Not Building a Unicorn

TL;DR: In a market that has historically idolized huge, splashy financings and exits, an increasing number of entrepreneurs are realizing that everyone else’s definition of success – particularly among certain large VCs – isn’t necessarily aligned with their own.

While I work with a few companies in Silicon Valley, the vast majority of my clients are either in Austin or ecosystems that look much more like Austin than SV; “second tier” tech communities. Over time it has become crystal clear to me, and has been confirmed by CEOs I work with who spend time in both places, that the SV community has a far more binary outlook on business success than “normals” do. There is very little time for, or interest in, companies that would legitimately call a $50MM or $100MM exit a true success.

This is most clearly highlighted in the “unicorn” boom we all saw over the past few years, where founders raised very large rounds, with terms very onerous to the underlying common stock, hoping they could eventually justify billion dollar valuations to skeptical acquirers or public market investors. The result of the binary philosophy is, in fact, truly binary outcomes for founders. The handful who truly succeed at justifying their valuation in an exit achieve “buy a yacht” level wealth. And those who in a different world may have built a business that made them “merely rich,” walk away with virtually nothing; their stock under water. 

A good portion of the newer generation of entrepreneurs has, in my opinion, wised up to this reality; certainly outside of SV, where I work. They’re thinking much harder about what kind of business they want to build, and what kinds of people and resources they want to use in building those businesses. And many are accepting, and even flaunting, the fact that, while they absolutely want to achieve success and wealth, they have zero interest in following the conventional “unicorn track.” The below is a list of issues that founders should keep in mind when deliberating on their own desired path to scaling their companies.

1. The binary “get yacht-level rich or die trying” mindset is driven, first and foremost, by large institutional investors. 

Success for institutional VCs is driven not by absolute dollars returned, but by % returns on capital. If I put in $2MM and get out $10MM in a $50MM exit, that’s a solid 5x return. But if I put in $10MM and get out $15MM in a 50% larger exit, that was still a waste of my time; only 1.5x. Large funds write larger checks because they lack the mental/resource bandwidth to actively manage a portfolio of smaller investments. Most individual VCs can only support about 7-10 companies at a time. And large checks require very large exits to achieve good returns.

Entrepreneurs sometimes assume that accepting money from a large fund is better than a smaller fund, because they have more “dry powder” to deploy for follow-in financings, but this is a dangerously simplistic way of assessing investors. A large fund is much more likely to get impatient with an executive team if the business is growing, but not growing fast enough for their needs. Align yourself with a fund whose exit expectations are not totally misaligned from your own.

2. Higher valuations almost always require larger rounds, which drive binary outcomes.

Some founders assume that a higher valuation is always better than a lower one, but they are wrong.

First, investors will sometimes be willing to take a higher valuation if it means getting a heavier liquidation preference. Should you accept a 3x liquidation preference with a $15MM valuation instead of a 1x preference at a $8MM valuation? If you’re confident you’ll get a huge exit, maybe. But for normals the answer is almost certainly no. That 3x preference has dramatically increased the hurdle you need to clear in an exit before the common stock (you and your team) get anything, and it will likely get duplicated in future rounds. Onerous liquidation preferences push the common stock further under water, and increase the likelihood that the common will get little or nothing in a “merely rich” exit.

Secondly, most institutional investors have a minimum post-closing % they need to own in order to justify an investment. By driving the valuation up, you’re usually not reducing your dilution in the round; you’re just increasing the size of the check they need to write in order to get to their desired %. That can be good if you truly believe every dollar will lead to more than an extra dollar in an exit, but keep in mind that liquidation preferences are tied to dollars in by investors. If the investors have a 1x preference, a $5MM round means the investors have to get $5MM back before founders get anything; and the same is true for a $15MM round. More money raised means more liquidation preference, which again means a larger hurdle to clear in an exit before the common gets anything. Large rounds, again, drive binary outcomes.

When an investor tells you that you should keep your Series A smaller, they truly are sometimes doing you a favor. And, sorry, but if you know you’re not building a unicorn, don’t talk to your investors about why you should get that lofty valuation just because X or Y company in SV got it too. Likely exit size ties directly to what seed or Series A valuation is appropriate.

3. Angels/Seed Funds v. Institutional VCs think very differently.

Put the above two points together, and it shouldn’t require very much explanation for why Angels and Seed Funds tend to be more amenable to “merely rich” exits than large VCs. They write smaller checks at earlier, lower valuations, and therefore an exit that wouldn’t move the needle for a large VC still looks great to them. Obviously they too prefer larger exits over smaller ones, but their definition of success is still much more aligned with “normal” entrepreneurs.

