How to Start a Startup. Lecture 9 Summary. How to Raise Money

Disclaimer: We know we hardly have time to sit through an hour class (even if it’s online). This is why the Innowest team has put together some summaries from Sam Altman’s How to Start a Startup video lectures. This series, initially given at Stanford in Fall 2014, covers everything we know about how to start a startup, and features some of the world’s experts. When you get the chance, watch the whole lectures here:


Lecture 9: How to Raise Money


In this lecture of How to Start a Startup, Sam Altman holds a Q&A panel featuring Marc Andreessen (Founder of Netscape and Andreessen Horowitz), Ron Conway (Founder of SV Angel), and Parker Conrad (Founder of Zenefits). Here are the main takeaways:

Raise Money

What makes you decide to invest in a founder company?

Ron: While they’re being talked to, they think of “Is this person a leader, “Is this person rightful, focused, and obsessed by the product?” “What inspired you to create this product?” – in hopes that it’s created because of a personal problem and they look if the founders has communication skills. So when you meet a major investor, you should be able to say what your product does in one compelling sentence. You have to be decisive – the only way to make progress is to make decision. Once you have a great product then it’s all about execution and building a great team.

Marc: Two general concepts. First, venture capital business is a game of outliers. The statistics are in four thousand venture fundable companies that want to raise venture capital about 200 will get funded by a top tier VC and about 15 of the 200 will someday get to a hundred million dollars in revenue. Venture capital is an extreme business, you’re either in or not. Second, invest in strength versus lack of weakness. Companies that have really extreme strengths often have serious flaws. Companies that have a good founder, idea, products, and initial customers may not always have something that makes them really remarkable and special. If you don’t invest in the bases with serious flaws, you don’t invest in most of the big winners. Aspire to invest in startups that have really extreme strength and dimension.


Could you talk about your seed round and how that went and what you should have done differently for raising money?

Parker: In early days of a previous company, my cofounder and I pitched to almost every VC firm in Silicon Valley and they all said no. Someone at a VC firm told us we were not the guys at Twitter who can say anything and get investors. We needed to make our pitches easy and have stuff ready for other VC firms. Rather than accommodating their pitches they decided to become the twitter guys. I realized you can’t count on there being capital available to you and so, the business I started seemed like one I could do without raising money. Turns out, those are exactly the kind of businesses investors love to invest in. You can build the business where everything is moving in the right direction.

Ron: Bootstrap (be a business that does not require investors) for as long as you can.

Marc: The key to success is to be so good they can’t ignore you. Build a business that is going to be a gigantic success. If you come with a theory and plan but no data, you are just one of the next thousand and it will be harder to raise money. You are always better off making your business better than making your pitch better. Raising venture capital is the easiest thing a startup founder is ever going to do compared to recruiting engineers, selling to large enterprise, getting viral growth, getting advertising revenue. Finally, raising money is not actually a success or milestone.


What do you guys wish founders did different when raising money?

Marc: The single biggest thing entrepreneurs are missing both on fundraising and how they run their companies is the relationship between risk and cash. Andy Rachleff’s onion theory of risk says basically that you can think about a startup one day as having every conceivable kind of risk and you can basically make a list of the risks:

    • founding team risks, founders going to be able to work together;
    • product risk, can you built the product?;
    • technical risk, maybe you need a machine learning breakthrough or something
    • are you going to have something to make it work, or are you going to be able to do it?
    • launch risk, with the launch go well?
    • market acceptance risk, you will have revenue risk
    • a big risk you get into with a lot of business is that have a sales roce, is can you actually sell enough to pay for cost of sales?
    • if you are a consumer product, you have viral growth risk

You raise seed money in order to peel away risks, basically peeling away risks as you go. As you achieve milestones, you are making progress and justifying more capital. The best way to pitch to someone is to say which milestones you achieved and which risks you eliminated. Pitching this way is more systematic than raising as much money as possible, building offices, hiring, and hoping for the best after.

Ron: Don’t ask people to sign an NDA because that immediately says “I don’t trust you.” Relationships between investors and founders involves lots of trust. One of the biggest mistake is to not get things in writing. When someone makes a commitment to you, email them for confirmation. A lot of investors have short memories and forget.


