The Web and the World of Business

August 22, 2008

Not Caring About Terms

This has happened to me several times now. I've found an amazing lack of caring when it comes to negotiating terms amongst supposedly experienced investors. This is both among angels and venture firms. It doesn't happen every time, but it happens enough. I have also found that people who put the most money in have the most to lose, but yet don't step up to lead a negotiation on terms.

Why would this happen even with seemingly experienced individuals who have put up a large sum of cash for investment? Here are some reasons I've seen:

1. There is inherent trust in the entrepreneur. This occurs most in rounds with family and friends. Experienced individuals who jump into these rounds may not negotiate over terms and just sign whatever paperwork comes their way, on the assumption that the entrepreneur won't ever do anything to screw them.

2. Some investors have lots of money, but don't have enough knowledge on financing terms and their future implications. In my own experience, the only way I have learned (and that learning is burned into me) is to have done lots of deals and continually do them. Most angels don't invest that often and it's easy to forget how terms can affect their investment.

3. Some investors simply don't care. They just put money up for investment and they are totally passive, and are happy to be part of the deal and gain some sort of return later. They don't care about the details at all.

With 3, I believe that even at large sums of money, and this can be upwards of 500k-1MM dollars, this still is a drop in the bucket for their entire holdings and thus can afford to not care about the details.

Also, I think that for many investors, they are just doing it as a hobby and they are not serious about it. Thus, their level of care drops considerably on the details.

4. I have also seen investors simply avoid confrontation. They don't want to get into an argument over terms, so they don't start.

5. Some investors don't want to spend lawyer fees to deal with the terms. They don't want to spend anything extra and just want it done.

6. There is also something more serious, which is that if you lead, you could take on extra liability in case something in the terms causes the entire deal to go sour at some point. I've heard of cases where you could get sued for that. So investors get cold feet and avoid leading.

On some deals, I have pushed back on the terms because they weren't to my liking. I do that even when I go in at my very low investment level, and I am never large enough to be a traditional lead investor. Entrepreneurs often counter that their most experienced investor is OK with the terms and thus the terms must be acceptable. In fact, because the other investors have not spoken up, the terms get accepted by default.

I have to say that this is frustrating. I have met only one other investor who invests at my level and ALWAYS speaks up about the terms. Everyone else just follows whatever is happening and assumes someone else is dealing with the details.

The problem with the terms is that, unless a lead investor produces a term sheet, you're almost always given a term sheet that is company friendly. It will always favor the company and provides zero protection for investors from negative events.

My message to entrepreneurs is this:

You're probably doing the right thing from a negotiation standpoint in starting out with a document that favors you totally. But I would truly warn you against making the assumption that since an experienced investor(s) have reviewed it, that it is truly an acceptable document. As discussed before, there are myriad of reasons why an investor, or group of investors, are OK with what you produced. But bear in mind, that if you as an entrepreneur truly want to take care of your investors, then you should query your lawyer on why an investor might object to the terms set forth in the document that he gives you, so that you understand why we would have issues and the ramifications for us in the extreme cases.

By the way, a lawyer will ALWAYS produce documents that favor you initially. It's their job. If they are being a proper lawyer they will always seek to protect you and the company first UNLESS you specifically ask for a document that is more balanced. Also, NOTHING IS STANDARD. No matter what anyone tells you, it's true. In every deal I've worked on, the terms are always slightly different.

My message to investors:

First, following on the very last comment previous, NOTHING IS STANDARD. Don't believe it if someone hands you a term sheet and they say it's standard, in hopes that you will believe them and just accept it blindly. I've worked on many deals now and they are all different in small and large ways, with many of the entrepreneurs and their lawyers leading the discussion with "it's standard".

Second, hire a good lawyer and spend the money to have someone review the terms and explain to you the potential up and downsides of the terms. Too many horror stories abound where there was insufficient protection for investors and we've gotten squeezed out company ownership, cheating us of larger returns. As an early stage investor, we put up cash at the earliest stage and take the highest risk and it is my belief that we should be compensated for taking that risk early on. Without us, the entrepreneur would never have gotten anywhere.

Third, CARE ABOUT THE TERMS. Make sure someone good is negotiating on your behalf. Never assume that someone else is going to do it. If you're unwilling to do the negotiation, then at least make sure that there is someone who will do the negotiation. READ THE TERMS. Understand their implications to you and your money.

Fourth, we'd all like to work off of trust and a handshake, but I've already seen how friends can turn on friends in a business situation. It happens way too much for my taste. Thus, if we have a trusting business relationship, then there should be no problem putting that down in the terms. Be alert for when an entrepreneur gets upset at you implying that their trust is not good enough because you want it written down - to me, it's a sign of trouble. It's a psychological tactic to get at your good, trusting nature so that you won't require him to write it down. Don't fall for that. Walk away from the deal.

Last, do not be afraid to speak up regarding the terms either to the entrepreneur or to the lead investor. It's your money so take care of it! Besides, you never know if the entrepreneur might actually change something based on what you say; it's happened twice to me now where I'm on great terms with the entrepreneur and just asked nicely if we could make a change, and they did it.

Posted by dshen at 09:50 AM | Comments (0)

July 21, 2008

If I Put It Up, They Will Come....Right?

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."

Posted by dshen at 08:37 PM | Comments (0)

July 15, 2008

More Reasons Not to Invest in Notes

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...

Posted by dshen at 10:20 AM | Comments (0)

June 20, 2008

How Does One Advise So Many Companies at One Time?

Often I get asked by entrepreneurs to become advisor to their company and they take a look at my companies page and they wonder how I can handle so many companies at one time. Where does Dave find the time? Do the companies actually get enough support from me given that I am advising so many?

It's actually not so hard. Here's how:

1. I've found that advisor time commitment varies greatly from company to company. Some entrepreneurs use me as traditional advisors are used, which is to meet up once every month or quarter and give me an update and go through their plans and get my feedback. If all my companies were like this, I could definitely advise a ton more.

Others call or email me whenever they need something. I have many hours in the day and definitely can field calls or answer emails. Sometimes they ask for a site review or recommendations. This takes longer, but blocking out a few hours to do that isn't a problem.

Some have wanted meetings weekly for a while. The weekly meetings never last though; entrepreneurs are pretty busy and they get going on something and they don't have time to meet up any more. Or they learn enough or have firmed up plans enough to keep them going for a while and then they don't need my constant interaction.

2. Perhaps the greatest time commitment is just thinking about each company daily. I often have at least one (or more) of my companies swirling in my brain and I try to record any ideas down asap. If I am in front of my Mac, I'll open an email and just record the ideas in that; also, I have a small moleskin notebook that I carry around with me constantly to jot down ideas. Once I get all my ideas down, I check it over, do some rewrites, insert additional ideas that come to me on the fly, and then send it to the entrepreneur.

I like to get into the mode of a single company and its product and try to immerse myself in the product as a user, and the experience of needing/wanting that product. That enables me to really get into what I would want, and also what others could want in that product and where improvements can be made.

I multitask on this throughout each day, but sometimes I take some focused time and do this too.

Still, once a company receives these ideas and acts on them, they usually don't need further time from me for a while.

3. Another task I do for my startups is connecting them with potential partners and sources of capital (although definitely I do not bill myself as a fund raiser). This requires me to network a lot with both old and newly met folks. Thus hour long coffees and lunches are the norm and these take time out of my week.

Also, I write a lot of emails introducing my companies to these partners as well. Thinking about which partner to send the company to and also sending the email does take up time, but not all that much.

4. My favorite thing to say about advisor time commitment is that almost all companies need the most time at the beginning of our advisor relationship. There is a big spike in time and thinking from my side and also in interactions and then somewhere between 2 and 6 months later, that time drops to near zero, with little peaks of time to do emails and check-ins.

The rationale behind this is that the company is supposed to learn everything I tell them. They finalize their plans with my input and feedback. They take this knowledge and are off and running building their product. They don't need my interaction so much after this time because they have what they need from me.

This is one of my main goals: To transfer knowledge from my brain to theirs so that they don't need me any more. If I do this successfully, they should be able to function for a long period of time without my input. Over time, my goal over the term of my advisorship is to help them find resources that would manage what I help them with day to day. This is finding and hiring a great full time design resource and great product management resource. It can also mean finding/hiring a great sales program person as well, to help them monetize their advertising programs.

I've been advising for about 2 years now, so many of the companies on my companies page are off and running without further need of my help.

4a. One thing that I have consistently observed is that if my time requirements spikes again after the initial peak, the company is in trouble...so I keep watch for this and hopefully help prevent this from happening.

5. OK OK I admit it. Even working like the above, I still can get pretty busy in the short term. In fact there was a time when I thought I was overextending myself due to the pace of advisorship signups. So now I am very aware of the pace of companies I advise and have slowed down dramatically based on my current support load.

6. Next, I tell people I shouldn't be put on critical path for anything. It's not what advisors do anyways.

A lot of people ask me to be advisor, but really want me to do the design of their site for them. If they want this, they should either outsource their design or find a designer to hire full time, and not try to turn an advisor into a fake full time person. I think this is especially true in product design; in order to do a great job, you have to be immersed 24/7 with the product and team. It's hard to jump in and out or do it on the side.

If I'm not on critical path, that reduces time commitments from 24/7 to something much, much less and less frequent.

As advisor, I always tell people that I shouldn't be expected to be put on critical path for anything because we're both going to end up being disappointed and frustrated. Very bad!

7. Last, I love being involved in many things. It helps keep my interest level up and allows me to see the entire world of internet startups across the board, which is an advantage. I purposely try to get involved across a myriad of projects, across a range of areas.

It takes me out of being myopic into one thing, and allows me to help my startups by being broad in my thinking and not get too trapped into the details of one project. While this is important from an execution point of view, it doesn't help when you're helping to plan the strategies of these startups by not looking outward and seeing where the trends of the industry are going. Often I bring the broader view to my startups because they don't have time to look at it themselves. They're often too busy to do that. On the other hand, I want them to spend all their time executing and not get distracted.

I've really come to love advising startups. The connection with smart, energetic people working on cool new things is really great, and I enjoy helping broaden their vision and give them the help and knowledge they need to be successful.

