Relationships and Power in Startup Ecosystems

TL;DR: The highly unequal relationship and power dynamics in most startup ecosystems mean that what is visible publicly is not an accurate representation of how the game is actually played, because few people are willing to speak honestly and openly. This makes off-the-record diligence, and watching loyalties of your most high-stakes relationships (including counsel), essential in order to prevent repeat “money” players (investors, accelerators) from dominating the voices of less influential “one shot” players (first-time entrepreneurs, employees) both on boards of directors and in the market generally.

Background Reading:

There are a few underlying themes that have been covered in a number of SHL posts and are relevant to this one:

First, in startup dynamics there is a fundamental divide and tension between inexperienced, “one shot” common stockholders and “repeat player” investor preferred stockholders (VCs, seed funds, accelerators) that feeds into all of the most high-stakes decisions around how to build and grow a company. It has nothing to do with good v. bad people. It has to do with core economic incentives.

Common stockholders (founders, early employees) typically have their wealth concentrated in their one company (not diversified), do not have substantial wealth as a backup in the event of failure, do not have the downside protection of a liquidation preference or debt claim on the company, and have almost no experience in the subtle nuances of startup economics and governance. This dramatically influences their perspective on what kind of business to build, how to finance it, whom to hire in doing so, and how much risk to take in order to achieve a successful outcome; including how to define “successful.”

Preferred stockholders / repeat players (investors, accelerators) are the polar opposite of this scenario. No matter how “founder friendly” they are, or at least pretend to be via PR efforts (more on that below), their core economic interests are not aligned with one shot players. They are already wealthy, significantly diversified, have substantial experience with startup economics and governance, and have downside protection that ensures they get paid back first in a downside scenario.  In the case of institutional investors, they also are incentivized to pursue growth and exit strategies that will achieve rare “unicorn” returns, even if those same strategies lead to a large amount of failures; failures which hit common stockholders 100x harder than diversified, down-side protected investors.

And the fact that some of the repeat players are themselves former founders (now wealthy and diversified) is irrelevant to the fundamental economic misalignment; though investors will often use their entrepreneurial histories as smoke and mirrors to distract now first-time founders from that fact. They can probably empathize more with the common’s challenges, and help with execution, but they didn’t become wealthy by ignoring their economic interests. In fact, I would argue from experience that the moves/behavior of entrepreneurs-turned-investors should be scrutinized more, not less, because they’re almost always far smarter “chess players” at the game than the MBA-types are.

Second, apart from the economic misalignment between the common and preferred, there is a widely unequal amount of experience between the two groups. A first-time founder team or set of early employees do not have years of experience seeing the ins and outs of board governance, or how subtle deal terms and decisions play out in terms of economics and power.  The preferred, however, are usually repeat players. They know the game, and how to play it. This means that the set of core advisors that common stockholders hire to leverage their own experience and skillset in “leveling the playing field” is monumentally important; including their ability to trust that those advisors will help ensure that the preferred do not leverage their greater experience and power to muzzle the common’s perspective.

This second point relates to why having company counsel who is not dependent on your VCs / the money is so important; and it also highlights why repeat players go to such enormous efforts to either force or cleverly trick inexperienced teams into hiring lawyers who are captive to the interests of the preferred.  We’ve observed this in pockets of every startup ecosystem we’ve worked in: that aggressive investors work hard to gain influence over the lawyers who represent startups.  The moment we became visible in the market as a growing presence in startup ecosystems, we lost count of how many of the strongest money players reached out to us to “explore” a relationship; even though they already had “relationships” with plenty of firms. It wasn’t that they needed lawyers; it’s their power playbook.

The point of this post is how these above facts – the economic misalignment, and particularly the greater experience – of influential investors (including accelerators) plays out into how they exert power, often covertly, in startup ecosystems; not just with lawyers.

Think of any kind of business that needs to work with startups as clients: obviously lawyers, but also accountants, HR, outsourced CFO, benefits, real estate, even journalists who need access to entrepreneurs in order to write articles. All of those people need strategies for “filtering” startups (finding the more viable ones) and then gaining access to them; and they’re going to look for strategies that are the most efficient and less time consuming.

