VC funding vs. Crowdfunding - let’s get real

Crowdfunding is all the rage. Even the SEC recently blessed one type of crowdfunding for which there was risk of an enforcement action. Several in the early-stage ecosystem have called for VCs to “up their game,” as alternative paths to financing create competitive threats to both incumbent firms and the venture model itself. I think drawing parallels between crowdfunding and VC investment is both silly and inappropriate and conflates several important factors, most of which have to do with whether a founder is dealing with a good VC partner or a lousy VC partner. There will always be good VCs and shitty VCs from a founder perspective, and the presence of crowdfunding is unlikely to impact this phenomenon. That said, here is the compare/contrast as I see it between crowdfunding and VC funding (assuming one is dealing with a quality VC who acts as a true partner with management). Please note that I am not looking to specifically address of whether crowdfunding may or may not be a good vehicle for accessing early-stage investment opportunities. I will say, however, that if one’s investment thesis generally revolves around the notion of “social proof” than I don’t hold high hopes for this corner of the asset class.

1. Mentoring and assistance

• VC: High
• Crowdfunding: Low

With younger first-time founders, I personally believe money is not at all fungible and that there is significant value to partnering with a great individual at a great firm. I have personally witnessed this as a founder, as an angel and most recently as a VC. Whoever says that “all money is green” and that the source doesn’t matter isn’t giving the inexperienced yet visionary founder very good advice. I believe this talk is a function more of ego and bravado than really trying to give a founder the best advice for building a sustainable, long term, profitable business. Cynics will say “Oh, you’re just talking your book.” My response: come back with a thoughtful argument and save the platitudes. I also acknowledge that many founders successfully build a suite of mentors and advisors both inside and outside of their funding syndicates, but I don’t see these relationships as a replacement for a VC operator that has interests and exposures closely aligned with those of the founders.

2. Stability

• VC: High
• Crowdfunding: Low

Most seed stage businesses with which I’ve been involved have not been “up and to the right” propositions from the get go. It has taken a bunch of time - invariably more time than expected - to achieve product/market fit and, more importantly, to figure out a scalable and replicable way to sell the product. And with this extra time comes extra financing requirements, often more than the start-up has on hand. Because of this, in purely angel-funded situations (and, by extension, crowdfunded situations where there is no ostensible deal lead with the responsibility and resources to bridge the gap), it is frequently either brutally painful and time consuming or impossible to secure this incremental capital prior to Series A-type metrics being hit. This is only one of the ways where a supportive VC partner can help keep the team focused on execution by injecting enough capital to hit the key operating milestones Series A investors are looking for. And this can generally be done quite quickly and painlessly, but has to be done in an environment of trust and support. It is important that both founders and the VC feel a bridge investment was done fairly and thoughtfully, but this is something that strong VC partners do every day. It’s part of life.

3. Friction

• VC: High
• Crowdfunding: Low

As crowdfunding platforms become increasingly turn-key and the information provided becomes better, it will become easier and easier to tap a broad array of accredited investors for start-up funds. VCs, regardless of how streamlined their process might be, will always represent more friction and require more effort in order to close a round. They will ask more questions. Spend more time. Likely distract to a greater extent. But in my experience this process is often healthy for the start-up founder and forces a level of self-awareness, insight, professionalism and transparency that did not exist previously. For more seasoned founders this might not be seen as valuable, and the more streamlined crowdfunding process might be more appealing. In fact, as I see it crowdfunding appears most appropriate in two distinct circumstances:

1. Where the money raised is to hack together a prototype, and the focus is purely technical and not on business-building; or
2. Where the money is raised from a seasoned founder who doesn’t value the tangibles and intangibles offered by a VC, and really does view dollars as fungible.

