UPDATED:
I got some comments via email which pointed to some confusing points in my post and thought about it some more and I think it boils down to this:
Keeping everyone happy with their return is hard but a worthwhile goal, and keeping startup valuations lower will result in better outcomes for all versus just some.
And, if you agree that keeping lower startup valuations is better generally, then you’d want to:
1. Raise less rounds of money, because raising funding is arguably the primary factor in how valuations rise. So work really hard to get to profitability on what you have raised.
2. However, raising less money is near impossible in general, and for certain businesses or industries, or due to competition, you may be forced to raise money to grow.
3. As you raise more rounds of money, it is tempting to keep valuations higher because that results in less dilution of founders, employees, and previous investors. Then two things come into play:
a. A higher valuation then tips the return in favor of the founders, employees, and previous investors and new investors are at higher risk of making lower return or nothing. (Remember my statement about better outcome for everyone, not just some..!)
b. At some point, you need to justify your valuation through actual progress and not just perception. If you cannot justify your valuation by the time a new valuation event happens (ie. new fund raising round, acquistion), then it will end up adjusting your valuation lower which is painful in many ways.
To some, maybe keeping everyone happy is impossible, or too hard, or not worth it. I’m sure some entrepreneurs have gotten shafted by investors in the past and they refuse to keep investors’ returns in mind as well as their own. There are also founders who have kept so much of their company in stock and given little to employees, and employees have virtually no chance of taking part in any exit event.
One could argue that me sitting in my position as an investor biases my opinions too.
Yes, entrepreneurs have a ton to worry about and deal with. However, I know for a fact that the entrepreneurs that take on the challenge of keeping not only themselves, but their investors and employees in mind when thinking about exits and total return gain much more respect for their efforts and will gain a much more loyal following of people who will work with them and invest in them if they ever choose to build another company.
/UPDATED

In one of my emails to an entrepreneur, I sent this statement:
I am a fan of the point of view to keep your valuations as low as possible in general. This will keep your and our outcome more substantial in the long run.
To which he replied asking for more clarification on that statement.
I went to Google searching for posts on this topic, because I thought I had read about it in the past. But for some reason, I could not find any post that addressed this topic, but only posts mentioning it in passing and in context of some other topics. I do admit I didn’t go paging deep into Google search results looking for posts, but in the results I did look at I couldn’t find anything addressing this directly. (Some of the posts I found are referenced in my post).
First, I should say that one of the key statements above is “in general”. So many variables exist in the generation of an exit and what the various players would get out of the division of the exit pie that any claim to certainty would probably be a lie. Still, I believe that keeping valuations low for startups generally will keep outcomes for everyone higher, or at least the probability of a higher outcome for all will be greater.
Who can win?
There are 3 groups of people involved in a company: founders, investors, and the other employees.
Founders
Let’s be clear first. In general, founders of the company will make out big in almost every case, even if the company sells at a valuation that is lower than the existing valuation of the company.
Check out Fred Wilson’s post on Slide’s exit, although he was talking about the importance of liquidation preferences. Max Levchin raised his last round at a $550M valuation but sold his company to Google for $228M. Even though some of the investors only got their money back and others made some money, Max was able to take home $14M (for his common stock portion of return, not including the $25M he got from his additional series A investment).
This is because he, like most founders of a startup, own such a huge amount of stock in the company that it is impossible to not make something substantial, even when the company sold for less than what it was last valued at.
However, keeping a low startup valuation will keep dilution of founders’ shares low and maximize your return.
Investors
The next set of people involved are investors. Investors can make out big, but only if the conditions are right, and one of that helps is a lower valuation. Most of the discussion on blog posts surround the return of investors when valuations are kept lower more than higher.
The more investors are diluted, or the more the percentage of ownership of investors is lowered, the less an investor’s return. So subsequent rounds of financing will dilute early investors, and although higher valuations of a subsequent round will protect somewhat the dilution of previous investors.
Keeping valuations lower means raising less money and fighting for growth/profitability with what you have raised, and investors’ dilution is also less.
Professional investors tend to want to maximize returns and have, in the past, been known to block smaller exits if they think an investment has the potential for a higher return. So if an investor is a professional investor and if they are in a position to affect an exit’s outcome, say either with controlling company interest of a board position, then they may be unhappy with a lesser return and can cause trouble to the team.
If the total valuation is lower, then the multiple return on capital would be greater and investors are happier with their return.
Knowing this, there are a new crop of investors who are less sensitive to multiples of return. Digital Sky Technologies, the Russian investment company, has famously put money into Groupon, Facebook, and Zynga. When you’re dealing with the amount of money they are dealing with, even some percentage points return will yield immense amounts of money. Andressen-Horowitz is another, having put $50M into Skype, and being less sensitive to stage of investment, but just putting money to work in great companies.
The terms definitely affect the return of investors. Look again at the title of Fred Wilson’s post: liquidation preferences helped those later investors get money back even in a lower than current valuation sale. In absence of those terms, those later investors would have lost it all.
However, if Slide had not raised money at a $550M valuation, then potentially those who invested in it may have made money when it was sold for $228M assuming that Max would have accepted an investment at a lower valuation. Or perhaps those investors shouldn’t have invested in Slide at all if the deal was going to be done at $550M.