How does the process of tactics go? Can people email directly or do they need to get an introduction? How many meetings does it take to make a decision? How do you figure out what the right terms are? When can a founder ask for a check?

Ron: At SV Angel we invest in seed startups and like to be the first investor. The amount they usually invest is between 1-2 million and they end up investing in one company for every 30 looked, “about” one a week. Our network is so huge that we take leads from our own network. We evaluate the opportunity: you have to send in a great short executive summary and if we like it we vote upon whether or not to make a call. Time is essential in the process. If we ask to meet you, we are well on our way to investing.

Marc: Top tier venture capitalists (generally) only invest in two kinds of companies in Stage : (1) if they have previously raised a seed round and (2) once in a while will go straight to company that hasn’t raised a seed round only when it’s a founder they have worked with in the past, a successful one (usually when this company is acquired by another big company). The best way to get introductions to the A stage venture firms is to work through seed investors or work through Y Combinator. They get two thousand of referrals through their network.


Speaking of terms. What term should founders care most about? And how should founders negotiate?

Parker: The most important thing at seed stage is picking right seed investors because they are the foundation of future fundraising events. If you can get an introduction from someone that the VC trusts and respects, it’s more likely to go better than an introduction from someone they don’t know well. Best thing to do is find the right investors.


How does the founder know who the right investors are?

Parker: It’s hard, but one of the best ways is to work with YC; they do a good job at telling you who they think the best investors are. This has ended up being most helpful and have best introductions.


How do you think about negotiations? How do you figure out what the right evaluation of their company should be? What are the terms?

Parker: When I was starting out, raising my seed and didn’t really know. I started too high on valuation. At Y Combinator’s Demo Day (a day where investors are looking at companies to invest) I started trying to raise money for a 12 or 15 mil dollar cap, but had to work down and raise at 9. No one would pay 12 but at a 9 million dollar cap, could have raised 10 million. There seemed to be a threshold for seed stage companies. There’s a rough kind of range that people are willing to pay. Get the money you need, not more than that.


Is there a maximum in the company that you think founders should sell in their seed round, their A round? Beyond what Paul was talking about.

Parker: It seems like it’s rough for Series A. You’re probably going to sell between 20-30 percent of the company. Venture Capitalist tend to be more ownership focused than price focused. When companies raise really big rounds it may be because the investor says “Hey listen, I am not going to go below twenty percent ownership but I will pay more for it.” Above 30% weird things happen with the cap. In most cases in the seed stage, there doesn’t seem to be any magic but 10 to 15% is what people say.

Ron: It’s important for the founder to say: At what point does my ownership start to demotivate me? If there’s a 40% dilution in Angel round, owners are “doomed” and going to own less than 5% of the company. If you give away more than there is, then you won’t have enough for you and the team, you’ll be doing all the work.

Marc: In the last 5 years, I have seen companies where they won’t bid because their cap table is already destroyed. Outside investors own too much (80%). Relatively young companies, within 2 early rounds sold too much of the company. It would be demotivating for the team to have that structure.


Ron and Marc, could you both tell a story about the most successful investment you ever made and how that came to happen?

Ron: The investment in Google in 1999. I met the founders through a professor in Stanford (who was an Angel Investor), but they were not ready. So after 5 months, I got to meet them again and they told me they would let me invest in Google if I could get Sequoia to invest in them (because they were late to market and Sequoia had already invested in Yahoo).

Marc: Airbnb. We didn’t invest early but in the first round (some of the junior team met them). VCs always go to the outliers, one of the good thing about Airbnb is that they were the outliers (the ones with the crazy ideas). Another thing about Airbnb was its founders, who were the type that, as the business grows, they also become more mature, have better judgement and get more humble. They don’t get swallowed by their positions. VCs knew that not only the business was going to grow but the guys were going to be able to run it.