Angels and seed investors may want enormous exits, but large institutional VCs need them, and they behave accordingly.

We’re increasingly seeing entrepreneurs who take on angel and seed fund investment, but are much more cautious when it comes to larger institutional checks. And as online tools and new ecosystem resources (i) allow angels and seed funds to syndicate larger early-stage rounds, and (ii) un-bundle the value-add resources once limited to larger funds, non-institutional Series As (or larger-than-usual seed rounds) are going to continue to be a thing.

It can often take a few years of being in the market to get a clearer picture of what kind of company, in terms of size, you’re likely building. It can be a good strategy to avoid making a hard commitment to an investor with hyper growth needs/expectations until you have that clarity. 

4. Understand the tension between “Portfolio” v. “One Shot” incentives.

Listen to enough VCs at large firms w/ broad portfolios talk about startup finance, and you will inevitably hear the term “power law” come up. In short, they’re referring to the fact that most of their investments either fail or merely return capital, and it’s the grand slams that make up for the other losses.

This is the distributed portfolio mindset; i’ve got stakes in a lot of companies, so it’s OK if most fail, as long as I get at least one unicorn. In fact, if I push them all to try to be a grand slam, I’m more likely to get at least one. On the others, at least I’ll get my money back before anyone else does.

The fact that (i) investors have a liquidation preference that prioritizes the return of their capital in an exit, and (ii) their money is distributed across a diverse portfolio, means that they are structurally far more inclined to favor fast growth paths that produce a handful of very large exits even if they also produce a larger number of companies for which the common stock get nothing. At its core, this is precisely why the idea that founders/employees (common) and institutional investors (preferred) are “fully aligned” economically is completely laughable. 

A strategy that maximizes returns over a diversified portfolio with significant downside protection can completely screw individual stockholders whose own stakes are limited to one company, and at the bottom of the preference stack.

Startup ecosystem “cheerleaders” who lament the lack of billion-dollar, headline-making companies in their city reflect part of this portfolio mindset as well. If I’m not toiling away for 10 years on one company, but stand to benefit from the broader ‘ecosystem,’ I may also favor a business philosophy that pushes entrepreneurs to build big, splashy unicorns (large rounds, very fast growth), or otherwise crash & burn.

Reality check: entrepreneurs don’t have portfolios, and don’t have liquidation preferences. They have one shot, and they’re slogging away 5-10 years for that one shot; not for your “ecosystem.” If I have 100x skin in a single game over everyone else, I’m going to have a fundamentally different outlook on how that game should be played.

When I hear someone complain that Texas hasn’t seen a lot of strong tech IPOs recently, my response is “so there’s no other way to be successful?” Why should we favor 1 billion dollar company over 10 $100MM companies, or 20 $50MM companies? I can think of a few arguments for why the latter is actually more robust long-term from an economic standpoint, even if it produces fewer NYT articles. It certainly provides more variety.

Obviously it’s great when any city sees a true breakout, international brand-building tech company emerge. And Silicon Valley produces, and likely will continue to produce, the lion share of those.  But those of us sitting on the sidelines, and not toiling away on one egg in one basket, need to be humbly mindful of how our discussions on success play out in the lives of entrepreneurs actually doing the work.

Elon Musk. Steve Jobs. “Change the world.” “Put a dent in the universe.” “Move fast and break things.” “Shoot for the moon; you’ll land…” yeah, ok, I think we all get it. Can we please let some entrepreneurs “just” build successful companies that make their stockholders “merely rich” – and skip the super hero cape, global domination, rocket ship, and mythological creatures? There is a big, lucrative world in the space between “small business” and “billions” that many smart, ambitious people are happy to fill. 

I think the greater awareness of this issue, and the overall shift in thinking among entrepreneurs, is an extremely healthy development for everyone. It will lead to more sustainable companies, and a healthier entrepreneurial culture. If you’re building the next Facebook, by all means go ahead, and align yourselves with people looking for a ride on that train. But the other 99.999% of the world doesn’t need to apologize, at all, for building companies that are “merely successful.”

Do I need a PPM for my startup’s financing?

TL;DR: Legally speaking, probably not. Most tech startups never prepare one.

PPM stands for “Private Placement Memorandum.” You can think of it as the private company equivalent of an S-1, the long disclosure document that companies produce when going IPO. PPMs are lengthy documents that include risk factors, financial projections, business plan information, etc.  For a broad description of what a PPM is, see this article.

