January 2011 Archives

The blogo/twittersphere is abuzz about the recent offer of $150K to every YC startup. You can read about the details here at 90% of Y Combinator Startups Have Already Accepted The $150k Start Fund Offer. You can also read a range of thoughts collected by Jason Calacanis on his blog, Angels+VCs are pissed off about Yuri/Ron Conway/YC deal-big time.

Initially I was miffed about it - it kind of pissed me off. At the last YC, I already felt like I was competing severely to get into investment rounds, having not mentored them and coming in late to their rounds even at the first Demo Day. Now it would be even harder. But then, after thinking about it, I am still sore about it, but that doesn't mean it wasn't brilliant.

And brilliant it is. For Ycombinator and its startups, and SV Angel/DST, it is totally the right move. Here's why:

1. I've always felt that every YC class, there were the stars that would get funded no matter what, and there were the ones that would fail no matter what. But, in between the stars and the certain fails there was a huge grey area of the startups who have a harder time to get funded because if only they have a bit more time, runway, money, and advice, they could actually get somewhere fundable with their projects. But, without further support after the YC time period, many would inevitably just wither and die. Now the have a longer runway given the $150K and have more time to prove out their ideas and/or pivot if necessary to something more fundable. Because of this, more YC's startups have a better chance of survival and, thus, giving YC a better chance at making more money.

2. More power has shifted to the entrepreneurs with this move at least in YC for sure. The world recently had moved from a combination of preferred equity rounds and convertible note rounds with caps to this note without a cap. Convertible notes without caps are very company friendly instruments into which investments are taken.

3. For SV Angel/DST, now they have a bets on most of the YC's startups and now will be less likely to have been shut out of a round. If you've been following YC (I've been watching the quality of YC startups since March 2008), you'll have noticed that the quality of startups has grown dramatically with each new class. It is not an inconceivable notion that there will be a big game changing startup that comes out of YC as time goes on. So creating a relationship where SV and DST can place bets on a lot of them, if not all, before the rest of the world gets to them is a good thing for them.

What about side effects? I'll throw some out there:

1. I think that the opinion that angels will find it less appealing to invest in YC startups in this class is correct. Here's why:

a. Before this $150K, YC startups only got $5K + $5K/founder. This mattered most to the startups who began life in/around the YC class. (NOTE: Each class, more startups who have been around for a while and willing to give up substantial common stock for a chance to go through YC are being accepted. For these startups, the $150K matters less.)

Given the ramen nature typical of YC entrepreneurs, that $150K means that many will not choose to raise any more money at all since they can go a long way on that much cash, conceivably ten times as long as their YC investment of ~$15K! So if these guys survived for about 2.5 months for only $15K, would they be able to have 10x2.5 months = 25 more months of runway?

Some of the startups may choose this route and if they are good, then we will miss the opportunity to invest in them now. Some time down the road, they will presumably have more progress and investing in them at that point will undoubtedly mean a higher valuation which is appropriate given their further progress. But higher valuations for an angel means less of chance to make a lot of money.

b. I believe that some of the startups will choose to raise additional capital on the terms of the convertible note w/o cap. This is also less attractive for an early angel investor because it means that we will not have established a potentially lower valuation for the early stage at which we would put money in. Instead, that valuation will come later, also presumably with more progress. Thus, we would put money in and not get any reward for early risk.

Why wouldn't a startup raise more money with another new convertible note with cap? I think some will, but some will not because they do not want to anger their previous investors, DST and SV with a structure that has more advantageous terms. I have not seen their note, so potentially it may have some terms in it to adopt the terms of succeeding rounds if they are more advantageous.

Some startups will just believe that they are justified in raising further money on these terms and not change. With the infusion of new investors around, I believe they will be able to close their rounds even with some of the more professional or experienced angel investors declining the opportunity.

Still, even if a lot of professional/experienced investors declining, I think there are enough professional/experienced investors will still take the deal, operating on the assumption that there will still be a high probability of a great outcome on a startup which is doing well.

2. This is still OK for venture capitalists. For the later stagers, they wouldn't have invested in a YC startup at early stage anyways and will just wait for them to come to them after they have matured more, like they always have. The early stage funds might not like getting into a hot YC startup early with a higher valuation, but they probably still have the ability to make money if a startup takes off, especially if they have reserved funds for follow-on investments. The majority of angels, in contrast, rarely make follow-on investments.

3. Paul Graham is highly respected, if not worshipped by all the would-be and current entrepreneurs. What happens in YC inevitably affects the larger community. YC startups have already had their pre-money valuations drift higher and have already moved towards note with caps and we've seen non-YC startups do the same. Now I'm sure there will be many that will now try to raise with notes without caps. While the not-so-great startups will try and still be declined, the hotter ones will be enboldened and will hold firm to notes without caps. Because they are hot, they will get funded no matter what. I have not seen any pattern to the contrary on this issue; money is not a problem for startups especially if they are hot and/or popular.