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Focus, focus, focus: Understanding your value stack

Distraction and diffuse efforts are killers, especially in nascent businesses. Trying to do too much sucks valuable resources from accomplishing the core mission, but is often viewed as being important for “keeping options open” or “controlling one’s destiny.” The goal of a seed stage company shouldn’t be optionality preservation but laser-focused customer engagement, and to let the market help drive the iterative product development process rather than engineering in a vacuum and trying to solve everyone’s problem. This is the big issue of developing a general platform versus solving an important pain-point through a vertical application. Platforms can have great capabilities, but it is hard to prove the value without specific use cases. This is why UI is so important even in data-driven API-based start-ups, as potential customers need to actually SEE the value, not merely have it depicted in a spreadsheet or on a series of charts. Being able to demonstrate value is no easy task and involves several key steps. Ignore them at your peril.

• Know your customer. This is especially difficult in two-sided markets, where seeding growth on both sides is often a necessary element of demonstrating value. But many B2B2C companies have similar issues. Do you need to get widespread consumer adoption before showing a clear value proposition to the enterprise? Can you be laser focused on building the consumer application and solidifying usage and deep engagement while seeding a small number of strategic enterprise relationships to illustrate the enterprise use case and prove the ability to monetize? Spend too much time with the enterprise and you risk losing focus on your user. Ignore the enterprise and you might not develop a consumer experience that benefits from enterprise engagement. It’s not easy. You simply can’t serve two masters early in the company’s life. Complexity can distract, drain resources and impact culture.

• Know your source of competitive advantage. Another crushing drain on the early-stage company is trying to do too many things: not simply trying to sell to multiple constituencies, but engineering more than you need to beyond what’s truly core to the customer experience. For instance, if you’re parsing text together with numerical data to generate a “score” (for creditworthiness, influence, purchase intent and 1000 other use cases), is the value in the database where the information is stored? Perhaps it resides in the harvesting and cleansing architecture to bring in the data and put it in a usable format? Or is the value in the algorithms used to develop the signal? Or might the value be in the application that creates the engagement necessary to monetize the signal? I think it’s safe to say that the algos together with the application are where the real differentiation resides, while the database and data ingestion layers are better done by and purchased from companies whose sole mission is to be the best at these things. While there are companies that ultimately require a “full stack” solution to deliver the best customer experience and to create the deepest competitive moat, most companies can go a long way towards demonstrating and creating value by focusing on the areas where they are truly differentiated and not worrying about the less essential elements of the value stack.

• Know where you are in your evolution. As mentioned above, the answers to your questions potentially vary with time. While ruthless focus on a single goal has to dominate in the earliest days, this will necessarily evolve as the business grows. When does it make sense to approach a new set of customers with a different use case? Should we built our own proprietary [key part of your stack currently subbed out goes here] because it will enable us to [more rapidly/better] serve our customers and create a turn-key solution for potential acquirers? Managing growth while managing culture (and finances, for that matter) is very challenging, and only something that should be taken on after you’ve nailed that first use case. And by all means, don’t mistake revenues for a scalable and replicable sales process. The road is littered with start-ups that confused revenue growth with product/market fit, funding rapid expansion before the repeatable machine had truly been built.

I have seen too many potentially great teams and companies make these mistakes by trying to do too much, too soon. Please do not let this be you.

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Taking the long view (when building the business)

In the wake of my SXSW chat with Lauren Lyster of Yahoo! Finance, I once again began to think about the relationship between equity valuation and business decisions. In my perfect world, a business is financed in a manner that optimizes financial outcomes by creating a set of decision points along its growth trajectory.

This “optionality” is created by raising capital at times, in amounts and from investors that fund and support the business to the next series of key operating milestones, at which point an assessment can be made: is this working how we’d like? Are we doing a good job tackling our execution challenges? Has the competitive landscape changed? Is our company of particular interest to one or more buyers who are willing to pay for the next several years of growth? This necessarily implies that different kinds of investors can help at different phases of a company’s growth, and that long-term founder goals are essential inputs to the decision-making process.

