Here are the questions VCs asked Redfin that changed how we think about our business.

1. What’s your deadly sin? Sequoia’s Roelof Botha
. . . → Read More: The Eight Best Questions We Got While Raising Venture Capital]]> VCs are good at asking questions. They are unimplicated in your dumb decisions, unmoved by your original sense of mission and far less concerned than you that a blunder could bankrupt you. They re-imagine your business in terms of all the other businesses they’ve seen, pulling the arms off one doll and the head off another to create a perfect money-making Frankenstein. And since the stakes are high, the whole philosophical exercise tends to result in action.

Here are the questions VCs asked Redfin that changed how we think about our business.

1. What’s your deadly sin?
Sequoia’s Roelof Botha said he only invests in companies that let consumers indulge in one of the seven deadly sins. He rattled them off with alarming familiarity. “You don’t want to be the site that people should use,” Roelof said. “You want to be the site they can’t stop using.”

2. Where’s the real money?
Venture capitalists’ focus on the size of our company’s addressable market made us realize that half of our potential revenues lay in the eight markets we’ve already opened. “What’s the rush to open Orlando,” a VC asked us, “when you still haven’t cracked 1% share here in Silicon Valley?”

Several readers commented on Hacker News that my first stab at a simulation was misleading because it showed negative average returns for low deal sizes, when in fact expected returns should be not only positive but constant regardless of deal size.

They are right.

I had been using payoff as the random variable, but rate of return as the measured variable. The formula for rate of return (x^(1/t)-1) places the most weight on the zero-payoff case (where return = -1.0), so the simulation results were skewed towards negative
. . . → Read More: A Simulation of Angel Investing, Part 2]]> This is a follow-up to my post A simulation of angel investing.

Several readers commented on Hacker News that my first stab at a simulation was misleading because it showed negative average returns for low deal sizes, when in fact expected returns should be not only positive but constant regardless of deal size.

They are right.

I had been using payoff as the random variable, but rate of return as the measured variable. The formula for rate of return (x^(1/t)-1) places the most weight on the zero-payoff case (where return = -1.0), so the simulation results were skewed towards negative expectations, especially for low values of D.

In this new post, I present a simplified and more accurate simulation of angel investing.

As before, my goal is to shed some light on this question:

How many angel investments are needed to make the combined payoff look attractive from an investment standpoint?

Revised simulation

I coded the following simulation in Python.

1. Create a pool of 10,000 different investors, each investing in D deals, with a fixed distribution of payoffs per deal. Randomly simulate each investor’s combined payoff,

If anything, it resembles buying a deep out-of-the-money call option, but with nonlinearity. If you win big you might find yourself in on the ground floor of the next Google or Facebook. That’s incredibly unlikely, but still possible.

More likely, you’ll end up with a solid 2x-5x return from a startup that grows into a viable long-term business. But most likely of all–by a long shot–you’ll lose your entire investment in another failed startup.

The most successful angels invest in a long series of deals over many
. . . → Read More: A Simulation of Angel Investing]]> In angel investing, it’s the extreme distribution of payoffs that keeps things interesting.

If anything, it resembles buying a deep out-of-the-money call option, but with nonlinearity. If you win big you might find yourself in on the ground floor of the next Google or Facebook. That’s incredibly unlikely, but still possible.

More likely, you’ll end up with a solid 2x-5x return from a startup that grows into a viable long-term business. But most likely of all–by a long shot–you’ll lose your entire investment in another failed startup.

The most successful angels invest in a long series of deals over many years. They know that any one startup in isolation is a gamble, and to eventually hit a big return, an investor needs to draw repeatedly from the payoff distribution.

How many deals?

A discussion with Gabriel Weinberg on this topic piqued my curiosity about the relationship between the number of deals an angel invests in, and the shape of the payoff he or she can expect from that specific number of deals.

It’s clear that a single investment would have a terrible expectation and huge variance, but how about five deals? 20? 100?

How many angel investments are needed to make the combined payoff look attractive from an investment standpoint?

Monte Carlo simulation of angel investing

I coded the following simulation in Python.

1. Create a pool of 10,000 different investors, each investing in D deals, with

I’ll accept that critique. And take it one step further. The option pool is absolutely a piece of the price negotiation. But it is a very important one as I’ll explain.

But first, let me lay out a few things for those who aren’t well versed in these matters. The
. . . → Read More: Valuation and Option Pool — Understand the trade off]]> One of the more contentious things in the negotiation between an entrepreneur and a VC over a financing, particularly an early stage financing, is the inclusion of an option pool in the pre-money valuation. As my friend Mark Pincus likes to say, “it’s just another way to lower the price”.

I’ll accept that critique. And take it one step further. The option pool is absolutely a piece of the price negotiation. But it is a very important one as I’ll explain.

But first, let me lay out a few things for those who aren’t well versed in these matters. The pre-money valuation is the value of the company before the money comes in. Let’s say we call it $4mm. And let’s say the financing is $1mm. Then the post-money valuation is $5mm and the $1mm round is 20% dilutive ($1mm/$5mm).

But to the entrepreneur it might be a lot more dilutive due to the inclusion of the option pool in the pre-money valuation. Let’s say that the VC’s term sheet says that a 15% “fully diluted post money” option pool needs to be in the pre-money valuation. What that means is that the investor wants 15% of the company, after the financing is closed, to be in an option pool that has not been granted to anyone.

In the case of the $5mm post money valuation,

Although vesting schedules can be infinitely flexible in theory, in practice they don’t vary that much. You’ll find that the majority of option plans and restricted stock agreements are identical in meaning and vary slightly with how vesting is structured. Most vesting schedules have the following parameters:

General Corporate Materials These documents include:

Can you really send your business plan over the transom and expect to get a positive response?  The short answer is “no” – don’t waste your time.

I know some VCs would take issue with this and somehow I’m sure that there are some success stories with this method but trust me this is worst way to approach a VC.

Why is it a bad idea?  Most VC firms receive
. . . → Read More: Getting Access to the Old Boys’ Club (how to approach a VC)]]> Many VC websites have a tab that will tell you that you can submit your business plans to enquiries@vc_company.com or some similar generic email address.  But does it really work?

Can you really send your business plan over the transom and expect to get a positive response?  The short answer is “no” – don’t waste your time.

I know some VCs would take issue with this and somehow I’m sure that there are some success stories with this method but trust me this is worst way to approach a VC.

Why is it a bad idea?  Most VC firms receive an unbelievable number of business plans every year.  It really is hard to process them all effectively so some sorts of filtering techniques develop.  I remember asking for advice from a law firm in 1999 (before my first fund raising exercise) the best way to approach VCs.  He told me that “most VC’s will figure that if you are truly an entrepreneur you’ll find somebody that knows them, develop a relationship with that person and find a way to get them to introduce you to the VC.  If you can’t do that then you’re probably not really an entrepreneur.”  It sounded a bit like an “old boys club” to me.

It may sound harsh but in reality I think it’s true.  If you can’t get a warm introduction to a VC then how on Earth are you going to break down the doors to get to the VP of Sales, Biz Dev or Marketing in the organization that you’re looking to sell your products to to or develop partnerships with?  If you’re not assertive and creative enough to get through a VC’s doors then how are you going to get the most sought after journalists to write your stories or the most skeptical buyers to part with their hard-earned cash?