In dense startup ecosystems, PPMs are rare.

Startups in dense, more mature tech ecosystems like SV or Austin usually don’t even think of producing PPMs; nor should they. Assuming that they are taking the classic approach of raising money only from accredited investors, a well-made deck and a solid operating plan are often their core needs for closing on early money. Delivering an Austin tech investor a PPM would send an immediate signal that the founders aren’t being well-advised, which itself signals poor judgment in choosing advisors. 

Asking for a PPM signals inexperience.

In less dense ecosystems, however, I do occasionally encounter tech companies who are told by advisors, lawyers, or other players that they need a PPM to close on financing. FACT: The vast majority of tech startups raising money solely from accredited investors are not creating PPMs, and legally speaking, they don’t have to.  Most repeat ecosystem players consider PPMs a waste of time and money. 

One of the main reasons that startups avoid non-accredited investors and stick to accredited-only rounds is that the legal disclosure burdens are dramatically reduced, which means no need for PPMs. In healthcare, energy, and a whole host of other industries, using PPMs in private fundraising is very common. For this reason, if your lawyer is telling you (a tech startup) that you need a PPM, that’s often a good ‘tell’ that they lack experience in the norms of emerging tech financing. 

Exercise diplomacy with more traditional investors.

All of the above being side, I have also on occasion encountered more traditional investors who, because they do not regularly invest in emerging tech companies, ask startups for PPMs (because PPMs are more common in other industries).  All money is green and, particularly for early angel money, you need to be respectful of the expectations that angels bring to the table; even if they’re ‘off market.’

In these situations, it’s best to diplomatically let them know that PPMs are not the norm in the tech startup space, and that the company would prefer (as should they) to focus its legal budget solely on those things that are truly needed.   Asking a more traditional investor what specific information she/he was hoping to see in the PPM, and trying to address those concerns more informally, usually goes a long way to bridge the gap. Sometimes hearing directly from a Tech/VC lawyer about the norms of startup finance also helps. 

Founders outside of Silicon Valley can sometimes forget that most of the resources – blogs, articles, podcasts, tweets, etc. – on startup finance and norms are, in the grand scheme of things, a tiny bubble in the overall business market.  When anyone says there simply “isn’t enough money” available for startups in Texas, or markets similar to Texas, what they really mean is that there isn’t enough money flowing into tech companies. There’s tons of money floating around elsewhere. People who can culturally build bridges between tech ecosystems and more traditional business networks have a competitive advantage in the market, and are often the ones forging ahead building new companies, and even investment funds, while others run around in circles soliciting only the ‘techies’ of the market.

Pre-Series A Startup Boards

It’s pretty well known that startups usually undergo a meaningful change in Board composition at their Series A round. At a minimum, the lead investor(s) of the round get Board seats; although they shouldn’t get Board control.

Less has been written about what startup boards tend to look like before a Series A round. Given that the time from formation to Series A has stretched out significantly for many companies in the market – due to pre-seed, seed, seed plus, seed premium, series seed, seed platinum diamond, whatever-you-want-to-call-not-Series A rounds. So here’s some info on what a board of directors tends to/should look like Pre-Series A.

A. Know the difference between a ‘Board’ of Advisors and a Board of Directors.

A lot of companies refer to their set of advisors as a ‘Board’ of advisors. That’s fine, even though they very rarely actually act like a board. There (usually) aren’t ‘Board of Advisors’ meetings where everyone gets on a conference call and talks shop. Instead, the company just has a loose set of individual advisors they work with on strategic matters, often in exchange for equity with a vesting schedule. Advisors often times are angel investors as well.

The important point here is that Advisors have no power/control over the company. They just advise. The Board of Directors, however, is the most powerful group of people in the Company, with the ability to hire and fire senior executives and approve (or block) key transactions. Big difference. Giving someone a seat on your Board of Directors is 100x more consequential to the company than naming them an advisor.

B. Know the difference between a Board Observer, Information Rights, and being a member of the Board of Directors. 

Most angel investors writing small checks are buying the right to a small portion of the Company, and that’s it. They don’t expect to be very involved in day-to-day, and are happy to just receive whatever e-mail updates the Company intends to send out.

Angels / Seed Funds who write larger checks may want a deeper view into what’s going on in the company. They’ll often ask for different variants of ‘information rights’ – which can include delivery of regular financials, and notification of major transactions (like financings).

