Post Category → Texas

Gatekeepers and Ecosystems

TL;DR: Relationships are important, but a business mindset that prioritizes ‘relationships’ over real value delivery enables gatekeeping and cronyism, both of which are contradictory to entrepreneurship, and can suffocate a business ecosystem.

Background Reading:

As I’m known to do on occasion, I’m going to get a bit personal with this post; because the backstory (my backstory) helps explain the message.

To say that, growing up, I did not come from money would be an understatement. When I was born, my parents (mexican immigrants) were selling tomatoes and avocados out of a pickup truck.

In a sort of american dream story, that pickup truck eventually became a moderately successful produce business, where I spent a good portion of my elementary school off-time sorting produce and invoices. Unfortunately, through a series of bad, misguided decisions, that business eventually ended in bankruptcy, and my parents in divorce. My sisters and I were raised by my single mother, who supported us by selling perfume at an indoor flea market; her small business, where I worked for most of my teenage years.

Yes, to get from there to where I am now took an enormous amount of work and hustle; hours a day commuting to public schools in better neighborhoods, days without sleep to get the grades that would get the scholarships that would pay for the colleges that I otherwise couldn’t afford, even while working, etc. But the real reason I tell that story, and this is where it connects to the crux of this post, is this: I would not be even close to where I am today if it weren’t for people willing to work with and support others purely because of their talent and merit, regardless of whom those ‘others’ knew or where they came from. 

Those people are the reason I’m here. And the underlined portion of that sentence is what makes all the difference.  Because I came from nowhere, and knew no one.

There are very few statements about business that I find more obnoxious than, “it’s all about relationships.” Not because I don’t value them. To the contrary, I think building trusting, deep relationships is one of the most important things CEOs can do. See: Burned Relationships Burn Down Companies. What truly unsettles me about that perspective is two-fold:

  A.  It reflects a pervasive mindset on how to achieve success that, when played out over time, concentrates opportunity in pockets of people who all know each other. People who go to the right schools, live in the right neighborhoods, etc. are able, despite being all kinds of mediocre, to leverage their ‘relationships’ to keep out those who are far hungrier, and far more talented, but simply don’t have the right ‘relationships.’ 

  B.  It creates gatekeepers, who can use their access to the right ‘relationships’ to control a market. And gatekeepers are the exact opposite of true business ecosystems. Gatekeepers, and the idea that you have to know specific people in order to succeed, are contradictory to entrepreneurship.

I’ve observed how, in a variety of markets and startup ecosystems, pockets of people have attempted to become gatekeepers. It never ends well.  Influencers/connectors, meaning people who serve as ‘nodes’ of an ecosystem by knowing lots of people and helping them connect with each other, are a great thing. Every town needs them. A gatekeeper, however, is an influencer/connector who has devolved into using their relationships to cut off the market from others who won’t go through them. Rather than facilitating an ecosystem, they use the “it’s all about relationships” fallacy to artificially centralize it. 

Relationships do matter. Relationship-building skills are important. But the people who most emphasize the supremacy of relationships, instead of prioritizing authentic differentiation and value proposition, are often the most mediocre. Fact. By stating that relationships are what matter most, you’re indirectly acknowledging that your success has come from whom you know instead of from what you can actually deliver. 

I remember as a kid driving through the “rich people” neighborhoods (upper middle class), imagining how amazingly talented everyone living in those homes must be. There’s no way they could be that successful if they weren’t the best of the best, right? Now, I’m nauseated by how many people I’ve encountered over the years who’ve coasted into success simply by (i) being competent, yet uninspiring, and (ii) leveraging relationships they built during their childhood and college years. Because it’s “all about relationships.”  When lawyers are coached on how to build up a client base, the first thing they almost always hear is “start building relationships.” And perhaps work on your sports trivia while you’re at it.

People who truly believe it’s “all about relationships” do not become successful entrepreneurs. Great entrepreneurs focus first and foremost on developing a legitimate, differentiated, and defensible value proposition, and then building the right relationships from there. Be so good that the right people – the ones who don’t think it’s all about relationships and quid pro quo – can’t ignore you. The relationships will follow. 

When clients approach our firm, I am happier when I hear that they have scoped the market. It serves as a great starting point for explaining how and why, instead of following the old playbook, we’ve built our reputation by completely re-tooling how law firms run: better technology, a unique culture built through unique recruiting, billing rates hundreds of dollars per hour below market, extremely high client satisfaction, strong policies against conflicts of interest, and competitive market compensation for top lawyers who work 25% fewer hours than the firms they leave.

