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Y Combinator Founder Paul Graham Issues New Warning to Start-ups (inc.com)
188 points by azazo on Sept 6, 2012 | hide | past | favorite | 56 comments

Just so everyone understands, I was not saying that Google Ventures is a bad investor and should be avoided. If we thought that, the email would have been a lot shorter. I was just talking about a structural problem that happens when you've already raised some money on a convertible note with a valuation cap, and an investor offers to invest at a lower cap.

That sort of offer puts founders in a bind, because if you take it (a) it can anger the earlier investors, and (b) perhaps worse, it can, like a "down round" give investors the impression that your prospects are getting worse.

My overall advice about fundraising is to do breadth-first search weighted by expected value. I.e. talk to every investor who's interested but focus on the most promising ones. This is one of many situations whose solution follows from that rule. An investor offering you money on worse terms is at least offering you money, which is better than nothing. But all other things being equal, the expected value of such an investor is lower than that of one willing to invest on the same terms as your existing investors, so you have any of the latter you should focus on them.

Perhaps Google is leveraging their name and their value as a resource? Google Ventures investing in you could also be seen as a strong positive signal too. And not that I know what those resources offered might be, and not saying it is fair to earlier investors, though I would give someone with say media reach more value than say a local silent investor who has nothing other than money to offer.

Google Ventures is not the "Google" of venture funding. And there are about 5-7 firms that would have this type of brand-value that don't even consider these kind of tactics.

It's still called Google Ventures to leverage Google's name. Regarding tactics, I guess it's a matter of knowing your poker hand and trying to put your best foot forward. I can see a point to perhaps doing such a lessened risk with incubator-founded startups, in that the model isn't yet proven of how the average incubator startup can compare to an external team that would have very different dynamics of being processed. It's in an incubator's best interest to make things look good - so the startup gets funding and the incubator's equity becomes more available - though it doesn't mean it was people on the team itself that could have achieved the same, nor that those same resources would continue to be available to the team (or at the same amount) once away from the incubator.

Paul, re: your comment "all other things being equal" -- wouldn't you agree that some investors are not at all equal to others? (YC itself included)

seems that GV resources are worth something more than other investors checks by themselves. while i agree there are many investors who are "just a check", there are at least some who bring a lot more to the table than just capital.

anyway, i understand the timing issue of subsequent / lower cap deals, but i wonder if this isn't just a result of a sequencing problem for diff "hi-res" financing negotiations within a period of 30-90 days around the same raise.

Sure, some investors are more helpful than others, and GV is probably above average for VC funds. But an investor would have to be really good to invest on a note with a lower cap than previous investors without messing up the startup's fundraising. It can work if the investor is a domain expert that the startup wants to recruit as an advisor, but not otherwise in my experience.

Isn't common or even expected for founders and 1st round investors to get diluted by subsequent investment? This comes off to me looking like YC just doesn't want to get diluted, but that happens. Is that not the case?

Dilution is usual and expected. A down round is different and worse. Please look it up.

This is actually a "first round investor" coming in later in the first round and asking for better terms then previous (maybe only days previous) investors got. It's not an additional round of investing.

Traditionally you'd give later investors higher valuations/caps/etc, particularly if you were at or approaching the magical amount of money you need point.

I don't know if this is true or isn't true, but Google Ventures' counter arguments are red herrings:

  "I don't know what Paul's thinking," Maris said.
  "It's just not true. Our portfolio speaks for itself."

  "We've already closed investments on companies from this class,
  so they don't seem to feel that way," Maris said.
Neither of those things mean that what PG is saying is false. Google Ventures is a desirable investor and entrepreneurs would be willing to trade lower caps for a Google stamp of approval on their round. The question is whether it's a matter of their policy to quote a cap at half of a company's existing one, and whether that is an ethical policy. Because they are skirting the question, it certainly makes them look guilty to me.

How could it be unethical? I could offer Ferrari $500 for their latest model -- they would would tell me to stick it where the sun don't shine, but it hardly makes the offer unethical. If I was Jay-Z, they'd probably accept my offer for the publicity value, which is what Google is hoping happens to them.

It'd be unethical if you knew $500 was undervalued and you thought Ferrari didn't, i.e. if they were inexperienced and possibly accidentally undervaluing their own car. Then you would be taking advantage of them.

I disagree. The CEO of a startup is an adult, maybe a young one, but an adult no less. They need to know what is over and undervalued for their company. On the other hand, the investor has a fiduciary responsibility to get the best round possible for their fund. In Google's case it is for their shareholders.

In other words it would be unethical for the VC to not work to get the best valuation.

Interesting code of ethics you're proposing there: that it's actually unethical not to take advantage of people, and your only ethical responsibility is to the people who pay you. Convenient, I'm sure.

If you invested what you consider to be a large amount of money with a VC to produce a return for you over a 10 year period would your rather they:

A) Care deeply about producing the highest return for you and in doing so use their expertise as negotiators including their competative advantage as a well branded firm (google). And in doing so dilute founders and less experienced investors in the process...

