Startup School Y Combinator: How to attract investment? [part 2]

Stanford course CS183B: How to start a startup . Started in 2012 under the leadership of Peter Thiel. In the fall of 2014, a new series of lectures by leading entrepreneurs and Y Combinator experts took place:



Sam Altman: I would like to talk a little more about tactics. How does the process of getting investment go? Is it possible to send you letters directly or do you need someone to introduce the startup to you? How many meetings should take place before making a decision? How do you define a deal? When can the founder ask you for a check?
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Mark Andressen: Five questions. It's a lot. Ron, come on, you tell me about the planting stage.

Ron Conway: Good. So, SV Angel invests in startups at the seed stage, we like to be the first to invest in the project. Now we, as a rule, invest in a startup anywhere from one to two million [dollars]. They used to invest only a million. Therefore, if we invest 250 thousand, it means that together with us the project is financed by another five or six investors.

Thirteen people are currently working at SV Angel. For some time now, I have not done due diligence, I am not engaged in the selection of startups. I only help portfolio companies that are just starting to grow with large projects. We have a whole team that keeps track of everything. In SV Angel for thirty applicants there is one company in which we invest, we approve approximately one application per week.

In fact, we do not make decisions on our own initiative. At the moment, our network of contacts is so huge that in fact we just focus on its behavior. We appreciate your opportunities - this means that you have to send a very good brief project summary, and if we like it, we will vote (although I don’t participate in these meetings) and decide whether to continue working with you or not. In the process, time plays an important role. And if a sufficient number of members of the SV team think that the project is interesting, then the person who calls the project founder is appointed. Usually the most experienced specialist in this field is selected. If the telephone conversation goes well, hurray! We want to meet with you. If SV Angel wants to meet you, then we are ready to invest.

If the meeting is successful, we assess the company's reputation, check for any kind of pitfalls, get a good idea about it and the market it is entering, and agree to provide investments. Then we start helping other investors who can add value to the project to become part of the syndicate. We would like other investors to become well-known business angels, provided we have the same amount of project work with them.



Mark Andressen: So, and I will talk a little about the stage of venture financing, about the round A. I think we can honestly admit that the best venture capital investors invest only in two types of companies in round A.

The first is if the company has previously attracted sowing investments. So we almost always invest in a company in round A, if she received one or two seed investments from Ron or from those with whom he likes to work (to be clear, almost always from Ron and from those with whom he likes to work ). Thus, if you want to get investment in round A, the first thing to do is to attract seed investments, in most cases this is the way to go further. From time to time we meet the needs of a company that has not attracted seed investments. Generally speaking, this happens only when the founder has achieved success in the past, and almost certainly this founder is someone we have worked with before.

We will announce this deal only in a few weeks, but [I will briefly tell about it]: once it was - there was the company's founder, I acted as a business angel, Ron, in my opinion, then also worked with us, it was 2006 At that time, the company did its job, and, ultimately, it was swallowed up by another large firm. And now this team is starting a new business.

So, in this case, we turn immediately to financing at stage A, because the guys are quite famous, and they have a ready plan. This exception is almost always Stage A preceded by investment at the seed stage. One more thing I already mentioned: we, as Ron told us, are tracking about two thousand projects a year with the help of our partner network. Among them is a very large percentage of businesses that received seed investments. Therefore, of course, the best way to establish contact with venture capital firms that provide investment in stage A is to go through a sowing round. Or go through something like Y Combinator.

Sam Altman: Let's talk about the terms of the deal. Which of them should founders pay the most attention to? How should they negotiate?

Parker Conrad: The most important thing at the seed stage is to choose the right investors, because they will serve as the basis for the next stages of obtaining financing. They will recommend you to investors at subsequent stages of financing, and how they present you will be of great importance to the project. Therefore, if a person to whom the venture investor entrusts and whom he respects can adequately represent you, the likelihood that everything will go well is much higher than if you were just introduced by a stranger to him. So the best thing you can do at the seed stage is to find the right investors.

Sam Altman: How can the founder identify suitable investors?

Parker Conrad: It is quite difficult. It seems to me that one of the best ways is to get into YC: YC is good because they say that this or that investor is one that helps you navigate. In YCombinator they determine quite precisely who will succeed in business; they presented us to the investors most interesting to us when we attracted funding for each of the rounds. The founders, who, in my opinion, seemed suitable, but who were not so highly appreciated in YC, did not succeed in the sowing round.

Sam Altman: Someday we will publish the names of some of them.

Parker Conrad: Then many will be upset.

Sam Altman: What do you think about the negotiations? How do you give an appropriate assessment of the company, on the basis of which you make your conclusions?

Parker Conrad: When the process of attracting seed investments began for my project, I did not know anything about it. As you know, there is a so-called Demo Day in Y Combinator. On this day, the company comes to evaluate a variety of investors. I requested too much money, having estimated the company's capitalization of 12 or 15 million dollars. Capitalization and assessment of the market value of a business are not the same thing, but close concepts.

And everyone thought that it was complete nonsense, that I thought too much about myself, and I would fail. Therefore, I began to gradually reduce the price. After a couple of days, I decided to get 9 million, and by luck, I stepped over the threshold of funding at the planting stage of 10 million, and it turned out that at this round the demand for capitalization of 9 million was almost unlimited. That is, no one would have paid me 12 million, having estimated the capitalization of 9 million, it would be possible to attract 10 million dollars. And I received funding in about a week after I “crossed” that threshold.

