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.
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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.