B) Ask them to negotiate in a way which maximizes other investors' returns and founder returns at the expense of your own returns.

Both cases you are paying them a fee to do this.

If you answer B, I encourage you to leave a response explaining your position.

Then consider you are a pension advisor who needs high returns to make sure that you will be able to pay the pensions of fire fighters. Would you make the same decision?

Your argument applies as well to Google Ventures as to Enron. I'm sure there's a line in your head that companies are not meant to cross in serving their investors, but it didn't make it into the argument.

Fiduciary responsibility is independent of ethics. You can't use ends to justify means.

Your argument applies as well to Google Ventures as to Enron.

Exactly! Enron would be the equivalent if Google Ventures decided to falsify their valuation documents they were sending to investors saying they were getting much better valuations than they actually were. Then one day in 6 years they said all of those financial reports they submitted to the SEC were falsified so there is a total loss in the Google Venture line. In doing so they violated their fiduciary responsibility.

I'm sure there's a line in your head that companies are not meant to cross in serving their investors, but it didn't make it into the argument.

Of course there is, but an arm's length negotiation with CEOs of angel invested startups seeking to be the CEOs of the worlds largest, most innovative companies is well within that line.

Fiduciary responsibility is independent of ethics.

Fiduciary responsibility is the core of business ethics that should never be violated. Within fiduciary responsibility you still can't do anything illegal. Of course ethics are always a grey area which is why there is a discussion about this topic here, but I disagree where the line is clearly with you.

You can't use ends to justify means.

That is not what I am doing.

Seriously, ask yourself what you would want the VC you entrust with your money to do.

"Seriously, ask yourself what you would want the VC you entrust with your money to do."

Is that all you need to ask in considering how ethical an action is?

The whole point of ethics is to reason in the context of tensions. Tensions between what you want and what others want. Companies have responsibilities to more than their investors. Their employees, their communities, their customers, their environment. Focusing exclusively on one side of the tension has nothing to do with ethics.

Focusing disproportionately on investors is also ethically convenient, because their interests are often aligned with yours.

"an arm's length negotiation with CEOs of angel invested startups seeking to be the CEOs of the worlds largest, most innovative companies is well within that line."

It may seem obvious to you, but it's clearly not obvious to grandparent since that is what the argument is about.

"Fiduciary responsibility is the core of business ethics that should never be violated. Within fiduciary responsibility you still can't do anything illegal."

I think this position doesn't require the word 'ethics'. You can get by with just 'laws'.

This isn't a rhetorical device. I think lots of people think this, and honestly am ok with it. At the least it's internally consistent. It just fails for me because it doesn't permit asking, "what should the laws be?"

We are discussing CEOs of startups and their negotiation with professional investors. In that scenerio, I cannot imagine a reason why a VC should give up something in the negotiation because he feels like the startup doesn't know what they are worth. Both sides have lawyers and advisors and the CEO is an adult who can analyze his future as well as anyone else.

If the CEO is unable to negotiate what they are worth, they should hire a dreaded MBA to help them.

VC isn't a single round game.

1) You're going to be in business with your investors for the next decade (if things go well).

2) The pool of investable startups and investors is pretty small, and reputation matters. If you screw a company once, you might juice your expected return from 50% to 55% (likely still an actual return of $0 on any given deal), but if you get a reputation for behaving badly, your dealflow will no longer include good deals, which hurts you far more.

You're wrong, very wrong

GV or other capital firms do this all the time, they can probably put a valuation exact to the cents in your startup (I'm exaggerating, still)

Everyone that is on a long lasting business (or better, those who last in business) knows that what comes around goes around

The article suggests that Google is offering half of what the entrepreneurs have already been offered. So the hypothetical Ferrari guy is choosing to sell to me for $500 over another offer for $1,000, even if the true value is $50,000.

The founders in YC are hardly naive innocents who are undervaluing their startups. A) the empirical evidence shows that they get the highest valuations for their seed rounds; and b) the current conversation explicitly addresses the case where they already have an offer with a cap 2x that what Google Ventures is offering.

> It'd be unethical if you knew $500 was undervalued and you thought Ferrari didn't

No, that's called business.

Ferrari hardly need Jay-Z (or anyone, really) for publicity, they're a household name on their own.

I do see what you mean, but I'm not sure the metaphor really helps because it reverses who's the big and famous player.

Thought this was amusing:

From the article: Google Ventures managing partner Bill Maris blasted back, telling BI that Graham's accusations were "patently absurd."

First example from http://en.wikipedia.org/wiki/Non-denial_denial#Types: Characterizing a statement as "ridiculous" or "absurd" without saying specifically that it is not true

I'm a little bit uncomfortable with that heuristic because sometimes things literally are absurd. I think in this case though, Bill Maris is literally not in a position to say whether they are coming in at half the value of other players. He probably doesn't know, or at least doesn't have as many data as Paul Graham.

^^ This is dead on.

Summary: PG warns that he sees a pattern at Google Ventures. Google Ventures isn't denying or confirming anything in regards to PG's statement.