Posted by dshen at 06:53 AM | Comments (0)

April 27, 2008

Our Economy Sucks, Raise More Money Now

Our subprime mess is very much underway and the economy is suffering from that and a host of other issues. When consumers feel the pinch, that means they buy less, and companies don't make as much money, and then they spend less on advertising and also on acquisitions. This is important to both startups and us investors: consumers spend less, so they are less willing to buy products and services from a company. Companies spend less and then they slowdown their advertising spend. Stats show that advertisers will maintain their online ad budgets when compared to offline budgets (woe to offline operations who are heavily dependent on advertising for revenue), but I can't help but wonder how much online advertising could have grown MORE if our economy wasn't so bad. Last as companies pull back and preserve cash, they will be less likely to acquire all these nice startups that we're working on now. Granted, the wiser and the more resourced companies will actually go on a buying spree, but they'll be after the startups at super cheap prices since they'll be lower performing towards the end of the year as revenues become tougher. Beware the corporate development folks who seem to slow down a bit; they're just waiting for you to go through your cash reserves and get to a more desperate place by end of year and snap you up at a discount!

When I meet startups, I am now telling them to raise more than they were thinking. I try to get them to run the numbers and to figure out how to survive until at least the second half of 2009, or further if possible. I want them to survive through the economic downturn and not be dependent on additional money until then. I tell them to expect that any revenue projections will be missed towards the end of this year, and advise them that if they try to raise money on poor metrics AND they have run out of money, they will have an extremely hard time doing it.

A lot of entrepreneurs are still coming to me with raising $100k-$300k in their plans. Then I try to convince them of the economic issues and that unless you can survive for 1.5 years on $300k, you'd better change the plan. Not all of them listen though. It will be interesting to see if I am right. To me, you should be at least $500k, even better upwards of $1-1.5MM, whereas in a decent economy, you could get by with $300k-$1MM.

Some of them only want to survive 6-9 months to get a prototype up and raise money on that. In a better economy, I would say that this is not a bad scenario. However, in today's world, I tell them that if they are getting traction on an idea in investors' eyes, that they should leverage that inertia and get more money now. If they build a prototype and are not gaining traction in a down economy, it's only going to show that you could not gain traction and investors be much less likely to participate as they look for positive metrics. It's much better to raise money on a beta and/or the idea and get as much money as you can now, and to plan on survival on minimal or no revenues for 1.5 years.

Another issue with the 6-9 month plan: August and the holidays. Running out of money by August really sucks for fund raising. This is because the venture community goes on summer vacation and it's nearly impossible to find someone to get a meeting. You have to wait until they all get back in September. Then you have about a two month window everyone gets distracted once again because it's Thanksgiving and then Christmas. From about mid-November to first/second week of January, the venture community goes on vacation, peoples' minds are on the holidays and families and not on funding you.

If you're an entrepreneur reading this now: raise more cash than you think, expect that any revenue projections you have will be missed, and try to plan to survive on minimal or no revenues until at least the latter half of 2009, and raise all that money now while you have investor inertia.

Posted by dshen at 12:07 PM | Comments (0)

April 20, 2008

Intuition, Gut Feel, and Seduction

A little while back I sat with another experienced angel investor and the topic of gut feel came up, as it relates to angel investing.

It was funny for both of us that for all the analysis we can do on a new startup's prospects, that if our gut said no, we'd not invest. How interesting to use such a undefined force and feeling to make such a prominent decision!

After I left Yahoo, I resolved to develop and listen to my intuition more. I really searched down deep inside myself and really tried to become sensitive to the most minute feelings that emerged about anything. I trained myself to be acutely aware of the good and the bad, and those nagging feelings of doubt or uncertainty. Then, once I could identify those feelings, then I told myself that I would act on them and never ignore them. This is because in the past, I feel that I have ignored my intuition and this has resulted in me getting into some really bad situations.

When I meet an entrepreneur for the first time, my intuition is on high alert. I search my feelings as I hear them talk to me about their business. I not only attune myself to pitch he is presenting, but also to who he is. Is there elation on the idea or some nagging uncertainty? Do I feel this person is trustworthy or not? These and more.

However, what can stymie intuition in the world of angel investing is seduction. This is when the pitch and/or the person delivers such an incredible perceived opportunity that it's like seeing the hottest, sexiest woman walk into a bar and you just can't resist. You're hooked emotionally and you're already reaching for your checkbook. Somehow, the seducer has blown past all your defenses and even your intuition seems suckered.

This happened to me in a pitch not too long ago. The pitch was perfect. It was seductive. It claimed solving so many problems and the benefits and monetization were straightforward. The team was experienced and veterans of the Internet, so no problem on solving any kind of technical challenge. But I countered by saying to myself that hottest, sexiest woman is still a person despite what we perceive is her perfection, and thus means she can't be perfect since she is only human. Thus, for this pitch, however sexy it was, I refused to fall under its spell and viewed it with objective eyes. I brought my intuition back online and ultimately felt too uneasy about it to participate.

Walk away from that hot, sexy woman - hardest thing you can do sometimes.

Avoiding seduction is crucial. We have to train ourselves to not fall under the witch's spell and view the entrepreneur and the opportunity with objective eyes.

This brings back the clarity of our gut and intuition, which we must cultivate to make sure we are not doing something that we're not comfortable with.

In Blink by Malcolm Gladwell, he doesn't like using the word intuition but instead he calls it a form of unbelievably quick thinking. For me, it's both. It's both the gut, the emotional aspect of immediate, primal reaction to something, and the incredibly rapid thought that allows us to make an instantaneous decision. One is cultivated within ourselves and our feelings, the other via years of experience in dealing in a certain area of expertise.

What does it mean exactly when we pass on an opportunity via gut feel?

Just because we pass on an idea does not mean that we think an idea will fail. It might actually succeed. However, I do believe that it truly means that we are not the right people to be involved and that our gut is telling us that, given who we are, how we work, etc, that this project is not right for us.

For the entrepreneur that gets passed due to gut feel, don't feel bad. In the end, it will be better if we didn't work together. Go and be successful, but just with someone else.

Posted by dshen at 09:28 PM | Comments (1)

March 18, 2008

Incubation 201: Should You Incubate?

My last post Incubation 101 went over basic concepts which I think are essential to the success of any incubation operation. Basically, I think that risk of failure increases exponentially if you don't follow these concepts in their entirety.

In this post, I want to bring out some subtle points mentioned in the previous post which refer to whether or not you SHOULD incubate at all. I assume that if you are thinking about incubating, that somehow you've reached a point in your career/life where you CAN incubate. But does it mean you should?

What are YOU personally willing to do?

Self-examination and knowledge is very important. You need to figure out exactly HOW you can contribute to incubation and the nurturing of ideas into businesses. Then you need to figure out what really motivates you and how you gain satisfaction, relative to the kind of participation you're willing to give.

Are you willing to jump back into the startup life of working 24/7?

If you're not in a position to go back to startup life, then you shouldn't incubate your own ideas. Remember, the idea originator has the resonance with the idea, and is best poised to take an idea to a successful conclusion. If you're not willing to do that, that's a clear sign you shouldn't incubate. Transferrence of an idea to someone else is nearly impossible and substantially decreases chances for success. Incubating at arm's length is still possible.

Do you have incredible, kick-ass product ideas and want to see them flourish?

This is better than having dumb ideas, or ideas that others are working on, or no ideas at all. You shouldn't incubate your ideas if you don't have great ideas to begin with. Again, maybe you should incubate at arm's length.

Being the "Guy at the Top"

The most dangerous thing you can do with incubation is try to be the "guy at the top" who directs things but doesn't get involved in the day to day of any incubated operation. You generate great ideas, and then hire a team to execute that idea, and then think you can sit back and watch the idea flourish, grow big, and you reap the benefits while being able to kick back and just manage it all.

Incubating Your Own Ideas

So you have great ideas and are willing to go back into the startup world. Incubation is a great way to figure out what to do next, if you have the resources to work on many things simultaneously. You will need to be personally involved in the day to day of each incubated idea, and you'll most likely max out at around 3-4 ideas, perhaps less.

Follow the principles in Incubation 101 and you'll do great.

Managing Incubation at Arm's Length

So you don't have great ideas, OR you aren't willing to put yourself back into startup mode regardless of whatever ideas you have.

My advice to you, is to let go of any notions that you be the "guy at the top" and find another way to help others with their ideas. Reorient your values and take great pleasure in watching others' flourish with their own ideas, but contribute in ways that allow you to be involved.

This can be through advisorships and/or investments. Provide value to your entrepreneurs as you invest money in their ideas and they will come to you for help. Create a positive relationship and you can gain some satisfaction in knowing that you contributed to the success of their idea.

Raise a venture fund and support people more through cash, if you aren't so helpful in other ways. Keep the incubated ideas and companies at arm's length as much as possible to maximize incentives and reduce your exposure to ideas that aren't going anywhere. Again, follow the principles in Incubation 101 and you'll minimize risk and maximize your chance of finding something great.

My Personal Experience

Back in early 2006, I attempted to raise a venture fund with an incubation component. I was having a hard time raising it, and ultimately this caused me to get involved with startups in a different way. Looking back, I was glad that I didn't fully realize the incubation operation as I think it would have gotten to a bad place.

In my self-examination, which happened much later, I discovered:

1. I was not willing to put my personal time into any one idea. This would have lead to a bunch of ideas run by me, the "guy at the top". This would have been a risk increasing move.

2. I really didn't have great ideas. I had some, but none that were earth shattering. I didn't have a way to generate great ideas but would have tried to execute some mediocre ideas, again increasing risk.

3. I realized I was much better at taking someone else's ideas and making them even better.

Thus, I am today at something-like incubating at arm's length. I feel that I have yielded a much better risk profile through my work with startups across a number of great ideas and entrepreneurs, and leveraging my personality preference for making an existing idea better versus coming up with a great idea myself. I also have higher personal satisfaction working in this fashion.

Read Incubation 101, do the self-discovery, and do incubation the right way for YOU.

