Monthly Archives: November 2010

Pickers versus Sprayers

Over the last few months, we’ve seen the emergence of super-angels and micro-VCs as early stage investing comes into its own. Out of conversations with many in the industry, I’ve boiled the strategy down to two categories: pickers versus sprayers. Before we get into who is a picker and who is a sprayer, let’s talk about them in their extreme stereotypes.
A Picker is:
1. Someone who goes through a more involved process of picking particular startups to invest in.
2. They will do due diligence, ranging from calling references, to looking at research in an industry, to collecting lots of legal paperwork from the company.
3. Someone who likes to manage more closely the startups they invest in.
4. Generally are more disciplined and follow a game plan of investing.
5. Invest in startups where they can leverage their preferences, personal interests, and areas of expertise to help the startups gain an advantage.
6. Invest in both people AND the idea.
7. Are more conservative than not, in an already highly risky investment class.
8. There is an upper limit to the number of startups they will invest in, either per year (or other time period), per partner, or even over the life of a fund.
9. Shoot for the big outcome/exit with every investment.
A Sprayer is:
1. Someone who goes through a less involved process to choose startups to invest in.
2. Often, they will invest in startups with no due diligence at all. They may not even meet the entrepreneurs in person.
3. Will invest in an enormous amount of startups, ie. >50 in a year (hence the term “spraying” their money around, or from the more deragatory phrase “spray and pray”).
4. They rely on social proof and others to do due diligence and to help the entrepreneurs, since they have no time themselves to devote to individual startups.
5. Their main exit return strategy relies on exits of mid-size (ie. >$20MM) all the way up to big outcome/exits. They are betting on a more index fund approach to investing in startups.
6. Someone who bets almost exclusively on the team, and on the assumption that smart, adaptable, entrepreneurial people will always find a great outcome (versus those who are not superstars). They bet less so on the idea and will skip a great idea if the team is lacking. (Woe to entrepreneurs who do not graduate from MIT, Stanford, Berkeley, etc.) Also, this means that they do invest in more exploratory projects by entrepreneurs (ie. projects without a clear plan, features-type projects, etc.
7. Speed is of the essence, as the competitive nature of today’s early stage market is intense and you have to have a fast decision process to get into deals.
8. They will try to get into every great, hot deal out there. In order to execute on their return strategy, they will have to get into as many hot deals as possible.
9. They have a higher risk tolerance and tend towards being OK with taking on high amounts of risk in the investments they make.
Who is a Picker and Who is a Sprayer?
The descriptions above are, as I said, extreme and stereotypical. The truth is, everybody is somewhere in the middle. Investors may lean more towards one way or another, but they rarely are at the extremes, except perhaps on the Picker end where many disciplined investors employ set strategies.
Sprayers, for example, do pick a little. If they didn’t, then they would invest in every startup with only smart people in it, which is definitely false.
Even pickers may start placing some smaller bets, which act as good lead gen for later stage deals, or education into a given space.
For me, I would say that I am a Picker with Spraying tendencies.
My personal capital pool alone limits me to pick the investments I make. I do not have the capital to place bets in a ton of startups. So I am forced to pick. But I also like to get more involved with the startups since I get a lot of personal enjoyment from working with them. So time constraints mean that I need to pick. And personally, I like to resonate with both the team and idea versus just the team and an idea with an unknown (to me) future.
But since starting to invest in 2006, I have invested in 21+ startups. That puts me in the low end of the Sprayer group. I will sometimes also bet on less certainty on the idea if I merely like it or it resonates with me somewhat.
Which strategy is better? Here’s my prediction:
Like startups, I think that success in investing is highly dependent on the person and their ability to execute whatever strategy they choose to employ. We can sit and argue about which strategy sucks and who’s gonna lose but I think in the end it will boil down to how the person operates and their skill and perserverence in pulling exits out of their investments.
Then, you couple that with external factors, like industry trends, competitive factors, and the economy, and that can either suppress a strategy or enhance it. Keeping an eye on the external factors and executing an investment strategy appropriate to the external factors, and that which resonates with a personal strategy will win big more often than not.

