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.
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[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.

Utopia Bets / Apocalypse Bets

I think that it is nearly impossible to figure out the exact changes that new technologies will create in the world. That's problematic because investing in startups is largely about figuring out whether or not a team with a new technology - or application of existing technology - will create a change large enough to support a big new company.

Not only is it hard to figure out what changes will happen, it's hard to figure out what changes will happen over given periods of time and if those changes are good or bad. In fact, it's probably safe to assume that any given technology will create badness over certain periods of time even if the long term impact is highly positive. Computers are a good example of this. During WWII, IBM punch card machines (not quite computers, but getting there) were used by the Nazis to organize aspects of the Holocaust. At the same time, Alan Turing was building the foundation of modern computing to crack Enigma. Internal combustion engines gave us mobility and trade on a previously unimagined scale, but also led to anthropogenic climate change.

Since there's no way to know every change that a piece of technology will produce, I think there are two ways of evaluating what to build and invest in. I think of these as Utopia Bets and Apocalypse Bets. The most extreme example of this dynamic comes from AI. In one framing, AI creates a world in which all of our hard problems are solved and humanity devotes itself to exploration, art, and generally being good. In the other extreme, the AI wipes us out.

I've found that many people like to talk about their Apocalypse Bets. There is something emotionally satisfying about being cynical and painting a dark version of the future. I think one of the reasons people do this is because they don't want to look stupid and they want to hedge against bad outcomes. If you predict something will go well, and it doesn't, not only does a bad thing happen, but, worse, you are humiliated for being wrong! If you predict something will go badly, and it does, at least you were right. If it goes well, your life is better, and everyone forgets about you being wrong.

Certainly, Apocalypse Bets are popular in the public imagination and press these days, as you can see by looking at books and movies where technology gets away from man and destroys us. Turning on the news or reading the paper, you can find any number of talking heads discussing why our love of technology gave us unstoppable pollution, weapons we can't control, and epidemics ready to wipe out half of humanity.

Add into this that whenever the market starts going down or volatility picks up, talk about how much worse everything is going to get becomes more common because people are scared. There are investors that have made a lot of money off betting that things will get much worse, mostly in the form of shorting the market in one way or the other.[1] No matter what the talking points are, though, I've never actually met someone who makes venture investments in Apocalypse Bets, regardless of how bearish they are about everything else.
I think this is because capitalism is a bet on the future. Investing over the long run has a positive expected return because markets believe, overall, that the economy will grow.[2] If you didn't believe this, you'd never invest. If that's true, then I think venture investing is an exercise in optimism.

The whole process of betting on future return is magnified by startups. In startups, the founders and the investors are betting that a small number of people can change the way the world works, and make a lot of money in the process. It seems that most of the changes that founders are trying to create improve the world. I can't think of ever hearing a pitch where the founders argued that the world getting worse would be a net positive for their business. This might be an argument made by arms manufacturers, but I don't know as I've never been pitched by one.

Startups, then, are making Utopia Bets. It is rare to find a founder who argues that their company will, by itself, bring about Utopia[3], but they mostly believe that the aggregate force of technological change is pushing humanity to a much better place.[4] This makes sense, seeing as how spending your life working towards making the world a worse place would be depressing for anyone that isn't a supervillain.

The best investors I know look for Utopia Bets as the direct rationale for investing in a given company. Investors rarely pick a specific solutions which they think will bring about a better future and then finding a company to do that thing. Instead, they'll often start with a question similar to: “In the future, cities will have 40mm people. What needs to be built to make those cities function well?” This leads to branches of sub-questions and hypotheses. The investor would probably need to think about transportation, communications, logistics, etc. Each of those areas gives rise to a potential set of companies, towards which those investors will be receptive.