What many of these service providers come to realize is that an obviously efficient strategy is to work through VCs and other influential investors/accelerators. They’re doing the filtering, and because they’re repeat players, have relationships with lots of companies.  So the service providers reach out to the prominent repeat players (investors, accelerators), who immediately recognize the power that this role as “gatekeepers” and brokers of relationships gives them over the ecosystem.

And when I say “power over the ecosystem,” what I mean is power over what people will say publicly, what they won’t say, and what “support” businesses become successful (or not) via the direction (or restriction) of referral pipelines. It heavily plays out into what gets written and not written on social media and in tech publications, and said at public events; because people are terrified of pissing off someone who will then cut them off from their lifeblood of clients.

“One shot” players are, by virtue of not being repeat players and lacking significant relationships, unable to counterbalance this dynamic.  Put together a system of highly influential and wealthy repeat players and inexperienced, less influential “one shot” players, and you can bet your life that it will inevitably tilt itself toward those who can exert power; with strategies to obscure the tilting from the inexperienced. The ability to offer (and restrict) access to valuable relationships is the leverage that repeat players use to exert power in startup ecosystems and ensure their interests are favored; even when they aren’t formally the “client.”

So let’s tie this all together. Founders and other early startup employees are significantly misaligned from the repeat player investor community in a way that has nothing to do with ethics, but core incentives and risk tolerance; and this is independent of the more obvious misalignment re: each side’s desire for more ownership of the cap table. They’re also totally lacking in experience on how to navigate the complexities of startup growth and governance, and therefore rely heavily on trusted outside advisors to level the playing field. Finally, the most aggressive repeat players will position themselves as gatekeepers to the ecosystem (or at least a valuable portion of it), exerting significant control over the market of advisors available to founders by their ability to offer, or deny, access to startups.

What’s the conclusion here? There are two:

A. What you often see written or said publicly in startup ecosystems is not an accurate representation of how the game is actually played, because very few people are willing to talk openly about it, for fear of being cut off by gatekeepers.  Others will say positive things publicly because of a quid-pro-quo understanding in the background. This significantly increases the importance of off-the-record “blind” diligence to get the real story about a particular repeat player. If you are diligencing an influential investor or an accelerator, it is important that said entity not know whom you are contacting (or at least not everyone) in conducting that diligence.  That is the only way that they cannot retaliate against any particular person who says something negative; and you’re therefore more likely to get an honest answer.

You will absolutely encounter people who will say that the whole idea of “retaliation” is some kind of paranoid fabrication, but remember how the chess game is played: the appearance of “founder friendliness” is often a marketing tool. Of course the smartest users of that tool are going to wave away all this talk of bad actors, doing heavy diligence, and protecting yourself as unnecessary. Come on, they’re good guys. Just trust them, or their tweets. We’re all “aligned” here, right?

When you have an inherent and substantial power advantage, it is an extremely effective strategy to create a non-adversarial, “friendly” PR image of yourself, downplaying that power.  Inexperienced, naive first-time players then buy into this idea that you’re not really about making money, and come to the table with minimal defenses; at which point you can get to work and surround them with relationships you “own.”

The money players with truly nothing to hide won’t be dismissive or defensive at all about the common’s need to conduct blind diligence and ensure the independence of their key relationships. Reactions are often a key “tell.”  If you truly have a great reputation, and you have no intent to use the common’s inexperience and unequal power against them, then what exactly is the problem with respecting their right to be cautious and protect themselves?

There are definitely good people in the market, including those who put integrity and reputation above money, but only idiots navigate a highly unequal and opaque world under the premise that everyone is an angel, and you should “just trust them.” Being a “win-win” person is not in tension with ensuring your backside is covered. Anyone who says otherwise is trying to cleverly disarm you, and is defending an approach that has clearly served them well.

B. To prevent repeat players from dominating the perspective of “one shot” common stockholders both on startup boards of directors, and in ecosystems generally, the “one shot” players must pay extremely close attention to the relationships of their high-stakes key advisors and executive hires, to ensure they can’t be manipulated (with bribes or threats) by the money’s relationship leverage.  No rational human being who cares about being successful bites the hand that most feeds them; no matter how “nice” they are. That is the case with lawyers, with “independent” directors on boards, with other key advisors, and also with high-level executives that you might recruit into your company. Pay attention to loyalties, and diversify the people whose rolodexes you are dependent on.