A step up from ‘information rights’ is a Board observer right. This means the investor has the right to observe everything that happens at the Board level, which includes hiring people, equity grants, approving major deals, etc. Do not dish out Board observer rights lightly. Having too many observers can make it difficult to keep confidential matters from being leaked to the market. It also can just be logistically cumbersome for a seed stage company to keep track of who gets to attend meetings, who has to be notified of what, etc.

Also, if you do give someone a Board observer right, ensure that it’s clear that they are a silent observer. This means that they can listen in on Board discussions, but they are not entitled to provide their thoughts/input, which can have legal ramifications and influence the true decision makers.

C. Giving seed stage investors Board seats is not the norm. Take it seriously. 

The majority of companies we see have Founders only on the Board before closing their Series A. Sometimes it’s just the CEO; other times it’s 2 or 3 founders. That’s very much driven by the personal dynamics among the core team.

Occasionally a seed or VC fund writing a large seed check ($250K+) will request a Board seat for their seed investment. While not the norm, it’s also not terribly off market if a large check is being written. Founders should just understand that giving anyone a Board seat, even if they don’t control the Board vote, is inviting them to give their input on every single major strategic decision the Company will make. It is a very deep commitment, and should only be given to people you believe can deliver real value to the business, and whose values are aligned with the founder team. Otherwise you’re asking for unnecessary and distracting drama.

If the fund that wrote the large seed investment has deep enough pockets to lead a Series A, and is interested in leading your A, this adds even more layers of complexity to the decision. A *true* seed investor who only invests in seed rounds can be an asset in sourcing Series A leads, because those leads are a complement to their position. A VC who dabbles in seed investment for pipeline purposes, however, has opposite incentives; assuming you’re doing well, they may prefer to lock out other potential competitors and take the Series A round for themselves. Having a VC already on your seed-stage Board can make it harder to get term sheets from outsiders for your Series A.

This dynamic of committing early to a VC before you’re ready for a Series A is discussed somewhat in The Many Flavors of Seed Investor “Pro-Rata” Rights.  My experience has been that getting trustworthy VCs on your cap table pre-Series A is generally a very good thing, so long as their participation is not contingent on terms that effectively lock you into having them lead your Series A. That is the startup equivalent of getting married as a teenager, before you’ve had a chance to mature and really explore the market.

VCs who ask for board seats at seed stage, or who require that you guarantee them the right to a large percentage of your Series A (50%+) are trying to get you to lock yourself in early. You should want them to invest, but still ensure that they have to earn the right to lead your Series A.

D. Board composition should ‘reset’ at Series A. 

If you’ve ended up giving a Board seat to a large seed investor in order to secure their investment, it is extremely important that it be clear between everyone that the seat is not guaranteed indefinitely. Boards can only be so large. If your seed investor who put in $250K is guaranteed a Board seat forever, it makes it a lot harder to make room on your Board for the people putting in millions, or even tens of millions of dollars.

The logic here should be that if the seed investor insisted on a Board seat at seed stage in order to ‘monitor’ things early on, they should be comfortable letting go of the wheel once they know larger, more experienced institutional investors are taking over. Their interests as an investor are more aligned with the new VCs investing in the Series A than they are with the Common Stock. It simply is not appropriate for a company who’s raised $5 million, $10 million, $30 million+ dollars of capital to still have someone who wrote a $250k-500k check taking up a board seat. Board observer rights should also terminate at Series A, or perhaps Series B, for similar reasons.

So, in a nutshell, founders should start with the assumption that no one will join their Board of Directors until a Series A happens, and someone writes a 7-figure check; as that is the norm. However, for large checks from investors with strong value-add and alignment with the founders, there can be a justification for giving them a seat at the table, as long as it’s structured in a way that will not cause any issues, or prevent competition, in Series A negotiations. For investors who want (and deserve) something ‘extra’ on top of their investment security, advisor equity, information rights, and silent observer rights should all be explored as alternatives.

Electing a Truly Independent Director

TL;DR Nutshell: There are few governance-related decisions with a more outsized impact on a company’s power structure than the selection of an independent director. Do not take that selection lightly.

Background Reading:

In assessing financing terms and interacting with their lead investors, most founders instinctively focus on two core things: economics and control. And, broadly speaking, that is correct.  But the devil is in the details, and too many teams overlook extremely important details. They’ll focus on high-level issues like valuation, liquidation preference, and board composition (# of seats), and then prematurely check out once a term sheet is signed. And that’s when sophisticated players start executing their playbook for maneuvering into a controlling position regardless of what the black-and-white text says.