Posted by dshen at 11:43 AM | Comments (0)

March 16, 2008

Incubation 101

Over the last few months, I spent some time interviewing a whole bunch of people about incubating businesses. It was very enlightening not for the information I uncovered, but the fact that it just brought to the forefront of consciousness things I already knew.

Incubation has had a bad reputation over the years, especially the large ones like IdeaLab and Internet Capital Group that raised enormous sums of money but didn't return nearly what they were supposed to. When I tried to raise my own venture fund 2 years ago and wanted to include an incubation component, I was advised unilaterally to not call it an incubator or else I would get nowhere fast! Investors had been burned way too much on the incubator model in the past to trust new ones.

Yet incubation is sexy. Generate new, cool ideas. Create new businesses. Find the next Google. Unbridled innovation, unlimited success! Wow!

If only it were that easy or certain. Incubation is really hard, but in my research I've uncovered some guiding principles which make incubation viable and possible as a strategy.

Here are the highlights:

Incubation works nicely for internet projects
Developing products and services for the internet has gotten so cheap and easy that invested capital can be very small relative to other industries.

Incubation is HARD
It's not easy to come up with a great new business. Attempting it is not for those wishing for a quick win. You have to be patient, focused, and be able to let go of projects that aren't getting anywhere or waste too much of your time and resources.

Go cheap
The less money you spend, the less money you need to properly incubate. Testing ideas as cheap as possible reduces overall investment. Don't invest a ton in infrastructure liking buying a pretty building and cool office furniture. Outsourcing can help with being cheap especially in the international marketplace for talent.

Build fast
Get your concepts out there fast and test. Being slow means competitors can get into a space before you can test properly. Also, the more ideas you can generate and test, the more chances you have of hitting on something worthwhile.

Fail and remove fast
If something is failing, close it down fast! Have the discipline to kill projects that aren't working. Throwing money at failing projects doesn't solve the problem either. The ability to let go of bad projects is extremely important. Otherwise, projects that are sitting around languishing just waste money and effort to keep afloat.

Go wide...Carefully
Risk is reduced if you cast your net wide of ideas to try. Throwing all your eggs into one or a small number of baskets increases risk substantially of failure. But go wide carefully, meaning don't stretch your resources too thinly.

The founder of an idea needs to go with that business
It is nearly impossible to properly transfer an idea to someone else. Trying to do so raises risk tremendously. To reduce risk, the person who comes up with an idea should stay with that idea, should that idea blossom into a business. This is because the originator of an idea typically has some intrinsic resonance with that idea as a business, and is the right person to build, innovate, and nurture it.

If you are not willing to take an idea through to its proper conclusion, my advice to you is to re-examine your life and what you want to do. If you're not willing to jump back into a startup, then I would tell you to just let others develop their own ideas and let go of your own. Take pleasure in nuturing others and their ideas into great businesses. Raise a venture fund and help others do well.

The team members also should go with that business
Shared resources developing an idea is a nice concept, but to reduce risk, as soon as an idea starts taking off, the development and product team should immediately be deployed on that project. Switching people on a project is hugely problematic and wastes time in education, learnings, and experience.

Any resources working in an incubator should be told beforehand that if they work on an idea, they can't just sit around and keep coming up with new ideas; they need to see the blossoming idea through to its conclusion. If anyone can't buy into that model, then they should find a job somewhere else.

Keep resources at arm's length
The more resources you can keep not on recurring payroll, the better. It's easier to remove people who aren't working out, or shut down projects. Hire the teams on projects that are flourishing to the corporations in which those projects reside.

Build a rolodex of resources you can deploy at a moment's notice. Find great people who are willing to give you great rates and can do great work.

Be disciplined in a process for evaluation
Set clear checkpoints for your incubated projects. If they do not reach basic minimum levels, then they should be shut down ruthlessly. Budgets, time, goals all can be used to create checkpoints.

Incentives are key
Nothing motivates people better than survival instinct and a life or death deadline. The survival instinct is activated when they know they're going to run out of money (like their salary, their means for eating and paying rent, etc.) if they aren't successful. The life or death deadline is activated when they know they're not going to get any more resources or help beyond a certain point. So they MUST be successful or else they're gonna starve.

On the other side of the coin, it is highly motivational to know that their success is also tied to success of their project in a large and singular manner.

Paying them a regular salary from the overall incubator pool is not motivating enough; it makes them too comfortable knowing that they could fail on any idea but still are able to go on surviving. It also severely reduces their urgency, knowing that they're still going to get a paycheck whether or not it launches today or 3 months from now.

Giving them large ownership in a separate corporation formed from their project is. Tying their salary to the separate corporation is even better.

Forming a separate corporate entity per project increases clarity in ownership and process
Keeping projects internally makes it difficult to track and assign costs properly to each project. When you have a separate corporation each with its own budget and resources, tracking becomes easier.

It also makes it clear who owns what part of what corporation, and how much of it. Keeping projects internally removes that fact as you're part of and being paid by the whole.

This clarity extends to funding as well. When an entity is running out of money, you have to take an official step to put more funds into that corporation's bank account, along with all the ramifications in doing so in ownership, and why you have to do so. It really makes you think twice about funding a business that may be faltering or flawed.

As mentioned before, when peoples' salaries are tied to the corporation, then incentives are highly aligned with the success of that corporation, and not blurred with the whole incubator.

Some ideas require a sustainability component to be fully tested
A recurring theme among internet products is that ideas can be launched quickly and once it's out there, people will come and use it, love it, and it will grow. Banking on an idea to grow organically by itself is a recipe for disaster. The problem is that not many ideas have the ability to do so. We often fool ourselves that by launching a new idea live, that people will just come and use it and it will be the next Google. It might happen, but probably won't. Then we get frustrated wondering why it isn't growing, and often end up thinking that the idea sucked and we should close it down.

However, it is deceptive to think that an idea which does not grow organically is a failure. The reality is that the idea might actually be good, but just requires people, time, money, and smarts to apply to it and then it might grow. Thinking through the sustainability of a launched idea and how that can be supported for at least some period of time is really important.

Incubation works great if you're personally trying to figure out what to do next
If you have some personal capital and want to find a new idea to work on, incubation could be for you. I've talked to a number of people who have employed incubation at a personal level successfully. Instead of working on just one idea, they launch 3-4 and work on all simultaneously. Each idea gets funding and their own team. At the end of the process, the most successful idea survives. The other projects are closed down or sold, and you become CEO of the surviving, thriving business.

It could work much better than working on singular idea and trying to determine if that idea is the right one or not. Or working ideas serially. Being serial takes up a lot more time than doing things in parallel.

Yes it takes a lot of time and effort, and requires a multi-tasking brain. But if you're a startup person, you're probably used to working like that anyways.

Find great startup people
Seems basic right? It's actually harder than you think.

Find creative, hard working, caffeinated people who are smart and motivated AND can take a project to a conclusion. Too many people float at the creative, idea stage and don't have what it takes to stay with an idea over time and develop it. Discovering people who are like this is very hard, so beware.

As mentioned previously, keeping them at arm's length makes it easier to get rid of inappropriate people. Be ruthless in culling people who aren't working out.

Young people are great. They can work for long hours, live cheaply, have almost no other attachments in their lives. They will try stuff because they don't know better, unlike us old, jaded, experienced people. They're not so great because they don't have enough business experience to know how to take a business further.

Build an idea with revenue generation on the mind from day one
If an idea is generating money, its ability to sustain itself grows dramatically. Creating products which bank on the free model and gain lots of users, but have no concept or plan for short term revenue, is great for people who have a powerful investor as backer and who is willing to fund growth beyond that point. For an incubator, I would say that this is not a good path to go down and substantially increases risk of failure.

Revenue generation sustains the incubation process
Following on the last principle, if you can find a way to generate revenue immediately, then the incubation process can be self-funded and sustaining, and opens up the ability to try new ideas without deploying more outside capital.

Good luck with your incubation efforts, and I'd love to hear how you're doing if you are going to incubate new businesses.

Posted by dshen at 10:02 AM | Comments (0)

March 07, 2008

Exploratory Products vs. Utility Products

Over this last year, the topic of exploratory products versus utility products has come up so many times. And I've always felt uncomfortable with products that engage users because it helps them "discover" or "explore" something.

"Discovery" and "exploration" are always so alluring terms. Throughout human history, we've always envied the explorer. Christopher Columbus set out to discover the New World. Lewis and Clark went looking for a way to the Pacific Ocean. Neil Armstrong sets his foot on Lunar soil and declares, "That's one small step for man, one giant leap for mankind." Even watching Star Trek with the Enterprise on their 5 year mission to explore new worlds, we can't help but wish we were on the Enterprise alongside Captain Kirk and Mr. Spock. It sounds so wonderful, so romantic, and speaks to our ingrained cultural tendencies that achieving, discovering, and exploring makes us feel that blazing new territory like pioneers puts us out of the comfort zone and sets our senses afire, and takes us out of our normal, boring lives.

First, I think that there is a segment of the population with a natural "gene" for exploration. I personally know people whose first inclination every morning right when they get up is to go to click randomly on news articles or websites, like StumbleUpon or Digg, or Del.icio.us. They always do this before doing anything else.

Second, I think there are differences in the manifestation of the "exploration gene" based on age. Young people seem to engage in more exploratory behavior. But once young people grow older, they get more responsibilities, their time gets occupied by a whole bunch of things, their lives get so full that there is little or no time for exploration unless you have a natural "gene" for exploration.

To me, exploration is either an activity relegated to a small population relative to the whole, or one that does not sustain itself as a person ages. Given this belief, I think there is a tremendous amount of risk associated with products that depend on "exploration" and "discovery" as the main reasons why users would want to and/or continue using a product.

What's the difference between an exploratory product and a utility product?

Utility products are those which depend less on exploration and discovery as primary tenets. Instead, utility products work their way into our lives because they are essential and we gain continual value from our usage and interaction with the product.

Here's an example. News sites like NYTimes.com are utility sites. We consume news every day and find value from that by being informed. But they also introduce exploration to keep things interesting with their Most Emailed Stories module. But it's not the focus of the site; it's secondary.

Another example: StumbleUpon. I consider StumbleUpon a classic exploration site. You go there because you don't know what you'll find. You have to like discovering new websites and are ok with spending your valuable time doing so. But yet traffic over the last year has been dropping.