In the case of lawyers, aggressive repeat players and their shills will often talk about how startup dynamics are “different” and it’s “not a big deal” for company counsel to have dependencies (via engagements and referral relationships) with the preferred stockholders. They even argue that the lawyers’ “familiarity” with the investors will help the common negotiate better and save legal fees. How generous. An honest assessment of the situation is that startups are different, but different in a way that conflicts of interest matter more than usual. Outside of the world of promising startups run by first-time executives negotiating financing/governance with highly experienced investors, you rarely see high-stakes business contexts where there is such a dramatic inequality of experience and power between groups, and such a high level of dependence on counsel (on the part of the one shot common) for high-impact strategic guidance.

Repeat players aren’t reaching across the table and manipulating startup lawyers because it’s “not a big deal.” They’re doing it because the payoff is so uniquely high, and the power inequality (reinforced by the preferred’s inherent dominance over key ecosystem relationships) makes it so easy to do. Couple a basic understanding of human nature/incentives with the fact that the Board’s primary fiduciary duties under Delaware law are to the common stock, and any honest, impartial advisor will acknowledge that experienced company counsel who doesn’t work for the repeat players across the table on other engagements, and who doesn’t rely on them for referrals (in other words, is not conflicted), is one of the clearest ways to (a) ensure the common’s perspective gets a fair voice, and accurate advisory, in key Board decisions, and (b) help the Board do its actual job.

There is a clever narrative pushed around startup ecosystems painting a picture of startup finance and governance as always full of warm, balanced transparency and generosity, with common stockholders and investors holding hands and being “fully aligned” as they build shareholder value together without bias, disagreement, or power plays. But notice how quickly the tone changes from some parts of the investor community the moment you suggest that the common be afforded even minimal defensive protections, like company counsel that investors can’t manipulate. Suddenly you’re being “overly adversarial.” Oh, so are the transparency and generosity, and “kumbaya” sing-alongs, only available if the common keep their necks directly under the boots of the powerful, but oh so benevolent and soft-heeled, money? Funny how that works. Smart common stockholders won’t accept “benevolent dictatorship” as the model for their company’s governance. The way you address power inequality is by actually addressing it; not by taking someone’s BS reassurances that they’ll be “really nice” with how they use it.

You should absolutely want transparency, fairness, and generosity to be the guiding principles of your relationship with your investors – that’s always my advice to founders on Day 1. Also understand that while the common’s perspective deserves to be heard and respected (and not muzzled or infantilized), it is obviously not always right. Balanced governance is good governance; and true “balance” requires real, independent ‘weight’ on both sides. Too many repeat players have manipulated the market into a charade – propped up by pretensions of “friendliness” and “cost saving” – where inexperienced common stockholders become unwittingly dependent on advisors to help them negotiate with investors 100x as experienced as they are, when in fact those advisors are far more motivated to keep the investors happy than their own (on paper) clients.

High-integrity startup ecosystem players should forcefully assert that the “friendly” ethos promoted by VCs and accelerators only has real substance if they’re willing to stay on their side of the table, and not use their structural power advantage to maintain influence over the key people whom founders and employees depend on for high-stakes guidance and decision-making. Call out the hypocrisy of those who put on a marketing-driven veneer of supporting startups and entrepreneurs, while quietly interfering with their right to independent relationships and advisory; including independent company counsel that repeat players can’t “squeeze” with their relationship leverage.

A lot of the most egregious stories of startup flame-outs that you see written about – who grew too fast chasing a unicorn exit, raised more money than a business could sustain, took a high-risk strategy that blew up, or perhaps achieved a large exit while returning peanuts to the early common – are the end-result of a complex game by which repeat players come to exert so much power over how a particular startup scales that the voice of the “one shot” players – the early common stockholders without deep pockets or contacts – gets completely silenced until it’s too late. Gaining control over key company relationships is a significant part of how that game is played. And what’s written about publicly is just the tip of the iceberg.

