The blogo/twittersphere is abuzz about the recent offer of $150K to every YC startup. You can read about the details here at 90% of Y Combinator Startups Have Already Accepted The $150k Start Fund Offer. You can also read a range of thoughts collected by Jason Calacanis on his blog, Angels+VCs are pissed off about Yuri/Ron Conway/YC deal-big time.
Initially I was miffed about it – it kind of pissed me off. At the last YC, I already felt like I was competing severely to get into investment rounds, having not mentored them and coming in late to their rounds even at the first Demo Day. Now it would be even harder. But then, after thinking about it, I am still sore about it, but that doesn’t mean it wasn’t brilliant.
And brilliant it is. For Ycombinator and its startups, and SV Angel/DST, it is totally the right move. Here’s why:
1. I’ve always felt that every YC class, there were the stars that would get funded no matter what, and there were the ones that would fail no matter what. But, in between the stars and the certain fails there was a huge grey area of the startups who have a harder time to get funded because if only they have a bit more time, runway, money, and advice, they could actually get somewhere fundable with their projects. But, without further support after the YC time period, many would inevitably just wither and die. Now the have a longer runway given the $150K and have more time to prove out their ideas and/or pivot if necessary to something more fundable. Because of this, more YC’s startups have a better chance of survival and, thus, giving YC a better chance at making more money.
2. More power has shifted to the entrepreneurs with this move at least in YC for sure. The world recently had moved from a combination of preferred equity rounds and convertible note rounds with caps to this note without a cap. Convertible notes without caps are very company friendly instruments into which investments are taken.
3. For SV Angel/DST, now they have a bets on most of the YC’s startups and now will be less likely to have been shut out of a round. If you’ve been following YC (I’ve been watching the quality of YC startups since March 2008), you’ll have noticed that the quality of startups has grown dramatically with each new class. It is not an inconceivable notion that there will be a big game changing startup that comes out of YC as time goes on. So creating a relationship where SV and DST can place bets on a lot of them, if not all, before the rest of the world gets to them is a good thing for them.
What about side effects? I’ll throw some out there:
1. I think that the opinion that angels will find it less appealing to invest in YC startups in this class is correct. Here’s why:
a. Before this $150K, YC startups only got $5K + $5K/founder. This mattered most to the startups who began life in/around the YC class. (NOTE: Each class, more startups who have been around for a while and willing to give up substantial common stock for a chance to go through YC are being accepted. For these startups, the $150K matters less.)
Given the ramen nature typical of YC entrepreneurs, that $150K means that many will not choose to raise any more money at all since they can go a long way on that much cash, conceivably ten times as long as their YC investment of ~$15K! So if these guys survived for about 2.5 months for only $15K, would they be able to have 10×2.5 months = 25 more months of runway?
Some of the startups may choose this route and if they are good, then we will miss the opportunity to invest in them now. Some time down the road, they will presumably have more progress and investing in them at that point will undoubtedly mean a higher valuation which is appropriate given their further progress. But higher valuations for an angel means less of chance to make a lot of money.
b. I believe that some of the startups will choose to raise additional capital on the terms of the convertible note w/o cap. This is also less attractive for an early angel investor because it means that we will not have established a potentially lower valuation for the early stage at which we would put money in. Instead, that valuation will come later, also presumably with more progress. Thus, we would put money in and not get any reward for early risk.
Why wouldn’t a startup raise more money with another new convertible note with cap? I think some will, but some will not because they do not want to anger their previous investors, DST and SV with a structure that has more advantageous terms. I have not seen their note, so potentially it may have some terms in it to adopt the terms of succeeding rounds if they are more advantageous.
Some startups will just believe that they are justified in raising further money on these terms and not change. With the infusion of new investors around, I believe they will be able to close their rounds even with some of the more professional or experienced angel investors declining the opportunity.
Still, even if a lot of professional/experienced investors declining, I think there are enough professional/experienced investors will still take the deal, operating on the assumption that there will still be a high probability of a great outcome on a startup which is doing well.
2. This is still OK for venture capitalists. For the later stagers, they wouldn’t have invested in a YC startup at early stage anyways and will just wait for them to come to them after they have matured more, like they always have. The early stage funds might not like getting into a hot YC startup early with a higher valuation, but they probably still have the ability to make money if a startup takes off, especially if they have reserved funds for follow-on investments. The majority of angels, in contrast, rarely make follow-on investments.
3. Paul Graham is highly respected, if not worshipped by all the would-be and current entrepreneurs. What happens in YC inevitably affects the larger community. YC startups have already had their pre-money valuations drift higher and have already moved towards note with caps and we’ve seen non-YC startups do the same. Now I’m sure there will be many that will now try to raise with notes without caps. While the not-so-great startups will try and still be declined, the hotter ones will be enboldened and will hold firm to notes without caps. Because they are hot, they will get funded no matter what. I have not seen any pattern to the contrary on this issue; money is not a problem for startups especially if they are hot and/or popular.
