Understanding Investor Terms & Incentives || Rookie Mistakes with Dalton Caldwell and Michael Seibel

It's almost as if they get to run this game every day with multiple companies and all you're trying to do is raise money and get back to work.

Hey, this is Michael Seibel with Dalton Caldwell and welcome to Rookie Mistakes. We've asked YC founders for their rookie mistakes so we can share them with you and help you avoid them.

Here's the last note written by a YC founder: You should care just as much about the terms of your fundraise as you should care about the economics, the valuation, and the amount of money you raise. There are lots of rights; there are lots of terms inside of a funding deal that can screw you, no matter how high the valuation is.

I think that investors are aware that founders want high valuations and they want the press release about, you know, they raised a lot of dollars or they raised at a high valuation or whatever. And so, they're very aware of this. One of the ways that you sometimes see investors take advantage of this need on the part of founders is to say, "Great! We'll give you your ask around valuation or amount, but you need to give us all this other stuff."

Often, the things they ask for are sort of jargon-filled, inside baseball that I, when I was a founder, wasn't familiar with. What participating preferred meant, or super pro rata, and we sometimes see founders give up those terms without totally understanding what they mean. And wow, is this bad.

Another example is board control. I've seen founders give up control of their board such that they could be fired—and are fired—to raise a million dollars.

As a founder, here's the trick: You're not going to be as good at this as the person you're negotiating against if they're an investor who invests in a bunch of companies and you're a first-time founder. So, by using standard paperwork and by using a lawyer who actually has done a lot of startup work, you prevent yourself from getting screwed.

This is one advantage of trying to raise money from people that have a track record of public companies because you know they're optimizing for you to build a really big company versus some investors optimizing for your company selling for 10 or 20 million dollars. They structure their entire documents around that kind of outcome.

This happens a lot internationally, and once again, I don't think the investors are being evil. I think that they're basically saying, "Well, I've never seen a deal that's become a billion-dollar company, and so I've gotta optimize for these base hits. I gotta figure out, if this thing only sells for 20 million, how does my fund not die?"

I think that's like so unfortunate because I think investors oftentimes on a pitch say, "Oh we've got our local experience so we have this, we have that." But when you're a founder, it's way easier to get better terms from someone who's passed than a billion-dollar company.

Here's the last kind of interesting way I've seen these terms versus valuation: I give you a term sheet at a great valuation, but the term is, "Oh, I'm going to only put in 1 million dollars, and the term sheet is for 3 million." So, you've got to go out and find 2 more million somewhere else.

It's like, "Oh, this isn't this great! I've got a term sheet!" And it's like, "Kinda, I've got a deal." But what is the investor really doing when they give you an offer like that? What's really going on?

This surprises a lot of people in YC, but this whole, "Hey, this is great! We love to invest when you find a lead. Just come back when you find a lead." If I translate that out of VC speak, it actually means no.

And founders are like, "What means no?" Here's why: To the extent that you were in a position where you did have a lead investor, it is very common that the lead investor would want to put in the entire amount of money to hit their ownership target. They would not want you to give more of the round to someone else.

Not to mention, if you had the lead investor already lined up, there would be a lot of other people that would love to invest alongside the lead investor. So when someone says, "Oh, this is great! Come back to us when you find a lead, you know, give us an allocation in there," what they're actually getting is a free option to invest in the future if you find an investor that they are impressed by.

It costs them nothing to say that, right? If you don't find a lead, they just manage to pass on your company while being very nice to you to your face. Yep, right? Like, it's like, "No, we don't want to invest." But if you somehow find a great lead investor and you come back to us, let's talk about it then.

And the founder walks away from that conversation like, "Wow, they're really interested! They want to invest! We have offers!" When in fact, they just did this ninja move where they said no, but that's not how you interpreted it.

Isn't that wild? It's almost as if they have to do this because this is their job. It's almost as if they get to run this game every day with multiple companies, and all you're trying to do is raise money and get back to work.

Of course, they're going to be better at it. Of course, they're going to have the cool lines. Of course, they're going to tie you into knots. It's like you apply to a job at Facebook and they're like, "This is great! Come back to us with your job offer from Google and Apple, and we'll go from there. So just let us know how it goes!"

Right? That's not a job offer! Consider this a provisional job offer, assuming that you can get an offer from Google and Apple. And like, even better, like sign something like, "Yeah! We'll sign something or we'll give you something that looks official, but..."

And again, to be clear, maybe someone will see this and be like, "Oh, but that's, you know, what about this? What about that?" Like sometimes there are cases of investors that can't write big checks and they want to invest alongside other people. This happens sometimes; that is possible.

So we're not suggesting this is all things in all universes. We're just saying a lot of YC companies hear this line and what it usually means, you know, what it means in our experience is no.

Let's talk about investor incentives. Do you believe investors are incentivized to tell companies to raise more money or less money and why?

I think it depends on the stage that the company is at. I think for tiny startups, investors aren't going to fund them anyway, and so saying what they want to hear—like saying smart things that capture mind share—so that when you do get successful they'll want to come talk to you, is not a bad idea.

So I don't know how to perceive that. I think for companies that they actually want to fund or perhaps they've already funded, I think it is reasonable as an investor to want the company to get huge. Investors are going for a huge outcome, so still with me, right?

And so that often looks like you should be growing faster. "Oh, your revenue looks flat; you should be spending more on sales; you should be spending more on marketing."

And so coming from a good place from their perspective, you might have a misalignment of incentives sometimes where the investor—the worst thing you do for an investor is, like, be profitable but not grow fast enough for them. Versus if you're a founder, that ain't so bad.

Well, I think what I've seen is the investment community has changed a lot. I think that, you know, 10 years ago we were seeing a lot more very small funds and a lot more angels investing in companies. I would argue that they were less professional.

And I don't mean professional in a good way; I actually mean professional in a bad way. Like their interests were a lot more aligned with the founder. I think that as there have been more and more kind of professional seed funds being built up, now those seed funds have obligations to their LPs, to their investors.

They have kind of internal goals about how much of your company they want to own to make sure their business works. And as the seed funding world professionalizes, it opens up doors for there to be a misalignment of incentives.

I've seen a lot of situations where a fund wants the founder to take more money, not because they think more money is going to help the company, but because they have an ownership target, because they want to own 10 percent.

And so I think that nowadays, there's so much money out there. Investors have a lot more incentive to convince founders they need more money. Right? Money is what the investors are selling. When there's a lot of money out there and a lot of investors out there, the easiest way to compete is like, "Hey! I'll give you more money! You need more money! Let me try to make you afraid that you don't have enough money so you'll take my money."

And I think that the best founders understand that investors have incentives of their own—not bad or good. They're not evil or like angels. It's just more like, "We're investors too, Michael! Yeah, that's our agenda here!"

Like I just think that a smart founder understands that people they're negotiating with have their own goals and incentives, and they take a second to think about those incentives when they're hearing the sales pitch, as opposed to just kind of believing things blindly.