Here are the Alexa graphs for NYTimes and StumbleUpon:

Do you want your product's graph to look like NYTimes.com or StumbleUpon?

My basic tenet is:

If you want a chance at success, you must make your product essential from a utilitarian point of view. You can use exploration to make your product more interesting, but if you make exploration your main purpose, you'll reach a topping out point of users and potentially decline over time.

Is it a perfect rule? No, of course not. I am sure if we thought hard enough, we could think of some sites who are successful at employing exploration as their main purpose. However, I'm talking about risk reduction of failure and increasing the probability of success dramatically in my opinion. Wouldn't you want to reduce the risk of failure by a great amount?

Posted by dshen at 08:41 AM | Comments (1)

February 11, 2008

Holding Someone's Hands

It's a shame.

Every week I encounter entrepreneurs. Given that I look at early stage internet deals, a high percentage of them are first timers. And practically all of them have nobody to help them or walk them through the details of creating a new company and funding it.

It's a real shame.

I would be the first to say that I'm no expert on this. But I try to help as many people as possible. Yes, it takes a lot of time but I'm willing to give that time out, even if it's for goodwill and I only get a positive relationship out of it. I just hate seeing people either stumble around on their own or worse, get bad or imperfect advice.

Investors give you advice, but sometimes they aren't entrepreneurs and can't really know what it's like to build product and a company. Or you wonder if the advice they're giving you has their interests wrapped up in there, especially where funding is concerned.

Other entrepreneurs give you advice, but many of them are bitter with past experiences of investors and tend towards telling you how to do things in investor unfriendly ways. Or they have ways of doing things that they like and these may or may not apply to your situation.

Lawyers are supposed to give you advice, but they are only giving you advice that protects you, which is very company friendly. Also, many of them don't understand the different phases of a company's life cycle; they may have only done big corporate financings and have not done early stage. As your experience grows, the things that are important are different based on the size and stage of the company. It's frequently up to the entrepreneur to educate the lawyer on how they want to do things, with the lawyer supporting. But you can't educate your lawyer until you educate yourself. Oh, by the way, you have to pay lawyers to talk to them....

I'm probably one of the few people around who are schizophrenic and can wear both an entrepreneur and an investor hat; my model of advising and investing has helped me understand both sides of the equation. I also try to lay it all out and talk as broadly as I can about the implications of as many things on the table, both company and investor friendly and unfriendly. On topics in which I do not have experience, I say so and try to point them in the right direction.

Yes, my experience base is relatively low, but I am still willing to spend that time with entrepreneurs, because it sure seems like no one else is willing to. In general, I find mentorship to be severely lacking in the hustle/bustle of Silicon Valley...

Posted by dshen at 08:43 PM | Comments (0)

January 13, 2008

Filtering and Referrals

One thing I've noticed about the startup funding eco-system is that everybody is out to get your money. Unfortunately, that means that you get both people with the good ideas and people with the not-so-good ideas. And it always seems that the people with the not-so-good ideas outpace the people with good ideas by a factor of 100 or more.

A while back I stopped going to the Tech Meetups and entrepreneur gatherings because whenever I handed out my business card and people notice the word "Ventures" in my company name, the emails don't stop. I get pitched by everyone. I even got pitched the other day on Facebook. At some point, I may need to remove my business name from Facebook!

It's too much. The deluge of emails coming in is too much to deal with. I hear it's the same at venture funds; they too are getting too many pitches and are trying to make sense of it all while not losing the opportunity to find that next big thing amongst all the not-so-good things.

Over this last year, I've pretty much switched to the referral model. It means that I never go to tech gatherings but only field introductions from people I know. It's slowed the pace of pitches considerably while filtering them in a much better way. After all, somebody you know isn't going to send crap your way; you have a personal stake in that referral being worthwhile and not a waste of time and don't want to jeopardize the relationship. If an entrepreneur is able to convince someone else that they're good/cool/savvy enough to be intro-ed to me, then I'd love to talk to them.

The same goes with venture funds. As I've gone out there and networked with them, I'm finding that we angels can play a great role in filtering for them as well. We can be a great first line of defense for them, sending only those that we feel good about to them and doing some of the leg work in finding hidden deals through our networks, which are often hidden and hard for outsiders to break into. I've also gotten referrals from venture funds on deals that were too small for them to handle, and also those that I've helped them check out. It works really well in both directions.

As the venture fund world evolves, I can see the relationship between venture funds and angels is going to grow tighter and more useful for both parties over time.

Posted by dshen at 08:49 AM | Comments (0)

December 21, 2007

Investor Fatigue?

The last half of 2007 saw for me an acceleration of deal flow. I've spent numerous hours with a host of startups. I've passed on a few, gotten further with others. Most I've not gotten involved with, and the remaining few I've stuck with them through the process and told them verbally that I was committed, as long as other things fall into place.

Some of these deals have taken a long time to close on investment, or finalize my involvement. I find that as the weeks become months, that I am feeling a bit of fatigue on these deals.

I have heard this happening to other entrepreneurs where if they take too long, their investors just lose interest and don't want to do the deal any more, or just move on to other projects which are taking up their time. Now that I am toe-ing the edge of this fatigue on deals, I can relate to how these investors feel.

As an investor, I told myself I would not be flaky. When I say I am committed, I want to be just that and not be wishy-washy. I do not want to frustrate entrepreneurs and make them do extra work in chasing down investors who can't figure out if they want to do the deal or not but just stay in that grey zone; I want them to finish the fund raising part of their company building and move back into building the product and business. I have heard too many stories about investors who can't seem to just make a decision to say yes or no and don't want to be like that.

But now I feel some fatigue setting in, and start to ponder not just the fatigue aspects but also the reasons why it's taking so long.

We investors tend to like to pool our due diligence process by watching the reactions and analyses of other investors. So if an entrepreneur can't get the commitment of prominent investors in a short amount of time, then perhaps that is saying something about the project itself. Perhaps something is amiss; perhaps the entrepreneur's pitching skills need work, or the pitch itself needs re-work, or the business plan itself. Add to that other projects demanding my attention - I cannot help but feel that fatigue may actually pull myself out of commitment on certain projects due to my own wavering interest, but also the real reasons why it's taking so long to close on an investment round.

Now that I am experiencing this time lengthening process firsthand, coupled with my own fatigue on projects, I offer this advice to entrepreneurs, which is to close on investment as soon as possible, doing whatever it takes to prepare, make a great pitch, and herd the investments to a close date.

It's a bit like dating; if I go out with a girl many times and it doesn't seem to go anywhere, shouldn't I stop wasting time and move on to someone with whom a great relationship would develop?

Posted by dshen at 02:55 AM | Comments (0)

November 03, 2007

Analyzing Myself Into Ultra-Conservatism and Inaction

So far, I've spent a little over a year angel investing. I've noted before that it's been a fun and rewarding educational process in learning how to angel invest. I've talked to people and got some great pointers, read some books on the subject, read some insightful blog posts, and leveraged my own Yahoo! knowledge in trying to figure out whether I should invest in a business or not.

I've also noticed that I've begun, and now attempting to prevent, a slow slide into "analysis ultra-conservatism." What exactly is this?

Just recently, I've started looking at a lot of deals and but invested in none. I felt like the frequency of my investments has dropped dramatically. Yes, there were many reasons why I did not invest and some of them were out of my control. But I also wondered if something else was at work.

As an angel investor in early stage internet companies, I know that high risk is part of the game. They all have not been in business long enough to show traction, and you need a healthy dose of faith in order to put money in them. Yet, I felt that I was thinking more deeply into a business now than I did before. For sure, I have more knowledge now; I have looked at a lot of companies, heard other peoples' objections and analysis, developed my own analysis process in what I like and don't like. It has definitely moved from an emphasis on liking the product and the team to many other business aspects. This is all good and makes me more seasoned. The bad thing is that the more knowledge I get, the more things I find wrong about a business and shy away from investing.

So, as your knowledge and experience grows, you get better at analyzing companies but as you get better at analysis, the list of problems grows and you start finding reasons to not invest, hence, the term "analysis ultra-conservatism."

A friend of mine once said something very insightful about early stage investing, which is:

There is always something f**cked up about EVERY early stage startup.

I find myself repeating this to myself over and over as I do not want to fall into the trap of "analysis ultra-conservatism." I cannot remain an early stage investor if I do. I know that it is a good thing to get more experience in analyzing companies and opportunities, but I have to remember my friend's insightful quote and stop myself from over-analyzing and becoming risk averse simply because an opportunity has faults in it. ALL EARLY STAGE OPPORTUNITIES HAVE FAULTS! I must remember to keep in mind that there will be faults and to decide on the positive factors that remain.

Posted by dshen at 09:51 AM | Comments (0)

September 03, 2007

Investors and Entrepreneurs: Joining the Herd and Not Being Forgotten

These last few weeks have been really hectic. For a while, it seemed like I wasn't looking at any new deals whatsoever. I resigned myself to working on the companies I had signed up with but also could see that my work with them was starting to taper off in an expected fashion.

But then it changed. All of a sudden, a flurry of new opportunities came down and I found myself meeting with companies every week. It actually got fairly hectic, meeting up with entrepreneurs and actually going through some due diligence processes with a few companies. But one by one they dropped off my radar. As they dropped off my radar for a variety of reasons, some interesting observations came to light about the way startups and investors strategize with each other.

The Entrepreneurs' Perspective

The most sought after entrepreneurs/startups get deluged by requests from angels to invest in them. Typically, they are also pursued by venture capitalists who also like what they see and want to participate. The availability of money to these entrepreneurs creates an situation where they can pick and choose the money they receive. I've seen them go in these directions:

1. They go directly for the big VC investment and skip angels altogether. Let's face facts: raising money sucks. It's time consuming, you get a lot of negativity from people who don't believe in you, and you'd much rather be building something than begging for money. So why not skip all the nonsense and just take the big money and go back to building your business and hiring people you need.

2. They take the VC investment but only bring on some angels who are either high value or friends. Similar to 1., they get the big money but only bring on those people they like or those angels that can help them later.

