Angel Investing/Venture Funds: July 2008 Archives

You know what - if we all sat down and thought for a while, we can all think of at least one company that made it big all by itself, nice and viral like, without any help from anyone but users, and that first user was able to drag all his friends in, and then exponentially drag all their friends in as well, and so on, and so on. Pretty soon it became an internet dynamo, a dominant force on the Web and its founders made a gajillion bucks off it for practically doing nothing.

No advertising. No SEM. No SEO. No nothing. Just magic. Maybe a bit of accidental viral-ness, but nothing else.

The funny thing is, I've met so many entrepreneurs whose site growth strategy depends on this magic.

I listen to them tell me their idea, and sometimes their idea is pretty cool. Sometimes they've got the site up and their idea's coolness is actually reflected in what they built. I tell them I really like it and then ask them if they are going to start a company. Then the story gets murkier.

Each one tells me yes they really want to start a company. Each one has big dreams. Then I start asking them about how they're going to get the word out about their product. Then it's unclear. They say they want to put it up and see how it does.

Well....Okay.

I tell them do they intend on doing marketing, even some marketing on the cheap like reaching out to bloggers, or SEM, or something. As soon as the mention of spending more money comes into play, the answers get murkier and murkier.

I persist. I ask them why don't they go out and raise money and become a startup. Then they would have money to spend on marketing. They give a range of answers from not wanting to leave the comfort of their current job to fear of committing to something that might not work to "still thinking about it." Mostly, they got the site up and are just waiting to see what happens.

At this point, I have my answer at least (which is "no I'm not investing").

You know, it's hard to leave the comfort of where you are now. You're making money to support a great lifestyle, or a family. You are comfortable, and don't want to face the potential chaos of the unknown, let alone a startup and its challenges. You might even fail - god forbid what others might think of you, or worse, what you might think of yourself. You might fail, and end up with no money, no job and you bet it all on this one thing and now you might have....zip...nada....nothing.

So you say you'll just put it up and see what happens.

My thoughts to you are:

1. Growth by "magic" into an internet dynamo happens SOOOOOO infrequently that the chances of what you built doing that are so vanishingly small.

BUT - what you built might actually be useful and cool enough to grow into a decent sized business (or even a dynamo) IF you were to put some sweat and money into distribution and marketing so that users know you exist.

In absence of full commitment, you might as well be playing Lotto.

2. Since you won't fully commit, you're unfortunately not risk tolerant enough to become a great entrepreneur. No offense, and I don't say it as negative criticism. Not everyone is built to deal with the uncertainties of being an entrepreneur, and the chaos that inevitably ensues from running a startup and living on the edge of having no money. So just stay home, make your money, live your life.

And don't be delusional about the chances of your site which you just "put up" and are "watching what happens."

Way back when, I was happy to have encountered Josh Kopelman's excellent post, Bridge Loans vs. Preferred Equity, to which I did sort of a re-post but also added my spin on the subject in Convertible Notes versus Preferred Equity Parts 1, 1.5, 2, and 3.

Now that I've been out here for about two years angel investing, I've uncovered more reasons not to do notes any more. So much to learn but yet no one to learn from except to fumble about and get myself into trouble. Now I've firmed up my rule to never invest in notes. I *might* do a note with a price cap on it, but it is still not without potential future issues. Here are some more reasons why notes are awful:

1. It is possible that the company you invested in achieves significant revenue, enough to do one or both things:

a. The valuation will inevitably jump. So when you put in your money, you expected the valuation to be one value, but when your note converts, the valuation has gone higher and now you've taken all the early risk with your note investment, but have lost share in the company upon conversion.

b. The company has enough revenue that it may not need further investment. Or it can delay seeking investment. If the company does not need further investment, then you're in risk of just getting paid back and not obtain any share of the company. This can also happen if the delay in seeking further investment takes the next fund raise period out beyond when the note is due. Again, you could just get paid back instead of converting into equity.

It is possible to convert still, even if there is no conversion. But it depends on the entrepreneur and they are under no legal obligation to do so.

2. The valuation may jump anyways independent of revenue. Again, if/when you convert, the value of your participation will shift from where you originally put in the money, and it doesn't reflect the risk of your early investment.

3. The terms of the next equity financing are unknown to you at the point you invest. While it is easy to ignore this in the excitement of doing an investment into a note, any problems that may arise will come up later during the conversion process.

You would think that at conversion time some large and/or experienced investor would take care of negotiating the proper terms. In most cases, this is true. However, it is also possible that not-so-favorable terms may appear and seem to be proposed by seemingly experienced investors. The big issue is that you don't know what you're converting to with a note at the time you give up your money; then, if you don't like the terms, you're kind of stuck into accepting them because you can't get your money back. Unless you're leading the investment, you won't be able to affect them much. However, if you do get stuck in one of these situations, I would advise you to speak up about the terms; you never know when you'll be heard and someone might actually change the terms to your liking.

Notes don't align investors and entrepreneurs, and now I've discovered other reasons not to do notes...