To put a bow on this post, healthy skepticism over what you see and hear publicly, and good instincts for understanding the importance of incentives and loyalties, are essential for any inexperienced team entering a startup ecosystem. The image of wealthy, powerful people “winning” only by loudly and aggressively pounding the negotiation table is a caricature of how complex business actually works; but it’s a caricature that often dupes inexperienced founders into thinking that everyone else who smiles and seems helpful must be aligned with their interests. Assholes are easy to spot, and the smartest winners are almost never visible assholes. Good people still follow their incentives; and aggressive but smart money players know how to assert their power while preserving a public image of selflessness and generosity. Navigate the market, and recruit your advisors, accordingly.

“Top Startups” Lists and Accelerators

TL;DR: “Top Startup lists” are being used as complements, and in some cases replacements, to accelerators for helping entrepreneurs signal their talent to investors. Generally speaking, the “network effects” of accelerators are diminishing over time from the simple fact that they don’t really “own” their networks; making it harder for traditional accelerators to justify their cost as the “network” detaches from the gatekeeper. Long-term, many startup accelerators run a real risk of adverse/negative selection killing their core value proposition.

Background reading:

The value proposition of elite universities is a fairly straightforward 3-part bundle:

A. Education

B. Talent Sorting / Signaling

C. Network

Data showing that top students who attend elite universities perform on average the same as those who are similarly accepted but attend lower-ranked schools proves that the actual education elite universities provide isn’t nearly as important as some people think; at least for most students. But their talent signaling and network functions are fairly important and durable, and it’s very hard for competitors to build viable business models to deliver them; though some are succeeding.

Respected employers willing to not require elite educations are, for example, talent signaling competitors to elite universities. Being  “Google Alumni” can be seen as more value determinative than being “MIT Alumni.”

Now, the value proposition of top accelerators is also a fairly straightforward 3-part bundle:

A. Education

B. Talent Sorting / Signaling

C. Network

Look familiar? Many post-accelerator founders will tell you that the actual educational content accelerators provide is hardly that big of a deal to them. I’ve definitely known some entrepreneurs who find it useful, but the more hustler autodidact types will say it’s just re-hashed versions of what you can find online and in books. But the other two propositions (talent signaling and network) are harder to build.

To the extent accelerators build respected brands – and by that I mean respected by investors and other ecosystem players entrepreneurs want to connect with – their ability to sort through the ecosystem’s “noise” and signal talent, and therefore reduce search costs, is extremely important for founders. I would say most of the founders we work with understand instinctively that the main reason to attend any accelerator is to simply make it a lot easier to connect with investors. And yes, for the right accelerators, it works. Big time. 

Sidenote: Attending a B-class accelerator can be worse than attending none at all. If the A-accelerators reject you, you can just pretend to be one of the many companies that never even try to attend them; and just find other “signals” to use. But by attending a B-class accelerator, people now know you tried and were vetted, then rejected. Can be a scarlet letter.

Education? The best information is online and in books. Network? Not proprietary. Founders who can hustle know how to access all the same top people, many of whom want to ensure their own personal brands aren’t captive to an accelerator; ensuring significant “leakage” of the network. The networks of accelerators are compilations of the personal networks of individual people, and by bringing all of those people together for a period of time, without the leverage to lock them in, they’ve made it far easier for the network to be unbundled and re-bundled without the gatekeeping fee.

But it’s the reduction in search costs for connecting with investors (the talent sorting / signaling) that is the real money maker for accelerators. And yet talk privately with many investors, and they’ll tell you they resent the “hunger games” demo day and investor herding dynamics some accelerators produce, even if it’s the price for having someone else do a lot of the company filtering for you.

A short list of accelerators have built real and durable talent signaling brands, and are worth their cost tenfold; at least for now. The challenge for some has been maintaining them, and not supplementing themselves with business models misaligned with the goal of being very selective. Accelerators heavily tied to real estate/co-working, for example, are tempted to dilute the accelerator brand by accepting a lot more people, because they can still monetize them with offices (even if their equity isn’t worth anything). Lower your standards to fill office space, and your talent signal weakens, which means fewer top people show up to your events, which dilutes your network proposition, which further weakens the quality of your startups, and now you’re in a death spiral.

One thing you’re seeing all over the place in startup ecosystems today is “top startups lists.” “Top startups to watch.” Top this, top that. Top 50. Top 25. Top 10.

