Monday, March 26, 2007

Did anyone else notice that TechStars and Y-Combinator have the same application?

They aren't exactly the same of course, but they are surprisingly similar.

Y-Combinator says:
If by August your startup seems to have a significant (say 20%) chance of making you rich, which of the founders would commit to working on it full-time for the next several years?

TechStars says:
If after the summer the business appears to be viable, which of the founders will commit to working on the business full time for several years?

The other questions are similarly similar. I guess that should make life easier for anyone planning to apply for both programs. I wonder how many teams will do that?

Personally, I'm very curious to see how successful TechStars is in cloning the Y-Combinator model. Maybe we will see programs like this springing up around the world. I believe that we are getting an early glimpse of the future of education and investing. The programs will need to evolve of course, but perhaps companies like Y-Combinator will come to form something like an alternate university system. Is that what Steve Yegge was thinking in his (somewhat cryptic) "Wizard School" post?

Update: In case it's not already obvious, these questions originated with Y-Combinator (which has been around a lot longer than TechStars). has the older versions of the YC application, such as this one from March 2005. As they say, imitation is the highest form of flattery.

Thursday, March 22, 2007

How to be right 90% of the time, and why I'd rather be wrong.

It's easy -- every time you hear about a new idea or business, just say that it won't work. Say that it's a bad idea, the wrong thing, bubble thinking, a hobby and not a business, hopelessly naive, not innovative enough, too different, that it's been tried before, that it won't appeal to regular people, or any of hundreds of other criticisms seen in the comments on reddit, techcrunch, or elsewhere.

Are these people wrong? Only about 10% of the time. For one reason or another, most new things don't work. That's why it's easy to be right 90% of the time (though the naysayers are likely to misidentify the cause of failure).

What if instead of dismissing everything new or daring, we acknowledge that the future is uncertain, and pursue some of these new ideas despite the risk? History has shown that no one can reliably pick the winners, but what if we were clever enough to pick the right ones 20% of the time? That would mean that were are still wrong 80% of the time.

Is it better to be right 90% of the time, or wrong 80% of the time? It depends on the risks and rewards. If we look at it as an investment where the losers go to zero and the winners have a 10x return, then we can see that it's potentially better to be wrong 80% of the time:
   .20 * 10 + .80 * 0 = 2

If we can be right 20% of the time about something with a 10x return, then we should be able to double our money! This is roughly the bet that startup investors are making. They hope that all of their investments will succeed, but realistically they expect that most will not. Of course there are no guarantees -- it's quite possible that due to bad luck or bad bets, none of their investments will succeed.

Aside from possible investment returns, I simply like new things. I like new ideas, new businesses, and the possibility of creating something that will change how people live and work. This is why I would rather be wrong 80% of the time. Not everything will work out the way I would like, but at least I tried.

And now, a fun quote from the earlier days at Google -- it's from a "letter to the editor" at the Wall Street Journal, in response to their "Boom Town" column about Google:
J. Claude Tenday writes: Old habits die hard. For Sergey Brin to expect to grow a $100 billion/year business from an obscure $60 million/year niche player in an already mature Web-search market shows that Mr. Brin is still California dreamin'. And for the Wall Street Journal to take him seriously shows reporters may still be prey to dot-com hype!

Of course Google still isn't a $100 billion/year business, but I'd say there's about a 20% chance that they will become one :)

Recommended reading: Fooled by Randomness. Taleb does a good job of exploring risk and explaining how most people have a very poor understanding of it. He makes his money being wrong most of the time, buying options that usually expire worthless.

Tuesday, March 20, 2007

Looking for a co-founder? Try attending the REAL startup school.

I've noticed a number of people saying things like, "Where can I find a co-founder for my startup?", and perhaps, "I also need funding... and a good idea." Not you, of course -- you already have a great idea, so you just need a co-founder and funding, right? Do you also have intelligent and experienced people who you trust to offer reasonable advice, to help you refine your "great idea" into something that will actually work, to help you out when things go wrong?

Do you think those problems will be solved by attending Startup School? Do you think that you'll meet all the right people, find that co-founder that will perfectly complement you, and learn all the inside information that you need to make your startup succeed? I hope that's not what you think. Startup School is a really good idea. It will give you a nice overview of things to think about, create a sense of possibility, and hopefully convince you to make the jump. Also, if you're there at 9:30, you'll get to hear a talk by a very sleepy me. As great as all that is, it's still just a one day event -- it's unlikely that you'll suddenly know all the right people and be ready to create your own startup.

So where is the REAL startup school, the one where you can find a good co-founder and all that? In my opinion, it's going on right now inside of the thousands of startups that ALREADY EXIST. You don't need to find a co-founder and funding and an idea, you just need to find an interesting startup and get them to hire you. I hinted at this in my previous post, "My startup path", but I'll say it more explicitly now: If you don't already know what you're doing, just join one of the many startups that already exist!