A lower valuation for the company would have yielded more positive options for the investors in outcome, versus putting more risk for return in the company for an exit that can be difficult at a much higher valuation.
However, there are cases where even if the company is sold at an amount higher than the existing valuation, they may not make any money at all, or even lose money. We are seeing pressure being put on exits up to $10-20M where the acquirers want the employees and founders to keep most of the money and not return much to the investors. So starting with a lower valuation can protect against this happening somewhat.
Employees
Employees who do not have huge founder stakes in the company are last on the totem pole for return. Here, lower valuations matter the most to the employees and the stock options they own because they the lower the strike price, the better their return. If the valuation gets driven higher, employees who are hired later get progressively higher strike prices which make it harder to make money off the options. This is why employees often make barely anything relative to an exit of a company, but make most of their return simply from salary.
Consider this post from Don Dodge regarding Facebook shares; many people think that if they can get into Facebook now they can make a million bucks when they go IPO. The problem is that the valuation of Facebook is so high now that the difference between what someone gets options for now and what share price the company could IPO at is going to be so minimal that it is not possible to make a lot off the selling of those shares.
Also, consider the 409A Valuation requirement by the IRS mentioned in Don’s post. As the company grows in valuation whether by further financings or growth progress, the 409A Valuation requirement will force a re-price of options and drive their strike price higher; it is no longer possible to keep option prices low for the benefit of employees coming in at any time. Higher valuations therefore suppress gain by employees. If your wish is to extend some gain to the rank and file, you should aspire to keep your valuation low as low as possible.
Valuation vs. Company Progress
If a company’s valuation gets too high relative to its progress, this could cause problems. That doesn’t mean you can’t raise money to a high valuation; you can easily do so if you can pitch well and have a great team and idea. However, at some point, your company’s progress needs to justify the valuation. (See this post Startup Valuation and Calculating Startup Worth.) The danger of high startup valuations is that at some point, you may need to raise more money and if you can’t justify your startup’s value to investors both from a perception and from a reality standpoint, you may be forced to raise money at a lower valuation than before. This is usually a painful process and will cause dilution of one or more of the involved groups, reducing their return. So keeping your valuation lower and marching your valuation upward in lock step with your progress is worthwhile.
For other related posts on this topic, please see:
Quora: What are the disadvantages of an absurdly high valuation for a startup?
Plugged.in: Startup Valuation and Calculating Startup Worth
Techcrunch: So High Valuations Are Back. But Does that Mean You Want One? [Video]
Techcrunch: A Conversation with Greylock’s Reid Hoffman and David Sze [Full Video]
A VC: Here’s Why You Need A Liquidation Preference
Don Dodge on The Next Big Thing: Will Facebook have an IPO bounce? Has 409A changed the game?
Quora: Startup Advice & Strategy: How much money should I raise?

In thinking about my angel investing strategy going forward, I started thinking about how venture funds always talk about taking their pro rata allocations in their winning companies, or even raising their share of the companies. They do this to keep “leaning on the winners” meaning that the will increase their investment “bet” on these companies which are doing well (and stop investing in those that aren’t doing so well). This then increases the return they get, while also minimizing the risk somewhat.
I thought that this may be a good angel investing strategy as well. In the world of the so-called lean startup and capital efficiency, everyone talks about finding a startup that only requires one round of financing, then gets to breakeven and profitability without requiring more rounds of financing. They get big and then an exit happens making everyone happy with the return because there is no dilution.
However, in practice, this is very hard to find. The twists and turns a startup can take invariably means that more money needs to be spent before they get to breakeven/profitability. Also, in today’s competitive world, getting huge quickly can give you a leg up on the competition and doing so may mean that you need some more funding to build your team quicker and to scale the business faster; without that funding, your organic earnings can’t give you that velocity of growth. The probability of needing another round or more than one extra round is definitely higher than the probability of getting lucky and dropping into a business that needs only one financing round.
As more financing rounds happen, then previous shareholders get diluted as someone new wants a piece of the company. We can either let ourselves be diluted, or, if we invest further, we can maintain at least our percentage ownership. Then when an exit happens, we maximize the return we get instead of watching our percentage ownership dwindle and get screwed for us helping the startup so early.
Here I started thinking that this may be a good way to invest even as an angel investor.
If you invest only in the first round as an angel investing strategy, then you must try for the lowest pre-valuation and hope for capital efficiency so that an exit can happen without further rounds of funding. But waiting for the perfect funding opportunity may mean you will pass on or miss some of the best opportunities even if the pre-valuation is not the best. Or the probability of a startup being truly capital efficient enough to get to be huge, or just to a decent exit, without further rounds of funding is very low.
Also, you must put in a large amount of money in the beginning, thus commiting capital at the most riskiest moment of a startup’s life: the beginning.
Then I started thinking that perhaps assuming I would not invest only in the first round, but also in subsequent rounds, then I could gain some advantages.
If I assume that dilution will happen, or assume that further rounds of financing will be required which is probably a more likely case, then I could commit lesser funds in the beginning, take my pro rata on each subsequent round, and still maintain my percentage ownership into the future. At some point in the future, I would have been diluted to this percentage ownership in any case. I would be, in effect, dollar cost averaging into the investment. Over a period of time, I could place relatively small bets into the winners of my portfolio, with each amount being within the range of my single investment amount.