So yeah, I'm still sore that potentially this could mean that it may not make sense that I should invest in some of the better startups in the Valley, which will come out at this next YC class. But like all things in business, you do what you do to gain an advantage over others in your space and Ycombinator, along with SV Angel and DST are doing just that. For that reason, I'm sore, but also I cannot help but applaud their brilliant move.

On the other hand, I'm now, more than ever, thinking on how I can build my own brand, reputation, and value to entrepreneurs so that I can still get into the rounds at the time, terms, and valuation that will make sense for me to participate.

Miso Music at their Office 1-25-11

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Miso Music is a new startup creating an amazing new iOS app that allows you to learn and play stringed instruments by playing your own instrument. No need to plug a cable from your guitar to the iPad - you just sit it there and it listens to you play and knows what notes you play. They won the People's Choice Award at TechCrunch Disrupt 2010.

Here they are in their office in Santa Monica.

Nice art deco type for building number - very Hollywood!

Their front entrance:

Their front door:

Two pugs jumped on me when I walked in, now they're bored of me and are sacked out on the couches:

A buddha guards the front door:

Chandelier and candles on their main conference table:

The dream team:

Look for their incredible app this spring for iPhone and iPad. I'm gonna buy a guitar soon!

The Due Diligence Customer Call

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Friday afternoon, I had the pleasure of jumping on a conference call with one of my current potential investment's customers. It was a rare occasion where an early stage startup actually had a customer testing their product and I was able to get some feedback on the startup from a customer's perspective.

The call was thankfully overwhemingly positive; the customer had implemented the startup's system, and it installed and ran without a hitch. We found out that the startup's personnel were extremely easy to deal with and were extremely responsive to issues. We also found out some nice, unexpected results of the installed system; it gave them some enhanced marketing functionality, and they found that they increased sales by quite a bit after using the system! Of course, the customer was extremely happy about that as well.

All this served to reinforce the positivity on investing in the startup. It was very refreshing to hear all the great things a customer had to say about this company!

A little while back I wrote a post called The Lack of Due Diligence is Appalling and Foolish. In my experiences as an angel investor, I was shocked to find out that often I was the only investor asking for due diligence materials from a startup raising money. Recently on Quora, I suggested some other due diligence things people should do. Calling a startup's customers is one of those that should be done. Some thoughts on this:

1. If you're fortunate enough to encounter an early stage startup that has customers and are accessible, definitely try to give them a call. Many early stage startups are in the very beginning stages and don't have customers yet so sometimes it's hard to be able to talk to them at all.

2. Customers who are the average consumer are harder to talk to directly than customers who are businesses.

3. For consumers, you may not be able to talk to them directly at all, but must rely on customer feedback, or public reviews on other blogs, magazines, etc. Occasionally, there will be some prominent beta customers who you may be able to get hold of directly.

4. Businesses are potentially much easier to contact. There is usually a point of contact over at the customer and, if they are willing, you can talk to them.

5. Ask the entrepreneur to make the contact and introduction to their customers. I would also recommend that the entrepreneur should set the context with the customer(s) but ultimately should not be on the call/meeting. This is so we can get a unbiased view from the customer without some possible social interference by the presence of the entrepreneur.

If the entrepreneur is unwilling to facilitate access to their customers or hedges against it for any reason, be wary. A startup should NEVER EVER disrespect an investor's request for any kind of due diligence. If they do, this is a red flag. You should reconsider investing in them.

6. A quick phone call should suffice, or even better if the customer is local and you can go meet with them.

7. If there are more than one people on a call or at a meeting, you should consider discussing beforehand the questions that will be asked. In this way, the call/meeting can go quickly and in an orderly fashion. Customers, whether they are consumers or businesses, are as busy as you or me. We should respect their time and not waste it by being unorganized. Then organize the questions into a written list and have it handy to refer to during the call. You can print it out and scribble notes as you walk through the questions.

8. Here is a possible template of a due diligence call and topic areas to ask for a typical product; adjust/edit/add as necessary given the particular startup and its products:

Introduce yourselves, and say why you're calling (ie. we're potential investors in company X, and we'd like to know more about your experiences with company X and its products)

How did you first encounter the product? What were the first impressions?

Describe the signup process.

Describe the installation process.

Describe the product experience itself from your perspective. Any positive and/or negative experiences?

How did the product perform? Did it do what you thought it would do? Was it below/meets/exceeds expectations? How so?

Describe any problems in the product that you see.

How much does the product cost? Was it too much? Too little? Just right?

Did the product enhance your life/operations/sales/task/etc.? In what ways?

How were your communications with the company, if any? With the company personnel? With their customer service? Through email? Through marketing materials? Any positive and/or negative experiences?

Would you recommend this product to a friend/colleague/co-worker/another company? What would you say to them?

Thank them profusely for their time, end call.


Yes we're all way too busy. But making time for these calls, and ultimately going through due diligence on a startup can really make a difference in your decision process. As I've seen on calls like these, I not only gain more assurance that I'm making the right investment decision, but I'm also learning a lot about a startup's business from a perspective that is often very difficult to get hold of.

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