3. They delay VC funding to push up their valuation, and only pick a handful from the crowd of angels wanting in. The most bold of entrepreneurs who are on to a good thing will press their advantage by not taking big money now, which could mean they have to give up more of their company at this point, and wait to build their business a bit more which raises valuation for later and, thus, gives them a larger advantage for not giving up so much of their company later in exchange for a large VC raise. They instead raise a smaller amount (ie. $500k - $1MM) which gives them the ability to run for enough time to build their business to a more valuable state.

4. They want angels who are active investors and can bring value to their company. More and more I speak to entrepreneurs who only want angels who can help them in their business versus just bringing money alone. It makes sense; angels who can help are more motivated to help because they have skin in the game. It does make for a tough environment for those angels with only money to give.

5. They are limiting the number of angels and/or investors. Managing a lot of investors can be troublesome to entrepreneurs. Simply cutting all the paperwork (ie. stock purchase agreements, stock certificates, etc.) can cost more money. Collecting the money can be tough for those angels who are dragging their heels in transferring the cash into your account. Dealing with nervous investors can be a draw on resources as you need to respond to their requests for information and calming their anxieties about whether or not you're going to make money for them.

This all goes out the window for those entrepreneurs who don't have something hot enough to attract lots of investors.

The Investors' Perspective: Herd Mentality, Joining the Herd

As an investor, I want to get in on the great deals. Finding deals that are good but are hidden can be really tough. It's more often that there is a common opinion about a startup and that everyone wants to get a piece of the action.

I try to do my own due diligence. I also try to form my own opinion about a startup. But I do find it difficult to ignore what others' think about a company. Over these last few weeks, I've looked at bunch of deals where there was a large number of investors trying to get in. But I've somehow lost out on a number of them. Why was that? Some observations:

1. Herd mentality is inescapable. For some reason, when many people think you have a hot deal, then you tend to think so too. They must know something you don't, or you bank on someone else's expertise, or you just don't have time to do all the due diligence yourself. Thus, I tend to look more seriously at deals with lots of interest, even when I tell myself I'm going to be disciplined enough to do all the due diligence on my own.

2. The investor herd piled in, wanting to invest into a startup. It's a common scene around the valley. The hottest deals get shopped around the most popular and prominent angels who are all high value and high profile. They have lots of money and value to bear on a deal. But they also have their friends who come in on the deal. So a combination of being able to keep in an entrepreneur's mindset and haivng the herd not forget about you, thus keeping you in the entrepreneur's mindset, helps to get you into a deal...or not. I have not been really part of any investor herd before so it was literally impossible for me to stay in an entrepreneur's list of investors as they get deluged by a huge number of people and can barely manage the flow of communication. I know I've been dropped off investor lists because of not being part of a herd.

3. Joining a herd became a worthy goal. As I thought about reasons why I missed out on deals over these last few weeks, I started thinking about how I could join a herd. I don't like to bill myself as a guy who can do lots of investor intros now, but knew I could get there in a few years as I worked with more and more people. But now I think about the networking aspect more, and using entrepreneurs to introduce me to some prominent angels and VCs around the valley. Slowly but surely, I am starting to not be forgotten amongst the investor herds, which is a good thing. So far, I think a combination of personality and value has helped me stay in the mindshare of herds. I meet people and show them that I'm a cool guy and not a wonk, and that my experience can actually help a company that we may all be investing in, and things seem to be happening.

4. I am trying to standout in a herd. If you demonstrate that you can bring high value to the company, staying in the list of investors for a given entrepreneur becomes easy. I can sometimes stay in a deal where other investors with lesser or no value to a company beyond just cash get dropped. I have found a great variance in entrepreneurs in whether or not they find value in what I could bring to their companies. If entrepreneurs don't find value in what I bring, then the probability becomes much greater that I will get dropped from their investor lists.

5. I need to constantly follow-up on deals I want in on. In the past, I've relied on entrepreneurs to contact me when they're ready to talk investing. However, a number of them have dropped me simply because I didn't do my part to stay in their mindshare. Shouting loud via email or phone works well and helps a lot.

Lots to keep track of in the ecosystem of investors and entrepreneurs in order to not be forgotten amongst the herds of investors roaming Silicon Valley.

Posted by dshen at 08:13 AM | Comments (0)

August 21, 2007

The Three Faces of My Schizophrenia

In working as advisor and angel investor to startups, I find that I can be schizophrenic at times. Three faces I wear, when dealing with entrepeneurs:

INVESTOR

Characterized by:
1. Paranoia about losing my money.
2. Saying "sell the company"; starts when my return crosses about 5x my investment, and becomes a yell when my investment hits 10x.
3. Motivated by what my terms say for Notes.
4. Recommending courses of action which generate a lot of cash for the company, which increases value of the company and thus my investment.

ADVISOR

Characterized by:
1. Recommending courses of action which build the company.
2. Seeking the best ways to create product and do business.
3. Balanced view towards generating revenue in the company versus building product, which can be at odds if, for example, we're talking about advertising and internet users.
4. Might recommend against selling the company given what I have seen when bigger companies absorb smaller companies.
5. Seeks the best employees and resources to do the job. Pushes those resources to build the company bigger and faster to exclusion of other things like sleep.

DAVE SHEN HUMAN BEING

Characterized by:
1. Tends towards recommending humanistic approach to treating employees.
2. Wants to grow employees, sees them as learning over time, nuturing them to be better.
3. Coaches people to balance life, work, and family. Asks what makes people happy and what keeps them motivated, encourages people to find this in the company.

If you've been in the startup game for a while, you'll know that these three faces I wear are often at odds with each other and conflict in goals. For example, how can I counsel people to balance work and life and go home at 5pm to make time for family when as advisor, I want these guys to work 24/7 because the startup needs it, and as investor, I want them to work so freakin' hard so my money isn't wasted?

When I start working with someone, one of the first things I tell people is that I can be schizophrenic. They always laugh and sometimes I can see that they don't get what I mean; the more experienced ones snicker and thank me for being upfront!

It can disconcerting to have a guy like me advising you to do one thing and then tell you to do something else in opposition to what I just said a while ago. It's because I do wear many different hats, and the forces within me struggle every day to push/pull me in several directions. It's a challenge to find a balanced answer, and I like the challenge of finding a solution that satisfies all of my three "identities". I just hope I do not drive any of my entrepreneurs nuts by my triple schizophrenic state...

Posted by dshen at 03:46 PM | Comments (0)

August 20, 2007

Ycombinator Demo Day: Summer Class in Mountain View

I went to my first Ycombinator Demo Day this last Thursday. I wasn't sure what to expect, except for the fact that a whole bunch of startups created by near-college grads would be presenting their projects. I definitely wasn't expecting any well-thought out business plans but was hoping to see some really cool stuff.

After the event, much has been written about the companies themselves, and you can read about them at VentureBeat: The Ycombinator List and at TechCrunch: Ycombinator Demo Day: The Summer Class. There has been enough coverage about the companies, so rather than do that I wanted to write about something else regarding the Demo Day.

Usually when you sit through pitches, they can be relatively dry. You see lots of graphs and how big the market opportunity is and it's usually a more serious and professional presentation.

For Demo Day, I was pleasantly surprised that each presentation had a healthy dose of humor cleverly injected. I found myself chuckling at funny demos, laughing at jokes made at competitors' expense, and smiling to see them laughing at themselves. During one of the breaks between presentations, I stopped to say hi to Paul Graham (co-founder of Ycombinator) and asked him about whether or not he encouraged humor to be part of the presentations. He said they were actually more humorous during the dry-runs and that he actually pulled them back from being too over the top. I shudder to think what they were like before he pulled them back...!

Sitting through 19 demos for 3+ hours could have been a truly grueling affair. I am glad that the young graduates of this summer's Ycombinator class threw some humor into their demos and turning a potentially boring, lifeless afternoon into a more lively event.

Posted by dshen at 08:02 AM | Comments (0)

August 14, 2007

"The Business Opportunity" and the Epiphany

I was just recommended this excellent book called The Four Steps to the Epiphany by Steven Blank. It describes a particular problem I've encountered with some of the startups I've met with.

Some of the entrepreneurs I've met with lead with the business opportunity. They say that the market is this big. They have charts and research to back that up. They show millions upon millions, if not billions of dollars spent in this market alone.

Then they present this product that fits into this market. They go on to say that we can attack this market opportunity by building a product to gather all these eyeballs, users, consumers, whatever and then sell this market to advertisers and marketers.

It always worries me when they lead with business opportunity.

Most likely what I discover after is:

1. The entrepreneur is not a model customer of this market. They have come upon this opportunity through research.

2. The entrepreneur has researched business opportunity but has not researched what customers want. While it may be true that marketers spend millions and billions of dollars trying to reach these consumers, the entrepreneur has not asked consumers whether they want the product he is building.

3. I often get a defensive response when I tell them this is an issue.

Which brings me back to The Four Steps to the Epiphany. Author, Steve Blank describes the Customer Development Model, which is an iterative method of figuring out what customers actually want, versus driving a business with financial projections and product development and assumptions that the product will be accepted by consumers. He argues that every successful startup runs by this model, and that running it by traditional product development models brings a huge amount of risk into whether the business will be successful or not.

Reading about the Customer Development Model brought me back to those meetings with entrepreneurs who are trying to build companies using traditional methods. Those meetings left me feeling uncomfortable and ultimately, following my instinct on these matters, I would often let the opportunity go. I am glad to be reading this book, because now it frames my uncomfortable feelings into a way of articulating them better.

As an angel investor, I want to reduce risk whenever possible. I find that when entrepreneurs resonate with the market and are building a product that they are target markets for, then it minimizes risk. This also means that you get extra passion for the product because the entrepreneur wants the product for himself, and you may reduce the need for external research to figure out what customers want, which reduces cost and time which could be used in building the product.

That's not to say that someone couldn't be successful if they don't fully or completely resonate with the product and are the target market. Success is a probability game and when entrepreneurs are themselves the target market and they resonate with the customers, then you stack the odds in your favor by a great deal.

Posted by dshen at 08:34 AM | Comments (2)

April 12, 2007

What If I Advise But Don't Invest?