I could also invest capital only when risk was reduced, meaning that if a company were successful and growing and could raise another round to grow further, then I would commit more capital rather than committing it all at the first round, when the chance for losing it all was greatest.
Now the problems with this are…
Getting my pro rata investment ability can be really tough in later rounds. A lot of venture terms exclude small investors in later rounds from being able to take their pro rata. If I don’t have specific pro rata rights, I would have to fight for my ability to invest further by having a great relationship with the founders and/or CEO. I may not be able to take my pro rata and maintain my percentage ownership.
At some point, the amount I would have to invest in a given round will inevitably grow to be beyond my ability to invest. My hope would then be maintain percentage ownership as long as possible before I couldn’t invest any more because that amount exceeded my ability to invest out there at any one time. So I might still get diluted if further investment rounds happen.
A lot of early investment rounds are in notes with caps, and those notes have no terms defined yet. It is quite possible that if I invest in an opportunity like that, that I will have no pro rata rights at all when the round finally converts into an equity round. Thus, I take a lot of risk when I invest in those companies with respect to employing this strategy.
When I talk to VCs, they always tell me that “leaning on the winners” meaning investing in futher rounds, taking their pro rata or even increasing their percentage ownership in the companies of their portfolio which are doing great, results in the greatest returns. So shouldn’t I do the same, even as an angel investor?
I would love to hear from more experienced angel investors and see if they have ever tried to employ this strategy in investing.

OK I admit it. I hang out mostly in two of the biggest tech startup communities ever, which are Silicon Valley and NYC. So when I blog about what I see, it is most often through the lens of someone who experiences the tech startup/investing ecosystems of those two places and not much of other places (NOTE: I do hang out in Los Angeles a lot too, but haven’t invested much there).
So yeah, I’m a Silicon Valley/NYC tech investing snob and when I write my snobbiness is evident and the facts are biased towards what I see in those two places with respect to tech and internet. Unfortunately, as I’m often reminded by folks, other sectors, and places in the US and the world have much different ecosystems. What are those differences?
1. Availability of capital is not as easy elsewhere. I wrote in my post What Startups Need Most Of Today that startups don’t need more of funding. Well, unfortunately that seems to only apply to Silicon Valley and NYC where for tech/internet startups this is true. For other types of startups, it can be a dry world indeed.
But there is hope. Thanks to Mark Suster who pointed me to A Moveable Feast of Mugs, Maniacs and Masters of the Game – David B. Lerner:
* Not all angels live in Silicon Valley!
* Not all angels are interested in consumer internet companies!
* There are vibrant angel communities in NYC, Boston and in other cities around the US!
* Angels account for 90% of all start-up funding in the US!
* Angels put up $20 Billion a year into approximately 50,000 startups!*
* Friends & Family put up an estimated $60 Billion a year into startups!*
* There are an estimated 225,00 angels in the United States*
* There are currently ~300 active angel groups in the United States*
Source: Angel Capital Association
According to this, perhaps funding IS NOT so scarce. However what makes funding scarce could be:
a. Networking to funding is tougher in other areas. In the SV and NYC, there are so many people investing and working on startups that it’s so much easier to bump into someone who can help you network into a pool of entrepreneurs or investors. I can believe this is much harder elsewhere if the networks are much more spread out or less organized, or startups are just not nearly as common as they are in SV/NYC.
b. The filters that investors put on startups before investing is a more conservative, traditional filter than for in SV and NYC. By conservative and traditional, I mean they want to see revenue and business plans and progress before funding; in SV/NYC, it is more likely that you can find investors to bet on you simply because you’re smart and energetic, and/or your idea is innovative but still has an unproven business model. Again this applies mostly to tech/internet startups; for other sectors, I find that the crowd tends towards the more conservative filters.
c. The experience base tends towards other sectors in other parts of the country. Thus, unfamiliar sectors may find funding very very scarce simply because the investor pool generally likes to invest in things they understand or have prior experience in. Here in SV/NYC, you can find many people who made a lot of money through the internet booms and have extensive experience building internet projects. But these guys rarely invest outside of the internet; so the opposite is true here in SV where if you’re working on something non-tech/internet, you could be very frustrated at seeing all these internet “dipshit” startups getting funded while you, with a really cool non-internet idea, can’t find anyone to bet on you.
2. Following on the networking comment, it is also much easier to get help as an internet/tech entrepreneur in SV/NYC. You can more readily find help here in SV/NYC as the available pool of entrepreneurs and helpful investors is higher. But if an internet/tech entrepreneur goes elsewhere, it could be very hard to find help. Also note that there are places where tech/internet help is building, like the cities where Techstars is popping up. For other sectors, this may be also true in SV since the variety of startups that are worked on here is very great. But for other parts of the country where the concentration of a given sector’s startups may be scarce, it could be very hard to find help.
Help can also come in the form of business contacts. If you’re in starting a company in a place where there are few or no others also working in that industry sector, then you will have to fly to find these contacts and that makes finding help harder.
