Investor Herd Dynamics

by tlammens • 13 years ago

224 52 13 years ago

rjvir• 13 years ago

Seeing that YC's demo day is coming soon, it's awesome to be able to peer into PG's mind - this essay along with "How to Convince Investors" must be the exact advice relayed on to the current YC batch.

pg• 13 years ago

That is exactly right. I'm trying to get a complete guide to fundraising done in time for Demo Day, so I don't have to repeat all this stuff verbally (and incompletely) yet again. There is at least one more coming on fundraising tactics.

earbitscom• 13 years ago

Would love to see some info about the difference in strategy for raising in a toxic industry/vertical.

beat2• 13 years ago

Thanks for sharing this with all of us outside the YC world! I've really appreciated the shower of wisdom in your recent burst of essays, and I'm sure others appreciate it too.

cperciva• 13 years ago

After you raise the first million dollars, the company is at least a million dollars more valuable, because it's the same company as before, plus it has a million dollars in the bank.

This seems a bit specious. Sure, the lower bound on the pre-money valuation for investor #2 should be the post-money valuation for investor #1, not the pre-money valuation for investor #1; but the valuation per share won't necessarily be any different.

johnrob• 13 years ago

Startup valuations are not accurate. Your comment essentially proves the point: If an investor is going to fund a company at valuation X, they prefer that X is a combination of cash and stock and not purely stock. This implies that a dollar of valued startup is not worth a dollar, which should be an axiom.

A 3 MM dollar company comprised of 2 MM stock and 1 MM cash is more desirable than one with just 3MM in stock.

dfabulich• 13 years ago

"VCs will sometimes ask which other VCs you're talking to, but you should never tell them."

Why not? (Unless I missed it, the article doesn't explicitly say.)

moogabi• 13 years ago

My guess is that in negotiations the risk of telling them who they are competing against outweighs the benefit of keeping them guessing. I suppose they could think you are bluffing and not really talking to any other VCs at all, but if they believe you actually are meeting with other VCs, I could see the benefit of keeping them in the dark.

beat2• 13 years ago

VCs are a small world. And VCs need each other more than they need you (as an individual startup). Most entrepreneurs will climb that VC hill once or twice, ever. But VCs will partner together on deals for years, decades. So if your negotiations really have you pitting one VC against another, it's likely that you will lose, not them. After all, there are always other startups.

marpeluso• 13 years ago

Every situation is different, and the reasons for not sharing names change depending on the the stage of the discussions. For example, if discussions are advanced enough to involve negotiations on valuation, in general, you want potential investors to compete, not collude. Unless you know the parties involved well enough to know that they will not join forces to work against you in negotiating valuation and/or governance, it is not a good idea to share the names of other VCs you are talking to.

larrys• 13 years ago

"Why not? "

One thought that comes to mind is if you mention that you are also talking to "Sam " then "Bob" (who you are having a conversation with) can start to game Sam, or Sam can game Bob (when Bob mentions it to Sam later if they know each other).

So in terms of general business "loose lips sink ships" this is something to avoid.

So either party can play mind games with the other. And depending on the relationship of the two this could create a problem.

Other thing is that this gives the VC you are pitching a chance to drop things in your mind about the other VC that might affect your judgement. "Oh well he's a great guy but the one thing you need to consider is..."

My guess is PG might feel that the type of people in YC don't have enough experience to manage this situation properly so it's really similar to an attorney saying "don't say anything let me do the talking".

ganeumann4• 13 years ago

Sigh. I do this all the time as an early-stage investor. But I don't do it to game the valuation, I do it so we can share the task of due diligence. Maybe I understand the market/customer and the other VC knows the founders, or vice-versa. It's nothing sinister, it's just a more efficient way to get the information I need quickly and cheaply.

There is a lot more than gut judgement involved in deciding to give somebody I just recently met a large sum of my money. I don't let other VCs dilute my judgement but I certainly listen to them when they have more knowledge of the relevant facts about a company, its people, its product, or its market.