Lower Valuations = Better Outcome…Generally [UPDATED]

I got some comments via email which pointed to some confusing points in my post and thought about it some more and I think it boils down to this:
Keeping everyone happy with their return is hard but a worthwhile goal, and keeping startup valuations lower will result in better outcomes for all versus just some.
And, if you agree that keeping lower startup valuations is better generally, then you’d want to:
1. Raise less rounds of money, because raising funding is arguably the primary factor in how valuations rise. So work really hard to get to profitability on what you have raised.
2. However, raising less money is near impossible in general, and for certain businesses or industries, or due to competition, you may be forced to raise money to grow.
3. As you raise more rounds of money, it is tempting to keep valuations higher because that results in less dilution of founders, employees, and previous investors. Then two things come into play:
a. A higher valuation then tips the return in favor of the founders, employees, and previous investors and new investors are at higher risk of making lower return or nothing. (Remember my statement about better outcome for everyone, not just some..!)
b. At some point, you need to justify your valuation through actual progress and not just perception. If you cannot justify your valuation by the time a new valuation event happens (ie. new fund raising round, acquistion), then it will end up adjusting your valuation lower which is painful in many ways.
To some, maybe keeping everyone happy is impossible, or too hard, or not worth it. I’m sure some entrepreneurs have gotten shafted by investors in the past and they refuse to keep investors’ returns in mind as well as their own. There are also founders who have kept so much of their company in stock and given little to employees, and employees have virtually no chance of taking part in any exit event.
One could argue that me sitting in my position as an investor biases my opinions too.
Yes, entrepreneurs have a ton to worry about and deal with. However, I know for a fact that the entrepreneurs that take on the challenge of keeping not only themselves, but their investors and employees in mind when thinking about exits and total return gain much more respect for their efforts and will gain a much more loyal following of people who will work with them and invest in them if they ever choose to build another company.

