
Paul Graham may be right, but Chris Zacharias is righter - danshapiro
http://www.danshapiro.com/blog/2012/12/paul-graham-may-be-right-but-chris-zacharias-is-righter/
======
RyanZAG
Feels a bit like this whole issue is conflicting the management team with the
investors - which is obviously very common in the startup world.

Need to take a step back and look at the primary purpose of acquiring
investors: taking capital from them now in exchange for future cash flows to
them later. To maximize this in favour of our business, we need to take the
most money for the minimum amount of equity sold.

Now look at the primary purpose of the management team: to use the assets and
resources placed in their care to create the highest future cash flows
possible. This includes the tasks that Chris is conflating with investors:
secure deals, find the best lawyers and accounts, getting meetings with
difficult people. The management team is then compensated directly for their
efforts.

The above is how it works in traditional companies. The investors invest
capital and decide on the management team. The management team actually runs
all facets of the business. In the startup world this relationship is not as
simple, as the founders are both the primary shareholders and the management
team itself.

What Chris is proposing is not as outlandish as it sounds - he is proposing
joining the investors as part of the management team by selling shares to them
for cheaper. If a share is worth $10 on the open market, but we sell it at $5
in exchange for valuable help from investors, then we are doing something very
simple: we are paying these investors to be part of the management team, and
in this case we are paying them $5 per share. This is a good option to take if
the skills they bring are worth the $5, and a very bad option if we could hire
better/more skills by taking the $10/share and then directly hiring on the
market.

TLDR: Nothing to see here - you can pay people in equity or in cash, and the
choice is as difficult as it ever was.

~~~
sskates
You would expect that investors would help your startup more if they had more
equity from a lower valuation and were rationally trying to maximize the
expected value of their holdings.

However, in seed stage investing in startups, investors do not end up looking
at their equity stakes when they decide to help or not help a startup.

The primary determinants of whether an investor helps you are: 1) Whether they
are the type that generally want to help the companies they invest in 2) Their
relationship with the founders 3) How successful they perceive the startup
will be and whether they feel they can contribute to that success

~~~
diego
I have different amounts of equity in different startups. All else being
equal, I prefer to help the ones in which I have more equity. I like to help
companies that I invest in, but my time is limited. I've had to make that
call.

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pg
"Chris is doing something very smart: he’s fishing in a smaller pool. There
may be fewer fish, but he’s got them all to himself."

This is the mistake. This pool is not merely smaller (that may not even be the
case), but investors in it have a lower ratio of value to cost. Which is
precisely the reason someone who fishes in this pool has it all to himself.

I.e. the argument here is not akin to "Since this restaurant is too crowded,
I'll go to that other equally good restaurant that's empty, but rather "Since
this restaurant is crowded, I'll go to that other one that is deservedly
empty."

I find it odd to be arguing this side of the case, because I'm usually the one
telling founders not to chase high valuations. But these arguments are simply
fallacious.

~~~
kelnos
Chris states repeatedly that part of his experiment was to see if he could
find valuable (non-"deservedly empty") investors, and it seems that he has.
This may not be a good general strategy that everyone can emulate, but it
appears that it _can_ work in some situations.

He also marveled that he closed the funding round in just a few days. I
constantly read here and elsewhere that one of the huge pain points when
you're looking for funding is that you spend so much time dealing with
fundraising that you have to drop the ball on developing your actual product
for a while. Courting quality investors that tend to be priced out by many
startups with high valuations could reduce that problem's impact.

Again: I recognize that this certainly isn't a general solution that every
startup can pursue. But it sounds like you're dismissing it in general.

Then again, I'm just an armchair non-entrepreneur commenter who has never
faced any of these problems. ;)

~~~
pg
As I said earlier, there are also helpful investors who are willing to buy
stock at high valuations. Which means those who aren't have a lower ratio of
value to cost.

And lowering one's valuation is not an automatic way to make a round close
faster. I've watched literally hundreds of startups both succeed and fail at
raising money, and as a rule, if investors don't want to invest at a valuation
of x, they don't want to invest at x/2 either.