Initially, my reaction was to judge these lists as just PR plays. Politics/brand driven founders who want a bit of an ego stroke pander to publications to get on them, and in turn the publications get eyeballs and visibility, and can make money off of ads.

But analyze what these lists are, or could be, from the perspective of the talent sorting/signaling function of accelerators, particularly at early stage. To the extent some publications can build highly credible “top startup lists” – the kinds that investors and other players pay close attention to, they could prove to be viable (and far cheaper) competitors to the talent signaling proposition of accelerators.

I actually think many entrepreneurs understand this, and it’s why they care so much about getting on these lists, and why the lists are proliferating. If your ultimate goal is just to connect with investors, “top startup lists” that get real brand credibility could, much more cheaply, get you the “signal” you need to get meetings with selective investors.  Of course, it boils down to whether the right publications are willing to put in the time to build the needed credibility, and not make them simply politics or “pay to play” schemes. I suspect many won’t, but some will.

By no means am I under the delusion that accelerators and top startups lists are direct competitors; especially not at the highest tier. Many smart founders use them, wisely, as complements. The most important thing is for founders to understand what their real purposes are, and to judge them accordingly.  If many founders view accelerators as simply fast-tracks to getting the attention of investors (and they do), then you can fully expect there to be demand for cheaper alternatives, and players willing to experiment in delivering them.

The challenge long-term for many startup accelerators is going to be maintaining/justifying their value proposition, and therefore their cost. As alternatives to their educational and talent-sorting functions proliferate, and as their non-proprietary networks detach from the gatekeeping fee, many run the risk of adverse/negative selection. By that I mean that the top, most resourceful entrepreneurs will realize they don’t really need to pay the gatekeeper. At that point, the accelerator becomes a signal not of a top entrepreneur, but actually a less resourceful and more “needy” one. The emergence of leaner, lower cost accelerators in specific markets (asking for 1-2%, not 6-7%) is clear evidence of this. The price may just have to adjust.

Comparing Startup Accelerators

Related Reading:

Over the past several years, accelerators have emerged as a powerful filtering and signaling mechanism in early-stage startup ecosystems, allowing high-potential young startups to connect with investors, advisors, and other strategic partners far faster and more efficiently than before. While it definitely feels like the accelerator “bubble” has somewhat burst, and their numbers are normalizing, I’m still often asked by CEOs for advice on how to assess various programs. The below outlines how I would approach the decision:

Cash and Equity.

Very simply, what are you giving and what are you getting in return in terms of cash and equity for joining the program?

Re: cash, the more “unbundled” types of accelerators (less formalized) tend to not provide any cash upfront, but also typically “cost” less in equity, often just 1-2% of your fully diluted capitalization. More traditional and comprehensive programs often require 5-8% of common stock, but often provide between $20K and $100K up-front as well.

Anti-Dilution.

See: Startup Accelerator Anti-Dilution Provisions; The Fine Print.   Most accelerators, with a few exceptions, have much more aggressive anti-dilution provisions than a typical seed or VC investor would get, and the “fine print” can dramatically influence the total equity requirement depending on your circumstances and fundraising plans. This is something you should walk through with an experienced advisor, lawyer or otherwise, to prevent surprises.

Pro-Rata / Future Investment Rights.

See: The Many Flavors of Pro-Rata Rights. Some accelerators will require you to “make room” for them in future financings up to a certain amount. This is not necessarily a bad thing, and it’s very reasonable given that the ability to make follow-on investments in “winners” is virtually essential for very early-stage startup investors (angels, accelerators) to make good returns. However, for the most in-demand startups, over-committing on future participation rights can become a problem because it can require you to raise more money than you really need to.

Fundraising / general success of past companies.

See: Ask the users.  If fast-track access to investors is not at the top of your priority list, then this may not be as big of a deal for you. But 95% of founders I’ve worked with have viewed “cutting in line” to speak with investors as the main reason for entering an accelerator. And don’t rely solely on numbers reported by the accelerators themselves. There are lots of ways of fudging the figures, including by “annexing” already successful companies into the accelerator (in exchange for free help) and using their brand/fundraising numbers to puff up the accelerator; neglecting to mention that the accelerator had nothing to do with those numbers.