This also encompasses the concept of founder liquidity, which at appropriate times can be used to re-align motives between founders and investors. As a business becomes increasingly successful, is scaling rapidly and third-party acquisition offers are an ever-present option, it is important to re-visit the goals of both founders and investors. When a business is first seeded, founder/investor alignment is generally tight because both parties want to prove out the business, achieve product/market fit and secure happy customers. But once this happens and the company moves from “proving” mode to “scaling” mode, this alignment can often diverge, especially with first-time founders who haven’t made much money and have gone all-in on their start-up. It may be that both founders and investors believe the business can grow into a multi-hundreds of millions or even billion-dollar exit, but that an M&A offer for $80 million that puts $20-$30 million into the founders’ pockets is just too compelling to pass up. This is the time when a new growth financing coupled with a secondary purchase of founder stock could reduce the founders’ risk profiles, still preserve that vast majority of their ownership and give them the peace-of-mind to redouble their efforts to build a huge company. This closes the yawning mis-alignment bred by success but can only emerge from an environment of partnership, trust and long-term vision.

This is a completely different mind-set than founders saying: “I want to maximize valuation, minimize dilution and treat investors as fungible sources of capital.” In my opinion, this is a dangerous game for founders to play as it sharply reduces the margin for error in executing the plan. In my experience the business-building process is anything but linear and the unexpected and unplanned is the norm. Achieving product/market fit at scale is, as you well know, insanely difficult, and no seed stage company, by definition, has achieved this or they wouldn’t be a seed stage company: they would either shun investor money altogether or jump from a bootstrapped rocket ship to raise a later stage growth round. So just to be clear this isn’t what I’m talking about; I’m referring to the 99.9% of start-ups that have an early product, have engaged with some early customers and are looking for money to continue to prove out the market and achieve a measure of product/market fit. These companies in the best of cases are fraught with risk and will not be fundamentally de-risked for quite some time. This is when having strong investors who are aligned with you is particularly valuable, as they can help provide interested and knowledgeable third-party perspective, serve as a healthy counterweight to the unbridled optimism of early-stage teams and work with management to devise a set of KPIs and metrics for the business. Should additional financial runway be needed because of a delayed product launch, difficult in recruiting the go-to-market team, etc., the strong and committed investor can help provide the resources necessary to achieve the critical operational milestones essential for raising the next round. Either a group of angels without a distinct lead or a firm that is pissed off because they overpaid for a seed stage deal will not be awesome to work with during this challenging time. 

Angels are terrific, and we work with them in almost all of our companies. Really good ones have great domain knowledge, expertise and contacts and are super helpful. They are, however, not a substitute for a strong deal lead with reserves held against the investment position who can help drive a round extension or a bridge to the next financing. And inexperienced angels can freak out at times of trouble and be a significant drain on management bandwidth. Also, venture investors who were induced to pay a high price to get a deal may use a hiccup in execution to extract a pound of flesh from the founders in exchange for bridge capital, as they feel a measure of “buyer’s remorse” and are likely unhappy by perceiving they were oversold at the outset. One might say “caveat emptor,” but let’s remember who holds the cards at times of stress: those with the money. The honeymoon is over. The slick fund-raising presentation is long since forgotten. All that’s being looked at is the business and the price paid for the business – and the investor isn’t happy. This is a lousy situation for founders to find themselves in, but is exactly what they’re singing up for by treating the investor selection process as a game of “Who’s the highest bidder?” instead of “Who’s my best long-term partner?”