Seems simple enough.

As ugly as it may be, this is _business_, a.k.a. capitalism. Trying to interpret it as everyday human interaction using concepts like "ethics" will fail. Skip this step and try to decide whether you are comfortable or not without using these models from your past (human interaction) experience.

Guilty of leveraging their name and resources they perhaps offer?

I am afraid that unless Google is compelling people to accept a deal by force, that using a good bargaining position is just the free market at work.

I don't think the problem here is with Google Ventures. The problem is that founders don't understand convertible notes with caps. More by Mark Suster here: http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou...

Independent of capped convertible notes being problematic under some assumptions (essentially, when the market turns down and you raise at less than the cap -- that's 90% of the problem, and 9% of the rest is when you don't then sell for enough to blow the pref out of consideration), an investor trying to lowball you on the cap is no different from lowballing on equity valuation.

If everyone is investing at $12mm, and an investor says "fine, but I'm special, give me $6mm or I won't invest", there's no difference if it's capped convertible note or equity (except that it's technically more difficult to do the investment as equity with different valuations; you can hack it by giving warrants or other benefits I think.)

Maybe it's not that the founders don't understand convertible notes. Maybe they are taking the funding at a lower valuation because they're willing to gamble on the likelihood of a (big money, not acqui-hire) acquisition by Google later down the road is more likely.

Google Ventures, in my experience, tells entrepreneurs that they have little to do with Google. They do not invest in things because they are synergistic with Google, and they may even invest in things that compete with Google. They make it very clear up front that Google Ventures is a separate organization. At most, they may tap into their network within Google to assist you if it makes sense, but any investor worth their weight in Silicon Valley can connect you with Googlers and other important companies.

The phrase I've heard is "Google Ventures is not the Google of venture capital."

It is in Google's nature to try and dip their feet everywhere

Google Vultures?

Coincidentally, I was just reading this rather insightful essay on press releases http://paulgraham.com/submarine.html yesterday, and remember a line that stood out:

>'why he's writing about this subject at all.'

Makes one wonder what PG today, would say in response to PG (2005) :p

You started me of on a trail that ended up here (so far): http://www.nytimes.com/2012/07/23/business/venture-capital-f...

Pretty interesting stuff, possibly even inspiring some ideas.

@wamatt, agree regardless of the "why" PG's email feels petty, YCombinator and its way too many startups are jumping the shark

With their business model, the more startups the more likely they are to get a homeruns and base hits, as long as they can maintain a minimum standard that's strongly correlated to outcome (which PG seems to have figured out). It's an odds and numbers game.

YC is billed like the yankees, but singles more likely, how did the Seattle Mariners do with Ichiro all these years?

The warning:

"According to the website, the incubator's prominent founder said: "If you're talking to Google Ventures you may be part of a pattern. The pattern is: you've already raised some money at a cap of $x. Then GV says they're interested and wants to invest at a cap of $x/2.""

I'm a bit confused. Is the Google Ventures dig referring to companies that have already raised seed money from GV, and then try to get series A from them? Or is GV just doing this across the board for all startups that have raised seed rounds using convertible notes?

Why are startups often disasters internally, as PG says in one of the linked articles?

This was my favorite line from the article, actually.

The quote in question: "Practically all start-ups internally are disasters"

Not just "often", but "practically all" start-ups. It's true in my experience, and not necessarily a bad thing. Of course, it would be great if everyone acted thoughtfully, didn't let ego get in the way, planned things just enough (but not too much), etc., but that's not just not the way it happens.

Acknowledging this fact, getting okay with it and still forging a highly functional team in the midst of such chaos and tragedy is the key. That's a tall order.

One of the worst mobile website I've ever seen. I can scroll down on the article, so I click "go to full site". That takes me back to the main page, which is annoying, but I manage to click back to the article, at which point I am put through to the article on the mobile site again. And that's on top of the fact that I have to view a loading throbbler for a text article. Chrome for Android and the Android Browser

Meta: the Inc.com mobile website offers an horrible experience on my Desire w/ ICS + Chrome. Slow, cluttered and buggy (wouldn't let me scroll to the bottom, kept bouncing back).

It's text content. Why not just a nice simple HTML page: instead of all the 'HTML app' cruft on top?

I'm sure this is both true and reasonable for some companies that did notes with absurdly high caps earlier (which many have) and are now raising more money. Nothing to see here.

So is GV consistently approaching startups that are already being funded, i.e., making offers after the project has had a little time to mature?

If Google are willing to invest in your startup then why the hell would you turn that down?, it's like turning down a BJ from a supermodel, because she demands you do it at her house.

That's not what an investment is.

Did Apple,Google, Facebook, Twitter or Microsoft use an incubator company? Why do people think they are required to be successful?

It seems pretty hypocritical to be warning people "don't let google rip you off with lowball offers" when you run a company whose business model is "rip off college kids by taking a huge stake in their company in exchange for nothing". Wouldn't "dear google, please don't out-compete us in the ripping off college kids game" have been more honest?

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