06 Apr

Startup Investing 101

I am a startup entrepreneur. Before starting my fund raising, I spent hours pouring over information available for entrepreneurs raising funds. When I realized that I was still lacking understanding of how investors think, I started going though content written for the wannabe early stage startup investor.

I have distilling my discovery in this living document that is being updated continuously, as I get new insights.

Startup investing is very counter intuitive. The investment intuition you developed elsewhere will be counter productive here. If you get into startup investing without understanding it well, you will lose your shirt and kill the startups you invested in.

I know this post is a long and dense. But we entrepreneurs like our investors to be at least as intelligent, intense, hard working and competent as we are. If not better.

Note to entrepreneurs

Most of the points here were taken from Y-Combinator’s school for Startup investors (link at the bottom of the page). YC works with some of the best founders from all over the world. They assume that the investors will be talking to top-notch founders.

The rest of us may not have this much purchase power with the investors. However, your job is to become such an exceptional founder that you can command the kind of respect a YC founder gets.

Note to investors

Your job is to find the best founder your money can buy. The only way you can do it is to build a fantastic reputation for yourself. When you have a great reputation, exceptional founders will find you.

You want to fund the kind of founders who select their investors very, very carefully, based on their reputation. These founders are capable of taking away all your bargaining power. This is a good sign.

People quoted in this post

Silicon Valley’s early stage investors

  • Ali Partovi is a co-founder of Code.org, iLike, LinkExchange, an early advisor at Dropbox, and an early promoter of bid-based search advertising. Linkedin & Blog.
  • Andrea Zurek is a Founding Partner at XG Ventures, an angel investment company. Andrea most recently worked at Google, as a Regional Sales Manager, and as an Agency Training Program Manager, within the direct sales organization. Linkedin
  • Aaron Harris is a Partner at Y Combinator, a seed accelerator that has funded over 500 startups including Scribd, Reddit, Airbnb, and Dropbox. Aaron is also the Co-Founder of Tutorspree, which was funded by Y Combinator in 2011. Before Tutorspree he worked at Bridgewater Associates, where he managed product and operations for an analytics group. Linkedin & Blog.
  • Carolynn Levy is a partner at Y Combinator. She was previously at Wilson Sonsini Goodrich and Rosati, where she helped hundreds of startups with legal questions. She has a BA in political science from UCLA and JD from the USF School of Law and is a member of the State Bar of California. Linkedin
  • Elad Gil is a serial entrepreneur, operating executive, and investor or advisor to private companies including Airbnb, Pinterest, Square, and Stripe. Linkedin & Blog.
  • Jeff Clavier is a Managing Partner at Uncork Capital, a seed-stage venture firm in Palo Alto and San Francisco. He founded Uncork Capital in 2004 (then called SoftTech VC) to provide active support and capital for companies in their first 18 months of life. Linkedin & Blog.
  • Geff Ralston is the President of Y Combinator. He was the CEO of La La Media, Inc., developer of Lala, a web browser-based music distribution site. Prior to Lala, Ralston worked for Yahoo!, where he was Vice President of Engineering and Chief Product Officer. In 1997, Ralston created Yahoo! Mail. Linkedin & Blog.
  • Michael Seibel is CEO and a partner at Y Combinator and co-founder of two startups – Justin.tv/Twitch and Socialcam. He has been a partner at Y Combinator since 2013. Linkedin & Blog.
  • Paul Buchcheit is an American computer engineer and entrepreneur who created Gmail. He developed the original prototype of Google AdSense as part of his work on Gmail. He also suggested Google’s former company motto “Don’t be evil” in a 2000 meeting on company values. Linkedin & Blog.
  • Pejman Nozad was previously founder of Pejman Mar Ventures in Menlo Park, CA. He has invested in many companies, including Dropbox, Lending Club, SoundHound, Branch Metrics, ZenPayroll, DoorDash, and Washio. Linkedin
  • Ron Conway is an American angel investor and philanthropist, often described as one of Silicon Valley’s “super angels”. Linkedin
  • Sam Altman is an American entrepreneur, investor, programmer, and blogger. He is the former president of Y Combinator and now the CEO of OpenAI. Linkedin & Blog

Indian early stage investors

  • Suresh Sambandham is founder and CEO of Orange Scape (KissFlow), a super-hot no-code workflow management platform.

