How to Get $20M Pre-Money

A raging battle over how startups should be funded at the early stage become front page news this week with two new entrants and one industry veteran chiming in with highly-conflicting philosophies.

In one corner is Paul Graham or PG from YCombinator who told his companies this week to just say no to Google Ventures if taking money from them meant having to lower the cap on notes from other committed investors. In the other corner are Google Ventures and Vinod Khosla. They argue that startups are better off working with value-added investors even if that means taking a lower price. For Graham, it is a departure from his stated philosophy: “The most important thing to remember about fundraising is to get it over with and get back to working on the company.”

Like any VC, Google Ventures is offering valuations that they believe are appropriate. Others believe the prices are hyped up. One way of looking at it is that any investor is offering a major increase in valuation from what the startup accepted just 90 days prior when they entered YC. Graham invests at between a $200k-$300k valuation on entry. If Google Ventures offers $3M pre-money, that is a 10-15x step-up. Another view of this is that accelerators are not really investing in a priced round, but rather playing more of a co-founder role. Either way you interpret this, the stakes and emotions are high.

For any accelerator, it may not be the best strategy to alienate active investors like Google. To be successful, YC needs investors to keep showing up to demo days and funding these companies. And more importantly, incubators need other investors to take the lead at mentoring these companies for the 8+ years after their 90 days are complete. Vinod Khosla makes this point loudly, that YC companies need “help not hype.” But Graham seems to not agree: “Maybe you’ll find enough from other sources that you can blow off GV.” Graham later clarified that he did not think GV was ‘a bad investor’ but was rather offering advice on how to handle a down-round-capped-convertible situation.

Thomas Korte who manages AngelPad accelerator , ranked #4 by Forbes as a top global incubator sees things differently. “The right amount of funding is a lot more important than the cap – we help founders to understand the long term implications of high caps. The focus should be on getting the right (funding) team in place to increase the chance of a great outcome” Korte points out.

David Cohen, who founded TechStars, which is ranked #2 by Forbes as a top global incubator, agrees. “It’s our job to make sure the founders don’t destroy their company at the first financing event. This can happen if they take money at a valuation that they can’t live up to for the next round, or if they focus exclusively on price and end up making the deal impossible to do for the most value added investors”.

Ex-Intuit product leader Brett Hellman who graduated from Angelpad and launched Hall.com turned down the highest offer from a large VC. “By turning down the highest offer, we were able to attract value-added investors wanting to participate to build a big business” says Hellman. One of the investors Hellman wanted was Tim Connors, who cut his VC teeth at Sequoia and USVP has recently launched PivotNorth Capital as a solo GP. “We heard stories from other founders about some of the larger VCs writing checks and never being heard from again, never responding to emails etc. We didn’t want that.”

Some accelerator graduates have experimented with “differential pricing” to solve the value-add gap, giving different convertible note caps to investors based on how much value they can add. Korte of Angelpad points out proudly that to date, no AngelPad company has ever raised money with “differential pricing”. He says, “The argument that some investors add more value than others, hence get favorable caps can be addressed by advisory shares instead.” Cohen of TechStars says, “We teach founders that they have to go by their own moral compass. While there’s nothing immoral about taking notes with different caps, it should be fully disclosed. Changes in value can occur due to timing or the value one investor brings but I believe in transparency. After all, investor relationships should be built on the basis of trust and not on the basis of getting the best deal for yourself in some sneaky way.”

Connors adds, “Founders should innovate in how they solve problems for customers, not on how financings are structured” commenting that equity has worked well for decades and is fast and simple to close with efforts like SeriesSeed.com. He then throws down the ultimate gauntlet, “Accelerators would do founders a real service if they had a standard deal not just on entry, but also on exit from the accelerators 90 days later. Let investors compete on their ability to help the company for the next 8-10 years not on who will agree to the craziest terms” Now, how’s that for a challenge?

Taking in just the right amount from value-add investors, without getting clever and issuing multiple notes may sound old-fashioned. Even as PG, Vinod Khosla and Google Ventures duke it out, my personal favorite amongst all this drama – Foundry Group VC Jason Mendelson. When an eight-year-old founder (and his co-founder, a dog) asked for a $20 million pre-money for a company they started last week. Foundry VCs, instead of getting upset, wore bright florescent suits and danced to this crazy-funny song video that states the obvious:

“Twenty-pre? I can’t believe? You think that’s cheap?
For a company you started with your dog last week?”

Mahendra Ramsinghani, has invested in 40 startups, and has been suckered into “multiple cap” notes. The views presented here are entirely his own.

Photo courtesy of Shutterstock: http://www.shutterstock.com/gallery-730744p1.html