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Response to Adam Smith (not that Adam Smith)

Adam Smith, a  co-founder of Xobni and Y Combinator alum recently blogged about this year’s YC class and some trends he saw. I had a pretty strong reaction to his post so I thought I would share my thoughts (indicated by “ND”). As always, please leave your thoughts in the comments.

The Index Fund Strategy

Ron Conway and Keith Rabois invested in a number of these new YC startups. Some folks call this strategy the “index fund” approach.  Let’s define it as investing in more than five out of the 36 companies. The index fund approach might produce better returns (and/or risk-adjusted returns) than cherry picking the best one or two companies from each Y Combinator batch. I’m not sure.

ND: It’s still cherry picking. Just cherry picking 5 instead of one or two. An index fund in the traditional sense would buy a little bit of all 36 or some statistically significant sample. I’m not sure 5/36 is a statistically significant sample but regardless Ron Conway and Keith Rabois probably strongly believe in all 5 companies or they wouldn’t have put their capital at risk. If I’m some “Joe Angel” all else being equal I’d rather be in the 5 that Ron and Keith were in than any of the other 31.

The index funds have three main advantages: First, if you assume everyone’s throwing darts, then they’re more likely to invest in the home runs. Second, they can collect returns from the longer tail of singles and doubles without breaking a sweat.  

ND: I am only aware of one seed fund truly taking a shotgun approach at investing in startups. I don’t think many angels or seed to early stage VCs think they are “throwing darts” so I’m not sure that’s a fair assumption. That being said, we probably agree that some small subset will be grand slams, some larger subset will return invested capital or small multiple and some even larger subset will return nothing. 

Third, they can make investment decisions faster.

ND: I’m not sure how this makes investment decisions faster. As a former VC lawyer who represented many angels, I think most still do some level of diligence (even if cursory). Also this assumes the deal docs are standardized.

Interestingly, VCs still try to cherry pick. So do some of the new super angels. Anyone in the comments want to take a hack at the index fund versus cherry picking strategies, e.g. in environments with different levels of froth?

ND: Of course they cherry pick! They wouldn’t be able to raise LP money if they weren’t providing value. Most of these GPs and angels got where they got because of top of class returns consistently over time. With respect to frothiness, I will paraphrase Warren Buffett: “when the tide recedes you see who was swimming naked.” 

The World is Flat

VentureHack’s Angel List and YC’s Demo Day have made the fundraising landscape more flat.  It’s easier to see a wide variety of deals as an angel without doing heavy networking. This creates more competition.

ND: True

In particular, it removes a competitive advantage for heavily networked angels like Ron Conway.

ND: False. I will take Ron Conway’s money before I take yours (unless and until your track record supersedes his).

Networks and experience still matter a s***ton for providing value to portfolio companies, though. For example, a new investor from Hollywood could come in and start making lots of investments very quickly. But when shit hits the fan, or you need backchannels to an acquiring company, the movie star won’t be able to help (unless the acquirer is Roc-A-Wear and your investor is Jay-Z, in which case I’m pretty jealous).

ND: Exactly my point. So what competitive advantage has been removed? Awareness is different than access. 

[…]

Multiple Valuations: Early Bird Gets The Worm

Another factor: different valuations for different angels.  As Paul Graham recently pointed out, a startup can issue convertible notes at different caps to different investors. This degree of freedom could be used in a number of ways. Some companies are trying to use this to give different valuations to different investors as a function of the order that they invest. The idea is that the first investor to commit is taking the most risk, so they should be rewarded for that.

ND: Yes, this makes a lot of sense. Angels invest in herds and it usually takes one to be the lead before you can get the rest to follow. I’m happy to incentivize someone to be the lead if I think I can then close on the rest of the angels who have made verbal commitments. 

This can only go so far. If a company needs a minimum of $X to get to the next step, once a company has raised $X a valuation premium doesn’t make sense. $X for a YC startup is probably around $200k. I’ll stop there on this topic.  There are lots of dynamics at play, and it will vary company by company, but in summary I don’t think early bird valuation discounts will become super prevalent.