Preamble

  • Startups exist not just to make stuff, make money, or even serve customers. They exist to learn how to build a sustainable business. (Lean Startup, Eric Ries)
  • Typical venture capitalist needs a business model that can scale massively, in a short time. These are called hyper-growth startups. Hyper-growth startups are a subset of startups. But they get all the press.
  • Everything about a startup is counter intuitive. So is investing in a startup.
  • Early stage startups are still in the process of discovering their business. Any business plan they give you won’t be worth the paper on which it is printed. Save yourself the trouble. Skip the BPlans.
  • This post is about investing in early stage statups. This stage of investing is also called friends-and-family round, angel round, pre-seed, seed round, etc. Many of these companies do not (and cannot) have a track record.
  • If the company has a performance track record for several months that can be projected into the medium future, then it falls into Series-A. Plenty of what is in this post won’t be applicable for Series A companies.

Lastly, this is a long, dense and tedious post. This is optimized for utility, not for traffic. As a founder, I have read hundreds of posts like this. If the choice were up to me, I’ll skirt away from all investors who don’t bring that kind of dedication and energy into what they do.

This is what I learn from all the successful startup investors: Startup investing is hard work that takes years to master. But it is super-fun.

What is unique about startups?

  • Startups grow exponentially
    • Our intuition for exponential growth is bad (Sam Altman)
    • Startup investing is a business of home runs. Don’t play for singles (Sam Altman)
    • Don’t mind the failure rate. What counts is the magnitude of your biggest success (Sam Altman)
    • It is better to bet on extremely audacious ideas with poor chances of success than to invest on something that has excellent chances of success, but not going to be very large (Ali Partovi)
  • Typical characteristics of startup ideas
    • Sounds crazy, but right (Sam Altman)
    • Don’t chase bad ideas that look like good ideas (Sam Altman)
    • Generation defining companies have always been founded by the outsiders (Sam Altman)
    • Can you imagine the founder or the idea becoming a giant? (Sam Altman)
    • This the only filter I apply: Can it become a $10b company? (Sam Altman)
      • Note: Companies that sit on top of the power law are so rare, you select for only this and leave other things out
    • The idea is so rare, people want to proactively help for free (Sam Altman)
    • Is this company capable of recruiting hundreds of talented people who will otherwise go and start their own companies? (Sam Altman)
    • Great product (Sam Altman)
    • Gets more powerful as it becomes bigger (Sam Altman)
    • Don’t be afraid to invest outside software/your area of expertise. Great founders bring the domain knowledge (Paul Buchcheit)
    • Cynical ideas don’t make money (Paul Buchcheit)
    • Invest in the future you want to see (Paul Buchcheit)
    • Problems so dire, users are willing to try half-baked ideas (Michael Siebel)
    • Look for ideas that look stupid inside a big company (Paul Buchcheit and Elad Gil)
  • My best deals
    • Ridiculously cheap deals (Sam Altman)
      • Because I understood something that no one else understood
        • Don’t care too much about what other investors thing
        • Ask “what do I understand that other people do not”
    • Ridiculously expensive deals (Sam Altman)
    • Not limiting to good ideas is even a necessity (Paul Buchcheit)

Why do you invest in early stage startups?

  • They love the people they work with
    • Working with talented people with endless optimism is energizing (Sam Altman)
    • Love their innocence (Sam Altman)
  • Working with startups aligns with their personal motivation
    • It is interesting (Sam Altman)
    • It is energizing (Sam Altman)
    • It is fun (Sam Altman)
    • I can work on multiple things (Sam Altman)
    • It is humbling (Sam Altman)
    • I am not doing this for money. Here in the Valley, when they want to give back, they do angel investing (Michael Siebel)
    • The cause is close to my heart (Suresh Sambandaham)
  • Return of Investment
    • Some times, you get ridiculous returns

What can you say about the founders?