3. Hiring can be *really* tough elsewhere. It seems the cream of the crop of software engineers ends up in SV with the dream of working at Google, and then some head to NYC area if they like that atmosphere. Generally, around major universities or major metros is where hiring is best. However, parts of the country which don’t have major corporations of a given industry sector or are less desirable places to live (by whatever metric people use to choose) can make it abnormally hard to hire. At least universities seem to be graduating a ton of software engineers; compare that to the number of biomedical, mechanical, civil, nuclear, etc engineers that graduate. Then remove those that are unsuitable for startups, either mental makeup, attitude, life stage, etc., and your pool gets that much smaller. It’s tough enough hiring for tech/internet startups; I can’t imagine what it would be like for other types of startups.
Is there hope for other parts of the country? I think the answer is sometimes:
1. Places like Chicago (Excelerate) and all the Techstars cities are forming their own entrepreneurial centers and incubators for internet/tech startups. But they are the new generation. If you Google a city plus the word “incubator” you can also find many tech incubators already in existence. But those tend towards non-internet tech and more traditional ways of thinking and building businesses, which are different and potentially not as effective for internet businesses. Meetup.com is allowing entrepreneurs and startup people to form little to big networking groups.
However, I am not sure that forming more incubators for internet startups is the right way to go. I have seen startups coming out of incubators that were very similar to other existing startups. I also think that the ease of competitors popping up means that finding something truly unique to work on is getting harder and harder. So somebody has to realize that as they are picking companies. So far, Ycombinator who has been around the longest seems to be picking and directing startups to work on really innovative stuff (and unfortunately there are always those that end up after their brief YC stint with not so exciting and innovative startups or those that are very feature based).
At the very least this suggests to me that new incubators need to do a better job of realizing what environment they are operating in and helping/fostering/directing their entrepreneurs to build really innovative stuff versus stuff that already has competitors.
2. One of the biggest issues I see with doing internet startups elsewhere besides SV or NYC is that while you may think you are working on a great idea, it is highly likely that someone else is already working on it. This is a big problem where entrepreneurs don’t look around the competition hard enough to know who else is working on your problem.
As an investor, I am extremely sensitive to competition in the internet only space. If you are working on something similar to something in SV or NYC, I may naturally pick the one in SV or NYC simply because of the environmental factors that will give them edge over someone who is not in those locales. Outside of internet, I think the world is nowhere near as competitive because it is much harder to create a me-too startup in other industries.
3. I sometimes meet investors in other places who lament that they can’t find good startups to invest in. It seems that they see all this money being made in internet startups (mostly all in SV or NYC!) and they want to get into the game. A couple of responses:
a. Sometimes they don’t have experience in internet businesses. This is a big problem as it increases risk that their lack of experience could mean they will bet on problematic startup plans. In this case, I think it will be better to find a fund to invest in who specializes in internet/tech.
b. Investing in startups not near you brings it’s own problems. How do you keep tabs on them? How do you know what they are doing? Are they squandering your money? You can’t take a ride over and talk to them. Stick to investing in startups you can get to easily, or at least in places you frequent in.
But yeah it sucks if there are no startups near you, or at least not in the hot trendy sector at the time….
c. I still maintain that the risk profile for internet only startups is extremely high even if it seems that people are making a lot of money on them. The ship has, unfortunately, sailed for many opportunities. Newly created internet startups tend to be incremental improvements on existing services, or those that attack a niche market whereas the giants attack the overall market. The success probability for an investor in these startups is going to be really tough. Returns will be lower because many of these businesses are doing cool stuff, but are attacking markets smaller than giants who are attacking the overall market; therefore, the exits on these will be most likely sub-$100MM.
So should you jump in? I think internet is going to be an opportunity trend, just like microprocessors and personal computers (and the list can go on). People bet on these trends and they lasted for a long time but now they have topped out and it’s hard to find those game changing huge bets in those areas. With the internet and its ability to launch things with very little capital, I believe the internet has raced up to topping out and will continue to make it harder to find really game changing, super exits that we all want. Soon it may be hard to even get worthwhile exits in the mid-$10MMs (and by the way, the economy still sucks which further suppresses exits, as well as the lackluster IPO market).
I would say, wait it out. There will be another trend coming soon and you should hop on that. Or find some venture fund to help you get into internet startups but I still think it is an area fraught with peril for venture returns.
So OK, I’m a Silicon Valley/NYC tech investing, blogging snob. And the reality is, where there is easy money, help, community and resources like in SV, NYC, and maybe some other up and coming areas, then startups and investors will flourish. Like for the movie industry – if you’re going to make a movie you wouldn’t go to Indiana right? You’d go to Los Angeles where there was money/help/community/resources for movie making (or maybe NYC). If you wanted to be a music star, you’d probably want to go to LA, or NYC, or if you were a country music star you’d end up in Nashville.
The world isn’t fair. We congregate in a place, make it a mecca for something (startups, movies, music, etc.) and it becomes THE place to go to become successful in it. But we want other places to be like that, like maybe where we are living right at this moment. We don’t want to move; we like living where we’re living now. But the fact is, sometimes the rest of the crowd congregates elsewhere and makes it mecca for something like startups and investing whether you like it or not. Participating from afar really isn’t as effective as just going there and living it.

