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The Hacker's Guide to Investors

[The Hacker's Guide to Investors]

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| April 2007(This essay is derived from a keynote talk at the 2007 ASES Summit
at Stanford.)The world of investors is a foreign one to most hackers—partly
because investors are so unlike hackers, and partly because they
tend to operate in secret. I've been dealing with this world for
many years, both as a founder and an investor, and I still don't
fully understand it.In this essay I'm going to list some of the more surprising things
I've learned about investors. Some I only learned in the past year.Teaching hackers how to deal with investors is probably the second
most important thing we do at Y Combinator. The most important
thing for a startup is to make something good. But everyone knows
that's important. The dangerous thing about investors is that
hackers don't know how little they know about this strange world.1. The investors are what make a startup hub.About a year ago I tried to figure out what you'd need to reproduce
Silicon Valley. I decided the
critical ingredients were rich people
and nerds—investors and founders. People are all you need to
make technology, and all the other people will move.If I had to narrow that down, I'd say investors are the limiting
factor. Not because they contribute more to the startup, but simply
because they're least willing to move. They're rich. They're not
going to move to Albuquerque just because there are some smart
hackers there they could invest in. Whereas hackers will move to
the Bay Area to find investors.2. Angel investors are the most critical.There are several types of investors. The two main categories are
angels and VCs: VCs invest other people's money, and angels invest
their own.Though they're less well known, the angel investors are probably
the more critical ingredient in creating a silicon valley. Most
companies that VCs invest in would never have made it that far if angels
hadn't invested first. VCs say between half and three quarters of
companies that raise series A rounds have taken some outside
investment already.
[1]Angels are willing to fund riskier projects than VCs. They also
give valuable advice, because (unlike VCs) many have been startup
founders themselves.Google's story shows the key role angels play. A lot of people know
Google raised money from Kleiner and Sequoia. What most don't realize
is how late. That VC round was a series B round; the premoney
valuation was $75 million. Google was already a successful company
at that point. Really, Google was funded with angel money.It may seem odd that the canonical Silicon Valley startup was funded
by angels, but this is not so surprising. Risk is always proportionate
to reward. So the most successful startup of all is likely to have
seemed an extremely risky bet at first, and that is exactly the
kind VCs won't touch.Where do angel investors come from? From other startups. So startup
hubs like Silicon Valley benefit from something like the marketplace
effect, but shifted in time: startups are there because startups
were there.3. Angels don't like publicity.If angels are so important, why do we hear more about VCs? Because
VCs like publicity. They need to market themselves to the investors
who are their "customers"—the endowments and pension funds and
rich families whose money they invest—and also to founders who
might come to them for funding.Angels don't need to market themselves to investors because they
invest their own money. Nor do they want to market themselves to
founders: they don't want random people pestering them with business
plans. Actually, neither do VCs. Both angels and VCs get deals
almost exclusively through personal introductions.
[2]The reason VCs want a strong brand is not to draw in more business
plans over the transom, but so they win deals when competing
against other VCs. Whereas angels are rarely in direct competition,
because (a) they do fewer deals, (b) they're happy to split them,
and (c) they invest at a point where the stream is broader.4. Most investors, especially VCs, are not like founders.Some angels are, or were, hackers. But most VCs are a different
type of people: they're dealmakers.If you're a hacker, here's a thought experiment you can run to
understand why there are basically no hacker VCs: How would you
like a job where you never got to make anything, but instead spent
all your time listening to other people pitch (mostly terrible)
projects, deciding whether to fund them, and sitting on their boards
if you did? That would not be fun for most hackers. Hackers like
to make things. This would be like being an administrator.Because most VCs are a different species of people from
founders, it's hard to know what they're thinking. If you're a
hacker, the last time you had to deal with these guys was in high
school. Maybe in college you walked past their fraternity on your
way to the lab. But don't underestimate them. They're as expert
in their world as you are in yours. What they're good at is reading
people, and making deals work to their advantage. Think twice
before you try to beat them at that.5. Most investors are momentum investors.Because most investors are dealmakers rather than technology people,
they generally don't understand what you're doing. I knew as a
founder that most VCs didn't get technology. I also knew some made
a lot of money. And yet it never occurred to me till recently to
put those two ideas together and ask "How can VCs make money by
investing in stuff they don't understand?"The answer is that they're like momentum investors. You can (or
could once) make a lot of money by noticing sudden changes in stock
prices. When a stock jumps upward, you buy, and when it suddenly
drops, you sell. In effect you're insider trading, without knowing
what you know. You just know someone knows something, and that's
making the stock move.This is how most venture investors operate. They don't try to look
at something and predict whether it will take off. They win by
noticing that something is taking off a little sooner than everyone
else. That generates almost as good returns as actually being able
to pick winners. They may have to pay a little more than they would
if they got in at the very beginning, but only a little.Investors always say what they really care about is the team.
Actually what they care most about is your traffic, then what other
investors think, then the team. If you don't yet have any traffic,
they fall back on number 2, what other investors think. And this,
as you can imagine, produces wild oscillations in the "stock price"
of a startup. One week everyone wants you, and they're begging not
to be cut out of the deal. But all it takes is for one big investor
to cool on you, and the next week no one will return your phone
calls. We regularly have startups go from hot to cold or cold to
hot in a matter of days, and literally nothing has changed.There are two ways to deal with this phenomenon. If you're feeling
really confident, you can try to ride it. You can start by asking
a comparatively lowly VC for a small amount of money, and then after
generating interest there, ask more prestigious VCs for larger
amounts, stirring up a crescendo of buzz, and then "sell" at the
top. This is extremely risky, and takes months even if you succeed.
I wouldn't try it myself. My advice is to err on the side of safety:
when someone offers you a decent deal, just take it and get on with
building the company. Startups win or lose based on the quality
of their product, not the quality of their funding deals.6. Most investors are looking for big hits.Venture investors like companies that could go public. That's where
the big returns are. They know the odds of any individual startup

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