All that's really going on here is that Chris is mistakenly generalizing from
a single data point.

~~~
kelnos
Makes sense. If you don't think a company is going to succeed at a particular
valuation, you're not likely to change your mind for half the cost.

My assumption was that there's a group of investors that would love to invest,
but just don't have sufficient capital to do so at the valuations companies
are getting. But I guess that's too small a number -- especially when you
consider that you want _quality_ investors, too, which shrinks that pool -- to
be a general solution, as you say.

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jusben1369
I think this is a well meaning but misplaced assessment of Chris's goals. I
thought his point was more along these lines:

Angel Investors are helpful for the resources the provide. One is financial
and two is non financial (intellect/network connections etc) It seems like
Chris has decided that the focus at YC companies has become too much on the
former and not on the latter. He seems willing to reduce the amount of value
he receives via the monetary piece (not less dollars, smaller valuations) in
exchange for much higher value on the non monetary piece. "I'll give you a
lower valuation in the hope/expectation that you'll be much more vested in our
success and thus leverage your non monetary resources towards our success."

In a nice reinforcing circle: by taking a lower valuation he creates, or
perhaps reinforces, the right economic incentives to do that.

On a side note I thought he was extremely brave to challenge the system with
his original post.

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mehdim
What you talk about is a kind of "blue ocean strategy" applied to investors.

 _Red investors oceans represent to all the industries in existence today –
the known Investor space. In the red oceans, investors boundaries are defined
and accepted, and the competitive rules of the game are known. Here start-ups
try to outperform their other start-ups rivals to grab a greater share of
investment demand. As the funding market space gets crowded, prospects for
high valuation and rapid investments are reduced. Products become commodities
or niche, and cutthroat competition turns the ocean bloody; hence, the term
red oceans._

 _Blue investor oceans, in contrast, denote all the industries not in
existence today – the unknown investor market space, untainted by start-up
competition. In blue oceans, investment demand is created rather than fought
over. There is ample opportunity for high valuation and rapid investment. In
blue oceans, start-up competition for funding is irrelevant because the rules
of the game are waiting to be set. Blue investment ocean is an analogy to
describe the wider, deeper potential of investor space that is not yet
explored._

(Adaptation of Wkipedia article on blue ocean strategy for investment for
start-ups)

In your article the "guilder-investing angels" are the blue ocean for
investment in start-ups.

------
brudgers
The title of this article is on pitch to me. PG's comment does not come across
as a "calling out." It comes across as a general conclusion based upon his
experience and data.

On the other hand Zacharias's blog describes observing and responding to
feelings that there was a disconnect between the funding features available to
his YC class and his entrepreneurial gut.

As a "pre-cofounder" (I love the term) he was in a position to take a
different course. He also enjoyed the advantage of friendships with potential
investors.

I can't help but see what he describes as extending some of the fundamental YC
processes beyond the point where YC kicks the baby birds out of the nest. YC
works because of the trust founders place in the partners. It works because
founders don't worry about the investor screwing them over, and it works
because founders can spend more energy building rather than negotiating terms.

This appears to be what Zacharias did. He was careful about who he sold his
company to and conscientious about the price of shares which are likely to be
worthless.

It was a personal strategy - right for Zacharias. PG is right that it is poor
as a general strategy for YC companies.

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npguy
That is true not just for angels, but for VCs as well - Elon Musk feels
strongly about that - "Always Go With A High-Quality VC Even If The Valuation
Is Low"

[http://statspotting.com/2012/12/elon-musk-always-go-with-
a-h...](http://statspotting.com/2012/12/elon-musk-always-go-with-a-high-
quality-vc-even-if-the-valuation-is-low/)

------
amirmc
_"...and get the very best of the guilder-investing angels in their round."_

I can understand the reasoning but are the 'best' of this pool as good as
those from the dollar-pool? Wouldn't the really good/useful ones be trying to
enter the dollar-pool anyway? (NB I'm not aware of the back-story yet)

Edit: Just read both pieces and I agree that they're both right. I see this as
a difference between Angel vs VC. Angels sometimes get involved because they
can imagine having a useful impact on their portfolio. If an Angel takes a
tiny slice of a company which also has VCs and 'YC valuations' then they may
feel they have no real 'clout' or ownership in the company (not everyone wants
a board seat). Even though the economic argument may be to take-whatever-you-
can-get that doesn't make it _fun_ or worth your time.

------
jstreebin
I'm not sure how the leaps from "price-sensitve" to "smart money", and "price-
insensitive" to "dumb money" were made. I think it's much more accurate to
divide it amongst "price sensitive" and "value sensitive" investors. Yes,
there's still classifications such as "dumb money" and "smart money", but
they're often misused when discussing topics like this. And I've yet to see
any posts on early stage val's of the biggest companies in the past few years,
which could explain how "smart" or "dumb" either is. I also haven't gone
through the presos of funds of both types to see who's getting the best
returns, but I can remember anecdotally that both classes of investors had had
success. (Kauffman Foundation would have some good data on this.)

I will say that one nice thing about pricing on the higher side is it requires
more conviction on the part of your investors. Thus, it will be those that are
committed to your company, despite a higher relative price. (All investors are
price-sensitive, it's just to what degree.) So by pricing it higher you end up
with the same result as CZ and DS are seeking, except you keep more of the
company.

And as far as the price-sensitive, there are many reasons, aside from them
just being "smart": a) they're trying to raise a fund and need lower
valuations, "better" numbers, for potential LPs (since LPs are usually
investors with a more traditional mindset on finance, and thus more price-
sensitive), b) their existing investors want to see lower valuations, "better"
numbers, c) they're able to get "good deals" (I'm not mocking this, I'm just
noting it's a value judgement, not something concrete) at lower valuations, d)
they care more about potential multiples on their own fund(s) more than
investing in the outright best companies, and any number of other reasons.

Hunting for the cheapest relative startup isn't necessarily "smart" (nor is
investing in say uncapped notes), and investing in "expensive" startups isn't
necessarily dumb (nor is haggling over price).

------
sskates
I'm now curious if there are a segment of investors who use valuation to drive
their decisions, even if its irrational to do so (valuation in Chris' case was
a 2x factor, whereas success vs non success is a 100x one). If they exist, it
may be worth targeting them.