I know some might say, “You’re talking your book” or “That’s not the way YC does it” and my response to those naysayers is as follows: you’re wrong. Building a company is far more art than science, especially in the earliest days, and having the right support systems around the table – both knowledge and financial resources – is essential for managing the risks and opportunities of a nascent business. If you have complete conviction that you can and will achieve product/market fit and scale to the moon without hitting bumps in the road, then by all means raise a bunch of uncapped or high-cap convertible notes from a dispersed group of investors, none of whom has enough skin in the game or commitment to impact the outcome of the business. Just know that you are betting the entire company on Day 1 by pursuing this strategy. Eyes wide open and acknowledgement of the risks is all I ask. Alternatively, if: (a) you feel you’ve got something hugely exciting where you’ve proven some stuff but have a long way to go before feeling confident that you’ve achieved product/market fit, and; (b) you believe that you’d benefit from the mentoring, experience, commitment and financial resources of a top-quality institutional investor, then perhaps you could re-think the wisdom of the prior approach. Put a more stable capital plan in place through partnership with the right investor for your business with whom you cement aligned motives. This may mean not taking the highest-priced offer on the table, but I believe it will provide the greatest opportunity for maximizing equity value over time. If you are playing a long game, as I am, you need to adopt a long-term mind-set. It’s not about winning the tactical battle of getting the highest price for your seed round: it’s about winning the war. Don’t let ego and crappy advice get in the way.

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Come join the IA Ventures Family

I started IA Ventures a little over three years ago with Brad and Ben. The original thesis: build an early-stage venture firm designed for the long-term that focused on companies seeking competitive advantage through data. Infrastructure. Platforms. Applications. All of it. We’d take a life-cycle approach to investing, building our positions early, working hard in partnership with our founders to achieve “escape velocity” and providing additional capital to support growth over time. This was the playbook I articulated to investors in 2009 and the same holds true to this day. We remain convinced that our approach is well-suited to building valuable, long-lasting relationships with great business-builders and generating superior cash-on-cash returns for our Limited Partners. 

While our thesis and approach has remained largely unchanged since our founding, much has happened in the meantime. We have raised two funds, our first fund of $50 million which is now fully deployed, and a second fund of $105 million which has more than two years to be invested and over 2/3 of its capital untapped. We have 31 portfolio companies across the two funds, and have averaged approximately 10 investments per year. This has all been accomplished with an investment team that has remained essentially the same - the original three partners plus an analyst (initially the highly skilled Justin Singer who left to work for a portfolio company, and now the incomparable polymath Jesse Beyroutey). The good news is that we’ve created a very tight-knit team with a strong culture that is working well with and for our companies. The bad news is that given our strong deal flow and hands-on approach to working with our companies, we feel that our investment team is bandwidth constrained. Further, we are interested in getting some new perspectives in the Firm to help us look at opportunities through a different lens. We believe this is a positive and healthy development for our companies, our Limited Partners and the Firm. The time has come to grow the investment team.

We are already well on our way to bringing on a new analyst to work with us. The candidates have been spectacular and we are excited to announce a new member of the team in the next few weeks. But this is only one piece of the puzzle.

Now for the big news: We are committed to bringing on a new Partner at IA Ventures. This will be someone who shares our passion for early-stage investing in the mode of partnership with our portfolio companies. The person may have been an entrepreneur before becoming an investor or may have been investing all their life. We don’t have a pre-conceived notion of the “just right” background. We expect that every likely candidate will be passionate, articulate, interested in engaging in constructive debate and strong. While we all have a technical bent, we can see a wide range of people “clicking” with us. As with our founders, most of whom we backed at the seed stage (almost always pre-revenue and sometimes even pre-product!), so much is based upon chemistry and how we see a long-term partnership evolving. What we aren’t looking for is someone exactly like us. 

We fully expect this process to take some time and we’re signed up to make the investment in our future. We are easy to check out. Speak to our founders. Speak to other venture firms and angels that have worked with us. We’re proud of what we’ve achieved thus far, but we’re playing a very long game. And we’re looking for that right someone to come and play with us. If you’re interested please send me a note and whatever else you want to send to roger@iaventures.com. I look forward to hearing from you.