Note that I'm an angel investor, so I try to make sure the cost of due diligence is proportional to the amount I'm investing. If I were a fund and writing million dollar checks, I would spend the time to do all the due diligence myself.

joshu• 13 years ago

Same here.

There are a bunch of investors out there that I know, like, and trust.

Also slightly less importantly, there are investors I don't necessarily trust.

The composition of the syndicate is an important signal.

jacquesm2• 13 years ago

Big difference, angel and VC are not interchangeable in this discussion and the article explicitly mentions VCs, not angels.

pixelmonkey2• 13 years ago

Because they collude.

btilly• 13 years ago

My guess as to the dynamic is this. If a VC knows that SOME other VC is interested in you, they can't feel out other VCs to see who it is because it might get a third VC involved.

But if one VC knows who the other VC is, then collusion is simple and clearly in the VC's best interest.

crapshoot1012• 13 years ago

they really don't. I realize this is one of those conversations entreprenuers think VC's have a lot, but most VC's have ownership and $ thresholds they are aiming for in an investment - just splitting the baby in half with another VC firm doesn't get you there, and you'd be surprised at how many firms like working with firm a / b / c but hate d / e / f. The better argument for not revealing this is that its leverage - ie, the investor might think your other option is AH/Sequoia/Accel/Benchmark/Khosla/some other top-tier firm, while in reality it might be some relatively podunk firm - you get some potential benefit from that (and also potentially some downside if its the other way around).

The compromise position here is being honest but guarded - ie, especially if you are talking to one of those above - As a founder / CEO's, come back to the investor here and say we're talking to a couple of top-tier firms, which gives the signal effect to the investor that they need to sell / convince quickly while maintaining your leverage as an entrepreneur.

tkiley• 13 years ago

It seems like the earliest investor in a multi-party round invariably gets shortchanged in the literal dollar value of the deal. If committed investors raise the valuation of a startup, would it make sense for a startup to offer a slightly-sweetened valuation for the first investor to commit?

I understand that no one likes to have the price raised on them later, but perhaps the underlying truth of increasing valuations could be restated in a different way so it seems more like a discount to the first-in vs a price-hike to the last in.

robertlaing• 13 years ago

That's something I've seen angel investors argue about on panels but never really agree on.

Good post by Mark Suster here: http://www.bothsidesofthetable.com/2012/09/08/should-investo...

anigbrowl2• 13 years ago

What's lost in absolute $ terms is (IMHO) more than made up for by being known as the early bird, which status will yield other opportunities. In game theory terms being early is not optimal in a single round but close to optimal in the iterated competition that more often prevails.

harryh2• 13 years ago

But it's very rarely known who is the early bird in investment rounds.

_pius• 13 years ago

http://www.paulgraham.com/hiresfund.html

shykes2• 13 years ago

If committed investors raise the valuation of a startup, would it make sense for a startup to offer a slightly-sweetened valuation for the first investor to commit?

That is exactly what I did when raising seed money for dotCloud. It works great.

Our very first angel (Ash Patel from Morado Ventures) was not the first to express interest, but he was the first to actually sign a check. For that he got a better deal, as well as our lasting gratitude and permanent advertisement as "dotCloud's first angel". Everyone else in the round got identically unsweetened (but fair and attractive) terms. I was and continue to be very transparent about the arrangement, because it's very obviously fair, and doesn't make anyone feel like an idiot.

When we had the opportunity to further escalate the cost of the round, we didn't, because that didn't seem obviously fair and I didn't feel confident I could look an investor in the eye and tell him that it was. We may have left a little gravvy on the table, but in return we saved time, spared ourselves distracting drama, earned trust capital with our investors, and retained the ability to take the moral high ground in any future negotiations.