Entrepreneurs often celebrate faking it until you make it. Know that some accelerators do the same. When an accelerator says “our companies have raised an aggregate of $200 million,” they may be neglecting to mention that a huge chunk of that was raised before some of the companies (the top ones) ever “entered” the accelerator. 

Ask specific founders, off the record. Without a doubt, the overall “prestige” of the accelerator’s past cohorts will have a dramatic impact on the accelerator’s ability to deliver on its “benefits” to you. There’s a heavy snowball / power law type effect with accelerators where the best ones attract the best companies, which then attract lots of capital/great mentors, which then attracts more great companies, further improving the accelerator’s brand, and so on and so on. And the same is true in reverse: accelerators with poor reputations and bad averse selection (they are just getting the companies everyone else rejected) can actually make it harder to raise money, and are best avoided.

Time commitments and Geography.

Many accelerators involve a substantial time commitment (including travel time) in terms of going through the “program” of events, meetings, training, etc. Feedback (given privately) varies on the ROI of those obligations, depending on the accelerator, type of company, etc. Some entrepreneurs find it invaluable. Others find it a necessary cost to getting access to the accelerator’s network, which is what they’re really there for. In any case, travel and time commitments are a real cost, so take that into account.

Market Focus.

One of the most common complaints I’ve heard from entrepreneurs, after having gone through an accelerator, is that it wasn’t helpful for their “type” of business. Some accelerators are very up-front and overt about their market focus: biotech, energy tech, transportation, etc.  Others are more generalist, but if you dig deep you’ll realize that all or most of their cohort is slanted in one direction, which will mean the accelerator’s network of investors and mentors will be as well.

An example: a heavily hardware-focused startup may not find as much success in an accelerator where the vast majority of companies are SaaS based. The same goes for a health tech startup entering an accelerator full of consumer or B2B startups.

Culture.

In much the same way that entrepreneurs’ own personalities set the culture for their companies, the creators and managers of accelerators heavily influence both their “online” and “offline” culture. Personalities, ages, lifestyles, and values will vary. Some accelerators are well-known for being extremely friendly, generous, and community-oriented. Others are known for being more competitive and “eat what you kill” in their approach. I’ve seen more aggressive entrepreneurs feel that their particular accelerator was a bit too “kumbaya,” while those with opposite personalities felt right at home. 

Do your diligence before entering any accelerator, and make sure you assess its offerings in light of your company’s own priorities and needs. I’ve seen companies emerge with polar opposite opinions of the same accelerator, even within the same cohort.  In many cases, it’s less about the program being good or bad in an objective sense, and more about whether it was a good or bad “fit” for that particular startup. 

How Angels & Seed Funds compete with VCs

TL;DR: The emerging “seed ecosystem” of angel groups, seed funds, and accelerators now provides local startups a viable path to seed funding, and eventually “going national,” w/o having to prematurely commit to a Series A lead.  That has dramatically reduced the leverage that local institutional funds once had over their local ecosystems.

Background Reading:

Once upon a time, startup ecosystems (if they could even really be called that) outside of Silicon Valley had only a handful of local VC funds writing checks. Without AngelList, LinkedIn, Twitter, Accelerators, good videoconferencing, and the many other recent developments that have reduced geographic friction in startup capital flows, those funds effectively “owned” their cities, including most of the startup lawyers in those cities; which often resulted in harsh terms and aggressive behavior. For more on this, see: Local v. Out-of-State VCs.

Raising “angel” money in that era often meant needing close connections (family, friends, professional) to very high net worth individuals willing to make big bets on you until you were ready for one of the few local funds to take you under their wing. If you were one of those lucky few chosen, those local VC funds would then, once they were out of their own capital, show you off to one of their trusted out-of-state growth capital funds.

The pipeline was narrowly defined, and choice was minimal: local angels (or friends and family), then local VC, then out-of-state growth capital.

Times have changed.

Today, angel groups are much bigger, organized, and collaborative across city and state lines. Seed funds – which weren’t really even much of a concept a few years ago – will write checks of a few hundred thousand to a few million dollars for rounds that may have been called Series A 3-5 years ago, but are now “seed” rounds. Prominent accelerators have themselves joined the mix, writing their own 6-figure checks and serving as valuable filters / signaling mechanisms to reduce the search costs of investors.

