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Paul Buchheit

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The right investor, the kind who can help startups get over the inevitable “We’re Fucked It’s Over” (WFIO) moments, can turn a startup into a multi-billion dollar company.

The fact is that choosing the right investors, whether it be at the seed level or at a Series B or C stage is a life-changing decision for an entrepreneur and a startup. The wrong investor match could derail a startup. “It’s like a marriage and it might even last longer.” That’s how Kleiner Perkins partner Chi-Hua Chien describes the relationship between investor and entrepreneur. And he’s not joking in the least bit.

It’s a dilemma that many entrepreneurs face when it comes to signing term sheets—which angel, seed, and/or venture investor do I choose?

What got me thinking about this particular subject was hearing Dave Morin chat with PandoDaily’s Sarah Lacy about Path’s road to success. Referring to the company’s reported $100 million-plus acquisition offer from Google, Morin (who in the conversation didn’t elaborate much on the offer), did highlight that he didn’t want to sell, and having his investors on board with that decision was incredibly important for the company’s future. As Lacy had reported last year, the weekend Morin was making the decision, he consulted Moskovitz, who gave him the confidence to go with his gut feeling. As for being able to make the decision to turn down the offer and continue iterating on Path, Morin credited the importance of having the right investors who shared his vision for what Path could become. Which is now a $250 million-plus company.And rumor has it that someone with the power to do so has stated that Path would be worth buying for a billion

Survey any number of entrepreneurs, investors and VCs on the subject of choosing the right investors and you’ll find out that it’s actually a pretty controversial subject filled with horror stories of investment-entrepreneur matches gone bad. Here are some of the observations and advice that I put together from a number of startup founders, investors and VCs.

Asking The Right Questions

“What baffles me is the lack of questions that come from entrepreneurs at the table,” says Tony Conrad, who is a partner at True Ventures, and co-founder of About.me and Sphere (both companies were acquired by AOL separately). “You really need to look at the person across the table and understand what your needs are.” He explains that entrepreneurs are in as much of a buying position as investors.

Conrad says that in conversations with potential investors, it’s extremely important to understand how they think about cultural DNA and how these investors, with their experience and approach to involvement, could impact the culture of the company. “Entrepreneurs don’t realize it but early investors can play a significant role in shaping a company,” he says.

Bo Fishback, CEO and co-founder of mobile-focused peer-to-peer marketplace recommends asking specific questions around the nature of a VC or investor’s decision-making process within the firm. Fishback, who has raised $15 million in funding from angels like Ashton Kutcher, Paul Buchheit and Bill Lee, as well as from investors including Kleiner Perkins, and CrunchFund (*Disclosure: TechCrunch founder Michael Arrington also founded CrunchFund), says that one of the things he didn’t realize was important in the investor-startup relationship was understanding the decision-making process inside a VC firm.

In particular, he advises startups to ask questions about how autonomous a partner or investor is in terms of decision-making within a firm. Specifically with Zaarly, Fishback said that they ended up working with an investor (and declined to name names) who didn’t have full control over how much could be invested in the Series A round, terms and other issues, and slowed the whole fundraising process down. “These were decisions and conversations that should have gone fast,” he explains. “Ask a lot of questions about who at the firm ultimately makes decisions.”

With Kleiner Perkins he says, partner Chi-Hua Chien was able to make decisions independently, which made the investment process with the firm much easier. Fishback’s one piece of advice when it comes to choosing the right investor is not to fall in love with the a firm’s name or reputation but really focusing on whether the actual person leading the deal is the right fit.

The reverse of startups asking questions is also important, Fishback adds. He felt more confident with investors who actually asked compelling questions about the startup, the market, competition, business and more. It’s not just about acting interested, but actually doing the research to come into the meeting with educated questions, he says.

J.R. Johnson, serial entrepreneur and founder of recently launched social travel site Trippy agrees with Fishback’s view on investors and question-asking. Johnson has just under $2 million from Sequoia Capital, SV Angel, Rob Solomon, Rachel Zoe and others. “They need to find a balance between asking the hard questions and showing enthusiasm,” he explains.

He says the old school traditional VC mentality is that companies pitch VCs and they get to choose, but some of the investors and firms getting better deals are the ones who feel and act as if there’s a two way street in the decision making. Part of showing this mentality is coming to the table with research and thoughts about where the startup is heading, challenges in the industry and thought-provoking questions, he says. In the end it’s about finding a balance between asking the hard questions and showing enthusiasm, Johnson adds.