This thought process can be useful to investors in two ways. On one side, having a distinct view of how the future will be better gives investors a way to publicly talk about what interests them. If they say intelligent things, founders who are thinking about the same ideas will reach out to talk about those problems. Some of those founders will be really good, and may end up building companies which the investors can put money into. There are also many people who have thought deeply about these problems, but didn't think anyone would fund the crazy ideas they had to bring about a better world. When those people come out of the woodwork and build companies, not only would the investor likely the first opportunity to invest, but, even if the investor passed, there's a net good of new interesting ideas being tried in the real world.[5]

The other good thing that happens through this thought process is trickier. Thinking deeply about certain problems can be a really helpful filter when deciding to invest in ideas, but it can also be misleading. On the one hand, thinking deeply about a given set of ideas can help differentiate what is good and what is bad. Conversely, it can also create significant bias towards funding ideas that seem like a perfect Utopia Bet, without considering the founders. From this perspective, any bet is great if it stands even a tiny chance of making the world better.

That usually leads to funding companies that only seem good. It's much better to consider whether or not the founders are actually good and likely to build the company that will help make the Utopia Bet come true. You can get a read on this by working through how deeply those founders have thought through the idea as it relates to the way the world is going to change. In fact, the best Utopia Bets are about the founders and their views on how the world will change, rather than the a priori assumptions of the investor. These a priori assumptions can actually end up creating throwing false negatives,[6] because the best companies often exploit something in the market that outside experts have dismissed as non-viable.

This fits well with the idea that the best founders should know far more about what they're making, and be far more passionate about it, and be thinking far more originally about it, than anyone else. These founders should continually upend how the investor thinks and the investor should be learning more from the founder than vice versa. If an investor actually knows more about the idea, and is so passionate about it, that investor should build the company!

Founders who find investors whose view of the future echo - but doesn't mirror - their own end up in a relationship that is far more collaborative than those who take money from investors motivated only by returns. When looking for investors, it's important for founders to understand what sort of Utopia Bets individual investors want to make, because it will help frame the conversation and create a real dialogue in which both sides learn. That's a far more effective route to raising money than one sided pitching.

This isn't to say that the relationships formed through this process will always be smooth. In fact, when two people with strongly held visions of the future get together, every difference in that vision can lead to conflict. However if both sides are truly pulling for making the future better, they should be able to find a way forward together to build incredible things.


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[1] John Paulson (https://en.wikipedia.org/wiki/John_Paulson) almost $5B off of one set of linked bets against the rising housing market. George Soros “broke the pound” in 1992: http://www.investopedia.com/ask/answers/08/george-soros-bank-of-england.asp. That felt like an apocalyptic bet, but it also may have helped UK break a recession. He also then bet on the Pound and made more money! (thanks for the info, Elad!) I see these bets as different than shorting a company because of their basis on big macro trends.

[2] This isn't true of short term trades where investors are often betting against temporary pricing imperfections. That reflects a different kind of optimism - confidence that you are smarter than markets.

[3] Though I've met one or two. They're either crazy, working on AI, or both.

[4] Bill Gates talks about this quite a bit, and links it back to his and Paul Allen's original vision for computers: https://www.gatesnotes.com/2015-annual-letter?page=1&lang=en.

[5] We've actually noticed both of these trends in response to our Requests for Startups https://www.ycombinator.com/rfs/.

[6] False negatives are one of the scariest mistakes that investors can make because of the way returns in VC are dominated by the outliers. See: http://paulgraham.com/swan.html

Thanks to Andy Weissman and Elad Gil for helping me think about this.

Don't focus on the NASDAQ

While thinking about wiggles (Ignoring the Wiggles ), I looked at when the biggest tech cos in the world started relative to NASDAQ. At first, I thought I'd find no correlation between how well the index was doing and when successful companies were founded.



I love looking at this in chart form, which shows just how many market moves these companies have weathered as they've grown.

[1]

I was actually surprised to discover that most of the companies on my list were founded while the market was doing relatively well on a trailing 1, 3, and 12 month bases.

Of course, if the founders of Microsoft, Google, and Cisco had looked at the returns of the NASDAQ in the year leading up their decisions to start their companies, we wouldn't have three of the most successful companies in history. I'm glad they didn't stare at the market wiggles.