There has been a disturbing trend I’ve noticed in early stage investing. That is when there are no professional investors (ie. venture fund) in the round, then I often find that I am the only guy asking for due diligence materials.
To me, this is appalling. How can you know that you’re investing in a real company? How do you know what has transpired in the past won’t catch up with you later to nip you in your ass? How do you know if you’re just transferring your cash into someone’s personal bank account?
Fallacies:
1. “If all these prominent individuals are investing, then obviously these guys are legit.”
Apparently, in some of the early stage rounds I’ve encountered even with prominent individuals, I’m still the only guys who asked for due diligence materials. So I guess that statement is only a fallacy when I’m NOT in a round since you can be sure I did ask and review them.
2. “If they came through a prominent organization [ie. Ycombinator, Techstars, TC Disrupt winner, etc.], then they must be legit.”
Well, mostly true for some aspects but not others. For example, they may have been incorporated but not had any board meetings, or had their initial founder stock purchase plans created. How do you know there isn’t something beyond the basics that is wrong with them?
Still prominent organizations must do some level of due diligence themselves to protect themselves from liability issues later on. But I will tell you that it is by no means complete or as buttoned up as it should be.
3. “If they say they are a DE corp, then everything must be OK.”
A lot of guys go to those online instant incorporation services and just pay a few hundred bucks to create a company in DE. After reviewing some of them, they are always barebones docs and may not be complete (ie. Articles of Incorporation are filed and generic By-Laws created, but no further docs created like Board Meeting Minutes or Stock Purchase Plans). There is also no advice given on how many shares to create – for example, it is a better practice to create 10MM or so common stock shares to prepare for the future. This WILL create work and costs to fix later on.
To me, it is imperative that you do your own due diligence. I gather materials on every deal and review them with my lawyer. You never know when you might find something that is wrong with the deal.
Here’s an example. I met an entrepreneur who got referred to me by a venture capitalist. I thought that since the venture capitalist was investing, the due diligence would just be customary and there would be no issues. Boy, was I wrong.
First, the entrepreneur didn’t want to give me typical due diligence materials. This was strange. Every startup before this gladly handed over the docs. But he didn’t. I went through several email exchanges with the entrepreneur to convince him that this was standard procedure that it happens all the time. He kept saying that these were confidential and was happy to hand them over AFTER I put my money in. Finally he relented and was going to send me materials. But all this time, my confidence in this deal was dropping like a rock.
Then the kicker was when we were looking at signing me up as advisor. I saw the consideration and it was 1000 shares. Hmmm, I thought, it’s a bit low isn’t it? But then I realized that he had only created 1,000,000 shares of common stock in the whole company. Whoa. This was the second red flag – I could see when the next round would come in and then another venture fund would demand cleanup of the corporation and then there would be a tremendous dilution of my advisor options. In reviewing this, we also realized that there were only 1MM shares authorized but they had allocated out 1,111,000 shares, 111K shares over the authorized amount which is not good that they have not gone through the process of authorizing them.
I ended up not investing on the state of the materials I managed to get, and the reluctance of the entrepreneur to give them to me.
And this also when a prominent venture firm had gone into the round too. They had apparently looked at the materials and decided it was worth pursuing despite the issues. But we have to make our own decisions on the information and I decided to decline because these issues had fallen past the threshold that I was willing to stomach in a deal.
If I had not done my own due diligence, I would never have found these things out.
It is fortunate for us working on early stage that due diligence is fairly simple: the startup has not been around long enough to have more complex due diligence. I could not imagine the legions of lawyers poring through an acquisition of a major company by another. Thankfully we don’t have to do that here.
Whenever I do a deal, I ask for this list:
1. Articles of Incorporation
2. By-laws
3. Lawyer, law firm contact
4. Stock purchase agreements
5. Current employee list, their occupation/function, and bios if possible.
6. Current investor list, cap table
7. Current advisor list
8. Latest product plan
9. Business plan if any.
10. Your latest pitch deck
11. Financials to date, plus projections
12. Site/product performance to date if any, and projections, ie. # of users, sales, etc.
13. Board and shareholder meeting minutes and written consents, if any? Organizational resolutions?
14. Stock option plans and agreements
15. Office address/location
16. What is your website/product/etc.?
If they don’t have it, I ask them to just note that. Basically, this list clearly depicts exactly what I’m buying with my investment dollars.
Remember that buying stock in a company is more than just the guy who showed up with his Powerpoint and demo-ed his product to you. It is an entire operation that encompasses product and people and must follow the laws of the country it’s operating in. Unless you ask for due diligence materials, you will never get a clear picture of what you’re buying with your money.
And given my experiences, depending on others to check on the legitimacy of what you’re buying is foolish. So make sure you do your own due diligence and if you have to, pay a lawyer to help you out.

I just love the Stocktwits Macro Weekly. Gregor Macdonald of Abnormal Returns writes it and this week sums up some pretty important points.
This last week the Federal Reserve finally gave in and admitted that the economy wasn’t where it was supposed to be: high unemployment, US budget out of control, stimulus that wasn’t stimulated without the US Government pumping more money into our economy, creating pretty much an unsustainable loop. That took interest rates on US Treasuries to record lows and the stock market didn’t like that either. Too bad you optimist stocktraders – it still amazes me that anyone can think that recovery can happen with so many people out of work. Who is going to spend money if they aren’t making any money? Duh!