Your new startup job should give you the opportunity to:
  • Learn about startups.
  • Meet people who would be good future co-founders or employees.
  • Witness success or failure -- you can learn a lot from either.
  • Do things that you aren't qualified to do. I certainly wasn't qualified to build Gmail. This is another great way to learn.
  • Make a lot of money if the startup happens to be a big success, and you don't necessarily need to own a big slice for this to happen.
Of course not all startup jobs will offer these benefits, which is why you should look for one that's run by smart and ambitious people.

This startup school will take more than a day, and in fact it could go on for years if the startup fails to go out of business and you decide to stick around. However, my prediction is that you'll learn a lot more from the experience than you did during the years spent memorizing trivia in school, and you'll be in a much better position if you then decide to found your own startup.

Who are these great startups that you should be applying to? At some point I'll try to make a list, but for now, here is one suggestion: Xobni. Adam and Matt are definitely smart and ambitious, and they also have some exciting news, which I can't yet tell you about.

Update: In case it wasn't clear enough, I'm recommending both the YC Startup School and the real world startup school (i.e., joining a real startup).

Update two: Some people have gotten the impression that I'm telling you to join a startup and then steal their employees. This is not what I'm suggesting. What I am suggesting is that in a year or two the startup will either be a success (which is good!), or it will not be a success, in which case your co-workers will be looking for something new. Even if it is a success, it could be acquired by (or become) a big company, and the startup types may want to move on. Furthermore, in all cases you have learned a lot more about startups, which was my main point.

Monday, March 19, 2007

Equity math for startups

Many people don't understand how equity works in a startup. It's a little counterintuitive and I didn't quite internalize exactly what's going on until recently. I think this misunderstanding may also be part of the reason that some people think Y-Combinator is getting too much when they take a 1%-10% stake (they aren't -- if anything, they should get more).

The first thing to understand is that when shares are given to an employee or investor, they aren't taken from someone else -- they are newly created shares -- the pie gets bigger. Of course, your slice of this newly enlarged pie is now a smaller percentage of the total. That's dilution. A lot of people understand that. What they often don't understand is deeper in the details.

I'll explain using a simple example of a company raising a few rounds of investment.

To begin, let's say that the founders decide to join Y-Combinator, and YC asks for 6% equity and a 20% option pool (please note: these numbers are just an example -- every company is different). For simplicity, let's start with 100,000 shares.

Option Pool20,00020.0%


Next, the startup raises a little money from an angel investor: $100,000 at a $2,000,000 pre-money valuation. The "pre-money" is simply the value of the company before the new investment. Since there are 100,000 shares and the company is worth $2,000,000, we calculate the share price to be $2,000,000 / 100,000 = $20. Since the angel is investing $100,000 at $20/share, he will get 5000 shares. (Sometimes these early angel investments are done with a convertible note instead, but for this example we're just going to issue new stock)

Option Pool20,00019.0%
Angel investor5,0004.8%


That was easy. Now let's get some VC money! What's the company worth? Surprisingly, the answer seems to depend a lot on how much money they are raising. For some reason, a common pattern is that the first major VC round will take about 1/3 of the company. Let's do $5 million at a $10 million pre-money. Also, the option pool should be increased to 25%. That seems like no big deal since it started out at 20%, right? Wrong. They want it to be 25% of the newly financed company -- dilution is making that old option pool too small percentage-wise. In fact, the number of shares in the option pool is going to increase by 225%!

Option Pool51,00025.0%
Angel investor5,0002.5%


The company started with 100,000 shares and by now there are 204,000. Surprisingly, although the VC only took 1/3, everyone else's stake was cut in half. Also, notice that while the option pool is unused, the the VC owns (68,000 / (204,000 - 51,000)) = 44% of the outstanding shares.

What happens if the company decides to raise more money? That will depend a lot on how successful their business is. If it's a huge success and they barely even need the money (something like Facebook), then they can raise money at a very high valuation and have very little dilution. On the other hand, if things aren't going so great and they're desperate for cash, they may end up being forced to raise money at a valuation closer to $0 (I believe this is known as a "cram down"). That will cause massive dilution and basically wipe-out all of the previous owners. Not good. Employees may be offered additional options to keep them from leaving, but for any investor not participating in the new round, it will be a near-total loss.

One last detail: the investors will almost certainly hold "preferred stock" which gives them a number of special rights. For some reason, those rights seem to be slightly different for every deal, but expect there to be a liquidation preference guaranteeing that the investors get their money back (and perhaps a profit too) before anyone else gets anything. If the company in the above example were acquired for $5 million, that money would all go to the investors, and possibly only the VC investor if they included terms giving themselves priority over the earlier investors.

I hope this is helpful. Please let me know if I've made any errors in my examples or explanation. My goal for this post was to make the numbers behind startup equity a little more familiar and intuitive.