There's also an important lesson in here for me as an investor. It's easy to get excited about startups when startups are doing well and when the economy is roaring. It's harder to be as excited when public markets are down and I'm seeing flat and down rounds. The easy sounding lesson to draw is usually along the lines of being aggressive when others are fearful, and conservative when others are aggressive.

But I don't actually think that's right, I think the right answer is to ignore everything else and judge founders and their companies on their fundamentals. That seems clean and easy in principle, but is difficult to put into practice because one of the things investors do is make a bet on the paths of markets over time. When markets seem to be saying bad things about the future, and market pricing is a bet on the future, it can be tough to ignore them or bet explicitly against them. If markets are exuberant, it's almost as difficult to be confident that you're paying an appropriately high price or investing in an actual good company. It takes time to form that confidence on the basis of fact rather than just guessing and justifying it later. I'm still working on that.

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[1] Data is from http://www.macrotrends.net/. Scale is log.

Exceptionalism

Startups that do well often follow a set of common principles. These principles influence how they develop products, build teams, raise money, and get customers. The most successful startups, though, are exceptional and often seem to go against these principles in various ways. For founders looking to learn from the experiences and paths of other startups, this can cause confusion and lead to bad decisions.

I think this happens because of how hard it is for outside observers to understand the full context of why given decisions are made in other organizations. It is also nearly impossible to separate causation and correlation, even with perfect understanding of the rationale behind a decision. I've spoken with many founders who point to outcomes at other companies as justification for decisions that they are making with their own companies. These founders rarely give enough weight to to factors like timing, luck, and the impact of particularly skilled employees or founders in producing those outcomes.

That creates a paradox. One of the best ways to learn how to succeed is to follow good examples set by others. At the same time, following those examples can often lead to very bad decisions that harm companies. Figuring out which examples to follow, and how to follow them seems hard.

There is, however, a clear framework for figuring out what to do. First, don't do anything just because you see someone else doing it. For instance, there are many successful jerks, but that doesn't mean you should be a jerk. Some companies succeed while spending huge amounts of money, but you should probably spend as little money as possible to achieve your goals.

Second, when you see a successful company doing things that appear to break from sound principles, look at those examples through the lens of your own company and circumstance. If you take the set of things that exceptional companies do, and overlay it on the set of things that make sense for your business and team, you'll end up with the set of things you can learn from exceptional companies and mimic. You can do this even without perfect knowledge of causation, because simply knowing that something is possible is often enough, given the right people, to achieve it.

You can also look at your existing practices and plans to discover whether or not you have to change them. First is to look at the decisions you are making at your company and ask whether or not you've derived them from the logic of your own business, or if you're doing them only because you saw a successful company do something similar. If it's the latter, you then have to figure out if those decisions make sense in the context of your business without the benefit of outside examples. This is especially hard to do because you can't use your own exceptionalism as a reason for doing something. People and companies aren't exceptional because they say they are. They are exceptional because evidence shows them to be so.

What's really happening when you run this exercise is that you're deriving decisions for your company from first principles. Things other companies do may provide some ideas, but the best decisions come from focusing on what will help your company succeed on its own terms.

As your company grows, you may realize that many of the things you do don't line up with the principles you initially thought would govern your company. That's a good thing, because it means that you've figured out the pieces of your business that are exceptional. While you can't copy exceptionalism, proof that it is possible is everywhere. You can use examples of that proof to help make decisions, but ultimately, you'll have to create it yourself. And if you can create it, you have a good shot at building a great startup.


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Thanks, Geoff Ralston, for your help writing this.

Things that aren't progress

A few months ago, I wrote about things that look like work, but aren't. As I paid more attention to founders doing these things, I started thinking about why they were happening. I realized that the behaviors were largely a function of bad goal setting.

When founders choose bad goals, they create bad metrics around them and try to hit those metrics. This means that those founders are optimizing for things that look like progress, but aren't. This is dangerous for startups because founders that aim for bad goals warp everything they do towards measures of progress that don't help the business grow and succeed.