When I started David Shen Ventures, LLC, I originally thought I could advise only or advise and invest. The latter would be a form of watching my investment by helping the startup in a formal fashion. I also thought that in certain cases, I might only advise but not invest.

So far, I have not invested in all of the companies I am involved with. In most of these cases, I just missed the opportunity to invest because I could not get in on the series A, or that opportunity had already passed. But there is the case where I could invest but choose not to.

Originally, I had just started up with entrepreneurs and signed up as advisor whenever the opportunity arose. I had not given much thought to points at which they would get to raise funds, but only to make my involvement formal by completing the paperwork. But now I am wondering about whether I should continue this method of operating or change it.

Why would I not invest but still advise?

One big one now is that I am coming to the end of my allocation of funds for this purpose in my budget. I had originally set aside some money out of my own pocket for angel investing as a means of diversifying my overall portfolio while making a new career out of it. I was planning to stop when I reached the end of that block of money and take stock of my operations and investments to see how I was doing. I near that limit now.

Another reason is that I have, at the time of this posting, 8 companies I am working with. Being an advisor allows me to increase the number of companies I am involved with, but potentially lower my exposure to investment in too many companies that I could effectively watch over as advisor AND be investor in. My model is to not be a passive investor at this point, but be active only (I may change this strategy later). But I do have A.D.D. and love to be involved in more companies than less, so I know I can sign up as advisor in more companies than I could be investor in.

But sometimes, I work with the entrepreneur a bit and just come to a point where I think I can help the company but my funds are better deployed elsewhere. It's a hard choice to make as you think you can help anyone, but sometimes you can and sometimes you can't help them in a way to make the company take off on a super positive trajectory.

That doesn't mean that the company has no chance (in my view) but just means that I can't help them as much as I'd like to be helping them, whereas for other companies I am adding a tremendous amount of value and seem to be making a huge difference in their trajectories.

So in deploying my own funds, I have to make that hard choice in deploying money in the companies with the maximum trajectories and me helping them. And not everyone is on the same slope of trajectory. It's a really hard to choice to make.

Recently, there was an unanticipated effect. Because I have decided not to invest, other investors have begun to ask why I have not invested. This is naive in my view, as they just assume I would invest in everything I'm involved in, which is not true.

Seeing as how I may not be able to fully explain my operational model to everyone, this unanticipated effect has me re-thinking about whether I should advise a pre-money company but not invest. I do not want to inadvertently reduce a company's chances for investment by putting doubt in other investors' minds about a company's prospects.

No particular solution comes to mind as of yet, but it is something I am working on more fully now. I may slightly change my operating model with entrepreneurs to not officially sign up as advisor until much later and until a lot of the business and product plan as been set. At this point, I can really evaluate whether I will feel comfortable investing and advising or just not continue my involvement. If I sign up as advisor too soon, then I may get myself in a situation where I am advising but when the first funding round comes, I decide not to invest.

Posted by dshen at 11:53 AM | Comments (0)

April 03, 2007

Stemming the Introductions Frenzy

Definitely connections is one of the most important parts of my involvement with startups. I introduce them to people I know in other companies for potential partnerships, I help them hire people (although I have to admit my record here is abysmal), and I try to meet more new people in case they may present opportunities for investment, partnership, or acquisitions later.

So I try to meet as many people as possible. But I've learned a lot about this introduction and meeting thing. Some thoughts about it:

1. In general, I try to meet as many people as possible, and as many as will meet with me.

2. I have discovered that it is impossible to meet everyone that you want to meet. It sucks but it's true. More on why in a sec.

3. Time is a so precious. Filling up your day with meet and greets is tough and it doesn't give you time to get your other work done. So I have to limit these kinds of meetings as much as possible.

4. Filtering becomes super important. As you can imagine, those with immediate purpose and importance come first.

5. Making introductions is also an important skill. Here is my process and thoughts:

a. I identify a possible introduction that should be made. In general, I try not to do more social type meets but want them to have at least a purpose. Think of it as a courtesy on peoples' time demands and not wasting them, and also it gives them something to talk about which will reduce awkwardness.

b. I hold my contacts close and don't frivolously make introductions. I am keenly aware of not creating an image where Dave Shen sends frivolous introductions around. That would reduce the possibility of someone responding to an introduction. My goal is to have a 100% response and connection rate, so I think deeply about whether to make the introduction or not.

c. Timing on the introduction has come up often. When to make it is important as you don't want to intro too early and want to do it when both parties are ready.

For example, if a startup is working very hard and if I judge their resources to be strained too far, I won't make another business development intro until they get more resources or some brain space frees up. The worst thing is you send them the intro and then nothing happens until much later. Or if the startup has nothing to show yet, then I don't want the intro-ed party to feel like it was a wasted meeting because it was too early to talk about their product since there was no demo.

d. While I do not bill myself as a fund raiser, the few investor contacts I do have are important to me. Asking for money raises the stakes of an introduction. Thus I will not make an introduction to an investor until I feel the company is at a place to put a really good foot forward. I do not want to make it unless they will look good at the meeting. If they look bad, then I will look bad for sending an unprepared company to that investor contact. I also won't make an introduction unless I have put my own money in. I feel it is the ultimate vote of confidence for a company when you have your own skin in the game. I do not want to come off as sending what may be perceived as random companies to them. There are plenty of people who are professional fund raisers who do this and do not have any skin in the game. I want to operate with bit more confidence than these guys.

e. I try not to deluge someone with introductions. For example, at a recent meeting with a media company executive, we discussed many of my startups who may be potential partners of theirs. He got excited about all of them. But I did not want to throw all the introductions at him at once for fear that he may not get to them, or they may get lost in email, etc. So as a courtesy to both introducees (is that a word?), I think about the tide of introductions racing at them and try not to overdo it, and space them out.

f. I always try to follow up on introductions. I want to see how they went, and pass feedback back to either or both parties. I also want to double check my introduction methods and make sure I am hitting as close to 100% response and connection rate as possible. I also want to address potential problems on the rare occasion that they occur.

6. Getting deluged myself with introductions is bad. If I meet someone who can intro me to several people, I tell them to slow it down a bit. I do not want to drop one or two because they get lost in email or from my brain. Sometimes, I am scheduling out many months and my calendar is super-important to me. As a personal goal, I try to get to 99% of my emails and always try to get back to those whom I say I will meet up with. I like saying I'll do something, and then actually do it. I don't like it when someone says they'll meet up with me but don't mean it. I intend to be as clear as possible, which unfortunately is really hard. Better to head it off with the introducer and be clear with them before they send the introduction email.

7. I have found there are many who are not what I would call socializers, which enjoy meeting for the sake of meeting with no particular goal for the meeting other than to connect. There are those who don't seem to meet anyone who does not have a particular purpose for them. Whether this is good or bad I cannot be the judge, as everybody has their own way of working and time demands.

8. I always confirm a meeting the day before. You never know when someone else may drop you off their calendar. It's always good to remind them that you're meeting with them, again as a courtesy and also it's a good time to remind them of why you're meeting.

9. By the way, I always space travel time between meetings. I try not to pack them so closely together time-wise. This also goes for how many of these types of meetings I can do in one day. Generally, I try to space them out across days as well. Going through a whole day of meetings with people you haven't met before is tough for a guy like me (call me an introvert with extroverted tendencies!).

10. Some people network solely for work purposes. There is almost no notion of personal relationship they build. You can tell by what they ask you about, what the conversation is about, and reasons for contacting you later. You never go out for a coffee with these people, or grab a brew. It's kind of cold, sometimes empty. It creates this feeling that you are only useful to them for one thing, which is business. I prefer to look for opportunities to create a relationship that goes beyond that of business only. I think this creates a richer relationship than just for work alone. If they know and feel you are a good person and you connect with each other at that level, I think you'll find that the relationship tends to work better and have more opportunities than less. Who wants to work with someone who isn't cool to hang out with?

Bottom line: introductions, connecting, and meeting are important parts of my work. I do my best to try and not waste the relationships I have built with these people, and create value with each relationship I have.

Posted by dshen at 09:52 AM | Comments (0)

March 20, 2007

GRRRR ROWRRR ROWRRR

This is an impression of a "tough dog", as performed by entrepreneur whose determination is shown through gritted teeth and never failing optimism in the face of rejection, sleepless nights, and stress at starting a new company.

It's easy to give up. Retaining confidence, determination, and forward moving energy is super tough in the face of constant adversity. Rejection, business deals moving too slow, running out of cash, wondering when revenue is coming in, investors and partners beating on you, your staff is not working out and you need to fire them - the list goes on and on of things faced by new entrepreneurs.

But you can't give up. If you do, then you may never realize your dream of watching your company and idea flourish and grow. You need to learn that the world is going to constantly try to beat you down and you have to live with that, roll with the punches, and keep moving forward. There will be times where it will seem you've hit rock bottom, but only to fall even lower. You, the budding entrepreneur, need to expect this, prepare yourself, and keep saying to yourself that it will get better, and to drive towards making it better.

Because if you can't adapt, then maybe you shouldn't be an entrepreneur. You'll die of despair and never get anywhere. Know yourself before you embark in entrepreneurism.

Or...learn how to say:

GRRRR ROWRRR ROWRRR

It really works.

Posted by dshen at 03:06 PM | Comments (0)

March 17, 2007

The Importance of Indemnification

The other day, I met a guy who told me about a situation he was in where he was a consultant for a company who got in a legal dispute with another firm. Then he got tangled up in the lawsuit and got sued by the other firm and was forced to defend himself with his own funds because there was no clear indemnification in any contracting agreement.

At the moment, this guy is shelling out between $25K to $50K per month out of his own pocket to pay for legal fees. There is a soon to come happy ending though. It turns out that this guy was employed through another temp firm while working for the company. While indemnification was not explicit, it just so happens that employees are automatically indemnified via the California Labor Code (see section 2802) and is the same for pretty much every other state's Labor Code.

However, had this guy worked directly for the company without an official statement of indemnification as a consultant, he would have been really screwed. There would be no clear path for indemnification and thus reimbursement for legal fees.

Very scary. How would you like to pay out of pocket legal fees of $25K to $50K per month, and for months on end?