I’ve already written extensively on how one part of that playbook is for investors to push companies to use their ‘preferred’ company counsel. Another classic maneuver is to push the company to elect an ‘independent’ director with whom investors have significant ties and influence. 

Independent Director as Tie-Breaker

Independent directors are, arguably, the most important people on Boards of Directors.  They are supposed to serve as an objective voice on what’s best for the Company overall; balancing the incentives of common stockholders (management/founders) and preferred stockholders (investors) that can often pull in different directions. They should have no reason to be driven by control or personal payout.

It is not unheard of for there to be significant disagreement between the common and preferred stockholders on how to approach an important issue, and the independent director serves as the key vote in deciding which path will be taken. Having a trustworthy independent director is a great deterrent to stockholder lawsuits, as his/her approval makes it that much harder for a disgruntled stockholder to claim foul play.

For real independence, dig deeper

But what does “independent” really mean?

The wrong way to define “independent” is simply as “not an investor or employee.” That absolutely is part of the definition. But smart teams know that a person’s judgment and independence are heavily influenced by far more than just their front-facing professional status.

  • Does the candidate regularly invest in other startups alongside your investors, perhaps as part of a seed fund, accelerator network, or other group?
  • Is the candidate looking for other appointments, either as a director or a more-involved executive; potentially at companies where your lead investors could deliver access?
  • Does the candidate spend time in social / business circles where, if they were forced to make a hard decision that angered one side of the board, either members of management or the investor base could exert pressure out of retribution?

Sophisticated business players are masters at finding leverage in their social / business relationships to push a deal in the direction they want it to move. And some founders are quite good at it too. truly independent director should be minimally exposed to the carrots or sticks that either side of the Board might use to sway a key decision in their direction.

Ideally, an independent director will be someone who has a relatively equal pre-existing relationship both with the founders and with the investors. But because founders often have significantly narrower networks than their lead investors (who are repeat players), that is easier said than done.

More often than not, VCs will propose someone from their preferred ‘roster’ of independent directors; people whom the founders (particularly first-time founders) don’t know at all, or only barely know. Given the loyalty and history that ‘roster’ will have to the VCs for dishing out serial appointments, those people should almost always be avoided. They’re not independent at all, no matter how much they might argue the contrary.

Specialized industry expertise is valuable.

If no viable candidates are available whom both sides can trust, then agreeing on a list of well-known industry players and pursuing their service together is often a very good idea.  Any arguments that an independent director must be local should be pushed back against if the right person is located elsewhere. Videoconferencing and teleconferencing are highly effective, as are airplanes.  If your independent director doesn’t ‘feed’ from your local ecosystem, that can be a good thing in the right context.  Skillset trumps geography.

Someone who not only has the necessary character to be independent, but has specialized knowledge that management and (often) generalist VCs do not, can be invaluable by opening up industry contacts, and helping overcome challenges that are unique to the market a company is engaging.

If you’re building a health tech, or energy tech, startup taking on a massively complex and entrenched market and no one on your board has engaged deeply with that market, that is usually a red flag that politics has trumped performance in determining the board makeup.

Avoid an empty seat.

When no one is available locally whom both sides can trust in the independent director seat, companies will often be pushed to leave their independent director seat empty until after closing. I typically suggest that companies avoid a vacancy if they can, unless they’ve built such a strong level of trust/rapport with their VCs that they’re 100% confident a true independent will get selected, relatively quickly, post-closing.

If you are closing with a balanced board structure of 2 common, 2 VCs, and 1 independent, but your independent seat is empty, you are set up for a stalemate; and stalemates work (like a game of ‘chicken’) against the people with the most to lose; which means founders. By simply refusing (often with any number of excuses) to approve a key transaction, a key hire, or a new fundraise, investors can push founders into a corner to get their preferred independent director elected. Yes, this happens.

Agreeing on a ‘temporary’ independent director to take the seat at closing, to be replaced when a permanent one can be found, is sometimes a good idea. Not ideal, and you should still be very careful who gets chosen, but it is often better than an empty seat.  If you are stuck with an empty seat at closing, push hard to keep the selection of an independent director on the near term agenda, and call out delay tactics when you see them. Your leverage decreases proportionately with your bank balance.

It’s not cynicism. It’s experience.