This “seed ecosystem” of organized angels, flexible seed funds, and accelerators has not only increased the amount of “pre-VC” capital available to startups, but very importantly, it has significantly reduced the leverage that local VC funds have over their local startup ecosystems. 

As I wrote in Optionality: Always have a Plan B, sunk money has very different incentives from future money. A seed fund/angel that has mostly maxed out the amount of capital it can fund you with has every incentive to help you find a great Series A lead at a great valuation; they are quite aligned with the common stock. They want a higher valuation and better terms for the existing cap table, just like you do, because they are being diluted too.

However, a VC fund that wrote you a small seed check but wants to lead your Series A has very different incentives. The “seed ecosystem” wants to maximize your Series A options, while a VC fund wants to minimize them, until it gets the deal it wants.

Foreign capital will usually require some heightened level of de-risking or credible signaling before it will cross state lines. It’s much less risky to rely on my local referral sources, and “monitor” my portfolio where I can drop in by the office whenever I need to. If I’m going to write a check a thousand miles away, I need a little more reason to do so. In that regard, it’s well-known that there is a “flipping” point beyond which the pool of capital available to a startup moves from being mostly local to much more national: that point is somewhere between $500k-$2MM ARR (it used to be higher, and can be even lower if you have a strong network). 

Historically, reaching that flipping point was almost impossible without local VC, and this effectively kept startup ecosystems captive to their local funds. The new seed ecosystem, with its ability to often fund 7-figure rounds all on its own, has changed that. Now, if a desirable startup wants to, it can often raise $1-2MM in seed capital without taking a single traditional VC check, then use that to hit the “flipping” point, after which the number of VCs it can talk to goes up considerably. 

Of course, this dynamic is not always so clean cut.  More progressive VCs have wisely developed symbiotic relationships with this seed ecosystem for the obvious reason that it can serve as a pipeline when startups are ready for bigger checks. That is a smart move. What we’ve also seen is that large VCs are playing much “nicer” in seed rounds than they used to, as an acknowledgement of their reduced control over the market. Years ago you much more often saw VCs condition a $250K or $500K check on a side letter giving them the right to lead your Series A. That is increasingly becoming an anachronism, and for good reason.

At the same time that AngelList, accelerators, LinkedIn networks, and other signaling / communication mechanisms for startups are giving foreign capital more “visibility” into other ecosystems, allowing it to invest earlier and more geographically dispersed, the emergent seed ecosystem is also increasingly allowing local startups to “go national” without having to commit themselves to a particular VC fund. The obvious winners in this new world are entrepreneurs and investors willing to be open and flexible with how they fund companies. The losers are the traditional investors – particularly those who used their old leverage to squeeze founders – who haven’t understood that the old game is gone, and it’s not coming back.

Why Startups Need Signals

Here are a few uncontroversial facts about the general early-stage startup ecosystem:

  • The cost of starting a tech company has dramatically gone down over the past 10 years.
  • In the early days, the caliber of the founder team is at least as important for success as the caliber of the idea/technology.
  • New networks – like AngelList and LinkedIn – have dramatically increased the transparency of relationships in the market, and the ease with which currently unconnected people can become connected.

Putting the above points together, you could easily conclude that it’s never been easier for talented founder teams to obtain needed resources in the market, particularly early-stage capital. But, in some ways, you would be wrong.  Many would argue that while the difficulty of starting may have gone down, the difficulty of actually succeeding has gone up, due to increased competition (and noise) in the market. 

The reduction in cost/friction in the startup world has been met with an increase in volume, and that volume has made the market far more noisy and competitive. Far more entrepreneurs producing far more ideas, and flooding top tier resources with far more pitches. If you want a clear illustration of this, look up newly created companies on AngelList.

Where there’s an increase in noise (weak teams, weak products, me-too companies, etc.), the value of signals – credible ways to cut through the noise and indicate to the right people that you are, in fact, worth talking to – goes up. This post is about why all early stage entrepreneurs need to be very mindful of the importance of signals in the marketplace, and what those signals often look like.