Due Diligence

VCs and angels tend to do a tremendous amount of diligence on a company and founders before investing. From a financial point of view, this just make sense. But many of the VCs and founders I spoke to agreed upon one trend: not enough entrepreneurs do the same sort of diligence on investors, and can thus find themselves in dissatisfactory relationships down the line with these individuals and firms.

Andreessen Horowitz general partner and entrepreneur Scott Weiss firmly believes in reference checks. Weiss was the co-founder and CEO of IronPort networks, which was acquired by Cisco in 2007 for $850 million. “Always do reference checks on the investor, especially if he or she is going to be a board member.”

Chien, who has served as a company founder, early employee of several startups as well as an investor in his career, compares the choice of investor to dating someone, and potentially making a long term commitment (i.e. marriage) to them. He says entrepreneurs should evaluate how many investments an investor makes in a given year, and ask for references from 3-5 entrepreneurs who worked with the investor. And it’s important to get references from startups who have both succeeded and failed with the investor (if applicable).

“Talk to as many CEOs of the companies angels or firms have invested in as you can,” warns Fishback. “Many founders take it for granted that an investor will be the right fit because they have done a lot of investments or had big wins but you have to do your due diligence.”

Bringing Value

It seems like a given that you’d want to choose investors that bring value to the table, but strategically it is important to understand what that value is ahead of signing any term sheets.

Weiss’s advice when it comes to finding investors who could bring value stems from his days founding IronPort. “When we were first launching the business, we tried to find people that know and understand the market. Find experts in the field, perhaps the top ten individuals, and just ask for advice and thoughts about your company and your idea.” He says that if you can get them excited about the opportunity, many of these individuals could end up investing in the company. And because these investors also happen to be involved and knowledgeable in the market, they “have driven through potholes you’re about to drive through and typically have a lot of contacts and potential employees for your business.”

When raising his seed round for Trippy, Johnson said that one of the main objectives when evaluating potential investors was “How can this person support the business.” With Brian Lee, a serial entrepreneur who has co-founded ShoeDazzle, LegalZoom, and The Honest Company; Johnson felt his insight from a product standpoint would be invaluable to Trippy. Johnson said that Factual CEO and founder Gil Elbaz as an investor made sense because he was one of the smartest people he knew and because Trippy is dealing with so much data, Elbaz’s experience would be helpful. And with some of the less traditional angels such as celebrity fashion stylist Rachel Zoe, and musician Jason Mraz, Johnson felt that each had a unique following of people who would trust their recommendations, and their brand would help grow the business in different directions.

Zaarly’s Fishback is also of a similar mindset to Johnson. “I’m a big believer in the Ocean’s Eleven model for the seed round with lots of people putting in small amounts of money,” he says. “It’s about putting a network of people around you.”

Fishback raised seed funding from Ashton Kutcher, Felicis Ventures, SV Angel, Paul Buchheit, Bill Lee, Michael Arrington, Naval Ravikant and Lightbank. In fact, Fishback says that even in the actual arrangement of the seed round, he started to see some of the benefits to having a well-connected group of angels. According to Fishback, Kutcher felt that SV Angel would be a great fit in the seed group for Zaarly, but the round was full. So Kutcher dialed back his investment to let SV Angel into the round.

While having a group of well-connected angels can be a huge win for an early stage startup, Conrad advises startups to have an anchor in larger rounds. “Rounds with 20 investors where there is no leadership can be really messy,” he says. “Having an anchor in these seed rounds is very important.”

Weiss also has advice to help entrepreneurs extract value from larger seed rounds. He says that from the round, put together an advisory board of the four people from the round that will be most helpful to the startup and have that board meet every month to six weeks.

Chien says that he asks founders to give him actual jobs. Each week, he spends a day or an afternoon (depending on his to-dos for each company) at his portfolio companies, which include Path, Klout and Zaarly, and has a set of responsibilities for each of them. “Having that kind of hands-on support from investors in both the good and difficult times inspires confidence in startups,” he explains.

The Warning Signs, WFIO And The Hard Times

Weiss says there is a term in the Valley for the challenging moments startups face: “We’re Fucked, It’s Over” (a.k.a. WFIO). He says that so many startups go through WFIO, but sometimes it’s the investors that can help pull companies from these “Valleys of Despair” as he puts it. At Andreessen Horowitz, part of the mentality of hiring partners who are previous founders and CEOs of technology companies is that these individuals can help during the WFIO times as well as the peaks.

He adds that it is important to have at least one investor who has experience as a founder, or in the particular market a startup is tackling, and can help calm the CEO during a storm, which will inevitably arrive during the course of a startup’s life. “Having old hands on the table that can be a calming force is very important,” he says.