The question that I haven't addressed: Is it a good idea to give away 64% (or more) of your company? The answer: it depends. 36% (or 10% or 1% or 0.1% or 0.01%) of something big is worth a whole lot more than 100% of nothing, which is what you'll probably end up with if you are overly focused on retaining ownership. Your primary concern needs to be building a great product and a great company. If you can significantly improve your odds of doing that by giving partial ownership to investors, advisers, and employees, then that's what you should do. Of course you don't want excessive dilution, that's not good for anyone, but there is a healthy middle-ground.

Another fun example: In 1999 Google raised $25 million from Sequoia and KP at a $75 million pre-money valuation, meaning that the VCs together got 25% of the company (about 12.5% each -- I think there may have been a few smaller investors in there too though). That was exceptionally good. Supposedly, John Doerr was heard to say, "I have never paid more money for so little a stake in a startup." (source) By the time of the Google IPO filing, Larry and Sergey each owned about 15.6% of the company (from the S1). Sequoia and KP each had 9.7%. Considering that Google went public with a valuation around $30 billion, and has since risen as high as $150 billion, that was pretty much the best-case scenario for everyone involved. At today's price of $445/share, a 0.1% slice of Google would be worth $138 million!

Update: On news.YC, chandrab pointed out this nice VC dictionary, which explains liquidation preferences and the like.

Saturday, March 17, 2007

Welcome to Costco. I love you.

Idiocracy is a flawed movie. The whole is less than the sum of the parts. However, a lot of the parts are really good. Most movies are completely forgettable. This one isn't. I keep wanting to use some reference from Idiocracy the way I would with Office Space or The Matrix. Unfortunately, nobody has seen it yet, so the references wouldn't convey any meaning. Please watch this movie -- it's a funny and worthwhile use of 84 minutes. The movie is available on DVD, or you can download it.

Friday, March 16, 2007

My startup path

For some reason, I've always liked the idea of starting an important new company or building something really cool that everyone will use. In college, I became interested in founding or joining a software startup, but had no idea how to do that. I had read a few random books, such as Startup: A Silicon Valley Adventure and Steve Jobs & the Next Big Thing, but I still had no idea how to go about starting a company or even how to find a good one to join. Really, all I knew was that the cool startups seemed to be located in Silicon Valley, and so the only plan I could think of was to find out where this "Silicon Valley" was located and move there (I went to school in Ohio). Luckily, my friend Chad had recently taken a job with Intel in Santa Clara, and he reported that Santa Clara was in fact a part of "Silicon Valley", so I joined Intel too.

That was in 1998 -- I kind of assumed that the streets of Silicon Valley would be "paved with startups", and that I would probably run into them all over the place. As it turns out, that wasn't exactly true. After almost a year spent in the cubicles of Intel, I was ready for something new. I still didn't know much about startups, and the ones that I read about in "Red Herring" magazine all sounded really boring. Fortunately, working at Intel meant that I had plenty of time to read Slashdot, and so rather than do some kind of intelligent research, I simply sent my resume to the handful of local startups I had read about that seemed technically interesting.

I never heard back from most of those startups, but one actually offered me a job: Google. At the time, they were just a small team of people in a little office on University Ave in Palo Alto. Their "business model" seemed pretty unlikely to me, but I liked the product, the people seemed smart, the work sounded very interesting, and the office had a bright and high energy feel, a nice change from the two shades of gray at Intel. I didn't understand how they could possibly beat Altavista, which had more users, more money, more engineers, and more everything. If Google did start to take off, wouldn't Altavista simply match their product and kill them? So I pretty much assumed that Google wouldn't make it, but it seemed like a fun job and a great opportunity to meet new people and learn more about startups. Maybe I could find a better startup the next time around. As it turns out, I was only half-right: Google was a great opportunity to meet people and learn about startups (and technology, and products, and more), but of course the whole "Altavista crushes Google" thing didn't happen.

What's my point? You don't need to have it all figured out right now. The important thing is to keep moving forward. Seek opportunities to learn or try something new, something with uncertain outcomes. If you're interested in startups, don't sit around waiting for the perfect opportunity, just go find one that sounds interesting and get a job there. The startup will probably fail, but you will succeed because you have learned a lot more than you otherwise would have. (This isn't to say that you can't learn things in a big company -- you can. For example, you can learn how to be a worker bee.)

Where does my path lead now? Last year I decided that life at Google had become too predictable, and too typical. I quit. It was time to move forward to something new, something uncertain.

Wednesday, March 14, 2007

Are you my audience?

Every so often I have an idea or thought that might be worth sharing. But then I think of all the ways in which it could be misinterpreted or disputed, and then I think about how to better explain or justify myself, and then I'm just tired of all that thinking and so I don't actually write anything.

In an attempt to avoid that trap, and to clarify my own thinking, I've decided to write for a very limited audience: me, and people who might be similar to me.

My fear is that I will get drawn into some dumb debate or end up arguing with fools, which is no way to live. To avoid this, I'll probably just delete all comments that seem trollish, smell anything like spam, or are just hopelessly annoying.

Also, I'd like to preface everything I'll ever say with this: I don't actually know anything. (and neither do you)

Tuesday, March 13, 2007