As soon as I heard this story, I called my lawyer and thanked him for being so adamant about indemnification.

In my journey to implement indemnification, here are my thoughts and discoveries:

1. Ignorance of the state's Corporation Code, especially with respect to indemnification, is common among the lawyers I've worked with. So they err on the side of company favorable tactics, which is to never give anything away, including indemnifying advisors.

2. Not knowing or understanding indemnification is also shared by investors and other entrepreneurs.

3. It's very much a worst-case scenario discussion. It's difficult to discuss sometimes.

4. Experienced entrepreneurs have no issue with it. They just assume they'll protect anybody that does work for them. It's natural for them to thank people who help them in that way.

5. By the way, all the Corporation Codes stipulate that in the case of an external person causing harm willfully to a company, the Code states that indemnification is invalid, even if a contracting/consulting/advisory agreement calls for indemnification. By the way, there is the case of unknowingly causing harm which is a huge grey area and would probably have to be explored on a case by case basis.

If you're interested, you can read about indemnification in the California Corporation Code or in the Delaware Corporation Code.

6. No matter what, I do not want to put my personal assets at risk for another company. It doesn't make sense at all.

7. I will definitely walk away from any deal that will not indemnify me as an advisor. It is a deal breaker.

Posted by dshen at 03:48 PM | Comments (0)

March 08, 2007

The Mad Rush to Close

Raising money is never fun. When the time draws near to a date at which you want to officially stop fund raising and collect the money, things tend to get pretty hectic.

So what happens exactly? And who is involved? What are things you should watch out for?

Let's say you created a term sheet X weeks or months ago. You've met with a whole bunch of investors and some of them say they will invest (usually we say "we've soft circled them"). The term sheet has been negotiated and potentially changed, and you circulate that back to each investor and finally everyone says they're on board and they're ok with the final term sheet.

And then, time draws near and you realize it's time to get serious and actually get the money. What happens?

1. In the financings I've done, the law firm project manages this process. They help circulate the documents, gather signatures, send reminders, etc.

2. The law firm has an escrow account where investors wire their money. As one entrepreneur I met put it, "The reason why you wire to an escrow account is to prevent us from absconding with your money (if wired into our own bank account directly) to the Cayman Islands before all the official paperwork was finished ."

3. The law firm takes the term sheet and expands that into official paperwork that spells out the terms in detail. The investors sign these documents and they make everything official. This paperwork is passed back to investors for review and signature.

4. Due diligence materials from the company are sent to each investor upon request (and I HIGHLY recommend that) to make sure everything is in order. Every company document is sent, every record, every contract - just about everything. Thankfully for early stage startups, there isn't that much paperwork to review. But imagine if you were to do due diligence on buying a company like Yahoo! or IBM. The due diligence alone would be staggering as you reviewed every contract, every patent, every legal dealing, every lawsuit - everything that could introduce risk into the investment. You don't want to miss something that could turn what appears to be a great investment into zilch.

5. The CEO devotes his/her entire life to the closing during the last 2-3 weeks before close of the financing. He calls every investor and double checks to make sure they are still on board. He fields any last minute questions. He assures investors that the close will happen and makes sure everyone knows to sign papers, wire money on time, etc.

6. Investors need to prepare the cash for wiring. This could take some time to prepare if the investor needs to sell stocks, or get out of other investments. They may need to give their money manager lead time to make sure cash is available. Even the wiring process takes time. I fax in requests the day before with wiring instructions just to make sure that they get in on time. If the money is being wired internationally, you have to be wary of the fact that it could take additional time, or the wiring may not even be accessible to that account from theirs. More warning is always better than less.

7. Signatures also take time to collect. The law firm project manages the collection of the signatures and makes sure that everybody has signed the right papers on the right lines.

8. After the money is collected and the paperwork signed, then the law firm gets copies of signed paperwork back to the investors and, if it is an equity deal, prepares stock certificates and sends those back to investors as well. Other paperwork that goes back to investors can include receipts for the money wired; one law firm prepared a huge notebook for me which had all the involved paperwork in it. Very nice!

9. Be prepared for high stress situations as the time draws near, the lack of sleep, distractions up the wazoo. You must remain focused and determined through the whole process.

So there are never problems, right? HA. What COULD happen:

1. At the last moment, one or more investors back out and you're left with less cash than you expected, perhaps substantially less.

2. Other investors backing out could cause even more investors to back out. It might be interpreted as a vote of no-confidence for the investors.

3. Some strange investors could keep saying they'll send you money, but it never shows up.

4. Unfortunately, I have also seen the law firm flake out which is REALLY BAD. All the more reason for the CEO to keep tabs on EVERYTHING and make sure it's all moving along.

All sorts of things can happen which can spoil your day. As CEO of a startup and going through this process, you should make sure your full attention is on this and be ready to adapt to changing, chaotic conditions - but rejoice when you get every investor that you say you got and see that money arrive in your bank account.

Posted by dshen at 06:43 PM | Comments (0)

March 04, 2007

NDAs and Me, Ideas and Execution

It's so funny when I hear people being so protective of ideas. (People who want me to sign an nda to tell me the simplest idea.)

To me, ideas are worth nothing unless executed. They are just a multiplier. Execution is worth millions.

- Derek Sivers, president and programmer, CD Baby and HostBaby

I just found this quote in 37Signals's book, "Getting Real", which is an awesome book on super fast Web development.

It says it all.

So far I've had a few entrepreneurs ask me to sign an NDA before talking about their startups. Each time, I politely decline. My main reason for declining is just what Derek Sivers says in his quote. Ideas are just that - they are just ideas. No substance, no solidity yet, but just words. Execution is harder than you think. Just because you tell me your idea doesn't mean I am going to go out and build it. In fact, I have no desire to build it. I recognize that it's your idea and that you are the best person to execute it, not me. And I don't have the time or desire to execute it, nor is it my business model to build stuff.

So in essence I am saying that there should be no fear about sharing ideas and that goes both ways. I don't mind throwing ideas their way as much as I like hearing them. I toss out ideas all the time and I don't look for monetary return because I know that 99% of the time, they won't be able to or have time or desire to execute on them.

But occasionally, they may find value in my ideas and actually do something with them and make their product stronger. That's a good thing. But most of the time, they'll need the originator of the idea to fully explain the idea enough to the entrepreneur so that they can internalize it and be able to execute against it. In that, I build value for my services and it helps sell my value to a startup.

Here are my thoughts about NDAs:

1. If I sign an NDA, then I'll be bound to not reveal any ideas from my interactions with them for the length of time designated in the NDA. While I have no problem signing one if I do work with them in official capacity, it is possible that I might end up not working with them. If I don't work with them, I could be hampered from working with any other company in the same space because I might inadvertantly reveal some bit of knowledge that could be taken as confidential by the company I signed an NDA with.

2. If for some reason I were to sign lots of NDAs, I would have to manage the NDAs which is a nightmare. I'd have to remember when each NDA started and when they would end. They could all have variable expiration terms. The chance of slipping up would be incredibly high which could put me at legal risk.

3. Negotiation of NDAs would increase my legal fees. There are mutual NDAs and one-way NDAs. There are those that go in perpetuity and those that end in 1, 2, 5 or any number of years. There is no standard NDA; the conditions are written based on the situation. I'd have to go through negotiation on every one.

4. If there is something you don't trust me enough to tell me, then don't tell me.

5. Trust is an essential part of my business. You gotta know when to keep your mouth shut and no piece of paper is going to help with that.

6. I have and will walk away from companies who require NDAs to hear about what they are doing. It doesn't matter how cool the company seems to be. It just isn't worth the hassle. There will ALWAYS be other companies and opportunities.

Posted by dshen at 09:40 PM | Comments (1)

Rejection Sucks

Rejection sucks. You spend umpteen hours on your deck, you go through trial runs and field criticism and incorporate feedback, you redo it again and again, you spend hours driving around to meetings, you brush your hair for the first time in weeks and pretty yourself up for the pitch. When you get there and start, you look around the room and the body language is clear:

What is this guy talking about?
This'll never work.
Where am I going to lunch?
This is a dumb idea.
I can't believe my partner dragged me into this meeting.
When is this presentation over?
I need to pee.
Way too many competitors. Why even touch this market?
Yawn.

And the list goes on. All from subtle and not-so-subtle bodily cues. Or overt vocalizations.

You throw your heart into the pitch and you wonder how these guys could be so blind! Why don't they get it?

At the end, they usher you out with a polite, "We'll get back to you."

Your heart drops. You walk out dejected. Nobody likes you. Everybody hates you. Self doubt creeps in. Life sucks. You grab a beer and drown your sorrows vegetating in front of Tivo.

You wish everyone could just see why your idea is so great. But it's just not so. I wrote about resonance way back and think it also applies to investors. They need to be able to feel the idea, to get their brains and hearts around it. And unfortunately, not everybody can resonate with every idea. It's just the way the world is.

So steel yourself for rejection. It will come and you'll see it a lot. Build your resistance to letting rejection take you down emotionally and energetically. Practice blowing it off so it doesn't wipe you out. Because it only takes ONE investor to resonate with you and your idea, and they will give you the cash to make it to the big time, and then you can say, "I told you so" to all the nonbelievers.

Posted by dshen at 08:58 AM | Comments (1)

February 25, 2007

Swimming with the Sharks: Part I

Last week I had a meeting with a friend turned entrepreneur. We talked about the company he was forming and it sounded really interesting, interesting enough for me to put in some early money into it. We then moved to talking about possible angels who would fill out a first funding round.

These were angels who were also individuals very prominent in the area of business he was going into. They were definitely going to be helpful in building the business and be able to make the chance for success much higher.

Since he was my friend, he also told me what these people were like. They are very money focused. And they will do anything to maximize their gain, potentially at the expense of others.

I thought about this for a moment. At first, I thought what could happen if I were to invest early, probably into a convertible note, and then convert to the preferred series? Aren't I protected by preferred rights?

