our RFS.

Knowing the pet theories of the investors with whom you're talking is helpful. They may be more likely to fund startups that fit into pet theories and are likely to know a lot more about those theories than they do about other fields. That's great if you know what you're doing, but dangerous if you're half-assedly working on something. Let's assume you're in the first camp, because the second group shouldn't be talking to investors anyway.

You can learn a lot about the pet theories of investors by reading what they've written or spoken about in the past. Some investors - Fred Wilson, Andy Weissman, Chris Dixon - make this easy by writing blog posts that frequently reference what they think about and why they make the investments that they do. Other investors work at firms dedicated exclusively to particular pet theories. You can learn still more looking at an investor's career and past investments.[1] These are all pieces of information that can teach you about how an investor thinks, which will allow you to prepare better for actually meeting them.

Knowing an investors' pet theories can also help you get a meeting. An email directly referencing something near and dear to an investor's heart will get a response much more easily than something generic.[2] At the same time, the hurdle for getting a meeting on a pet theory is going to be high because the investor has likely seen many teams and ideas in the space.[3]

The really cool thing about meeting with someone who has a pet theory about what you're working on is that you won't really pitch them, you'll have a real conversation focused on the heart of what you're doing. These investors will be unlikely to ask simple, surface level questions. You'll be engaged and thinking the whole time, which should lead to better answers, and the best demonstration of how good you are.

Things will start to get really interesting when you begin to challenge the preconceived notions that an investor has as a result of how much he's thought about a given problem. Chances are that if you're doing something new, this is going to happen. It's where you'll be able to evaluate the quality of the investor. The best of them are flexible. They'll adapt their frameworks in response to new information and knowledge. The worst will be dismissive of ideas they hadn't considered before.[4]

There are also plenty of situations in which someone hasn't thought that deeply about a theory they discuss at length. Maybe they want to sound smart or look cool. Regardless, you should be able to figure that out pretty quickly and move on.

You should learn about an investor's pet theories when deciding if you should talk to them, and when preparing to actually meet. In the end, this is just one of the pieces of information you should have. It isn't as important as building a great business, but understanding the picture will help you pitch better, so spend some time on it.

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[1] Keep in mind, though, that investors generally don't only invest in their pet theories.

[2] This seems so basic, yet I get enough generic emails that I'm convinced it has yet to sink in.

[3] As always, warm intros are an even better bet.

[4] True in all situations, not just those related to pet theories.

Taking advice

I ask for a lot of advice. Maybe too much. Sometimes the advice is great, sometimes it ends up seeming worthless and wrong. Invariably, I attributed the outcome of following advice to the giver - following advice from good people led to good outcomes, and vice versa. In the last few years, I've found myself giving a lot of advice and have realized how wrong I was in attributing cause and effect.

There are two axes that determine the goodness of advice. The first is the obvious one: the quality of the person giving advice. This it the part which most often get discussed. We're told to seek out high quality mentors and advisors. These should be people who think clearly, have experience, have the time to think through problems and help.

While these things might be hard to find in a single person, they're not typically that hard to evaluate. What's much harder, and probably more important, is the other axis: how good you are at describing reality to someone with much less context than you have. It turns out, this is really hard to do for a number of reasons.

  1. Honesty is difficult, especially about issues we're facing. When you ask for advice, you are implicitly saying you don't know how to do something. That's hard, but seems to be accepted. What's much tougher is making sure you know the reasons you're having the issues you're having. Often, figuring this out is the point of advice (even if you started asking for something much more surface level).
  2. Context is hard because it is vast. Think about how much you know about your company. Think about how little anyone else knows, no matter how involved they've been. At best, they see a series of snapshots and can construct a reasonable amount of context themselves. This is nowhere near what you have rattling around in your head. Being able to rapidly construct necessary context is important for an advisor, but they rely on you to give them relevant details.

If you can't pull off these two inputs when asking for advice, you'll get bad advice no matter how good the person on the side is.[1]

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[1] Yes, this does constitute advice, but I'm pretty sure this is of the type that's good in all situations.

The importance of honoring pro-rata agreements

I've recently heard about a number of fundraises in which the company raising has refused to honor pro-rata agreements with early, small investors.[1] The most frequent reason seems to be that newer, larger investors demand a certain percentage in a funding round, and tell founders that it can either come from the founder stake, or by locking out earlier investors. Sometimes they just say "lock out the early investors."

This is bad behavior on a number of levels.

It's bad for the founders to do this because they're violating an existing legal agreement. As a founder, your word is your bond, and going back on a deal is a great way to destroy trust. Unfortunately, there's rarely an immediate/obvious impact because the small investors are unlikely to sue or cause a big stink. They don't want to piss off the big investors or get a reputation for being "troublesome," so they're stuck.

For the early investors, this is really bad. When an early investor negotiates for pro-rata, the money they invest buys equity now, and the opportunity to maintain that equity later. This is critical for early stage investors, especially those investing out of a fund. The cumulative impact of dilution is material and their models and expectations are built with that in mind. Investors would not/should not make certain deals if they knew they were going to get screwed out of their rights. Take a look at this model for a sense of just how important pro-rata rights are to early stage investors.

For the later investors, the behavior is actually pretty smart on several levels. By getting the stake they want from early investors and not the founders they can insure that the founders retain skin in the game (or are given opportunities to sell secondary). They can also weaken the ability of early investors to have a say in the company's future by reducing their combined voting power. Finally, this type of behavior may hasten the end of "super-angel" funds by handicapping their returns. Less competition is a good thing for those left standing.

Given how much competition there is around fundraising at the moment, it's unlikely that this behavior will stop any time soon. At the end of the day, the founders have to make the decision. If you find yourself in this situation, stand up for the agreements you made. If you'd like to discuss how, please reach out.

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[1] Dave McClure recently tweeted that he's seeing the same.