  • Importance of founders
    • Founder is absolutely critical. Everything else just derives from that (Paul Buchcheit)
    • When you see exceptional founders, don’t over analyze it. Get on the rocket ship and move (Pejman Nozad)
  • Chemistry with you
    • Only find founders ou want to spend lots of time with (Sam Altman)
    • Only find people who are better than I (Paul Buchcheit)
    • It is always about the character of the founder (Ron Conway)
  • Characteristics of the founder
    • Obsession (Paul Buchcheit)
    • Determined (Paul Buchcheit)
    • Committed (Paul Buchcheit)
    • Focus (Paul Buchcheit)
    • What probably mattered the most was the determination (Ron Conway)
    • Determination (Elad Gil)
    • Obsessively focused and persistent (Pejman Nozad)
    • Don’t give us easily (Pejman Nozad)
    • Resource efficiency
      • Frugality (Paul Buchcheit)
      • Accomplishes a lot with little (Paul Buchcheit)
    • Love (Paul Buchcheit)
    • Larger than Life
      • Delusion (Sam Altman)
      • Impossible ambition (Paul Buchcheit)
      • You can’t learn to be ambitious and driven (Ron Conway)
      • Not afraid to take big risks (Pejman Nozad)
      • Not easily rattled (Pejman Nozad)
      • When a genius starts a company, the right thing to do is to invest in it (Ali Partovi)
      • Startup founders are often umemployable. Not always, but often (Michael Siebel)
    • Communication
      • Great communication/evangelists (Sam Altman)
      • Clear/concise communication (Paul Buchcheit)
    • Speed
      • Great execution speed (Sam Altman)
      • Moves fast (Sam Altman)
      • You can’t build a company by procrastinating (Ron Conway)
    • Ideator
      • Have ideas all the time (Sam Altman)
      • Generates frivolous ideas (Paul Buchcheit)
    • Leadership skills
      • Talent magnet (Paul Buchcheit)
      • Every successful company is the product of a giant team. You must always try to evaluate founder’s ability to become a talent magnet (Jeff Ralston)
      • Good captain of the ship (Pejman Nizad)
    • Learner
      • Improves/learns quickly (Sam Altman)
      • Fast learning (Elad Gil)
    • Salesmanship
      • Good at sellign (Elad Gil)
    • Solo founder
      • Can they learn enough coding to do an MVP? (Sam Altman)
    • Fit
      • Good founder-market fit (Elad Gil)
    • Problem they are solving
      • History with the problem they are solving (Pejamn Nozad)
      • Solvign very specific problem (Pejman Nozad)
    • Risk mitigation
      • Paranoid (Pegman Nozad)
      • Doubel and triple checks everything (Pejman Nozad)
    • Vision (Pejman Nozad)
  • What are considered negatives in a founder?
    • Wrong motivation (Sam Altman)
    • I never made money on a mediocre founder (Sam Altman)
    • Can you imagine this founder becoming a giant (Sam Altman)
    • Any thing in a founder that cannot improve with time (Sam Altman)
    • Bad team (but depending on the context, it may just be a neutral sign) (Elad Gil)
    • People who have never failed are bad choices (Paul Buchcheit)

How do you evaluate the market?

  • Market Growth
    • Market is small today. But it will be huge in 10 years (Paul Buchcheit)
    • Growth is the life blood of innovation (Ron Conway)
    • Markets trump everything (Elad Gil)
      • Great market + Great team = Magic
      • Great compounding even in the early years
      • Marquee paying customers
      • Customers paying premium price
  • Market Trend
    • Real trend is when users rave about it (Paul Buchcheit)
  • Timing
    • Why now (Elad Gil)
  • Existence of moats
  • Product-market fit
    • Running out of money is just a proxy for not having product-market fit (Elad Gil)

How to make investment decisions?