Many don’t realize it, but that last part has been part of my core mission the whole time. Our firm is built, from the ground up, to allow lawyers to have healthy personal lives, instead of pushing them (for the enrichment of partners) into workaholism. So that they don’t end up overworked and divorced. Like my parents. I told you the backstory mattered here.

Yeah, we’ve got relationships. But they were and are earned; not given, and not bought. To this day, I shut down any suggestion that we establish economics-driven (as opposed to merit driven) referral arrangements with anyone. Not everyone is happy about it. You can’t make everyone happy. It is not all about relationships.

A true business ecosystem cannot be controlled. And true entrepreneurs cannot be held back by gatekeepers; they find a way around them, eventually. It’s what they do. Give people a chance if they are hungry, and can demonstrate real skill. Even if they come from nowhere, and know no one. 

Angel Investors v. “Angel” Investors

TL;DR: The term “angel” investor has connotations that in reality don’t apply to a significant portion of early-stage seed investors outside of Silicon Valley. Historically, angel investors were very wealthy individuals who’d take big, almost irrational (from a risk-adjusted perspective) bets on entrepreneurs for reasons that go well-beyond a profit motive. Many “angels” that you’ll encounter as an entrepreneur, however, think and act in a much more self-interested, conservative manner; much like venture capitalists, but with smaller checkbooks. Both types are crucial to startup ecosystems, but knowing the difference is still important.

Related Reading:

One of the core reasons behind this blog’s existence is that the majority of legal/fundraising advice available to startup entrepreneurs comes from places (like Silicon Valley or NYC) that are dramatically different (in terms of access to capital and key resources) from the environments in which most tech entrepreneurs find themselves. That doesn’t mean at all that SV or NYC advice is bad or wrong. On the contrary, much of it is very very good and founders who look only to local advice will screw themselves – see: The Problem with Localism. But founders also need to understand the mismatches between the advice/culture they’re exposed to on the most popular podcasts, blogs, etc., and how things tend to work for normals.

One important area where I see the disconnect arise is in founders’ expectations in interacting with “angel” investors. The typical “angel” investor that you encounter in Austin, Houston, Atlanta, Dallas, or Miami does not look, think, or act like what Silicon Valley people have historically referred to as “Angels.” 

Classic Angels

While the full origin of the term “angel” investor goes beyond this post, in general very early stage investors were very wealthy individuals who, in addition to other activities, wanted to “give back” to the business community by making bets on promising entrepreneurs that no one else (rational) would be willing to make. Hence, their investments were “angelic.” While this doesn’t mean at all that Angels didn’t scrutinize their investments, or that that they acted completely out of charity (hardly), the term absolutely has (correct) connotations of motives that are much broader than just making a great return.

These classic “Angels” were wealthy enough that writing a $100K or $200K+ check barely moves their needle, and so they could take the risk of investing in a company with little more than a very promising team and an idea, and perhaps the very early beginnings of a product. If it fails, NBD. They’re doing it for the relationships, the excitement, and the chance at supporting something new.  I often see founders take very early money from investors that fit the classic “Angel” profile, but those relationships take a long time to build. They don’t spark over a pitch contest or business plan competition.

Anyone who says there isn’t enough money in Texas/the South is painting with way too broad of a brush. There’s tons of money floating around here and elsewhere. The core difference is that in Silicon Valley, the true capital-A “Angel’ money was created in tech, and therefore much more easily flows back into early-stage tech (because the Angels trust their judgment on tech teams/companies). Outside of that environment, much of the ‘Angel’ money comes from other industries (like Energy, Healthcare, etc.), and so much more relationship-building, selling, and (cultural) translation is needed to convince it to go into a tech startup.  Great t-shirts and a pitch deck won’t get you there.

Most “Angels”

In most other tech ecosystems (outside of SV), when people speak of “angel” investors they are often talking about successful individuals who, while willing to take on the risk of early-stage seed investment (which is great), are not so wealthy and altruistic that they’ll barely feel losing $100K-$200K.  That means that most “angels” seen in non-SV ecosystems are much more conservative in how they pick their investments (and will therefore have higher expectations), because to many of them angel investing really is about making a great financial return.