If you find yourself thinking that these things are progress, you need to examine what you're aiming for.

Things that look like progress but aren't:

  • Conversations with large enterprises - This is a big one for companies that rely on enterprise sales. Usually, these "conversations" are non-binding, low level, and scattered. They rarely lead anywhere. There is a type of conversation that is actually progress, but it is generally paired with a clear sales plan, a list of stakeholders, and clear asks met along the way.
  • Press mentions - This feels so good, which is why it is tricky. External validation is awesome! But it isn't as awesome as engaged users or paying customers. If you're looking to get press as a means of building SEO, then press mentions can constitute progress. That only makes sense if SEO is part of your strategy and you're measuring things properly. Russ D'Souza talked abut how they do this so well at Seatgeek: http://chairnerd.seatgeek.com/how-seatgeek-measures-pr-coverage/.
  • Winning awards - This is another one of those pieces of external validation. Certainly helpful when proving to your mother that you're not wasting your time, but not material to the success of your company. Awards may recognize either the progress you've made, or how good you are at PR. Focus on making progress.
  • Getting retweeted by someone famous - This is similar to press mentions, but even worse. When a founder is trying to do this, they're usually working on their personal brand at the expense of their startup. That's definitely the wrong thing to do.
  • Meeting someone famous - Famous people are really interested in startups these days. It feels good/cool to say you met someone famous. Don't underestimate the value of having great experiences, but don't mistake it for a sign of success.
  • "Getting into" elite conferences, like Davos - This is some strange combination of awards and meeting famous people.
  • Eyeballs - Had to include this because it's part of what drove valuations in the tech bubble. Turned out this wasn't progress. There's a corollary today: uniques. That can be a good measure of progress if you're a media site generating revenue off of impressions, but in almost all other cases, it's a vanity metric.
  • Cumulative registrations - The cousin of eyeballs. People who register for your company but don't use it aren't actually helpful. In fact, this is probably a bad sign because it means that people don't actually want to use your service. (Suggested by Geoff Ralston)
  • Hiring - When you hire for the sake of a world class team, that isn't progress. If you're hiring because you can't handle the load on your service or product, then it probably is a good sign and it is progress. (Suggested by Paul Buchheit)
  • Fundraising - So many founders confuse raising money with success. That's how the press views it, but it's one of the worst things that founders can tell themselves. Fundraising is just a tool to accomplish your real goals, not a goal in and of itself.
  • Getting into an accelerator, even YC - This is a corollary of fundraising and awards. At YC, we'll do our best to help you figure out what your goals are (if you don't already know), and work with you to achieve them, but it's what happens after you get in that counts, not getting in. YC is neither necessary nor sufficient for success.

I and We

Starting a company is, in large part, an act of ego. When that business is a startup, the ego component is even larger. This is a good thing.

Ego is what gives the founder the confidence to create something new. Ego powers the belief that the new thing the founder creates will be good enough to change the way that tens, thousands, even millions of people live their lives. Maybe we don’t always call this ego -- maybe we call it vision, or confidence, or passion -- but the idea is the same.

But as important as ego is to the founding of a company, it is also corrosive to the creation of a good culture. Unbridled ego becomes arrogance. It doesn’t allow for other people to achieve and contribute. Founders who do not keep their egos in check are unwilling to acknowledge the help given to them by others, and have a hard time building and retaining great teams.

To start a company founders need ego, but to build a great company, founders need to be modest. Modesty is what allows founders to see all the things that contribute to their success, especially the things over which they have no control. With modesty, founders can see the important role of luck in their success. They can recognize, acknowledge, and reward the part played by cofounders, employees, and customers. They’re resilient when things go wrong because they can see beyond themselves.

The interplay between ego and modesty is obvious when you hear founders talk about their companies. As a company grows, the best founders increasingly talk about “We” and not just “I.” Every discussion about the achievements of the company is a chance to highlight the contributions of other people and of the organization overall.