We’re in for a long haul here. Double dip, single dip, whatever. The economy sucks and now the general population is pulling back its spending after realizing that things weren’t getting better even as the Fed was blowing sweet smoke our way. If people keep spending less, then how can businesses make money? So they are pulling back also and not investing as much. And the cycle continues.
But what this means for startups is…it’s harder than ever to make money. Back in my post, Mark Fletcher at Startup2Startup and the Evolution of Startup Business Strategy, I noted how Mark smartly adjusted his funding and operating plan based on the environment at the time. He noted three stages that he had raised money and built startups in; now I believe we’re entering into yet another stage. This is because we’re in an economic downturn AND I believe there is a serious bubble forming in internet only startups.
What’s a startup to do?
Raising money doesn’t seem to be a problem. If you have a star team and a decent idea, you can woo one of the many super angels or micro VCs. They are all operating on the strategy of investing in what I call “exploration” which is to give you enough money to leave your job and then work for a year or less and see if you can get anywhere. Regular angels can also be part of this effort, although I’m sitting on the sidelines (see my bubble post).
However, if you want this to NOT be a 6-12 month sabbatical into the world of entrepreneurship, at the end of which probability says you’re gonna be left without a job because you couldn’t get your idea developed into a business, you’re going to have to do things a little bit differently.
Item 1: The general population is pulling back in spending.
This means either whatever product or service you’re making has to be EXPONENTIALLY better than the competition or else you’ll never get enough users on board to pay for your service. INCREMENTALLY better might have worked when there was no bubble in internet only startups or in an economically better climate. But now you’ll have next to zero chance.
Corollary: Go for revenue from the get-go.
Going for revenue has been talked about extensively, but I still meet entrepreneurs with no notion of monetization. Now that the available pool of consumer cash is shrinking, the fight for their cash is going to be even more fierce.
Item 1a: Businesses sense the consumer pullback and they are pulling back too.
The pullback trickles through businesses to your B2B startup. Internal budgets are tightening up as companies conserve cash as they don’t know where the economy is going to go. So building something EXPONENTIALLY better for them is critical too, rather than incremental improvements on what’s out there.
Item 2: Competition is ridiculous.
Corollary: Instead, tackle a business that NOBODY ELSE is tackling.
This is a serious problem of the bubble. Competition pops up everywhere. To me, the unsexy is in, as these are the last bastion of untapped areas where the internet can go and disrupt. But still people want to make photo sharing and social networking just a little bit better. Too many people tackle the sexy problems and not enough of the unsexy problems.
The other areas besides unsexy are completely untapped business opportunities. Yes, it’s tough to find these. But still, I meet entrepreneurs who have found them. If they can find them, why can’t you? No more social networking photo sharing apps please! Nobody said entrepreneurship was easy; it’s damn hard to find business opportunities that are completely untapped.
Item 3: Users are bombarded by too many services AND now they have less money to spend. Likewise, for businesses, their budgets are being cut.
Corollary: One year is not enough, two is barely enough, maybe need more time. Startup austerity is IN now more than ever.
Still people are raising for one year. I can’t see how anyone in this climate can get to any kind of breakeven in one year. Of course there are always outliers, but most of the ideas I meet won’t get there in a year. I have been telling people to plan for two years (remembering there are two levers here, what you raise and what you burn) but with the economy the way it is, I am wondering if even two years is enough. It seems that our super smart folks in the US Government aren’t doing the right thing to truly stimulate the economy, and I say that knowing the trying to drive the economy is not an easy thing (and especially cleaning up the mess created by all our nice lobbyists, politicians, and Wall Street greed). It’s going to take years for us to get back on track, now that the inertia of consumer confidence is moving downward.
No matter what, austerity in spending whatever you raise is going to be even more important. You need to survive as long as possible, giving yourself the maximum amount of time to try things and to pivot several times if necessary, and along the way praying that the economy is going to come back.
But it’s obvious to me that many entrepreneurs are unwilling to go into starvation mode for that long. All I have to say is, good luck to you and let’s talk at the end of a year after your raise.
Item 4: More entrepreneurs keep piling into the internet space.
Corollary: Radical idea: Try creating a startup in another space besides the ultra crowded space of internet only startups.
You have strong entrepreneurial desires? Then why try to build a business in an industry where everybody who wants to be an entrepreneur is piling in en masse? I am getting connected to startups in other industries and there are some really interesting things going on out there in the world beyond the internet. In my bubble post, I posted about an emerging space that is hardware plus software plus internet – what other spaces could use your entrepreneurial energy to go and disrupt? Are there any industries that are adjacent to what you learned in school, or where your interests are, or where your previous experiences lie? How about another location where there is growth like another country?
Someone once said to me that in times of economic distress, there were tons of opportunities and investing in these times could yield some amazing results as long as you reserved some capital to do so. These are definitely some interesting times as an angel investor. Like Mark Fletcher, I am doing the smart thing by watching the economy closely and adjusting my investing strategy based on the conditions of the environment at the time. More entrepreneurs could do better by applying this tactic as well.