If in reading the above, you feel the advice carries a perspective that is a tad too cynical and untrusting, I suggest that you go talk to multiple founder CEOs who have gone through rounds of funding with institutional investors.  They will educate you, off the record. Some stories will have happy endings. But others will teach you the value of a little preparedness and skepticism.

Trust is extremely valuable in business, and I always tell companies that if they’ve found people that they can really trust, and who have proven themselves to be trustworthy over time, hold onto those people with their lives. Make them directors, advisors, officers, your kids’ godparents. Surround yourself with people you can really trust. See: Burned Relationships Burn Down Companies.

But institutional investors have a job to do, and it’s not to be your BFF. It’s to make a lot of money by (1) getting into attractive deals (buttering up), and then (2) once inside, pushing companies to achieve lucrative exits as fast as possible (turning up the heat). Pay close attention to how the behavioral incentives at stage (1) and (2) are very different, and prepare for it, so you don’t end up as the cooked turkey.

The best analogy I’ve found for how companies should interact with their lead investors is that of foreign diplomats engaging in high-stakes trade negotiations. They have something you want, and you have something they want. And while you’re visiting, smile, crack jokes, share photos of your kids and focus on growing the pie together. Try as hard as you can to make the ‘partnership’ resemble something close to a friendship. But when you get back home, make sure the arsenal is well-oiled; just in case.

When all your eggs are in one basket, and you’re sharing that basket with money-driven people who are 10x more experienced than you are, a healthy dose of skepticism keeps you alive. Others will say to relax, let your guard down, and not be so cautious; but their net worth isn’t riding on one horse. Do your diligence, and then build a relationship that you can leverage for the success of your company. But never lose sight of where everyone’s incentives lead. The moment you do, the reality check will be costly and painful. 

Having a balanced power structure, instead of a founder-controlled or investor controlled one, is a great way to build trust and alignment. If your VC terms call for a balanced board, make sure what gets implemented is actually, not just superficially, balanced. Treat the selection process of your independent director as seriously as that of your company counsel, and don’t let anyone take it off the agenda.

Local v. Out-of-State VCs

Some things in life are certainties. The sun will rise tomorrow, you will be taxed for something… and startup ecosystem players across the world, outside of Silicon Valley and NYC, will complain about the lack of local VC capital, and the need for more foreign capital. Are they correct in complaining? I’m not going to answer that question. Too debatable, and the debate gets you nowhere.

What I am going to say, and I’m saying this as someone who manages a legal practice with visibility into a decent number of 2nd/3rd ‘tier’ ecosystems in the U.S., is that there are a lot of reasons to be optimistic about the overall trends in this area.

The Historical ‘Scarcity Culture’ of Local Venture Capital

Not just in Austin, but in many tech ecosystems that have a similar profile, there’s historically been a culture among the institutional investor community that directly reflected the scarcity of local capital, and of information about that capital. I will call this ‘scarcity culture.’ Trying not to come off as too judgmental, because all institutional capital plays a vital role in the business community, regardless of its approach, I would say that scarcity culture is largely summarized with the following statement:

“You don’t like our terms or our behavior? What can you do about it? What alternatives do you actually have?”

Does this mean that all local VCs outside of the densest markets think that way? Of course not. But it is definitely there, in a variety of ways.

Anyone with a broad enough visibility into American venture capital knows it is an absolute fact that California VCs are generally ‘friendlier’ than the VCs of any other ecosystem. By ‘friendlier,’ I mean that they are OK with higher valuations, they are more transparent in their intentions, and they tend to show significantly more deference to a founder team in terms of providing coaching/opportunities for growth as opposed to an early pink slip.  Why is that?

Is it something in the water? The weather? Have they achieved a new level of enlightenment? Hell no. California VCs have the same job as VCs anywhere else: to make money.  The answer lies in one very simple word: competition. And increasingly over the past few years it is magnified by one more factor: increased transparency through technology and decreased friction in networks. 

Competition and Reputation. 

Let’s use an analogy here.  Do you think that restaurant service is better or worse in dense urban environments relative to small rural areas? Obviously it’s better. There’s more competition.

Do you think the existence of Yelp, and the ability of restaurant goers to (i) easily find information on the past experiences of patrons of a specific restaurant and (ii) easily express their own experience about those restaurants, has improved or reduced the quality of restaurant service? It obviously has improved it. There’s a million times more transparency, which dramatically raises the reputational stakes.