This isn’t to say that the best founders disappear into the background of their own companies. The “I” still plays a strong part. It remains the founder’s job to consistently set the vision and the example for every employee. When that goes away, a company risks moving into stasis or decline.

Perhaps the most important place to use “I” over the life of a company is when things go wrong. When figuring out what happened, and who bears responsibility for fixing a problem, “We” is insufficient and even dangerous. In that case, modesty doesn’t drive the use of “We,” arrogance does. Arrogance won’t allow a founder to admit that he was wrong, so he slides to “We” to cover for it, to blame the organization. But diffuse blame means that no one figures out what actually happened and how to fix it. Do that often enough, and the badness grows until it kills the company.

It’s tough to balance “I” and “We” and it gets harder as a company grows and becomes more successful. As a company does better, the easiest stories for the press to write are those about the genius of the founders. At the same time, as more and more things happen at a company that the founders don’t directly touch, founders may start to feel disconnected from the thing that they created. This is a hard thing to face, and some founders respond to it by claiming sole credit for successes that are the work of many people. From the other side, as the company grows, some founders fade into the background and stop providing the singular vision and leadership that the company needs to succeed.

There doesn’t seem to be an easy answer as to how to strike the right balance, nor is there a single paradigm for what works best. What does seem clear, though, is that founders need to keep these questions in mind, and, if they find themselves only using “I” or only using “We,” to think long and hard about what they might be missing.

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Thank you, Colleen Taylor, for your edits.

Presumption of stupidity

I've noticed a common bias that shows up in some founders: they believe that their competitors are stupid or uncreative. They'll look at other businesses and identify inefficiencies or bad systems, and decide that those conditions exist because of dumb decisions on the part of founders or employees. 

This is a bad belief to hold. In truth, competitors in the market are usually founded and run by intelligent people making smart and logical decisions. That doesn't mean that all the decisions they make are necessarily the right ones, but they're rarely a function of outright stupidity.

Where companies do things that diverge from what seems smart from the outside, it's a much better idea to ask why those companies are doing things from the presumption of intelligence and logic rather than the presumption of stupidity. If you don't ask these questions, you might find yourself making the same decisions, or ending up in the same place with your own set of rationalizations. I see this all the time.

In fact, we made this mistake when we started Tutorspree. We looked at all the local agencies and the way that they acquired customers and charged for packages of lessons. We assumed they asked for so much money up front because they were greedy and not smart enough to figure out a better system. It turned out that packages of lessons were a logical outgrowth of high upfront acquisition costs and the long term dynamic of tutor/student relationships. A large enough subset of customers appreciated the breaks on pricing and commitment created by booking multiple lessons up front that it made sense to model the business that way. It took longer than it should have to realize this because of our bias.

If, instead, you presume intelligence and analyze the reasons a business looks the way it does, you will often see the challenges you might face ahead of time and, as a result, design a solution that is actually better, as opposed to simply looking new. It is a lot harder to think this way because it means that you can't just dismiss the things other people do and assume you'll be better. You actually have to prove that you know how to be better. That can be really scary because, much of the time, you might not be able to figure out how to be better. Everything you think of might lead you to the same place you see your competitors.

That, though, is no reason to stop working on your company. I think it's actually a reason to keep going, and to keep gathering information and generating new ideas. This is part of what's so cool about starting a company, you get to make up new rules as you go along, and you can toss out old ones as you go along. Two founders looking at the same problem can easily come up with multiple solutions. Each solution might look similar from far away, but the small differences add up. Importantly, if you know that other smart people started in a similar place and ended up with the wrong answer, you'll think a lot more critically about each of your decisions and never get lazy about challenging your own assumptions.

Of course, just because you presume intelligence doesn't mean that every decision made was smart. People and organizations make bad decisions for all kinds of reasons. The thing is, you don't learn much by understanding that a call was bad, you learn by understanding the inputs and the organization that enabled the bad decisions.