First, a quick clarification: signals are ways of effectively indicating information, but they are not the information itself. In other words, they are ways of credibly sending a message to someone like “hey, we’ve got something truly interesting over here” when simply saying those words won’t work – perhaps because everyone says that, or because you simply can’t get the face-to-face time, and when hard metrics like revenue growth/customer traction may not be available (because it’s too early).  Imagine the startup world as a very dense fog – and the fog is getting denser, btw – good signals are your very visible beacons to flash into the fog so that investors and other resources can find you.

A Series B company needs to worry far less about signaling its value proposition to investors, because its history, financials and reputation in the market can already speak volumes. Successful serial entrepreneurs don’t have much trouble either. A seed stage, or pre-seed company run by new entrepreneurs, however, is in a completely different situation, and needs a different toolkit.

Common early-stage startup signals:

  • A really good logo
  • A really good website
  • A really well-done AngelList profile
  • A strong social media presence
  • Well done blog content
  • Very well-crafted messaging
  • A great pitch at a pitch competition
  • Connections to respected people on LinkedIn
  • Acceptance into a well-respected accelerator
  • Strong academic or professional history

Notice how none of these really have anything to do with the fundamentals of your business/technology? You’re a very early-stage startup. No one really knows whether your business will be successful, and at this stage you can’t even get the face time with the right people to sell them on it. That’s what signals are for.

Remember the point about how startup investors care at least as much about the strength of the team, especially the CEO, as they do about the business? Why is that? Because talent (properly defined) is highly correlated with success, and talent is easier to analyze in the early days than the future prospects of a business. Great entrepreneurs tend to be highly talented generalists (multiple skills); it’s what allows them to hit milestones without a staff of more specialized people.

Doing any or all of the things on the above list credibly signals some kind of skill/talent. Just take a good logo (which may seem silly to an engineering type, but that’s a big mistake): it takes good judgment/taste (marketing skills), and the ability to find a talented logo designer (recruiting skills). Strong LinkedIn connections signal strong networking skills. A great pitch signals strong sales skills. A degree from a respected school, or employment with a well-respected company, certainly isn’t essential, but it clearly signals strong technical skills/training.

Getting into a top accelerator is one of the strongest signals available (because of how thoroughly they vet companies), and that’s why demo days are so well attended by early-stage capital. But getting into a top accelerator often requires its own earlier set of signals.

Yes, in many ways the world has become flatter, more transparent, more meritocratic, etc., and it’s a very good thing.  Yes, the “good ol’ boys” network is weakening in the sense that there are far fewer true gatekeepers. But don’t delude yourself for a second into thinking that this means success in the market has gotten easier. And absolutely don’t think that networking and referrals from well-respected people don’t matter.

A warm referral from someone known and respected in the market is still – simple, cold fact – an incredibly powerful signal. Think about what it takes to get a strong referral. You first had to get connected to that (usually very busy) person (networking skills). Then you had to interest them enough to think your business is worth supporting (credible business idea, sales skills). People care so much about good referrals because in a market full of noise, they are a very efficient filter. And no one has time to work without filters.  

This point is worth repeating: the “democratization” of the startup landscape has certainly reduced the power of gatekeepers – specific people (usually men) whose approval you needed to raise capital and connect with important resources – but it has not (and will not) eliminate the importance of building relationships with credible, trustworthy people who can then refer you to other people who trust their judgment. The democratization arrived in the form of diversifying the number of possible referral sources; not from eliminating the need for referrals altogether.

Utopian visions of a world in which great entrepreneurs will frictionlessly connect with capital purely based on the merit of their technology/business, eliminating all the superficialities of networking and personal marketing, are a dead end.  Someone on your team needs to be good at building relationships, because relationships are incredibly powerful signals. 

Just don’t expect your lawyers to connect you with investors. See: Why I (Still) Don’t Make Investor Intros. Signals can be negative. And the fact that, of all the people in the market whom you could’ve convinced to refer you, you chose someone you’re paying (instead of someone who refers based on merit), is very often, in today’s environment, a negative signal.

A good logo, or a well done AngelList profile, can seem superficial, but signals are often about how seemingly superficial things can help people with low information sort through noise. If it takes talent to produce it, and it’s the kind of talent needed for market success, it’s a signal worth caring about.