In an environment where a quality founder team can, if they don’t like one particular set of VCs, walk almost literally across the street and talk to 10 more, investors have learned (rightly) that to be an asshole is to step right into a massive adverse selection problem. Combine a truly competitive market with inter-connected networks where reputational information flows freely, and you have a system that naturally corrects for bad behavior.  The really good companies, the one’s that everyone would want to invest in, don’t have to put up with anyone’s nonsense; and they do their homework. 

Contrast that with ecosystems where only a handful of investors, many of whom collude with one another, are available for companies that need serious funds, and you have a very clear explanation for why California capital is ‘sunnier.’  California VCs are more “founder friendly,’ because their circumstances make founder friendliness an almost essential requirement for deal flow. Most assholes can’t even survive in that environment, so it selects for ‘nicer’ people.

I am not saying that west coast money is all cotton candy and rainbows; nor am I saying that non-SV local VCs are all difficult to work with. But broadly and relatively speaking California VCs tend to be much easier for a founder/management team to get along with. It is also no surprise that the rise of industry/vertical-focused VC and VC ‘value-add services’ has come out of California. They’ve got to find a way of differentiating themselves in the noise.

Transparency and Friction.

A decade ago, if you needed to connect with X person for whatever reason – to diligence an investor, to connect to an investor, to find out some piece of information – you faced enormous opacity in finding a path to doing so. This opacity added friction not only to connecting with people far outside of your personal network, but also to obtaining information, including reputational information, about market players. Information is essential for separating marketing/branding from reality.

Blogging is marketing. Twitter is marketing. Talking on panels is marketing. Free office hours is marketing. That free beer at the ‘get to meet investors’ meet-up is marketing. This should be obvious to smart CEOs. Yes, this blog is marketing. Calling something marketing doesn’t mean it’s false; it just means you’re acknowledging the incentives behind it. And that you need a mechanism for verifying what you’re being told.

My method in biz dev is simple: “here’s a list of my clients. reach out to any of them, and don’t tell me which one. Ask them about our rates, and our responsiveness, and the independence of our counsel. I welcome diligence.”

Today, if I run into a set of founders who are talking to VCs, whether they are clients or not, I say “Here is a list of their past investments. Get connected to the founders of those companies, and start asking questions. And don’t tell anyone which ones you are talking to. Don’t treat any single ‘review’ as gospel, because it is a one-sided story. But look for patterns.” For a team that is even mildly good at networking, that is a fairly straightforward task. LinkedIn does 80% of the work for them by letting them know exactly who in their existing network, whether they’re local or not, can connect them to their target.

Tools like LinkedIn, AngelList, Facebook, and Twitter, and the way in which they eliminate huge amounts of friction and opacity in networking, have done two game-changing things for founders: (1) they’ve made expanding their networks beyond their local ecosystem 10x easier (I didn’t say easy, I said easier), and (2) in doing so, they have made finding accurate reputational information about market players 100x easier. That ease of accessing accurate information influences the behavior of investors in exactly the same way that Yelp influences the behavior of restaurants.

In an opaque market in which influencers can control access to people and information, you can reap the benefits of being an asshole without facing many of the costs. Today, the transparency brought about by modern tools and networks has made the costs of bad behavior 10x higher. Technology makes technology investors ‘nicer’ by opening up access to accurate information on market players. Knowledge is power. 

Improving Local VC. Accessing out-of-state VC. 

Thinking of this issue broadly with the above concepts: improving transparent access to accurate information, removing friction in expanding networks, increasing competition, I think we can arrive at some useful ideas for both improving the local investor environment in non-SV markets, and in increasing the flow of capital between markets; beyond the “great companies attract great capital” truism that rightfully causes eye-rolls among founders.

1. Founders/management need to talk to each other more, in places that aren’t controlled by the investor community. 

Information flows most freely when the consequences of sharing it are minimized. You better believe that in some markets where key players serve as gatekeepers (see: Gatekeepers and Ecosystems) the threat of being black-listed somehow for speaking honestly is real. You will never get accurate market information on blogs, on twitter, on panels, or in highly public events where anyone and everyone is watching.

To use Brad Feld’s categories: there are entrepreneurs, and then there are “feeders,” which sort of means everyone else. Events and communities where the whole ecosystem is invited are great. But that entrepreneur v. feeder divide is crucial, and there need to be ways for entrepreneurs to share information with each other, confidentially and alone.

That is the best way to create the following causal chain: (1) bad market behavior -> (2) information shared to broader entrepreneurial community -> (3) adverse selection for bad market player -> (4) correction to behavior.  You get along much better with the VC community when, instead of moralizing about their tactics and behavior, you try to understand their goals and their incentives; and find ways to align them with yours.