  • Decision making
    • Be very deliberate. Don’t be dithering (Paul Buchcheit)
    • Investment in startups involves great deal of luck (Paul Buchcheit)
    • Be prepared to lose some money before you become an expert (Paul Buchcheit)
    • When you invest, write off the money (Michael Siebel)
    • Investment is not for he indecisive (Ali Partovi)
    • When you have a strong intuitive feeling, go with it (Ali Partovi)
    • Angel-investing is lot like falling in love (Ali Partovi)
    • 3 Bs: Brilliant founder with a big idea that sounds bad (Ali Partovi)
    • If you get a feel for the culture of the company, you are going to feel much better about the investment (Ron Conway)
    • In a brand new company, they may not have answers for every question (Aron Harris)
    • Trust your instincts (Andrea Zurek)
    • Invest only on people you want to live many years with (Elad Gil)
  • Value based decision
    • Value investing is a bad idea (Sam Altman)
    • There really isn’t anything called value investing in the startups (Paul Buchcheit)
    • Bargains are bad (Paul Buchcheit)
    • Never decline to invest only because a deal is expensive (Paul Buchcheit)
    • Don’t get emotionally attached to a deal (Sam Altman)
    • Don’t invest out of pity (Paul Buchcheit)
    • Don’t invest just because the numbers are great (Paul Buchcheit)
    • Don’t be penny wise and pound foolish (Ron Conway)
    • Valuation does matter. Though it isn’t the single most important factor (Elad Gil)
    • If you believe in power law, and invest with that in mind, it doesn’t make sense to split hair about little things (Carlynn Levy)
  • Good practices
    • If the company is doing an up-round by a top-tier VC, you should always do pro-rata (Sam Altman)
    • Write big enough check so that when there is an excellent return, it actually matters (Michael Siebel)
    • Investment you make must have a little bight to make you think and get serious about the investment (Michel Siebel)
    • If one of your friends start a company, and you have FOMO that it would become a billion dollar company, just shut up and write the check (Michel Siebel)
    • It is nice to have a partner to keep you grounded (Ali Partovi)
    • Let’s all work together to make the ecosystem better by bringing consistency, honesty, integrity, transparency, etc. (Ron Conway)
    • When you are in negotiation, one side is likely to have more leverage than the other. But do not push your leverage beyond reason. (Aron Harris)
    • Always negotiate in good faith (Aron Harris)
    • Your word is your bond (Aron Harris)
    • You are trying to start a trusting relationship (Aron Harris)
    • Don’t promise to invest the money you don’t have (Aron Harris)
    • If you are not honest with them, they will not be honest with you (Aron Harris)
    • Don’t go calling the board behind the founder’s back (Aron Harris)
    • Write the check for 10% of the company and maintain that percentage for as long as possible (Jeff Clavier)
    • Don’t invest in competition companies (Jeff Clavier)
    • You must be willing to pivot (Andrea Zurek)
    • Do you hustle (Andrea Zurek)
    • False signals: Other investors (Elad Gil)
    • Expect to fail and accept it gracefully (Carlynn Levy)
  • Closing
    • Help founders before closing (Sam Altman)
  • Warnings
    • Even if you think it is going to be a success, it can turn out to be a disaster. If you think it is going to be a disaster, don’t even touch it (Jeff Clavier)
    • Massively unequal cap-table are warning signs (Michael Siebel)
    • This is not an over-night success industry (Andrea Zurek)
    • There is as much art in it as there is science (Andrea Zurek)

What comes after the investment is done?

  • Conduct
    • After making the investment, get the hell out of the way (Aron Harris)
    • Maintain relationship with the founder even after they have closed a round (Michel Siebel)
    • Being a great investor is an incredibly hard work (Michael Siebel)
    • Even if all goes to shit, I am going forward (Michael Siebel)
    • Very rarely will an investor have a really big impact in the course of a company (Michael Siebel)
    • Investors are better mentors than managers (Ron Conway)
    • Once you start playing with the house money, stop worrying about wins and start becoming an adviser/mentor to the founders (Ron Conway)
    • In the first year, nothing really happens (Pejman Nozad)
  • Help in
    • Bring your friends in (Aron Harris)
    • Shaping the future (Sam Altman)
    • Hiring (Sam Altman)
    • Fund Raising (Sam Altman)
    • Try to be available all the time for tactical advice (Sam Altman)
    • Do anything to get your company off the ground (Andrea Zurek)
    • Your primary responsibility as an angel investor is to help companies become successful (Elad Gil)
    • You don’t have to be in the board to help the company (Carlynn Levy)

How do you become a professional at this?