Chien says that in his experience as a founder, employee and investor, what separated the winners from the losers of every one of the companies that went through periods of significant challenge was whether or not the investors stuck with the company.

Conrad says that founders should look for investors who have reputations amongst portfolio companies for having steady, predictable behavior. One of the warning signs he has seen both as an entrepreneur and as an investor, is that when things are going well at a company, “investor x” is awesome, but when things get weird or there is a challenge at a company, the investor is uneven emotionally, or even unsupportive. He believes that many times, these scenarios occur with younger investors. And he doesn’t mean by age—he says experience as a founder or early startup employee tends to make investors more reliable in times of crisis as well as during the good times.

As for warning signs of what could be red flags for startups when it comes to investors, many times this can be a gut feeling, specific stipulations in a term sheet or even responsiveness. Many of the individuals I spoke to said a potential investor who is not responsive via email or phone during the fundraising process is likely to be the same post-raise as well.

Conrad highlights blocking rights to the sale of a company as a term he dislikes in the VC and investment world. “I think it is inappropriate for us to have a blocking right on the sale of a company,” he says. He used Kevin Rose’s recent sale of mobile development lab Milk, in which True Ventures was an investor, to Google. “Kevin felt like it was the right thing to do. Would I have liked to see him to go deeper and longer. Yes. Do I think he could have? Yes. But this is his decision not ours,” he explains.

However, whether you have the pick of the investment litter or are more on the “beggars can’t be choosers” side of things, it’s helpful to think through some of the advice mentioned above when deciding to whom you give that final “I do.”

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The startups that presented at Y Combinator’s Demo Day last week were remarkable in their own right, but perhaps the most striking thing was the sheer number of them.

With 66 companies and 180 founders in this season’s batch, the auditorium at Mountain View’s Computer History Museum was practically bursting with angel investors and reps from every notable venture firm last week. And that was just the latest class. Since 2005, Y Combinator has since spawned more than a dozen batches of startups including Dropbox and Airbnb. The last two classes alone have created more than 120 companies.

So it raises the question of how Y Combinator has been able to grow in size while sustaining both the quality of startups it churns out and the value it provides for founders.

Essentially, how do you scale a company that creates companies?

The Strategy and Vision

“Our whole approach to scaling Y Combinator is the standard approach to scaling software,” said Paul Graham, Y Combinator’s co-founder.

There are a couple rules, he said. 1) You can’t predict in advance where the bottlenecks will be so you just keep going until you hit the next one and 2) You can always scale a lot more than you originally predicted. ”When you scale things, they often turn into other stuff that you would have never imagined,” he said.

Graham doesn’t have an exact size in mind when accepting companies for a new class. The early-stage venture firm accepts as many companies as the team thinks are worthy. Nor does Graham know how large Y Combinator should ultimately be.

“Imagine if you had asked Mark Zuckerberg that question when Facebook had just two universities,” Graham said. “A lot of what drives us is curiosity about what happens when something like this gets bigger.”

Indeed, some of the other partners liken working at Y Combinator to building a university or a new type of institution that’s never been seen before.

“If you think of YC as a corporation or a company, it has these characteristics that every big company would love to have,” said Harj Taggar, an alum who later became a YC venture partner. “It’s a bunch of smart people working on projects that they love and have upside in. But they are all linked together and get the benefits of being a part of a larger group. YC is effectively inventing a new form of organization.”

Given the scale of Graham’s ambition (which shouldn’t be surprising since he tells founders to have “frighteningly ambitious” startup ideas), we walked through some of the many bottlenecks YC has faced through the years:

Applications:

Y Combinator’s increasing cachet has brought a ballooning number of applications. Last October, Graham said that the firm was seeing about one submission per minute on deadline day for the most recent class.

Every one of the firm’s venture partners used to read every application. Now they don’t. They might read one-third of the applications. It’s the alumni who make the first pass, depending on how much time they have. Some do none while others read as many as 100 applications or more.

“We went back over the years and saw that we had never accepted a company for an interview where the alumni were majority ‘No,’” Taggar said. “This weeds out really bad applications so we can focus on the borderline ones, which take more time.”

But just in case they miss a potentially good company, Y Combinator is starting to use data mining software. They’ve fed a program all of the old Y Combinator applications to find predictors of success and apply them to new submissions, creating a backstop in case they miss something.

“There are two kinds of mistakes: funding a bad startup or missing a good one. Our biggest fear is missing a good startup,” Graham said, adding that Dropbox’s co-founder Drew Houston was actually rejected the first time around. They’ve used the program to generate a top 10 list of factors predicting the probability of acceptance. ”I don’t want to share it, but it was fascinating,” Graham said.