Classic Angel investors were/are generally very wealthy senior executives and business people with net worths well into 8 figures and above, who will bet on team, vision, and minimal traction (if any); so very early stage. The majority of “angels” that entrepreneurs encounter in their own ecosystems, however, come from broader backgrounds (lawyers, doctors, real estate, business owners, etc.) and are affluent/comfortable, but not quite the 0.1% (their angel investments are material to them), and they”ll often want to see clear customer traction, revenue, and a more mature product; and a lower valuation. 

Of course, there are far more “angels” than Angels, so I’m not suggesting at all that the more conservative, self-interested nature of typical “angel’ investors is bad or a problem. They are crucial to startup ecosystems. I’m not running around writing $100K checks on team+vision either. But the distinction between the two categories often gets lost on first-time entrepreneurs, with negative consequences.

You likely need a Pre-Angel Plan

So the net result of the above is that tech entrepreneurs outside of the most dense ecosystems like SV and NYC encounter much higher expectations from “angels,” and therefore (and I’ve written this in prior posts) pre-angel money, what is typically called “friends and family” money, is often essential to building something attractive to “angels.” If I encounter a founder team planning to start a company without a viable path to $50K-$200K in initial funds, either from their own savings, friends and family, or a classic Angel, that is very often a red flag. Not game over, but it is a concern. 

It’s certainly been done before, especially when the founder team is very self-contained and willing to work for nothing until there is real traction, but most companies will never make it to the “angel” investment stage (product, traction, revenue) without either bootstrap/F&F funds, or a classic Angel investor willing to make a big bet. Accelerators have helped with this issue by (often) being the first non-F&F money in and serving as a valuable signal to “angels”, and they deserve credit for that, but even getting to a point where you’re attractive to a top accelerator often takes some real cash.

In short: most angel investors are much more conservative, and have higher expectations, than the term “angel” suggests, because they’re in a different category from the classic wealthy “Angel” investors that give the term its meaning. Be mindful of that fact, and prepare for it in your early-stage fundraising strategy.

Did you get a “good” valuation?

TL;DR: What a “good” valuation is depends highly on context: geography, industry, timing, size, team experience, value-add of money, control terms, and a dozen other variables. Be careful using very fuzzy guidelines/statistics, or anecdotes, for assessing whether you got a good deal. The best valuation for your company is ultimately the one that closes.

VC lawyers get asked all the time by their clients to judge whether their financing terms are good, fair, etc; especially valuation. And that’s for good reason. There are very few players in ecosystems who see enough volume and breadth of deals to provide a truly informed assessment of a financing’s terms. Executives have usually only seen their own companies. Accelerators see only their cohort’s. Most advisors/mentors have even more limited visibility.

But VC lawyers/firms with well-established practices see deals that cross geographic, industry, stage, etc. boundaries.  In addition to a firm’s internal deal flow, there are third-party resources that can be subscribed to with data on VC valuations across the country and the world. Those resources tend to be expensive (5-figure annual subscriptions), and only firms with deep VC practices will pay for them. Given how much you’ll be relying on your lawyers for advice on your financing terms (for the above-mentioned reasons), ensuring that they are objective (and not biased in favor of your investors) is crucial. 

The above all being said, founders should understand that determining valuation at the early stages of a company (seed, Series A, B) is far far more an art than a science. It is for the investor making the investment, and it is for the people judging whether the terms are “good.” That’s why relying on broad metrics like “median Series A valuation is X” is problematic; there are simply too many variables for each company that could justify deviating from the median, in either direction (lower or higher).

What some people call a seed round, others might call a Series A. Some companies raise a Series A very early on in their company’s history because the nature of their product requires serious capital expense to even get to early milestones. Other companies bootstrap for a decade and only use a Series A as true growth capital (the way others would use a Series C or D). I saw a $150MM ‘Series A’ once. I’ve also seen $500K ‘Series A’s. And everything in between as well. So whenever someone asks me “what’s a good Seed or Series A valuation?” the answer has to start out with: “it depends.” 

Below is a break-down of the mental analysis that I might use in assessing a company’s valuation. Remember, it is an art, not a science. There are widely varying opinions here, and this is just one of them. Consider it a set of suggested guidelines, not rules.