  • Systems and processes
    • Create a system to invest quickly. Often times, you have an hour or a day to make an investment (Michel Siebel)
    • Best investor gives money quickly, signs the paper quickly and then shuts the hell up (Michel Siebel)
    • You must have enough confidence in your process to write a lot of checks (Michel Siebel)
    • Do not invest the money you cannot afford to lose or lock in for a long time (Michel Siebel)
    • Invest probably not more than 10% of your net worth into this asset class (Michel Siebel)
    • Move your angle cash to a separate account (Jeff Clavier)
    • Starting with an investment of $100k to $1m over 3 years is a good start (Michel Siebel)
  • Portfolio construction
    • Many options are available; but be consistent (Jeff Clavier)
    • Check size: 10k, 25k, 50k, 100k (Jeff Clavier)
    • Number of investments per year: 10 to 12 over 3 years (Jeff Clavier)
    • Decide on the sectors (Jeff Clavier)
    • Stage/traction: Pre-seed, Seed, Post-launch, In-revenue (Jeff Clavier)
    • Geographies: Local, National, Global, Rise of the rest (Jeff Clavier)
    • Maintain ownership during follow on (Jeff Clavier)
    • Getting clarity on all these will give you clarity on inbound deals (Jeff Clavier)
  • Risk management
    • The worst that can happen is that you lose everything (Jeff Clavier)
    • Don’t write a large check when you are just starting out (Andrea Zurek)
    • Don’t have a random investment that you cannot explain (Andrea Zurek)
    • It is a very risky business. Spread your risk across many companies. Say, 25k in 10 companies. Even if one of them win, you will be playing with the house money (Ron Conway)
    • Get to the point where you are playing with the house money (Ron Conway)
  • Speed matters
    • The industry is not sympathetic towards people who hum and haw and take a lot of time (Ali Partovi)
    • Weeks are too long. If you are going to take weeks, you are going to miss deals (Ali Partovi)
    • If you are taking weeks, you are hurting your reputation (Ali Partovi)
    • Sign the documents quickly. Send the money immediately after signing the document (Aron Harris)
    • Be respectable of other people’s time (Andrea Zurek)
    • Decide quickly (Sam Altman)
    • Respond quickly, even if it is to say no (Andrea Zurek)

How do you ensure deal flow?

  • Investor’s reputation
    • Investors have lost their leverage. Founders are in the driving seat. So, don’t fuck up your reputation (Sam Altman)
    • Founders do reference check on you
    • In this industry, reputation drives profits. So, reputation is more important than making money (Aron Harris)
    • Being good is not a personality aberration. It is a strategy (Ron Conway)
    • In the past, it might have helped the VCs to act bad. It doesn’t work that way anymore (Ron Conway)
    • If you keep helping the founders, keep building your relationships and networks so that you can solve problems for them, you’ll be successful (Ron Conway)
    • Being good directly correlates with your deal flow (Aron Harris)
    • If you are helpful, the founders will talk about it (Aron Harris)
    • Founders have a long memory. Startup is a small world (Aron Harris)
    • Respect the founder’s time (Aron Harris)
    • If you are being a jerk to them, they will remember (Aron Harris)
    • Good = Returns (Aron Harris)
    • Just because your founder had demonstrated a bad behavior, it is not a good idea to be a bad investor (Aron Harris)
    • Reputation matters. How else do you ensure that you get the deal flow (Andrea Zurek)
    • What is the value you can bring to the table, other than money (Andrea Zurek)
    • Angels acting badly (Elad Gil)
      • Doing things that are good for self, but bad for the company
      • Giving bad advice (on stuff they don’t know about)
    • Projecting yourself in the founder’s position is bad (Elad Gil)
  • Branding yourself
    • Think what you are going to stand for ethically (Andrea Zurek)
    • How are you going to stand-out from the crowd of investors (Andrea Zurek)
    • You can’t build reputation based on what you are going to do (Andrea Zurek)
    • Hire people who represent you and what you stand for (Andrea Zurek)
  • Channels
    • From other founders (Sam Altman)
    • Random cold emails (Sam Altman)
    • Are you attending/being-invited to the right events? (Andrea Zurek)

How do you learn to become a better investor?

  • From past
    • Investing in seed stage involves a great deal of luck (Paul Buchcheit)
    • Don’t over learn from your past mistakes (Paul Buchcheit)
    • Learn everything from the past mistake and then ignore the past (Paul Buchcheit)
    • Failure is part of the business model. Don’t be upset about it (Ron Conway)
    • There is no great investor in the world who hasn’t made mistakes (Elad Gil, Paul Buchcheit)
  • From peer group
    • Joint an angel group so that you can learn from other angels (Andrea Zurek)

References

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