After they pick a cohort of companies to interview, they fly them in. They used to do a single track interview process where every single partner had to be present in the room. Last time, they did two interview tracks with half the partners in one of two rooms that went through half the finalists each. This time, they might do three tracks simultaneously.

Following the interview, the partners decide immediately within the next five minutes about whether they should accept the company or not.

“We have to be very disciplined,” Taggar said. “By the end of the day, when you’ve done twenty-something interviews, you can barely remember what happened in the first one.”

Advising:

Y Combinator’s big initial bottleneck was that there was one Paul Graham, and he only had 24 hours in a day. So the company brought on additional venture partners like Gmail creator Paul Buchheit and alumni like Taggar, Posterous co-founder Garry Tan and Aaron Iba, who successfully sold AppJet to Google. Geoff Ralston, who was chief executive of Lala, the music startup that exited to Apple in 2009, is joining as a partner for this round. Plus there are part-time partners like Loopt co-founder Sam Altman and Justin.tv founders Emmett Shear and Justin Kan. They joined YC’s original partners Jessica Livingston, Trevor Blackwell and Robert Morris.

“It turns out that this is almost perfectly parallelizable,” Graham said. “I know from experience that one partner can deal with 20 startups and if we have 66 startups, we’re at more than 2X over capacity.”

All of the partners are available for office hours and there’s an internal scheduling tool that Y Combinator uses to gauge demand and urgency from founders. Ash Rust, who co-founded SendHub, had an HR issue once. He was able to get office hours within 30 minutes and the right documentation almost immediately after that.

“I know how hard it can be to get help as a founder if you’re not the belle of the ball,” Rust said. “But I’ve never experienced that here.”

If that still sounds a little impersonal for something as unpredictable and idiosyncratic as founding a startup, Buchheit points out that YC’s alumni network is now so large that the firm is starting to have world-class experts on running companies in many areas.

“As YC gets larger, it actually gets better,” Buchheit said, pointing to the firm’s 800 alumni. ”Half the time, I’m sending founders to talk to different alumni. If you’re doing a video startup, then I know the person you really ought to talk to is Justin Kan.”

The firm taps this alumni network when it holds mini-conferences around issues like user acquisition or iOS development.

“There’s this real feeling of appreciation,” Buchheit says. “The founders are very grateful for the experience, so they have a real loyalty and want to help out other companies. There’s a little bit of a pay-it-forward model built into the network.”

Tan even built a private social networking tool for YC founders. Taggar says it’s useful for putting faces to names and that they’ll probably add a section for skills like the ability to code in Python and so on.

Y Combinator’s emerging network effects:

Not only are alumni helping with admissions and advising, they can serve as market-makers for new startups. Many of mobile payment startup Stripe’s customers are part of Y Combinator while Exec is now offering special corporate accounts to run errands for other startups.

“Y Combinator has a built-in economy,” Buchheit says. “We have this tremendous network and another YC company can be your first reference customer when others won’t take the risk.”

Then if one company isn’t quite a home run, its founders and employees will likely be able to find work at another Y Combinator startup. When Jeff and Dan Morin were considering next steps after working on event startup Anyvite for a few years, Graham paired them with another founder, Olga Vidisheva, from the most recent batch. Now they’ve rounded up funding from Greylock Capital, Andreessen Horowitz, SV Angel and Benchmark Capital to bring independent fashion boutiques online at Shoptiques.

The alumni also come back to Demo Day to angel invest in startups from later batches and companies like Parse, Carwoo and Dropbox have raised angel funding from other alums.

Demo Day and Investors:

Maybe the next big bottleneck is the most obvious one: helping investors wade through the dozens of startups it launches every half-year. The firm had to move Demo Day to The Computer History Museum because its offices no longer had space to fit the hundreds of investors. Y Combinator is also reaching the upper limit of how many startups can pitch in a single day.

Getting through 66 pitches is a slog. ”I don’t think we could handle a Demo Week,” Buchheit joked.

Taggar says he’s thinking about how to make it more efficient for investors to set up meetings with the right startups following Demo Day. Right now, the partners just have a mental map of the investor landscape and try to route the right companies to the right investors.

The week after Demo Day is an especially intense one as entrepreneurs and investors try to lock down deals. It’s kind of a weird biannual version of mating season.

With all the investor interest, the founders clearly don’t see Demo Day as the issue.

In fact, Rust had something else on his mind — how to efficiently get food on speaker nights. ”Seriously, the only scaling problem is the enormous dinner line,” he said.

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