ND: I disagree. The more runway you have the better unless you are a gambler. You are assuming if you hit your milestones more money will be available to you to go after your next set of milestones. Sure, in some cases. But not after the dot com crash or during the recent financial crists. Cash spends, milestones don’t.

Multiple Valuations: Value Add

But as the angel investing world gets more flat, the average investor will become more vanilla, and investors like Ron Conway will become more differentiated by their savvy, connections, and in some cases the time they can devote to helping the company. I predict that it will become more common to reward value-added investors with valuation discounts. ESPECIALLY if these value add investors commit earlier.

ND: Wait, now the startups have to assign a pecuniary value to their investors?

Often the big value add investors will commit earlier because they understand the space and get really excited about it. For example, one YC company yesterday had already raised money from a big time executive in their industry who can help them with intros/advising/etc.  Those situations can call for valuation boosts. Valuation boosts, while rare, were previously done by issuing extra common stock (sometimes specifically called “advisor shares”) to the value-add investor.  But that approach was a little too heavyweight if the angel wasn’t going to be heavily involved. So I think valuation cap differences will become more common for compensating value added investors, especially when they are the first money in.

ND: I agree that the first money in will continue to be rewarded and I agree that the first money in will likely come from the angel or angels who “get it” and can add value, so I suppose by that math the angels who “get it” and can add value will be rewarded.

Secondary effect 1: non-value-add investors will be paying more for their equity, at least in theory, since entrepreneurs can now price discriminate.

ND: Fair enough, you have to pay for access. That being said, how much dumb money do you want?

Secondary effect 2: more angel investors will try to be value add. Especially super angels who have more resources and more companies to amortize fixed cost value adds across.

ND: Startups should seek out investors that can provide value. That being said, its important to choose wisely. Gadfly investors can take down a startup with their distractions.

A startup story, and a few lessons learned.

Five years ago this month, I had just started my third year of law school after clerking at a big law firm in New York. I still wasn’t sure I wanted to practice law and was much more interested in finding an operational role. Everyone always said you could do anything with a law degree. Well, I suppose that might be true, but the traditional channels of finding an entry level position (on campus recruiting, job fairs, etc.) are not accessible to many law students. I determined the most likely way to get such a job was networking and I began experimenting with online social networking. I found that nothing really existed specifically for law students. That’s when I started JDspace.

While JDspace was certainly not a financial home run, it was an educational grand slam. I learned a lot about myself and made a lot of contacts in the Austin startup community, which I leveraged to get a job with the talented team at Andrews Kurth. It was a happy compromise: I would be practicing law but working with awesome startups.

Over the last four years, I have gained nearly 8,000 hours of experience in corporate and securities law with a focus on venture capital and M&A. Having been a part of many wins, a few losses and even a couple draws, I had enough data points to take on an operational role. I suppose it is ironic that I will be using those data points to sell data.

This Monday I embark on a new mission to democratize the world’s access to structured data as VP - Business Development and General Counsel of one of my clients, Infochimps, where I will continue to build on my business and legal background. Before I go, here are a few take aways from being a startup lawyer:

- have a very good reason if you are incorporating as anything other than a Delaware C-Corp
- have a very good reason if you are splitting founder stock unevenly
- have a very good reason if you are not having cliff vesting on the founder stock
- have a very good reason if you are selling common stock (as opposed to preferred) to investors
- issue convertible debt if you don’t want to set a valuation
- make sure every employee signs a PIIA and every consultant signs a consulting agreement

To sum it up:

- have a very good reason if you are deviating from the KISS principle

Data for Marketers: A guest post by @mbaconsultant

In sharing a home with the latest addition to the Infochimps team, it’s no wonder I have data on my mind. I’ve been thinking about how marketing groups at startups to CPG multinationals alike are allocating more mindshare and budget to data-centric intelligence in the form of new partners, reports and employees. This signals a call to action for me that applies to brands as well: to stay ahead of the pack, we must get our hands dirty in creating and interpreting relevant data. Being a savvy listener who can translate qualitative customer insights into product recommendations is only half of the equation.