I don't claim that this is the best method. Certainly not every founder who successfully raised money did it this way. But it worked for me.

jessaustin• 13 years ago

I'd always wondered if anyone could upstage PG on HN. Apparently, Elon Musk can.

anigbrowl2• 13 years ago

Heh, true. However, this short essay contains more useful actionable advice for HN readers than is typical even for PG, so I hope it doesn't get overlooked. Very very impressed, here.

robrenaud• 13 years ago

The best investors aren't influenced much by the opinion of other investors. It would only dilute their own judgment to average it together with other people's.

I don't know anything about startup investing. But I do know about machine learning. And you can often improve an ensemble predictor by adding (many) weaker features and averaging them with an already strong predictor.

One shouldn't confuse the prediction of an average predictor with the average of a bunch of predictions that come from a pool of on the whole mediocre predictors. Averaging is really a strong operation for prediction. Of course, it does help if the individual predictors are themselves independent or uncorrelated with each other, which I guess tends to be very untrue in a herd.

nadam3• 13 years ago

Can someone point to a link which explains the math of startup fund raising? I was thinking about it, and what I get is a paradox:

I assume the definition of raising money is that the original owner gives some percentage of the company to a new owner, and the new owner gives an amount of money to the company.

Let's say the company's valuation is 1 million dollars. Let's say the owner sells 10% for 0.1 million dollars.

In a perfect market the company's new valuation is obviously 1.1 million dollars: the original value in the company's resources (people, etc...) plus the 0.1 million in the bank.

On the other hand in a perfect market perfect owners made a deal in which the original owner's wealth is the same before and after the deal.

Before the deal he was worth 1million. After the deal he is worth 0.9*x, where x is the new valuation of the company.

So:

1million dollars = 0.9x

x = 1.1111' million dollars

So which is the correct new valuation: 1.1, or 1.1111'? Or something different?

Maybe the deal have to be made in infinitely small pieces, so the result is coming from some kind of differential equation?

kken• 13 years ago

In a perfect market the company's new valuation is obviously 1.1 million dollars.

Why? It is still 1 million dollars. The only difference is that the owner now owns 0.9M$ worth of company shares and 0.1M$ cash.

nadam3• 13 years ago

I thought the money goes to the company, not the original owner. I think this is what pg suggested in the article.

sdpurtill• 13 years ago

All your questions can be answered in the Transparent Term Sheet from Founders Fund: http://foundersfund.com/termsheet

It has a calculator that provides economic breakdowns and a supporting article defining the key terms of a term sheet.

ganeumann4• 13 years ago

The money buys new shares in the company. Think about it in per share terms. In your example:

- Pre-money there are 1,000 shares, valued at $1,000 each

- The company sells 100 new shares for $1,000 each

- Post-money there are 1,100 shares

So after selling 100 shares, the original owner now owns 1,000/1,100 shares = 90.9%. The new valuation is 1,100 shares * $1,000/share = $1,100,000.

nadam3• 13 years ago

Now everything is clear, thanks!

harryh2• 13 years ago

The fact that selling a portion of your ownership (so the cash goes in your pocket) is different from your company raising an investment (so the cash goes in the company's bank account) is the source of your confusion.

pisarzp• 13 years ago

You confused a little bit pre-money and post-money valuation.

If company is worth 1m, and someone invests 100k, they get 0.1/(1+0.1) (current value of company + additional $100k after investment) worth of shares, what gives investor c. 9% of shares.

Founder now has 91% of shares, what still give him $1m. (91% x $1.1 = $1m)

LekkoscPiwa4• 13 years ago

Company isn't necessarily worth $1m more because it has $1m in the bank. Think of the dot-com bubble in 90s. All these companies with millions in their bank accounts that never sold anything to anyone for even one cent. But were burning through cash like crazy. Would you invest in them just because they have millions on the bank account?

The market is washed with cheap money courtesy of the FED. According to one study VCs in the US gave worse return in the past decade than blue chip stock. High risk, high return companies have had worse performance in the past decade than low risk, low return. This is not good statistics at all.

http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture... http://www.verisi.com/resources/venture-capital-performance....