So yeah, I’m still sore that potentially this could mean that it may not make sense that I should invest in some of the better startups in the Valley, which will come out at this next YC class. But like all things in business, you do what you do to gain an advantage over others in your space and Ycombinator, along with SV Angel and DST are doing just that. For that reason, I’m sore, but also I cannot help but applaud their brilliant move.
On the other hand, I’m now, more than ever, thinking on how I can build my own brand, reputation, and value to entrepreneurs so that I can still get into the rounds at the time, terms, and valuation that will make sense for me to participate.

Friday afternoon, I had the pleasure of jumping on a conference call with one of my current potential investment’s customers. It was a rare occasion where an early stage startup actually had a customer testing their product and I was able to get some feedback on the startup from a customer’s perspective.
The call was thankfully overwhemingly positive; the customer had implemented the startup’s system, and it installed and ran without a hitch. We found out that the startup’s personnel were extremely easy to deal with and were extremely responsive to issues. We also found out some nice, unexpected results of the installed system; it gave them some enhanced marketing functionality, and they found that they increased sales by quite a bit after using the system! Of course, the customer was extremely happy about that as well.
All this served to reinforce the positivity on investing in the startup. It was very refreshing to hear all the great things a customer had to say about this company!
A little while back I wrote a post called The Lack of Due Diligence is Appalling and Foolish. In my experiences as an angel investor, I was shocked to find out that often I was the only investor asking for due diligence materials from a startup raising money. Recently on Quora, I suggested some other due diligence things people should do. Calling a startup’s customers is one of those that should be done. Some thoughts on this:
1. If you’re fortunate enough to encounter an early stage startup that has customers and are accessible, definitely try to give them a call. Many early stage startups are in the very beginning stages and don’t have customers yet so sometimes it’s hard to be able to talk to them at all.
2. Customers who are the average consumer are harder to talk to directly than customers who are businesses.
3. For consumers, you may not be able to talk to them directly at all, but must rely on customer feedback, or public reviews on other blogs, magazines, etc. Occasionally, there will be some prominent beta customers who you may be able to get hold of directly.
4. Businesses are potentially much easier to contact. There is usually a point of contact over at the customer and, if they are willing, you can talk to them.
5. Ask the entrepreneur to make the contact and introduction to their customers. I would also recommend that the entrepreneur should set the context with the customer(s) but ultimately should not be on the call/meeting. This is so we can get a unbiased view from the customer without some possible social interference by the presence of the entrepreneur.
If the entrepreneur is unwilling to facilitate access to their customers or hedges against it for any reason, be wary. A startup should NEVER EVER disrespect an investor’s request for any kind of due diligence. If they do, this is a red flag. You should reconsider investing in them.
6. A quick phone call should suffice, or even better if the customer is local and you can go meet with them.
7. If there are more than one people on a call or at a meeting, you should consider discussing beforehand the questions that will be asked. In this way, the call/meeting can go quickly and in an orderly fashion. Customers, whether they are consumers or businesses, are as busy as you or me. We should respect their time and not waste it by being unorganized. Then organize the questions into a written list and have it handy to refer to during the call. You can print it out and scribble notes as you walk through the questions.
8. Here is a possible template of a due diligence call and topic areas to ask for a typical product; adjust/edit/add as necessary given the particular startup and its products:
Introduce yourselves, and say why you’re calling (ie. we’re potential investors in company X, and we’d like to know more about your experiences with company X and its products)
How did you first encounter the product? What were the first impressions?
Describe the signup process.
Describe the installation process.
Describe the product experience itself from your perspective. Any positive and/or negative experiences?
How did the product perform? Did it do what you thought it would do? Was it below/meets/exceeds expectations? How so?
Describe any problems in the product that you see.
How much does the product cost? Was it too much? Too little? Just right?
Did the product enhance your life/operations/sales/task/etc.? In what ways?
How were your communications with the company, if any? With the company personnel? With their customer service? Through email? Through marketing materials? Any positive and/or negative experiences?
Would you recommend this product to a friend/colleague/co-worker/another company? What would you say to them?
Thank them profusely for their time, end call.
Yes we’re all way too busy. But making time for these calls, and ultimately going through due diligence on a startup can really make a difference in your decision process. As I’ve seen on calls like these, I not only gain more assurance that I’m making the right investment decision, but I’m also learning a lot about a startup’s business from a perspective that is often very difficult to get hold of.