Partners

It is not just traditional and digital advertising agencies, PR firms, research houses or even more specialized web analytics and search optimization firms that are in the business of collaborating with marketers anymore. Social business design consultancies, E- and M-commerce providers and DaaS destinations are coming of age to support established agencies and their clients today. In addition to APIs, many offer one-stop shopping for everything off-the-rack to highly customizable reports. I was never exposed to this group of resources in my marketing training in business school over the past two years. I know my colleagues will benefit from this information since we all convinced soon-to-be employers during interviews that we’re pros at making sense of minimal and ambiguous information.

Takeaway: Agencies of record no longer always trump or control other a company’s partner relationships. Take the time to get to know emerging likeminded partners and update your company’s preferred vendor list in advance of needing to contract services.

Reports

There are thousands of sales and marketing dashboards, models and automation tools available today. Many that I have seen at the 5+ companies I’ve worked and interned for are wildly complicated and take days to weeks of training to begin to understand. This past fall, I was fortunate to be part of a SaaS marketing team that took the time to create a framework for choosing which automation product it would invest in. By the time the business case for the chosen system was made, a culture around the product was already developing, employees were embracing its reporting language and it was clear how the system’s metrics would inform KPIs.     

Takeaway: Having more reports does not equal having more insight into what channel and content levers optimize various marketing outcomes. Experiment and iterate with multiple tools and formats to ensure you have the simplest and clearest tools for your purposes.   

Jobs

Just two years ago (when I left the workforce for business school), marketing jobs were centered on brand management, strategy and planning. Today, most openings I come across are of a new breed. The modern marketing manager is now an Online Marketing Manager, Marketing Analytics Manager or Customer Acquisition and Retention Manager. The visionary marketers from the past decade anticipated these changing roles and morphed as soon as they could. Others found roles outside the marketing organization, often in Community Management, where they could utilize their strategy and customer relationship skills.

Takeaway: Having the ability to improve ROI metrics is now often a requirement for marketing jobs. Craft your resume and prior work experience stories around these successes, and jockey to work for an employer that is participating in the marketing metrics dialogue and providing digital marketing training.

For every foursquare there are a dozen wesabes.

Do you have a net worth of $1 million?

Some of you probably do and some of you probably don’t, but I bet that most if not all of you think you are sophisticated enough to invest in startups. Unfortunately for those of you who don’t meet that standard or any of the other accredited investor exemptions promulgated by the Securities Act, most startups won’t take your money. This post is not about whether startups should take money from non-accreds as there are ample posts on that, see here, here and here. This post is about what the “accredited investor” standard should be. As it stands approximately 8.5% of the US population is estimated to be accredited. Recently congress thought about raising the bar which would have resulted in just over 1% of the population meeting that standard. Luckily they got wise and took that provision out. I, for one, think we should expand the definition. That being said, I agree with the public policy behind the existing legislation: we don’t want people putting money in illiquid securities who might need that money (ever) and it is easiest to determine who can take the risk using a bright line test. So what might an expanded definition look like? I would suggest exempting family members who often invest anyways and intimately know the individual actors and holders of certain professional degrees or accreditation (i.e. JDs, CPAs, CFAs) who understand the risks. If companies like SecondMarket are successful in creating liquidity for private company stock, it would strengthen the argument to expand the definition, and any expansion would greatly help the startup ecosystem.

What’s a ‘fan’ really worth?

A social branding firm in Atlanta says $3.60 based on the following formula:  

1M impressions x 2 posts x 30 days = 60M impressions  

60M impressions / 1000 x $5 CPM = $300,000

Of course this will be debated ad nauseum in comments to blogs, including this one. In today’s marketing metrics driven environment it is important to determine the value of your social media efforts. That being said, I think the value per fan depends much more on who the fan is than the number of fans (i.e. higher attribution for tastemakers, brand champions, etc.). There is a high standard of deviation from the mean.

Services such as Nutshell Mail (disclaimer: client) help bridge the gap between facebook fandom and actionable email newsletters. The key to deriving value through social media efforts is converting fans to sales or at least in-network product recommendations. Note that the terminology is changing, with “becoming a fan” becoming “like”.