2. Outreach to foreign capital needs to come from people who don’t benefit from a scarcity/opacity environment.

Do not expect for a second that market players who benefit from scarcity of local capital and opacity of information will improve the environment for you. In a variety of ecosystems, I have seen circumstances in which local capital deliberately tries to keep out-of-state capital off of a cap table if it is not willing to enter on their terms. If a founder team builds local support and then themselves builds independent relationships with out-of-state capital (directly or via local relationships), that will create very different dynamics relative to a situation in which their local capital syndicates with its own existing out-of-state syndicate partners.

Is building those out-of-state relationship easy? Of course not. But it needs to start early. The companies that successfully receive out-of-state participation in their Series A round often were building those relationships at seed.  And the best intro to a particular investor is through a founder that they already invested in, so local founders who’ve accepted out-of-state capital are vital to encouraging that capital to engage more local companies. Once a foreign VC has made an investment in a city, it is a lot easier for them to look at others.

The angel v. institutional capital divide, highlighted somewhat in “Protect Your Angel Investors” is important here too. True angel investors – not the ones that behave essentially like micro-VCs, but the ones who are playing with their own money and who are really in it for more than just a return – typically behave very differently from institutional capital. They are usually more patient, more attached to the founder team, and usually aren’t laser-set on a “10x or bust” mindset that institutional investment often brings. Angel investors with broad networks can play a huge role in encouraging out-of-state capital to enter new ecosystems.

Just please for all things holy ignore any set of lawyers pretending to provide ‘special access’ to out-of-state investors. There is a hierarchy of paths to investors. If lawyers are even on it, they are near the bottom.

3. De-risk long-distance investment by improving communication.

If I’m an investor deciding whether to invest locally or make a bet on a team 1,000 miles away, I see substantial additional risk in the latter simply because of the added friction in communication. This is particularly important at seed/Series A, where feedback loops between investors and founders are more important. Think of ways to signal to long-distance investors that you will actively remove that friction.

Videoconferencing, well-done regular investor updates like through AngelSpan, committing to flying to meet-up in person regularly, are a few ways to do this. If entire companies can run with remote teams, leverage similar mechanics/tools to make long-distance startup investment seem natural and logical.

4. Reduce search costs. Successful curation is king. 

Finally, while communication issues often make long-distance investment at least seem difficult, you should never ignore the fact that to any investor, simply vetting out-of-state companies is much harder than vetting local ones. Most institutional investors build in various filters and qualification mechanisms into their pipeline/deal flow, and they often break down when looking at companies that are mostly outside of their usual network.

So creating credible, successful curation mechanisms to reduce the ‘search costs’ of institutional investors exploring non-local markets is essential. The obvious answer here is, and has been, accelerators; at least to the extent that accelerators aren’t beholden to particular local funds (in some markets, they are). The most prominent accelerators are playing extremely important roles in connecting companies in one market to investors in other markets, because those investors trust that the accelerator has done a significant amount of pre-qualifying for them. In fact, this curation dynamic is part of the core value proposition of accelerators in the first place.

Another obvious answer is angel investors with prominent personal brands. As angel investors develop broader reputations for selecting winners, out-of-state institutional capital can leverage them to reduce the search costs of exploring other markets.

So, is raising a Series A outside of Silicon Valley and NYC really hard? Absolutely. Then why the reason for optimism? Because every single variable/dynamic mentioned above is improving, and at an accelerated pace. Founders are finding each other and communicating directly, sharing accurate information about the investor community and other market players; aided by modern networking and communication tools. Local angels and entrepreneurs are actively using those same tools to expand their networks far beyond their local ecosystem. Tools for long-distance communication and investor relations are maturing. And accelerators and prominent angels are increasingly becoming curation mechanisms leveraged by institutional investors to reduce search costs and explore new markets.

We are certainly seeing all of this happening at an increasing rate in our work in the market. As additional funds that are more comfortable operating in the new environment pop up, and as geographic barriers are reduced for capital flows, the more established players are increasingly more concerned with their brands and reputation. Instead of a “scarcity culture,” an open, transparent market culture favors investors that deliver real value and build durable, authentic brands.

Raising local and out-of-state institutional capital, and ensuring you’re working with good people, is still extremely hard if you’re not in a top-tier ecosystem. And speaking as ‘just’ a lawyer, I don’t want to minimize that fact in any way.  But the truth is that it’s also never been easier, and the core trends suggest it will keep getting better.