~~~
aneth4
2x on the note is the difference between 50x and 100x. Often such companies
are 3x overvalued, and 33x vs 100x massively changes the risk/reward ratios.
Capital is always limited, and even in the 2x case, that means one can invest
in twice as many companies with twice the potential upside.

Suggesting pricing is not a rational factor in investment decisions is exactly
the sort of irrational statement that indicates the peek of a bubble.

Furthermore, if you pay double, that means you've already lost 50% of your
money. Valuation is essentially potential upside discounted by risk. If risk
is not factored in properly, investors lose money and nobody wins. Investors
expect most of their bets to lose, and winning bets to provide a significant
return. That return may average out to around 20% annually for a very good
investor. If that investor is paying double, that goes down to 10%, hardly
worth the risk of angel investment.

~~~
sskates
Log base 2 of 100 is 6.6. That means you need 6.6 effects the size of
valuation in Chris' case in order to have the same impact on your outcome as
picking a winner. Can you explain why using valuation to drive your decision
is preferable to using the startup's likelihood of being a winner?

~~~
aneth4
I'm not sure why you are using logarithms.

A) 50K at 5M valuation is 1%

B) 100K at 10M valuation is 1%

If the company sells for $1B, the first investor gets 200X, the first investor
gets 100X. The first investor can also invest 50K in another promising
startup, increasing the likelihood of them making money with their 100K
capital. Given that any individual company has a low chance of a $1B exit (if
it had a high one, the valuation would and should be much higher,)
diversification is important to investors.

Alternatively assuming a fixed investment amount:

A) 50K at 5M valuation is 1%

B) 50K at 10M valuation is 0.5%

If the company sells for $1B, the first investor gets 200X, the first investor
gets 100X, and made a drastically different amount of money - $10M vs $5M
(less investment). If the investor has a large number of investments, a 200X
vs 100X can significantly change the overall outcome of the portfolio. This is
less so when we are dealing with these ridiculously high numbers (very few
startups exit with this kind of return), but with more typical $20-100M exits,
the valuations of the investments makes even more difference.

The key point here is that the startup's likelihood of being a winner is a key
component of the valuation. If a startup had a very high chance of exiting for
$1B, then a $100M valuation may be perfectly reasonable. YC startups, on
average, do not have a high chance of a $1B exit.

When a startup raises at $15M instead of a more reasonable $5M, it is riskier
to invest because the upside, and therefore the expected value, is much
smaller.

The idea of getting a piece of something no matter how small at any price is
just bad investing and bubble mania.

This sort of unsustainable logic is what leads to boom busts cycles. It's
important for everyone involved to maintain rational pricing in a market,
because volatility breeds fear is ultimately damaging to the startup
ecosystem.

~~~
sskates
It's more important to focus on whether a company will be successful than its
valuation. Nowhere did I say valuation did not have an impact. Focusing on
valuation and ignoring whether a company will be successful is a mistake.

I, and any other investor, would have gladly bought Google stock at any
valuation before its IPO, whether at $5MM, $15MM or $100MM. Whereas it doesn't
matter how great your terms are if the startup you invest in fails.

~~~
aneth4
What kind of investor focuses on valuation and ignores whether a company will
be successful?

You said "there are a segment of investors who use valuation to drive their
decisions, even if its irrational to do so".

It is not irrational to use valuation to drive decisions, though it is
obviously stupid to have that be the only factor. It is however, a major one.

Of course if success is highly probably, one should not be deterred by
valuation, and in fact valuation should be higher. These days, many companies
are not risk discounted enough, making many investments a bad deal for
investors. Companies raise at $10M valuations and go out of business 6 months
later. This is not healthy.

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saosebastiao
I don't think either position is more right than the other. I think both have
valid points. Chris' genius move isn't something that magically allowed him to
find gold...it was merely a tradeoff of equity for the ability to handpick
your investors and advisors.

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gtz56
I think the title is backwards, it should be, "Chris Zacharias is right, but
Paul Graham is righter".

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bartwe
Guilders have been out of circulation since the euro was introduced.

~~~
mmanfrin
Missing the forest for the trees.