1. What was the last valuation a professional investor was willing to pay, and what progress has been made since then?

The easiest answer to “what is X worth?” is “whatever price someone was willing to pay.” While not entirely helpful in the VC context, it certainly is relevant. If you’re doing a Series A and you have institutionals who invested in a convertible note at a $5MM cap a year ago, the obvious question then is “how much progress has been made since then?” This, btw, is why it’s dangerous for companies to set their own valuations without a true market check from professional investors. Your earlier valuations will influence your later ones.

2. What city are you in?

Location. Location. Location. One of the strongest determinants of valuations is the density of startup capital in the city your company operates in; because density means competition. Silicon Valley valuations are not 2-3x those of the rest of the country because the VCs there are just nice guys who are willing to pay more. It’s a function of market competition. SV has the highest valuations. NYC follows. And then there’s the rest of the country, with variations by city. Austin valuations are generally higher than Atlanta’s, which are generally higher than Houston’s or Miami’s. General deal terms are also more company-friendly where there is more investment density.

While the entire concept of “founder friendly” investors does have an important moral/human dynamic to it, people who play in the space enough know that at some foundational level it is a form of self-interested brand differentiation. The ‘friendliest’ investors are the ones in the most competitive, transparent (reputationally) markets. Why take our money over theirs? Because we’re ‘founder friendly’… which can mean a whole lot of things; some of which are relevant, and others which are nonsense.

Yes, online networks are breaking down geographic barriers and you are seeing more capital flow between cities/states, but the data is still crystal clear that if a Silicon Valley VC is investing in an Atlanta or Austin company, they are going to want to pay something closer to Atlanta or Austin (not SV) prices. Much like all the Ex-Californians buying up Austin homes, they likely will pay slightly above the local market (and in both cases, it pisses off local buyers), but not much. 

3. How much is being raised?

Valuations can (and often do) vary widely between markets, while the actual dilution that founders absorb doesn’t vary as much. How is that? Because founders in markets with higher valuations raise larger amounts of money, and founders in markets with lower valuations raise smaller amounts of money; in each case getting the VCs/investors to their desired %. A $1MM raise at a $4MM valuation produces the same dilution as a $5MM raise at a $20MM valuation.

You should never close any round without modeling (lawyers often help here) the actual dilution you are going to absorb from the round, including any changes required to your option pool. Many investors focus first on their desired % and then back into the right valuation and round size. Smart founders should focus on %s as well. It’s not intuitive; especially if you have multiple rounds involved.

4. Who are the investors?

Value-add, known-brand institutional VCs and professional angels that will be deeply engaged in building your company after the check hits are (obviously) worth a lot more than investors who just bring money. And they will often price themselves accordingly (lower valuations). Some money is greener.

Diligencing the valuations your specific investors were willing to pay for their past investments is a smart move. Again, it still requires discussions about the differences between companies, but it can help address any statements like “we never pay more than $X MM for Series A.”

5. What are the other terms?

A $4MM valuation with a 1x non-participating liquidation preference looks very very different in an exit from a $6MM valuation with a 2x participating liquidation preference. So does a $3.5MM valuation with investors getting 1 out of 3 Board seats v. a $5MM valuation with them getting 2/3. The non-valuation terms matter. A lot. Juicing up valuations by accepting terrible ‘other’ terms gets a lot of companies in trouble. 

6. Other Business-Focused Variables

  • What are valuations within this specific industry looking like over the past 12 months?
  • What are the obvious acquirers paying for companies they buy?
  • Where is the company in terms of revenue? Revenue-multiples generally don’t have a place in early-stage, but a $25K MRR v. $300K MRR absolutely influences valuation.
  • Any serial entrepreneurs on the team? Good schools? Other de-risking signals?
  • What’s growth look like?
  • Size of market?
  • etc. etc. etc.

Obviously, multiple term sheets are a great way to have a very clear idea of where your valuation should be, but in most non-SV markets that is a privilege bestowed on a small fraction of companies.

Take-homes:

A. If your friend’s startup got X valuation for their Series A round, that can be totally irrelevant to what valuation you should get,

B. Other terms of the financing matter a lot too, as well as who is delivering them, and

C. If you have in your hand a deal that isn’t exactly at the valuation you wanted, remember that there are thousands of founders out there who got a valuation of $0.

Over-optimizing for valuation can mean under-optimizing on a host of things that matter far more for building your business. Get the best deal that you can actually get, given your business, location, and investors, and then move forward. And ignore the broad market data, particularly the Silicon Valley data, that isn’t relevant to your own company.