Then it dawned on me what could happen. Let's say the preferred round closes. Then a few months later, the board is faced with the other angel investors proposing to change their own rights. They propose changing them so that they can, upon majority vote of the shareholders, buy out any shareholder. My friend who will undoubtedly be on the board of directors may oppose this, knowing why this is being proposed, which is to squeeze me out. He tries to defend me but then the angels apply leverage in that they could make life much more sweeter to him and his business if he agrees to the change in rights. My share in the company leaves me no leverage at all. I have not put enough money into the company so that I can defend myself in this proposal through vote alone; I don't have enough share in the company.

In this scenario, the vote passes with my friend/entrepreneur bowing to the needs of the company and the next vote is buying me out, perhaps with a bit of profit, perhaps not.

There is a possible solution. That is to propose that I go in with my seed money and demand a board seat. This should protect me for at least one round of funding, but after that I will probably need to relinquish my board seat in favor of whomever is coming in with subsequent rounds of funding. I do not know if my friend would agree to this or not, or if I would even want a board seat. I am thinking on this some more...

Early stage angels are definitely in a tough position when we come in early, and often with small amounts of money relative to the cash coming in for later rounds. We take the most risk, but yet we are left with no leverage later on, as the needs of the company outweigh shareholder need.

Posted by dshen at 06:44 AM | Comments (0)

February 20, 2007

Legal Help is Showing a Depressing Pattern

So far, my scorecard for legal help for startups and investors has been pretty dismal.

Let's see. The stories go on:

An LLC agreement costs $6000 to create but upon dissolution of the LLC the agreement has ambiguous terms on who owns what and causes tons of issues upon dissolution. Note that an LLC agreement can be created and filed in about $1000.

A term sheet is created by a new associate who is new to Silicon Valley and barely has any experience in startups and financing. He tries to snow an investor during a call to defend his terms and the investor, who happens to be seasoned and coached by his really good lawyer, refutes every point made by associate, who concedes at the end of the call that investor was actually experienced and compliments him.

The night before the first investor meeting, a lawyer totally flakes on entrepreneur and doesn't have a term sheet done! It arrives around midnight the night before and there is no time for review at all.

Entrepreneur asks for term sheet, and lawyer delivers one. Investor reviews and finds provisions that have no meaning whatsoever to the current deal. It is obvious that lawyer cut and pasted from a previous deal term sheet and didn't bother to review and check for relevance to current deal, costing everyone in time and legal fees.

Entrepreneur asks for advice from lawyer on what to do from a financing standpoint, and gets almost no worthwhile advice whatsoever. Friendly investor guides entrepreneur through all the possibilities and helps develop a financing strategy.

Investor asks lawyer for help on looking at startup term sheet and gets back worst case scenario response on the whole thing. Investor initially gets cold feet, but quickly realizes that this particular lawyer is the most conservative, worst case scenario lawyer in the world, and investor realizes that risk is a part of life for the early stage investor and that this lawyer isn't the right person to advise on early stage investments. If investor had listened to this lawyer, investor probably would never make any investments at all and would rather sit home and stuff money in mattress.

Legal help is crucial to both the entrepreneur and investor. It doesn't matter that the legal help sits in a big expensive firm or a smaller shop. Why can't we find good, dependable, and experienced legal help?

Posted by dshen at 08:28 PM | Comments (1)

Convertible Notes versus Preferred Equity Part III: The Investor

In the last few months in working with financings, I have gotten to know the Convertible Notes versus Preferred Equity issue very well. As an angel investor, I am constantly thinking about maximizing my money and I don't have the cash to play the field in a broad, diversified way to not care about this issue like some larger angels. Thus, knowing when to take a deal or walk away is part of the game, and certainly financing terms are part of that decision.

Again, I reference Josh Kopelman's post on Notes and Preferred Equity and think it explains many details well. I'll talk about this topic with his thoughts and some of my own in mind.

Why would I be OK with a Note?

The terms must be good.

Often Notes have no anti-dilution provisions or special provisions that help us in case the next equity financing does not occur. They seem to be hastily drawn up and many details are left out. I have walked away from Notes that didn't have enough good terms in there.

They are mostly unsecured, so I'm OK with that. I know that I'm dealing with an early stage startup and they have little or no assets at this point. What would I do with 1/10th of a PC?

I also want to make sure I am not locked into a particular Next Equity Financing by default. I want to have the ability to back out if company conditions change.

If they require an auto-conversion provision in their to the Next Equity Financing, then I want them to insert a minimum on the money raised, to ensure that they don't do something screwy.

In truth, I don't pay much attention to the interest rate return for early stage startups. This is usually a make or break time for them. If they don't get the Next Equity Financing, then often the company will tank and I won't get any interest payment or my money back yet. I do just make sure it is in range of other Notes I've seen which is about 6-8% per annum.

There is a Preferred Series financing imminent.

Most Notes are used to gain cash to continue company operations just prior to a first Preferred Series financing. My goal is to always get share of a Preferred Series. If I know there is one coming soon, then I'm OK with a Note knowing that I'll convert in a few months. Time is minimized between the Note and the Preferred Series and there is a less of a chance that the company valuation will change dramatically, causing loss in ownership share from when I invested and when it converts.

Why would I NOT be OK with a Note?

There is no Preferred Series in sight, or I am not confident it will happen soon.

If the Note is being raised, but they have nebulous plans for raising the next Preferred Series. I won't do it. The risk of it dragging on for a long time is there, and the more time that drags on before I gain actual ownership in the company, the more chance that it goes not in my favor. The valuation could go up (meaning I convert to less ownership than I originally thought), the company could go under with not enough funds, or I mayjust get paid back and not reap any benefits of having ownership in the company, if the company starts gaining revenue. The company need not be going under for you to not gain the benefits of investing in a company.

Or they may SAY they are going for Preferred Equity fund raising, but I get the feeling they will drag their heels or avoid seriously doing it. As soon as I get some intuition that this is true, I won't do it.

This is a second (or beyond) Note they are raising.

This begs many questions. Is the company trying to be greedy and not give up any ownership? If so, they can build their company on other people's money then. I want to maximize return and getting interest rate return on my money is not the way to go.

Or you have to wonder why this is yet another Note. Why do they need another Note? Why haven't they raised their Series A? Or what is wrong with them that they can't raise their Series A? Many Notes are written vaguely that the Note will convert to Next Equity Financing. They may actually want to convert the last Note holders to the terms of the second Note which may be less favorable to them!

Unfavorable Terms.

Although this may seem like a given, it could mean that the company opportunity is really good, but the Note terms are not.

Terms always take care of the worst case scenario and nobody wants to see them come into action. But sometimes, the terms are there and you can't change them. I've already had a case where I wanted to change the terms but the entrepreneur did not because the current terms were already approved by the lead investor, and he did not want to scare the lead investor off. But, it was obvious that the lead investor didn't really read the term sheet carefully because some of those terms were bad even for him.

By the way, I think this happens frequently in the Valley. There are so many large investors that when they invest, it is a small amount for them but large enough to make them lead investor. But they go through so many deals that they don't seem to be spending time on the terms at all. I've heard from one person that they just write off investments that get diluted to nothing or fail, and employ diversified investing across many different investments and hope that a few make it big to cover the many that return little. Very frustrating for us smaller angel investors.

Always be ready to walk away no matter how good parts of the deal looks...

Investors are not aligned with interests of the company in building value.

Clearly stated in Josh Kopelman's post, it makes sense that as investor I want the valuation kept as low as possible so that I convert to as high ownership as possible. But my model is to help entrepreneurs as much as possible. So if I end up helping them and sign up as advisor, but feel that a Note they may be presenting may not be in my best interests, I may end up not investing at all.

Why I like Preferred Series.

I have ownership in the company.

I gain immediate ownership in the company and this point is not nebulous, as in the situation of the Note.

Generally, preferred terms are pretty favorable to me.

There will be provisions for voting, company control, preference in paying back, potential dividends, etc.

I am aligned with the interests of the company.

Once I have ownership in the company, I can freely and without reservation help the company build value, as my own value in the company will also grow.

Why not Preferred Equity?

Not many reasons to not jump into an investment if Preferred Equity is offered, assuming all other factors are positive.

Sometimes, there is a gotcha in the terms.

Potentially the terms could be not quite right. This happened once where the voting rights were not favorable to the Preferred Series Angel round. I caught this at the eleventh hour and thankfully the entrepreneur agreed to a change in the docs to make this more favorable. Otherwise, our terms and rights could have been wiped out without us having any say in it! You always need to review the terms no matter what and I would do it with a seasoned lawyer who has done many financings before, and hopefully from the perspective of company and investor.

Caveat Emptor - "Let the Buyer Beware" - words to live by and in the investing world you have to dig into every little detail in every deal. It costs more in time and money, but it keeps me out of trouble.

Posted by dshen at 05:47 PM | Comments (1)

February 19, 2007

Convertible Notes versus Preferred Equity, Part II: Enterpreneurs

In reading my last post, one may start to think on why either method may be more or less desirable to an entrepreneur seeking to raise cash.

Why a Note?

It is Cheap.
Early stage startups typically have little cash to spend. Closing a Note allows them to bring in money in the cheapest possible way. Preferred Equity will cost them 10 to 20 times more.

It is Fast
Often startups need cash as fast as possible to fund short term operations. A Note closing can be accomplished in as little as two days.

It is Unsecured
For early stage startups, every Note I've seen has been unsecured. If the company goes under, there is no obligation to pay the Note holders back. It could be secured by assets, but generally for early stage startups it is not. Why would you get paid back with 1/10 of a PC?

Maximum Flexibility
In the case of early stage startups, we talk most often about a Convertible Note which Note holders want to convert to some version of stock in the company. Depending on how vague the language of conversion is, a startup could convert the Note holders to common stock, to Preferred Equity, or even to the terms of another Note. There is the potential for maximum flexibility on the part of the company as, in theory, it could convert to anything if they word it right. Another aspect of flexibility comes in next financings. For instance, with a Note, valuation for the company has not been set yet so there is freedom to adjust. It also means there are no preferred shareholders and could be more attractive to certain large investors who want more control in the company.

It is Low risk
The Note holder often has an interest in helping the company and getting in on the ground floor, and they can be generous with the payback period and the terms. Assuming the company either gets to a place of generating money or raising more, a Note of this type can be paid off prior to the due date, or converted to preferred in the financing, i