The market is drunk on the money provided by the FED. We'll all have horrible hangover after all is said and done. (i.e. the FED eventually rises interest rates).

edit: I love it how people down vote just because I said something opposite to what PG claims. And then no response neither ;-) Somehow this actually makes me feel good! Because it looks like I'm right as nobody replied.

lsc3• 13 years ago

the business cycle goes up; the business cycle goes down. We all know this to be the case, and the business cycle is obviously up, so quit whining and get to work.

If you have no name, this is the time to make your name. If you have a name, this is the time to make money with that name. These are the times in which you have the most leverage.

Yes, of course, the business cycle will go down again. when will it change direction? How sharp will that transition be? Nobody knows. Worrying about that is... trying to know the mind of god. We all have a set of tools, a set of resources and abilities. We need to use those resources and abilities to make enough money (or enough notoriety) that we will be able to deal with the thin times. Now is the time to run hard, not to wonder about macro. There will be plenty of time for that during the next downturn.

Sitting here and complaining about the business cycle doesn't help you, it doesn't help me, and who knows, maybe some people feel that it brings that day of "the business cycle goes down" closer to now. That was the primary reason why I'd guess you got down-voted.

The other thing? Do you remember the '90s? I worked through the crash. It was not at all obvious ahead of time, which companies would come through, and which companies would not. I mean, it seems obvious now, sure, but it was not obvious then.

LekkoscPiwa4• 13 years ago

the business cycle goes up; the business cycle goes down. We all know this to be the case, and the business cycle is obviously up, so quit whining and get to work.

I do work. Business cycle is up temporarily on cheap credit. There is no substance to it. 70% of new hires since 2008 in the US are part time. The debt to GDP ratio is higher than ever. Food stamps are on record high. Inflation if used Ronald Reagan years formula and not today's hocus-pocus hedonistic whatever is at 10%. The whole thing seems to work just because of the interest rates at 0% since 2008. And you can't have them at zero forever.

Sitting here and complaining about the business cycle doesn't help you, it doesn't help me, and who knows, maybe some people feel that it brings that day of "the business cycle goes down" closer to now. That was the primary reason why I'd guess you got down-voted.

Wow. If 50 million Americans on food stamps, 10% inflation rate, and average real wage adjusted for inflation lower than in 1960s is up in the business cycle, I'm afraid to ask what will be down. Greece?

The other thing? Do you remember the '90s? I worked through the crash. It was not at all obvious ahead of time, which companies would come through, and which companies would not. I mean, it seems obvious now, sure, but it was not obvious then.

No, it wasn't. The same like right now it is not obvious to you that the "up" you perceive is just a bubble in the US Treasuries. Don't worry, will be obvious to you soon as well.

BTW, you haven't addressed anything that has to do with extremely poor VCs performance in the past decade from my post. And that $1m on the company's bank account usually doesn't translate into the company being worth $1m more. Which was my main point. Care to talk about this?

jacquesm2• 13 years ago

This is spot on. When I found out that a fellow entrepreneur had been pushed and pulled around trying to get funding for months without any solid commitment I put two of the angels involved on the spot in a meeting and asked them if I committed a certain sum of money for how much we could count on them. The round closed with 5 investors within a few days.

All it takes is for someone to cross the bridge of commitment and others will follow. The fact that I'm probably two orders of magnitude poorer than the other investors probably helped in embarrassing them to make a move, it was literally peanuts to them and the company went on to moderate success.

speeder• 13 years ago

This is a problem when noone wants to lead though.

Here at my company we tried to make a pre-A round of sorts (mostly because we are in Brazil, and investors here are unwilling to invest anything close to a A round here).

We had several people commit saying that if other people go, they will go too... But we found noone to commit as leader, and all the other commited investors refused to go without a lead investor, kinda annoying situation.

Happily our seed investor liked our recent results and expanded his seed investment instead.

pixelmonkey2• 13 years ago

I wrote about this issue a couple years ago, observing similar behavior. I used a modified horse gambling game as a metaphor for the investor dynamic.