The magnitude of this threshold changes over time, especially in the sowing round, when investors believe that there is no point in providing financing above a certain level. But there is an approximate range in which investors are willing to provide investment. Just need to figure out what is the range. Attract only the amount of investment that you need, no more. It's enough. Ultimately, it will not be so important for the company whether you received 12, 9 or 6 million.



Sam Altman: Is there a maximum share size that the founders share with investors in a sowing round, in round A?

Parker Conrad: I don’t know the exact rules. The bottom line is that in round A everything is pretty loose. Surely, you will sell about 20 to 30% of the company. Venture investors are more interested in their share in the company than the size of the investment. Therefore, it happens that companies attract a lot of investment, as investors say: “Listen, we want to have at least 20% share in the company, but we will pay more for that.” With a share above 30% in the end it may happen that there is not enough room for everyone in the capitalization table. Usually, everything fits into this framework, and there's nothing you can do. At the sowing stage, as far as I know, in most cases this proportion is from 10 to 15%.

Ron Conway: Agreed. I think it is important to get rid of this stage. But for the founder it is equally important at the very beginning to ask yourself at what stage his share in the company begins to deprive him of motivation. Because if at the sowing stage the share of investors in the company is 40%, I ask the founder: “Do you understand that you have already doomed your company to failure?” It will have less than 5% of the company at its disposal, if this is a normal company. That is why it is important to know these thresholds. Give no more than 10-15% , because otherwise there will be nothing left for you and your team, and it is you who do all the work.

Mark Andressen: Over the past five years, we have come across several interesting companies with which we decided not to conduct business simply because their capitalization table was out of order. The share of outside investors was too big. There was a company in which we wanted to invest money, but outside investors owned 80% of the company at the time of the negotiations. The company was relatively young, they sold too much of it in the first two rounds. We were literally worried that such a company structure would deprive the team of motivation.

Sam Altman: Another question before we give the floor to the audience. Question to Ron and Mark. Can you tell us about the most successful investment you have made, and how did it happen?

Parker Conrad: Apart from Zenefits.

Ron Conway: For me, obviously, it was Google’s 1999 investment.

Returns we received a truly "Gugol" [eng. googol - googol, a number equal to 10 to the hundredth degree]. Funny. I met Google through Professor David Cheriton of Stanford University, who still teaches computer science here. He became a business angel for Google and one of the investors of our fund. As a return service, our investors had to tell about all the interesting companies that they know.

We are fortunate that David Cheriton was an investor in our foundation, because we had access to information about projects created at the computer science department. We were at the reception at Vivek Wadhwa, where you had to be in a tuxedo (I hate tuxedos). I went to David, and we complained to each other about our outfits. Then I asked him what was going on at Stanford. He replied that there is one project called BackRub - a search engine of web pages based on ranking and relevance.

Today for everyone ranking and relevance seem obvious. Then in 1998 it was not obvious, but the developers created a product based on a ranking algorithm called PageRank. It was an algorithm that believed that if a website is visited by many users, and other websites direct users to this site, something interesting should happen on it. This was the original algorithm. The driving force was relevance.

So I told David that I must meet with these people. He told me that I would not be able to meet with them until they were ready. I called them every month for five months. And I eventually made an appointment with Larry and Sergey. Already at that time they had a clear strategy. They said that they would allow me to invest money in them if I agreed with Sequoia, which were Yahoo investors. And since we entered the market late, they wanted to be sure that they were cooperating with Yahoo. So I got my opportunity to invest in Google.

Mark Andressen: I will tell a different story about Airbnb, in which we invested not at an early stage, but at a growth stage. In 2011, at the first stage of large-scale financing at Airbnb, the estimated value of the company was one billion dollars. And it seems to me that this company will be one of the examples of the most impressive growth in history. I think the company has a great future, and I will tell you its story, because the success of Airbnb is not at all in the genius of its creators.

We paid no attention to them. I do not remember that we even met with them for the first time, maybe this was done by one of our subordinates. As I said earlier, venture capital usually gets start-ups, unlike competitors. One of the most important signs of such startups is that their ideas often seem insane from the very beginning.

If you make a list of the most delusional ideas, the creation of a website, thanks to which people can live in your home, would be in the first place. In second place among the most insane ideas could put the creation of a website, thanks to which you can live in someone else's house.

Airbnb organically combines these two unsuccessful ideas. Thus, it turns out that they discovered a completely new way of earning on real estate, they discovered this amazing global phenomenon. So this fact partially proved that we made a mistake in the initial analysis of the idea. And both the statistics and the actions of clients showed that we were absolutely wrong.

That is why one of the approaches of our company is financing at various stages, because in this way we can correct our mistakes and subsequently pay more to get into business if we fail at an early stage. I also want to note that we highly appreciated this company for the reason that by that moment we had spent a lot of time with the founders: with Brian, Joe and Nate. A friend of mine said that when people move up the career ladder, they get increasingly large tasks, and at some point these tasks become prohibitively large. As a result, a part of people “grows” out of their work, on the other part this work is “torn”. The difference is palpable.

At a certain stage, some simply lose their heads. One of the indicators of an extremely successful and fast-growing company, of which Airbnb is a typical example, was that its young founders never outpaced events. We thought: “How are they going to carry out such large-scale global operations?” We were simply amazed and amazed so far every time we are dealing with these guys: how mature they were and what significant growth they showed. It seems that they are becoming more mature, reasonable and modest as they grow. We were happy for them, not only because their business was booming, but also because these guys could now create something and manage their business very well.

[ Translation of the final part of the 9th lecture. ]