Even with this framework, there's no guarantee that you'll end up in the right place, no matter how much you analyze those whose decisions have left you with an opportunity. At the end of the day, there's only so much you can learn from looking at competitors. Truly great businesses aren't built as counterpoints to existing companies. They become great because they meet a deep need that isn't being satisfied. That usually requires the kinds of creative and cognitive leaps that no amount of market analysis could possibly give you.

Private infrastructure

When infrastructure is built, it usually starts out as a large scale project that can only be accomplished by government. It can be built in undeveloped areas for a fairly large amount of money, or in developed areas with massive amounts of cash and even more political capital. That's hard to do in democracies, though seems to work well in places like China.

This dynamic means that we'd expect infrastructure to fail over time as the inertia arrayed against repairs and new construction grows. That seems to be what's happening in the US.

When infrastructure decays and fails, though, it creates a lot of opportunities. Citizens who were meant to be served by the infrastructure become unhappy and are when that unhappiness is great enough, they will spend their own dollars on alternatives. This is a more direct process  than funding infrastructure through tax dollars, though it can produce different types of outcomes.

In the United States today, these opportunities are being exploited by a range of startups and companies who are essentially building private infrastructure, mainly for the relatively wealthy.

Food

Instacart is building new infrastructure to deliver food to homes. In most early use cases, this looks like pure convenience, however, over the long run it could impact and start to eliminate food deserts. By making food available in more places, Instacart has the power to change where people want to live. That process will reshape how cities grow and, eventually, are built. I'll also say that in a place like NY, where supermarkets are small, crowded, and overpriced, it seems clear that the current system only exists because there's no better alternative. Instacart is that alternative.

Transportation

This process is also starting to play out on our roads. Most of our highway system was created by a single gigantic bill, the Federal Aid Highway Act of 1956. It would be hard to imagine today’s Federal government getting its act together or finding enough money to repair roads on a national scale. Harder still would be believing that a place like the Bay Area would figure out a way to install effective and efficient public transportation to ease the stress on our roads and highways which are nearly always gridlocked. Technology is starting to provide ways to bypass those problems by improving throughput on existing systems without changing the physical plant.[1]

Self driving cars are the most extreme example of this trend. If we do actually arrive in a world where self driving cars are ubiquitous and built on the same standard such that they can communicate with one another at long range, congestion gridlock should largely vanish as the cars plan miles ahead and subtly change speeds to clear up slow downs before they start. Even before that future, though, apps like Waze help drivers plan better routes and alleviate some stress on the most crowded points in the system.

Energy

I think the trend is also impacting power generation and consumption in the US. Companies such as  Solar City will install your own power plant on your roof which means you're no longer subject to brownouts or price increases at peak times. In most of the US, this is more of a ‘nice to have’ and cost saving measure, but in the third world, solar power could provide a viable and efficient alternative to the construction of large power plants and electric delivery systems. These systems would be a fraction of the price of the old way of doing things and be significantly more reliable thanks to their distributed architecture.[2]

Private can’t mean wealthy

There is, however, an underlying tension in the rise of this new infrastructure in that the first segments of the population to get it are generally the wealthier ones who can afford to use it. Two tiered systems may be fine when they exist in non-essential parts of our lives. However, when there are two tiers, determined by wealth, for services as basic as energy, we're in a dangerous place.

That's part of why infrastructure exists the way it does. No single piece of the population would spend enough money to build services and systems useful for everyone. I think that's always going to be true for certain projects, such as bridges. But, as technology drops the cost of delivering the types of services we traditionally associate with infrastructure, I think we'll see the market extend its reach farther and farther. There's a huge amount of money to be made by ensuring universal coverage, but it won't be easy to unlock all of it.

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[1] At best, though, this is a partial solution. Throughput is well and good, but if the roads actually start to collapse, we'll need other solutions.

[2] Even though this seems like a good idea, there are still quite a few hurdles, not the least of which would be figuring out the right financing structure to make the installations profitable for the companies doing them. This is harder than it might seem for developing countries without sufficiently developed/ubiquitous banking systems.


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.

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