Occasionally in one of my conversations, we will talk about what we think makes a great investor, angel or VC. Most of the time, we talk about being lucky, having the ability to spot great companies and opportunities, and sourcing amazing dealflow and getting into deals that others can’t get into. But almost never talk about exit engineering.
Being able to create exits from your portfolio companies means that you are able, more often than not, to produce returns from everyone of your investments, even those that are seemingly lost causes. That means you will seemingly be able to produce returns in any kind of market, and consistently deliver over time. Those that aren’t so good at this leave making returns to the whims of events mostly out of all our control – that doesn’t sound like stacking the odds in your favor!
I think that exit engineering is both a science and a skill, some learnable and some not so easy to just “learn”. Here are some thoughts about what makes a great exit engineer, some which I think are readily achievable and some that are not:
Achievable Skills/Traits:
Natural Salesman – From always talking about your portfolio companies to actively pursuing an exit with a corporation or individual, you are always out there talking up your startups and either subtlely or overtly promoting them. You never lose the opportunity to sell how great they are to someone and always have in your pocket a bunch of startups to sell.
Great Negotiation Skills – Selling is one aspect, but you also need to be able to squeeze out the best possible deal and not just any deal.
Strong Relationship with the Founders and Board of Directors – If the other people who control decisions in the company trust you and your judgement and you can convince them it’s time to exit, then this helps things tremendously over trying to convince them it’s time to exit.
Knowledge about the Economy – With the recent economic crash, I’ve been thinking a lot about economic cycles (see my post Tough Economic Times Ahead and the Next Stage in Startup Strategy) and their affect on investing and startups. Great exit engineers need to be acutely aware of the macro effects of the economy and know when it’s OK to press your bet or to harvest returns before the rug gets pulled out from under you, either lengthening the time to harvest returns and/or suppressing the actual return itself.
Knowledge about the industry, sometimes proprietary – You must have your ear to the ground on what people are doing inside corporations and around industry. Your network must include people who can give you this information, and hopefully that which nobody else has. How else would you be able to sell a startup to a company who is trying to make headway with a stealth strategy? If you don’t know someone is looking to do something in a given area, then you’ll miss the opportunity to sell them a startup which could be something they are looking for to help them execute that strategy.
Great Network of People Who Matter With Respect to Exits – You might have a strong network, but you need to know the people who are the actual decision makers in organizations. Sometimes it’s clear, and sometimes it’s not. Talking to the rank and file is fine to get certain things done, but if you’re going to sell a company to another one, you need to figure out if the it’s the head of corporate development or the CEO that you need to be talking to. Perhaps even a board member may be the best person, or they also may be the worst person.
Not so Easy to Achieve Skills/Traits:
Creative – Creativity can play a big role in creating exits. Sometimes, you have to be able to package a startup in unique way to sell it to someone. It also may not be obvious who might want to buy your startup but with some creativity, it may be possible to sell a company to someone who you’d never think would want that particular one.
Great at Cultivating Exits – Some exits are more timely and obvious, like when another corporation makes is relatively public they are pursuing some strategy. Some are years in the making, as you network and plant the seeds of needing a particular startup to achieve some business goal. Great exit engineers will meet with folks regularly and subtlely steer people to want one of their startups and it could take a long time.
Intuitive – Intuition is so important, both in knowing what to do in a given market, sensing what the tipping points are in a negotiation, or knowing to whom to sell a company.
Amazing Sense of Timing – Acting on intuition and market knowledge, the exit engineer somehows just knows when it’s time to harvest returns on any investment. Anyone else is either too early or too late.
Trust Among the Network – Having a killer rolodex is the first step; what’s harder is actually having worked with many of them and they know you enough to trust you in something that you present to them, and will consider it seriously and first, over and above others.
Personal Relationship with Network – Having worked with people in your network and gaining their business trust is great; hanging out with them and their families, playing poker and golf with them, etc. makes that relationship even stronger and more likely that an exit will happen. Friends dealing with friends happens more often than you think.
Produced in the Past for People in the Network – Even better than trust and personal relationship, you’ve actually made money and/or other positive results (ie. fame, advancement, etc.) for the people in your network. Your network knows they won once with you; that means they are likely to win again working with you.
A bunch of us were noting that the best VCs were great at spotting fundable entrepreneurs and the ideas that they brought with them, and also giving them valuable business advice and helping them along build great businesses. However, we also thought that the VCs who rose to the top of the heap were the ones that were also great at exit engineering and time after time they seemed to be in deals that were able to exit for tremendous returns.
These are the Sequoias and Kleiner-Perkins of the venture industry who have been around the longest and have been able to produce returns for their investors fund after fund, and through any economic conditions. With the rise of so many prominent, active angels in the Valley, I think that we’ll see there will be angels who will have amazing returns and, as I theorize, be excellent exit engineers in addition to all the other help that they would give.