DISCLOSURE: I am not a direct investor in Stocktwits but rather an indirect one through my investment in betaworks. I love what they do, so go and sign up for Stocktwits newsletters and read everything they send you.

“There’s something f%$@#! up about every early stage startup…”
– Andy Weissman, @aweissman, betaworks
About 2 years ago, Andy Weissman over at betaworks made that statement. I thought it was funny at the time, but 2 years later, I have found that statement to be one of the most profound I’ve heard.
Since then, I’ve met a constant stream of early stage startups. Every one has something wrong with it; the idea, the founders, the competition, the funding plan, whatever. Sometimes there are multiple things wrong with them. I don’t think anybody has come with an idea and team and plan that was perfect. In fact, I think it’s impossible.
At early stage there are too many variables. That is why the risk of failure at early stage is so great. You don’t have enough of…everything…or anything…to properly pursue a business idea. And then there are the things that are totally out of your control, such as economic or competitive forces. These things will swing every which way and there is nothing you can do about it…and tanking your startups along the way as you look on with frustration and helplessness.
If you fixate on what is wrong with early stage startups, you’ll never invest. It’s way too easy to find something wrong with one.
Some of those I take as a given. For example, in the internet space there are tons of young founders who have never been at another job in their lives. But the idea is great, and we love their energy and creativity so we bet on them knowing at some point they may need to step down as leader of their businesses…or we’ll get into a painful argument with them about why they need to step down and they don’t want to. Sometimes we bet on these people simply because they are smart and theoretically smart people will adapt/pivot their way to success better than not-so-smart people, even though they lack real world business experience.
Some of those I know we will have to fix later. Whether we are willing to put in the effort to fix them later is another question; many investors hope that there is someone who gets involved who has the time and desire to watch over things. The need for a new, more seasoned CEO is one of those; perhaps the strategy needs to change, or somebody isn’t pulling their weight in their functional area, or can’t grow into a more expanded role.
Still, the number of f%$@#! up things any early stage startup has can be a scary thing. It took me a while to understand this and then just live with the fact that there are going to be things really wrong with every startup I meet and then fund. For me, it’s become a game of which f%$@#! up things are you willing to put up with, how many are OK with you, and why.
Accepting the fact there are going to be f%$@#! up things about early stage startups is critical; if you can’t live with that fact, you probably shouldn’t be investing in early stage. It may drive you nuts.

Last week, I had the pleasure of meeting Jim Robinson IV of RRE Ventures (twitter: @jdrive). In our conversation, he mentioned something I thought was super important, which was that successful investors also diversify across time, in addition to diversifying their investments.
I thought that this statement was extremely important and something that is commonly not done at all, and dangerous to ignore.
What is Time Diversification?
Time diversification is:
Adjusting your strategy based on what is going on in the economy at the time.
Learning from what worked and what didn’t in previous economic cycles, and applying those principles to where we are today.
Investing the right way for where you are today in an economic cycle and doing it across multiple economic cycles. The second part of this statement is hard for those investors who have not been doing this long enough to experience multiple cycles.
Why Time Diversification?
The main danger of not time diversifying is if you go out the gate strongly and put a sizeable percentage of your funds in a short amount of time, you may end up getting caught by the negative aspects of a given part of an economic cycle.
Anyone knows that predicting what will happen in the economy is near impossible. Famous economists’ track records on predictions are pretty dismal. So the only thing you can do is to spread out your investments across time and try to ride whatever upside is going on today while mitigating risks of the downsides that appear along the way.
But if you put out all your money in a short amount of time, you could end up investing at a time when there is a downturn right around the corner which could crater your current investments and leave you with little cash to recover. Think about all those investors who raised funds in 1999 or 2000 and put money into companies who had stratospheric valuations, only to see them disappear as the dotcom bust wiped out all that value in late 2000.
Or you may miss an upturn by investing in yesterday’s downturn driven investment strategy.
So ideally, your strategy will be affected by time diversification. For example, prior to the 2008 economic downturn, we were investing in startups who were building for users primarily and on the assumption that if you get users, you’ll eventually find a way to monetize. This strategy began to kill startups as we entered the downturn because:
1. Startups needed a longer time to generate revenue, and needed to survive a longer time to do so.
2. Startups’ burn rate was too high and they ran through money before they could get revenue or raise the next round. Many entrepreneurs were unwilling to give up their lifestyle and lower burn and thus died accordingly.
3. Prior to the downturn, startups could go raise their next round on little revenue but decent traction and great, quality product. As we entered into the downturn, investors became instantly conservative and if you didn’t have traction AND revenue after the seed round, your chances of getting funding dropped to zero.
Thus many of us changed our strategy and started looking for startups who could survive and gain early revenue to survive long enough to create a sustainable business model. This ended the popularity of consumer internet startups focused on interesting user activity and caused a rise investing in B2B startups, and those consumer internet startups who could build an early business model based on making money off users.
As economic conditions change, we should examine where the economy is at that time and what the conditions tell us about how we invest, and what we should invest in. Timing it is near impossible, so we hope that adjusting our strategy over time, taking our lumps if we don’t act fast enough, riding the upturns when they come can help us keep our returns in the positive.