In one of my emails to an entrepreneur, I sent this statement:
I am a fan of the point of view to keep your valuations as low as possible in general. This will keep your and our outcome more substantial in the long run.
To which he replied asking for more clarification on that statement.
I went to Google searching for posts on this topic, because I thought I had read about it in the past. But for some reason, I could not find any post that addressed this topic, but only posts mentioning it in passing and in context of some other topics. I do admit I didn’t go paging deep into Google search results looking for posts, but in the results I did look at I couldn’t find anything addressing this directly. (Some of the posts I found are referenced in my post).
First, I should say that one of the key statements above is “in general”. So many variables exist in the generation of an exit and what the various players would get out of the division of the exit pie that any claim to certainty would probably be a lie. Still, I believe that keeping valuations low for startups generally will keep outcomes for everyone higher, or at least the probability of a higher outcome for all will be greater.
Who can win?
There are 3 groups of people involved in a company: founders, investors, and the other employees.
Let’s be clear first. In general, founders of the company will make out big in almost every case, even if the company sells at a valuation that is lower than the existing valuation of the company.
Check out Fred Wilson’s post on Slide’s exit, although he was talking about the importance of liquidation preferences. Max Levchin raised his last round at a $550M valuation but sold his company to Google for $228M. Even though some of the investors only got their money back and others made some money, Max was able to take home $14M (for his common stock portion of return, not including the $25M he got from his additional series A investment).
This is because he, like most founders of a startup, own such a huge amount of stock in the company that it is impossible to not make something substantial, even when the company sold for less than what it was last valued at.
However, keeping a low startup valuation will keep dilution of founders’ shares low and maximize your return.
The next set of people involved are investors. Investors can make out big, but only if the conditions are right, and one of that helps is a lower valuation. Most of the discussion on blog posts surround the return of investors when valuations are kept lower more than higher.
The more investors are diluted, or the more the percentage of ownership of investors is lowered, the less an investor’s return. So subsequent rounds of financing will dilute early investors, and although higher valuations of a subsequent round will protect somewhat the dilution of previous investors.
Keeping valuations lower means raising less money and fighting for growth/profitability with what you have raised, and investors’ dilution is also less.
Professional investors tend to want to maximize returns and have, in the past, been known to block smaller exits if they think an investment has the potential for a higher return. So if an investor is a professional investor and if they are in a position to affect an exit’s outcome, say either with controlling company interest of a board position, then they may be unhappy with a lesser return and can cause trouble to the team.
If the total valuation is lower, then the multiple return on capital would be greater and investors are happier with their return.
Knowing this, there are a new crop of investors who are less sensitive to multiples of return. Digital Sky Technologies, the Russian investment company, has famously put money into Groupon, Facebook, and Zynga. When you’re dealing with the amount of money they are dealing with, even some percentage points return will yield immense amounts of money. Andressen-Horowitz is another, having put $50M into Skype, and being less sensitive to stage of investment, but just putting money to work in great companies.
The terms definitely affect the return of investors. Look again at the title of Fred Wilson’s post: liquidation preferences helped those later investors get money back even in a lower than current valuation sale. In absence of those terms, those later investors would have lost it all.
However, if Slide had not raised money at a $550M valuation, then potentially those who invested in it may have made money when it was sold for $228M assuming that Max would have accepted an investment at a lower valuation. Or perhaps those investors shouldn’t have invested in Slide at all if the deal was going to be done at $550M.
A lower valuation for the company would have yielded more positive options for the investors in outcome, versus putting more risk for return in the company for an exit that can be difficult at a much higher valuation.
However, there are cases where even if the company is sold at an amount higher than the existing valuation, they may not make any money at all, or even lose money. We are seeing pressure being put on exits up to $10-20M where the acquirers want the employees and founders to keep most of the money and not return much to the investors. So starting with a lower valuation can protect against this happening somewhat.
Employees who do not have huge founder stakes in the company are last on the totem pole for return. Here, lower valuations matter the most to the employees and the stock options they own because they the lower the strike price, the better their return. If the valuation gets driven higher, employees who are hired later get progressively higher strike prices which make it harder to make money off the options. This is why employees often make barely anything relative to an exit of a company, but make most of their return simply from salary.
Consider this post from Don Dodge regarding Facebook shares; many people think that if they can get into Facebook now they can make a million bucks when they go IPO. The problem is that the valuation of Facebook is so high now that the difference between what someone gets options for now and what share price the company could IPO at is going to be so minimal that it is not possible to make a lot off the selling of those shares.
Also, consider the 409A Valuation requirement by the IRS mentioned in Don’s post. As the company grows in valuation whether by further financings or growth progress, the 409A Valuation requirement will force a re-price of options and drive their strike price higher; it is no longer possible to keep option prices low for the benefit of employees coming in at any time. Higher valuations therefore suppress gain by employees. If your wish is to extend some gain to the rank and file, you should aspire to keep your valuation low as low as possible.
Valuation vs. Company Progress
If a company’s valuation gets too high relative to its progress, this could cause problems. That doesn’t mean you can’t raise money to a high valuation; you can easily do so if you can pitch well and have a great team and idea. However, at some point, your company’s progress needs to justify the valuation. (See this post Startup Valuation and Calculating Startup Worth.) The danger of high startup valuations is that at some point, you may need to raise more money and if you can’t justify your startup’s value to investors both from a perception and from a reality standpoint, you may be forced to raise money at a lower valuation than before. This is usually a painful process and will cause dilution of one or more of the involved groups, reducing their return. So keeping your valuation lower and marching your valuation upward in lock step with your progress is worthwhile.
For other related posts on this topic, please see:
Quora: What are the disadvantages of an absurdly high valuation for a startup? Startup Valuation and Calculating Startup Worth
Techcrunch: So High Valuations Are Back. But Does that Mean You Want One? [Video]
Techcrunch: A Conversation with Greylock’s Reid Hoffman and David Sze [Full Video]
A VC: Here’s Why You Need A Liquidation Preference
Don Dodge on The Next Big Thing: Will Facebook have an IPO bounce? Has 409A changed the game?
Quora: Startup Advice & Strategy: How much money should I raise?