Mark Suster

Different investor prices in the same VC round?

September 20, 2012: 3:30 PM ET

Should all early-stage investors live by the same valuation?

By Mark Suster, contributor

If you were on Twitter this past Saturday, you might have noticed a lively discussion with Dave McClure, Fred Wilson, Chris Dixon and myself. And a few others.

Luckily there are tools like Storify – so you can actually see a synopsis here.

If you do an uncapped note it's bad for the investor. If you do a capped note it's bad for the entrepreneur. I'm not sure why people don't see that. It has both a "full rachet" and "multiple liquidation preferences." I wrote more about it here.

Fred, who also wrote about convertible debt (significantly more succinctly than I) believes that the price of a single round should be the same for everybody.

For the most part I agree with Fred. I would never as a VC fund a round and then expect somebody else to pay a higher price right after me. I also would never expect another VC to do that to me. We're either "all in the round together" or we're not.

But Paul Graham really did have a point in his "high resolution fundraising" post – that there is a problem – particularly in angel financing – with herding cats.

Since 2009 I have been counseling people to offer discounts to the first angel investors. It is part of my stump speech:

With the tagline something like,

"Most investors are sheep. They hate making decisions. They're looking for "social proof." It shouldn't be – and most people deny it – but I have found it to be true.

The trouble is, nobody has an incentive to agree to write the first check. And no matter how rich people are – they still want a good deal. That's probably how they became rich in the first place.

So you need an anchor. But how to get one?"

If you remember the three rules of sales:

  • Why buy anything?
  • Why buy me?
  • Why buy now?

The last one kills all deals. There is simply no reason for the first angel to write you a check until you have the whole round secure, which is why people herd cats. Here is what I recommend very often – privately – to startup entrepreneurs for angel funding.

1. Price the round. Everybody deserves to know how much they're paying and the people who commit when you are at your most risky deserve to pay less for that risk.

2. You need an anchor. Two ways to get one. First, you can make somebody an advisor and get them working with you. And after you feel they're bought in intellectually and emotionally you can ask them to make a small investment. This can be time consuming.

The second way is to pitch them like normal but offer them a discount. The pitch is really simple:

"We're going to be raising $750,000 – $1 million. We plan to raise at a $5 million pre-money valuation.

We know how hard it is to get the first people committed. And we know it's a challenge to herd cats. So we've reserved the first $150,000 at a $2.5 million pre-money.

We would be honored if you would consider being one of our first angels."

3. You can do it with equity and a price. You simply draft up a series seed term sheet. In the document it outlines that you will issue stock at a $5m pre-money valuation and in recognition of the additional risks and commitments of early money you have allocated warrants to the first $150,000 of investors. You outline that you need at least $150k to do your first close and that your maximum round size will be $1 million in total. They way it works structurally is that you issue stock (let's say it's at $1 / share) and for the first 150,000 shares you also grant a warrant for common stock equal to $1 for every share they buy. That means they get a 50% discount to the round.

I don't believe that VCs or professional seed investors ought to get this discount. It's bad precedence for the reasons Fred outlined. But nobody would care if a high-profile (or not so high-profile) angel got it. Especially if it was memorialized in the documents why you were doing it.

That should offer enough "resolution" to do multiple closes. The next people who close pay full price and since you've already hit the minimum raised they can just close as you collect checks.

By the way, this is EXACTLY how VCs close their funds.

And if you absolutely had to do an interim funding at a mid-way point you could always issue a half-a-share in warrants for every full share purchased for the second $150,000.

I've seen it done several times. It works. The fact that you can't do it without debt is a canard. Think about it … once you DO convert your debt to equity in the future … this is exactly what you're eventually going to do anyways.

And finally, in my opinion – that first investor is taking real risk. The rest of the round might not close. They might have all of their money smoked. I'm ok with that getting a discount. And you should be, too.

