Angel funding structure explained by Chaos Monkeys

Chaos Monkeys: Obscene Fortune and Random Failure in Silicon Valley by Antonio Garcia Martinez explains some of the typical structures around seed-round investing in Silicon Valley:

This is how Y Combinator works. For three months, the selected startup founders meet weekly for a dinner with some eminent startup personage. The dinners are not relaxed social affairs: they’re competitive demos in which founders try to one-up each other with increasingly developed products, upward-sloping user graphs, or funding news, within a context of technocamaraderie and shared suffering. The weekly cadence imposes order on the always-full-throttle startup chaos, and is a welcome respite from the grinding toil and stomach-churning stress. I always tried to sit directly in the front row to take the speaker’s measure. Marissa Mayer’s hands shook and she spoke at an anxious clip; she arrived escorted by a Google “handler,” the only speaker to do so.

Enter the investor’s great friend: the cap. The cap dictates the maximum number at which the company will be valued, for the purposes of calculating the investor’s stake when the company takes more investment capital. In our previous example, say the initial $100,000 investment had been done at a cap of $3 million. Then, despite the company’s raising later at a valuation of $10 million, the angel’s stake amounts to $100,000 ÷ $3 million = 3.3%, a much bigger slice. The angel’s effective price per share is that of the cap (rather than that of the valuation), giving him a huge discount on the equity compared with investors who just put money in. As a result, this cap is perceived in essence, if not in contractual reality, to be a proxy for the valuation of the company at the time of the angel’s investment. Early-stage entrepreneurs will bandy about their cap number as if it were a real company valuation, when in truth it’s an input to a hypothetical calculation that may or may not play out in the future.

Sacca had a very different attitude toward potential deals. Which is why Sacca, or any VC really, would push you to mimic his own distorted risk profile, which prefers a tenfold return, even if it marginally increases the chance of complete failure. Twofold just ain’t cool enough for the limited partners, and not why they handed over their money to Sacca in the first place. The risk expectations of founders and investors can often be severely misaligned. I hate sports analogies, but here’s one to explain this vital point: most VCs are playing a version of baseball in which the only way to score is to hit a home run when you’re at bat. They don’t care if you disgrace or impoverish yourself and strike out, and they don’t care if you get a solid line drive that lands you on second. To them, strikeouts and getting on base are equally pointless, and so they’ll push to proverbially “swing for the fences” no matter the count or the team you’re up against.

The reason for this all-or-nothing approach is how their funds are structured. VCs (or so-called angels like Sacca) raise a fund, out of which they’ll provision some number of investments. Barring doubling down on the same company, which they might do if the fund still has money when a company raises again, those investments are effectively “fire and forget.” The fund’s total profit will be calculated from whatever those initial bets return. Unlike, say, a hedge fund portfolio manager, who rolls the winnings from one good bet into the next, compounding a series of returns into something truly huge, VCs do not take liquidity from one company’s exit and pour it into yet another’s.* This, at heart, is why the go-big-or-go-home strategy makes the Silicon Valley world turn, and why entrepreneurs push themselves to be either the next Airbnb, or nothing. The entrepreneur who bucks this and creates a long-term business of recurring revenue but relatively slow growth is dismissed as running a mere “lifestyle business,” which is a dirty word among VCs. Of course, the entrepreneurs are quite happy to run a revenue-generating concern that spits out cash as low-tax dividends, and dedicate their lives to skiing or guitar playing or whatever. But their investors will hate them for it, and the entrepreneurs will suffer a loss of social capital as a result, and perhaps find they can’t raise money for their next venture.

What about the larger culture?

As every new arrival in California comes to learn, that superficially sunny “Hi!” they get from everybody is really, “Fuck you, I don’t care.” It cuts both ways, though. They won’t hold it against you if you’re a no-show at their wedding, and they’ll step right over a homeless person on their way to a mindfulness yoga class. It’s a society in which all men and women live in their own self-contained bubble, unattached to traditional anchors like family or religion, and largely unperturbed by outside social forces like income inequality or the Syrian Civil War. “Take it light, man” elevated to life philosophy. Ultimately, the Valley attitude is an empowered anomie turbocharged by selfishness, respecting some nominal “feel-good” principals of progress or collective technological striving, but in truth pursuing a continual self-development refracted through the capitalist prism: hippies with a capitalization table and a vesting schedule.

Characteristics of a successful founder?

What’s it take to do startups? It certainly isn’t intelligence. I was in the lower third of my PhD class in physics at Berkeley, and I had to take my preliminary exams three times before I passed. Most of the founders I know are certainly crafty and quick-witted, but compared with some of the certified geniuses I met in academia, they aren’t going to win any Fields Medals or Nobels. It certainly isn’t technical skill. I’m a crappy programmer, and I can hack crude prototypes of finished products at best. Some founders are technical virtuosos, but I suspect most weren’t the top students in their respective computer science classes (assuming they even had a formal education). It’s not unique product or market vision. Anyone who used Google’s ads-buying tool for all of five minutes, and then registered that that piece of shit was a $70 billion per year moneymaker, could see the need for AdGrok.

In my limited experience, there are two traits that distinguish successful startup founders at whatever level of the game, from the forgettably minuscule (e.g., AdGrok) to the epoch changing (e.g., SpaceX). First, the ability to monomaniacally and obsessively focus on one thing and one thing only, at the expense of everything else in life. I lived, breathed, and shat AdGrok. Thanks to focusing on AdGrok, I watched my daughter grow up through the frame of a Skype window while I was in AdGrok’s Mountain View shit hole. I had no social life outside of schmooze-and-booze tech events, at which I would wear my AdGrok T-shirt and engage in techno small talk with people I didn’t really care about. I had no hobbies or outside activities of any kind, except very occasional trips to the gym. My sailboat, into which I had poured two years of money and weekends to restore, slowly rotted in the sun. I never read anything except the tech press. Movies were out of the question. The ladies? While I was nominally still in a relationship with British Trader, my penis was anatomically equivalent to my coccyx: a purposeless vestige of a bygone era.

Second, the ability to take and endure endless amounts of shit.

The typical exit?

The fact was that even as the wheeler-dealer CEO, I owned no part of AdGrok. Nothing. Not one share. Neither did the boys. As is the case for every early-stage entrepreneur. So to actually see any proceeds from the AdGrok side of the deal, I’d have to have been there at least another couple of months as the deal got finished up. At the end of the day, AdGrok was simply a long, stressful job interview for Facebook (and ditto for the boys at Twitter). We all claim we “sold” AdGrok, but in reality, AdGrok was merely leverage to score the job offers that actually made us the real financial upside, job offers we would not have been able to score otherwise. The corporate-development teams of large companies, insofar as their small-company deals are concerned, are really glorified HR recruiters with fatter checkbooks. That’s another little detail the self-glorifying founders of acquired companies often fail to mention.

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