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Founders: Eyes wide open

Raising money is a hard and sometimes scary thing. Friends & family money might be relatively easy to raise but often comes with lots of emotional strings attached. “What if I lose their  money? Might this adversely impact our relationship? Will I feel horrible and guilty?” Raising angel money is somewhat harder, but with less drama and entanglement. “These people believe in me and are trusting me, which is a huge obligation. But will any of these investors actually be able to help me to build my business?” And finally, securing venture investment is generally challenging for all but the brand-name and heavily pedigreed entrepreneurs, but hard work on both sides leads to a more balanced relationship: there are certainly clear expectations coming for the VC and often symmetrical wants and desires from the entrepreneur. And this is a good thing.

Early stage VCs and founders are bound together by a spiritual relationship around the founders’ mission. This is made more complicated by the financial and legal dynamics introduced by a financing. Taking VC money is like getting married: when it’s good it’s great and both productive and fulfilling. When it’s bad, however, splitting up is hard to do, both emotionally and logistically. So bringing a VC into the mix is not something that should be taken lightly.

However, if you do decide to take venture money, there are few things I’d recommend founders do to get the most out of the relationship:

Trust your new partners

I have heard way too many times from people who are ostensibly “founder friendly” that founders shouldn’t trust their investors but keep them at arms-length: they are simply not to be trusted. I have one word for this advice: bullshit. It is incumbent upon founders to do their homework and to pick their investors as carefully as they pick their co-founders and early employees. Each of these key relationships can and generally does have a material impact on the culture and future success of the company. The relationship with a lead investor is no different. But once you choose an investor, the value of having a truly trusting and respectful relationship is hard to quantify. If you constantly find yourself managing information flow and creating knowledge asymmetry between the founding team and the lead investor, something is fundamentally wrong. That energy spent “managing” could be spent engaging the investor - who is really your partner - on issues that are truly material to the prospects for the business. Use this leverage to your advantage.

Invest in relationships

Even after picking a great investor whom you trust, in order to get the greatest benefit from their skills, experiences and relationships you need to commit to building the relationship. This requires time on both sides to identify the best means of communication, the areas where the founders need the most help and where the investor can help plug the gaps and the right cadence of communication given the company’s stage and needs. Good things don’t just happen spontaneously; they require hard work. This relationship should be framed in the same manner as that of a key person in your personal life: there will invariably be ups and downs, but each is deeply committed to the other and have a vested interest in having things work out. If you’ve done a good job picking the right investor / partner, this investment will yield significant dividends over time.

Clearly communicate your expectations, wants and needs

Every relationship is different. What one founding team needs and wants can often be quite different than another due to background, team construction and business challenges. Even the most committed investor / partner can’t read the founder’s mind, and can’t possibly know what goes on day-to-day within the business. It is incumbent upon both the founder and the investor to communicate succinctly and honestly, with a bias towards actionable take-aways, e.g., “Can you interview these three Lead Developer candidates for us, as your perspective would be really helpful?” or “We’d love to get two proofs-of-concept going in different verticals. Can you help us identify the best potential candidates in [adtech] and [financial services]?” Good investor / partners love concrete deliverables because (a) it specifically helps their investment, (b) it feels good to help and (c) being recognized as a real (not bullshit) value-added investor both cements the relationship with the current founder and builds reputation among prospective founder / partners. In short, good communication breeds goodness all around.

Building a great relationship with a lead investor isn’t hard, but requires work both before the right partner is chosen and on an ongoing basis as the relationship evolves and the company is built. Problems arise when founders either pick an investor that isn’t the right fit or don’t properly invest in the relationship. From the investor perspective, few things are more frustrating than when you’ve done a ton of work to identify a team you want to work with and a business you want to help build, but where the founders don’t want to engage with you. And it’s a shame. My most satisfying founder relationships have strongly correlated with business outcomes, and I firmly believe that the “money is fungible” mantra is a load of bunk. But it’s up to the founders to decide on the go-it-alone or partner-with-investors path. My message is that if you do elect to take venture money, by all means do it the right way. Eyes wide open. 

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