Ron: In the case of Airbnb, all of the founders are as good as the other founder. That is rare. In case of Google, one was better than the other (and became the CEO). When you go start a company, find a cofounder that is as good or better than you. That’s what makes your chances of success grow astronomically. The anomaly is Mark Zuckerberg. He has a great team but the phenomenon when it’s only one person is the outlier.


Does money raising help you with exit on acquihire?

Ron: If you pick good investors that have domain expertise they are going to add more value than money. This is what you should look like when looking for type of investors.

Marc: Yes but It doesn’t matter because you should not start this looking for the downsize. Scenario you are not looking for. In which investor but not whether or not?


What should founders do for capital intensive companies?

Marc: The more capital your business is going to need you need to be more precise on which are the milestones you need to achieve. The risk is higher so you need to be very precise on what you are going to accomplish with your A round. If you end up raising too much money in the A round that is going to screw you over in the next rounds. The cumulative dilutions will be too much so you have to be precise about which milestones you’ll achieve in each round. If you walk into our office with a Twitter or a Pinterest that has a lot of growth, those are the easy ones. If you come with an idea that is going to need a lot of investment, there is going to be a lot of growth but after a few years, we are going to invest but we’ll put more weight on the team and the execution, if they come with an execution plan and milestones that’s how they measure the team. The plan should be very precise. (Ron: if you are going to be capital intensive there are other ways to get funds that from VCs). If you are going to get debt operational excellence is a must!


Which investors to avoid?

Ron: Those who have no domain expertise in your company and cannot help you with introductions for business development or for series A.

Marc: Think of this like a marriage, these are the people who are going to be in the board in the long run for 10, 15 years. These are the people who you’ll be discussing the future of the company in meetings late at night and you want them to be in the same team: understanding of the company, ethics, staying power when there are storms. Usually second time founders take this more seriously.

Parker: In the first meeting you need to feel that you respect this person and you have a lot to learn from them. Even when you don’t get money from them, they have so much insight that you walk out of the meeting feeling that it was a good use of your hour, knowing what to do and where to go, this is a good sign about how the rest of the years will go. A good indicator of a good investor would be if you want to have the person involved in the company even if they don’t have the money. If you don’t then that’s a bad sign.


What is the constraint on number of companies you invest in?

Ron: For Angel investors is one a week. So it’s a number of companies constraint. Also, if there is a company in the same space then we will disclosure to the other company (we don’t know the product strategy anyway. Our disclosure policy talks about Trust.

Marc: Opportunity cost, for everything you do, there are a bunch of other things you can’t do. There are two of these. First, conflicting companies. We don’t invest in two conflicting companies, there is only one in each category. So if we invest now on myspace, for example, then we can not invest in facebook three years later, or any other company that might turn out to be better. The second opportunity cost is the time and bandwidth of the general partners. Each partner can be in ten to twelve boards if he’s completely and fully loaded. Each new investment reduces the ability of the firm to do new deals.


What convinces you to invest with no product traction?

Ron: Founder and the team itself. Products tend to morph a lot. Pre-users the valuation will be lower unless the founder has a success track record.

Marc: Founder who we worked before or well known. Other categories are capital intensive. In case of SAS companies there is not going to be a final product because the customers are not going to buy an MVP they need the final product and that usually is finished by the first round of investment. Almost all those cases is going to be a founder who’s done it before.


What is the ideal board structure?

Parker: If you trust the people you are working with it shouldn’t be an issue. It never comes to a board vote at that time something is deeply broken anyway. Most of the power VCs have comes from outside the board. There are protective covenants that are built in the financing round (you can’t take on debt, you can’t sell the company, etc, without having them agree to it first). It’s less a big deal as people make it to be. As a founder, if things are going well you have almost unlimited power to do all the thing to do. The board or the agreements don’t matter. If you come and say “Listen, this is what we need to do, this is what we need to do, whether is a good or bad investor, even if it’s a bad investor, they will say you know, let’s do this. I want this to happen”. And when things are going badly, it doesn’t matter what protections in the system you built for yourself they will always have the control. (Marc: they will make you renegotiate all the terms).

Marc: I’ve been on boards 12 years and it has never come up to a board vote. The decisions have been unanimous. It’s all about the intangibles.