This also provides support for the argument that entrepreneurs should always try to find helpful investors who are also excellent exit engineers, assuming that your goal isn’t just to build a sustainable company but also to produce exits for those who own parts of the company. That should make exit engineers more attractive to bring on as investors than others, meaning you can get into better deals.
So it seems that this is a worthy skill to acquire, although some of it is learnable/achievable and some of it may be skills that are more about the individual and what they are capable of, than something that can be learned.
I, for one, will strive to improve my exit engineering skills over the next few years…

Over the last few months, we’ve seen the emergence of super-angels and micro-VCs as early stage investing comes into its own. Out of conversations with many in the industry, I’ve boiled the strategy down to two categories: pickers versus sprayers. Before we get into who is a picker and who is a sprayer, let’s talk about them in their extreme stereotypes.
Pickers
A Picker is:
1. Someone who goes through a more involved process of picking particular startups to invest in.
2. They will do due diligence, ranging from calling references, to looking at research in an industry, to collecting lots of legal paperwork from the company.
3. Someone who likes to manage more closely the startups they invest in.
4. Generally are more disciplined and follow a game plan of investing.
5. Invest in startups where they can leverage their preferences, personal interests, and areas of expertise to help the startups gain an advantage.
6. Invest in both people AND the idea.
7. Are more conservative than not, in an already highly risky investment class.
8. There is an upper limit to the number of startups they will invest in, either per year (or other time period), per partner, or even over the life of a fund.
9. Shoot for the big outcome/exit with every investment.
Sprayers
A Sprayer is:
1. Someone who goes through a less involved process to choose startups to invest in.
2. Often, they will invest in startups with no due diligence at all. They may not even meet the entrepreneurs in person.
3. Will invest in an enormous amount of startups, ie. >50 in a year (hence the term “spraying” their money around, or from the more deragatory phrase “spray and pray”).
4. They rely on social proof and others to do due diligence and to help the entrepreneurs, since they have no time themselves to devote to individual startups.
5. Their main exit return strategy relies on exits of mid-size (ie. >$20MM) all the way up to big outcome/exits. They are betting on a more index fund approach to investing in startups.
6. Someone who bets almost exclusively on the team, and on the assumption that smart, adaptable, entrepreneurial people will always find a great outcome (versus those who are not superstars). They bet less so on the idea and will skip a great idea if the team is lacking. (Woe to entrepreneurs who do not graduate from MIT, Stanford, Berkeley, etc.) Also, this means that they do invest in more exploratory projects by entrepreneurs (ie. projects without a clear plan, features-type projects, etc.
7. Speed is of the essence, as the competitive nature of today’s early stage market is intense and you have to have a fast decision process to get into deals.
8. They will try to get into every great, hot deal out there. In order to execute on their return strategy, they will have to get into as many hot deals as possible.
9. They have a higher risk tolerance and tend towards being OK with taking on high amounts of risk in the investments they make.
Who is a Picker and Who is a Sprayer?
The descriptions above are, as I said, extreme and stereotypical. The truth is, everybody is somewhere in the middle. Investors may lean more towards one way or another, but they rarely are at the extremes, except perhaps on the Picker end where many disciplined investors employ set strategies.
Sprayers, for example, do pick a little. If they didn’t, then they would invest in every startup with only smart people in it, which is definitely false.
Even pickers may start placing some smaller bets, which act as good lead gen for later stage deals, or education into a given space.
For me, I would say that I am a Picker with Spraying tendencies.
My personal capital pool alone limits me to pick the investments I make. I do not have the capital to place bets in a ton of startups. So I am forced to pick. But I also like to get more involved with the startups since I get a lot of personal enjoyment from working with them. So time constraints mean that I need to pick. And personally, I like to resonate with both the team and idea versus just the team and an idea with an unknown (to me) future.
But since starting to invest in 2006, I have invested in 21+ startups. That puts me in the low end of the Sprayer group. I will sometimes also bet on less certainty on the idea if I merely like it or it resonates with me somewhat.
Which strategy is better? Here’s my prediction:
Like startups, I think that success in investing is highly dependent on the person and their ability to execute whatever strategy they choose to employ. We can sit and argue about which strategy sucks and who’s gonna lose but I think in the end it will boil down to how the person operates and their skill and perserverence in pulling exits out of their investments.
Then, you couple that with external factors, like industry trends, competitive factors, and the economy, and that can either suppress a strategy or enhance it. Keeping an eye on the external factors and executing an investment strategy appropriate to the external factors, and that which resonates with a personal strategy will win big more often than not.

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.