"It's easier to play the option than the bet." http://www.pixelmonkey.org/2010/12/13/its-easier-to-play-the...

    In this new race, small signals have a big impact. 
    Charge ahead suddenly and you might get your 3 spots
    filled. Convince a top-tier gambler to go to bat for 
    you, and you’re all set — your other two spots will
    fill up quickly. If you’ve been in the race before 
    and had your spots filled up quickly, you’ll likely 
    get them filled up quickly when you enter the race
    again.

stevenj• 13 years ago

Does this mean that in most deals the investors involved don't know who else is in the syndicate until after-the-fact, if there are others?

oz• 13 years ago

"[2] Founders are often surprised by this, but investors can get very emotional. Or rather indignant; that's the main emotion I've observed; but it is very common, to the point where it sometimes causes investors to act against their own interests. I know of one investor who invested in a startup at a $15 million valuation cap. Earlier he'd had an opportunity to invest at a $5 million cap, but he refused because a friend who invested earlier had been able to invest at a $3 million cap."

I'm not surprised, per se, but rather always amazed whenever I hear stories of rich people acting in ways inimical to their economic interests. One would think that an experienced (I guess) businessman, such as a VC, would be somewhat more rational than that. Then again, this is an article about 'Investor Herd Dynamics', so I suppose that should inform my opinions about human behaviour.

buro9• 13 years ago

We're in a strange place right now, sat in the middle of two pieces of startup advice.

Piece of advice #1: "The time to raise money is not when you need it, or when you reach some artificial deadline like a Demo Day. It's when you can convince investors, and not before."

Piece of advice #2: The best time to raise VC money is when you have product/market fit and need rocket fuel to grow.

We were having conversations with investors to suss out the London startup scene (we feel like outsiders mostly having kept ourselves to ourselves) and to make connections with industry leaders who might make great advisors.

2 Weeks ago these conversations suddenly turned into "Shut up and take my money.". Once this started happening, it happened at every meeting, with investors swiftly upping the amount they believe we should take... we have a herd all telling us to take their money. We haven't done a proper pitch to anyone.

We were aiming at #2 (product/market fit), and have stumbled upon #1 (convinced investors forming a herd).

The problem is expectations. We are at seed stage, and are developing the product/market fit. We have customers lined up, but we're not yet seeing good traction with the existing customers we're engaged with. We want to carry on improving the product, testing as we go.

If we take VC money we very much believe we'd be under expectation to focus on growth before the product is the right one for the market (it has a lot of promise today, but it's not yet proving itself fully).

Our current view is to to explain to investors/VCs that we're still seed and take the money only if it doesn't come with conditions and is understood we're still seed.

Not a lot of wisdom out there on whether you should decline VC money. We're not of the belief that all money is good, especially if it proves to be a distraction from just making the a great product that customers really want.

shykes2• 13 years ago

If you have the luxury to choose from multiple committed investors (and I recommend you triple-check your assumption that these people are indeed committed), then I would use that leverage to set the bar for your ideal terms. Importantly, terms can have many dimensions: in addition to the dollar amount and dilution, you can set expectations in terms of your stage, your focus, autonomy in changing direction etc. You can also filter by personal fit with the investor, how soon they hope for liquidity, their personal track record and reputation (not the firm's), etc. Just like a great hire, you should be wow-ed and be excited to work with them.

The more explicit the expectations, the better! Get to know them, ask them about their styles and priorities, check their track record with previous entrepreneurs (not just active investments! their loyalties may be mixed and they will lack the perspective).

It seems like you also have the luxury of not raising money at all for another X months (another assumption I assume you've quantified and triple-checked), so that makes it easy to walk away if the bar is not reached. Just like any other deal, your leverage is only as strong as your plan B.

I may be stating the obvious. In any case, good luck! "Shut up and take my money" is always a good problem to have.

Investor Herd Dynamics

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