Why Do People Ignore or Don’t Time Diversify?
Some reasons why people ignore time diversification, or don’t do it:
1. Naviete – Simple lack of knowledge that this is important can mean that someone didn’t think about time diversification. Or they may have learned about it in school but wasn’t aware of its importance, and thus forgot about it. Or didn’t know how to integrate it into their strategy.
2. Lack of real world experience – Humans learn best through experiencing things first hand. Many people simply haven’t been through enough economic cycles to know what to do depending on where they are in one. That’s why talking to guys like Jim Robinson IV is so valuable because they’ve been in it since before the dotcom boom.
3. Irrational exuberance – Especially in periods of upturns, it can seem that you can do no wrong. Think about between 1995-2000; investors in the early part of that period made tons of money and, as Jim puts it, we all looked like geniuses no matter what we did. Or it could be a period of investment flurry, like what I believe is happening now where lots of internet startups are being funded left and right; you feel like you have to get in or else miss out. So during periods like these you may experience irrational exuberance and thus invest fast to try to get at as many deals as possible because you don’t want to miss out. The problem is that you ignore the fact that your funds are also dwindling fast.
4. Conversatism kills – Venture investing in particular is a risk taker’s game; you really have to be out there investing constantly in upturns and downturns (which is partly the reason for this post). If you’re a conservative risk taker (yes I think such a person exists!) and you wait until you’re “sure” that you’re in an upturn, OR you get in a downturn and pullback after the downturn begins, you’re always going to be investing at the peaks and pulling out in the valleys.
5. Economic cycles can be very long – In fact, long enough that an entire generation may no nothing but incredible growth and prosperity. This was experienced in the period between 1982 and 2000 where the S&P 500 rose from about 100 to an intraday high of 1552.87 in 2000. Those growing up in a period knowing only growth have not experienced downturns and thus we can get fooled that value of our investments will always rise.
What to Do?
Some thoughts on what to do:
1. Pace your investments. Don’t get caught up in having to invest in every deal that comes along. It may seem that every deal is super hot and can’t lose, but experience tells me that everything looks hot but the probability of success is very low.
2. Be disciplined in the amount of money you invest in each company. Do not get over-exuberant and start making bigger bets in the beginning. Look at the total amount of money you have and make it stretch across many years. Pick an investment size that allows you to do this. I made this mistake in the first years of my investing. Originally I thought that I should do $50K investments. That drifted upwards quickly as I got caught up in the excitement of being involved in deals to $100K. But now, I am down to $25K chunks in an attempt to still be involved but not run out of funds. Just think back to the number of investments I could have made if I had stuck with $50K, or even $25K, if I had not done $100K chunks. For each $100K startup, I could have invested more broadly into two $50K or four $25K investments. Another danger of going out with too high investment sizes is that you may pick a lot of losers, or get caught in an economic downturn. Then recouping your investment gets harder.
3. Be a student of economic history and do not ignore it. The first big downturn I lived through was when the first Bush invaded Iraq. It was a tough time but it didn’t hit me too hard as I had a job. The second period was the dotcom boom-bust. That was much more severe; having been at Yahoo, I saw our stock climb to amazing heights in 2000, only to watch them drop to amazing lows by the end of the year. There was a time when we all thought naively that the run up in internet stocks would never end. We even snickered at those who left Yahoo in 1999 or 2000 and cashed out at “such a low stock price” of 150. Now who had the last laugh? There is nothing better than first hand experience of such events and looking at the dumbass thinking we had back then. Lacking that, all I can say is that you should read a lot, talk to a lot of people, and take lessons from those who have lived through these times. I would also caution you to really watch out for books which were written for a given period. I remember reading about real estate investing and how buying houses was a great, no-loss wealth building strategy. Well, now look at where we are with that. Examples abound everywhere; be careful what you read and add it to your knowledge base.
4. Invest when times seem bleak – It is scary to be putting money out in times of economic downturns. However, these are times when bargains can be found. You also don’t want to miss the next run-up in the markets by waiting too long.
5. Resist the temptation to be over-exuberant – It is tempting to try to chase all the hot deals going on at any time. However, in the last 4 years of investing, I have never seen a time where there WEREN’T hot deals around. I doubt that will change anytime in the future, so be disciplined and keep to your strategy.
6. Track valuations from the marketplace. – Keep track of them and watch out when the valuations start climbing. It is a signal that something is going on. It is not necessarily a bubble forming, but it could be. Most likely the competition for the deals has become fiercer as more money has become available in the marketplace for investment into startups. I would develop a limit to the valuation you are willing to stomach, no matter what the deal is and stick to it. Be flexible to violate the rule if you find something that you really like because you may want to get involved for reasons other than the valuation being too high.
What am I doing? Tracking the economy closely. Seeing what the government is doing, or not doing, or doing a crap job of. Keeping my ear out on what’s happening with valuations. Talking to venture investors and angels who are out there investing actively. I meet regularly with my financial planner and listen to what he is seeing out in the marketplace. I also talk to the entrepreneurs and see who is geting funded and why, as well as those that didn’t get funded. And then who got bought, or just went IPO, and how/why. It’s an immense amount of information but all of it is interrelated and affects what I am doing now, how I do it, and what I will do in the future.