  • Almost every startup needs an anchor
  • Almost every wealthy angel wants a deal

Mark Suster (@msuster) joined GRP Partners in 2007 as a general partner after selling his company to Salesforce.com. He focuses on early-stage technology companies. He blogs at Bothsidesofthetable.com

  • Quick hack for speeding up negotiations

    Proximity is key to getting a deal done.

    By Mark Suster, contributor

    The very first time I ever negotiated a term sheet was very frustrating. I was desperate to get my funding finalized to derisk my business, as well as to get capital in the bank to meet our growing cash needs.

    But my VC didn't seem to be in such a rush. Nor did his lawyer. The process went something MORE

    Mar 21, 2012 12:09 PM ET
  • Should startups focus on profitability?

    By Mark Suster, contributor

    I find it amusing when a journalist writes about a prominent startup and decries that, "They're not even profitable!"

    I mention journalists because they perpetuate the myth that focusing on profits is always appropriate, and then I hear many entrepreneurs (and certainly many "normals") repeating the same mantra.

    There is a healthy tension between profits and growth. To grow faster, businesses need resources in today's financial period MORE

    Dec 27, 2011 9:08 AM ET
  • Rating Netflix's recent actions

    By Mark Suster, contributor

    A month ago I applauded Reed Hasting's bold decision to split his business into two components. Now he's reversed course.

    Netflix (NFLX) as a service has always prided itself on movie recommendations that are tailored specifically to you plus user ratings on the quality of films. So let me use their ratings system to judge their actions to date:

    The big price increase: 5 out of 5 stars. The MORE

    Oct 11, 2011 1:29 PM ET
  • Why Reed Hastings should be applauded for Netflix split

    By Mark Suster, contributor

    FORTUNE -- By now you've probably heard that Netflix (NFLX) is splitting its business into two parts: Its digital streaming business (retains the name Netflix) and its DVD mailing business, which was its original business (to be called Qwikster).

    If you haven't read Reed's explanation of this split make sure you do so. It's simply brilliant.

    1. He acknowledged mistakes in his past communications and apologized
    2. He offers a MORE

    - Sep 19, 2011 6:15 AM ET
  • 10 marketing lessons for tech startups

    How to, and how not to, market a tech startup.

    By Mark Suster, contributor

    I made every textbook mistake at my first startup, which is why I believe I was much more effective at my second one. We need to learn from doing, by trial-and-error. Good judgment comes from experience, but experience comes from bad judgement.

    So if I can help you avoid some of my first-time mistakes, it would be a victory. The MORE

    Jun 27, 2011 4:49 PM ET
  • What to make of Peter Thiel's "20 Under 20″ program

    Is higher education a prerequisite for entrepreneurship, or is it okay to encourage the best and brightest to drop out?

    By Mark Suster, contributor

    Several people have been asking me to weigh in publicly on the "20 under 20″ initiative announced by Peter Thiel, in which he will award up to $100,000 to 20 people under the age of 20 who agree immediately to pursue entrepreneurship (the implication of which is that MORE

    Jun 2, 2011 9:51 AM ET
  • What should you do with your crappy little services business?

    By Mark Suster, contributor

    There's a line of thinking in Silicon Valley that you should build product businesses rather than services businesses. This thinking is largely driven by the venture capital industry (and subsequently Wall Street) who are in search of high margin, highly scalable businesses. It's nearly impossible to get a services company financed by VCs. You're a small fish.

    So pervasive has this thinking become that on several occasions MORE

    Apr 26, 2011 9:40 AM ET
  • How startups can use metrics to drive success

    Mark Suster joined GRP Partners in 2007 as a general partner after selling his company to Salesforce.com. He focuses on early-stage technology companies. He blogs at www.Bothsidesofthetable.com

    One of the things I discuss the most with the portfolio companies I'm involved with is that "you manage what you measure."

    It's a very important concept for me because startups are constantly under pressure and have way too many distractions. Having a set MORE

    Apr 5, 2011 11:18 AM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.