Anything's Possible

Venture backed startups are incredibly ambitious. A startup team comes together to try to create something highly improbable and well beyond what can reasonably be expected given the scarce resources at hand. Once financed, everyone at the startup should have a reasonable salary, but the real compensation for achieving the improbable is the equity that is typically shared between all employees proportional to the expected contribution of each person.

Inevitably, I get into a discussion with my companies about bonus packages. The idea being that startups are cash constrained and should limit the guaranteed salary costs, but that if the company is achieving goals, it should reward its employees with non-guaranteed compensation for a job well done.

The logic is compelling, but faulty. Bonuses are toxic at startups.

Outside of sales rep commissions, I don’t think startups should be giving employee or management bonuses in the early years and not until the company has very well understood financial performance. The problem is that bonuses don’t match well with the audacious ambition of the startup and aren’t fair to the company or the employees.

Inevitably, startups don’t quite live up to their goals. Using revenue metric.s because they are simple, consider the startup that has $3MM in previous year revenue and is hoping to 4X that this coming year to $12MM. Instead they do $9MM in sales. The team bonus is based on hitting or exceeding the goals. The team has worked really hard and, by all means, has done strong work growing the business. Yet they’ve fallen short of the goal. Unfortunately, somewhere over the course of the year, the team members start to assume that they will get the bonus. After all, the team tripled the business and worked really hard to do it. Yet the bonus was clearly for meeting or exceeding the goals. What should the company do now? Disappoint their hard working team by not giving a bonus or give the bonus and suggest that the goals are soft goals and the team will get paid as long as there is general progress and the team works hard. Add to the scenario that at $12MM in revenue the company would be positive cash flow for the first time and have cash to pay a bonus and at $9MM the company loses $1MM and will need to raise more capital and suffer additional dilution to cover the loss and potentially the bonus. It’s easy to imagine employees leaving the company and saying that the goals are crazy – “we tripled the business and didn’t even get our bonuses.”

Most companies just pay out the bonus anyway. Did that make the employees happy? Not really. They expected it. Did the bonus help set the ambitious goals for the next year? Not really. Paying the bonus below the goal suggested that the goals don’t really matter, which undermines the idea that the bonus is a form of motivation that leads to retention.

Worse yet, bonuses are not effective at recruiting employees. Most people that I know are a bit skeptical of bonuses before they join a company. They have no idea how ambitious the goals are or how likely they are to achieve the target bonus. On top of that, there is an ego element tied to salary that is absent in bonuses. All other things being equal, most people would rather join a company offering $100K a year in salary than make $90K a year with a potential target bonus of $20K. That isn’t so much an issue of risk aversion, but more of self assurance that they are worth $100K salary combined with the unknown of how likely they are to get any bonus at all.

Bonuses also create a culture of sandbagging and therefore are a bad motivation tool. Instead of wanting to achieve incredibly ambitious goals, employees start to consider whether the goal is likely and whether they will achieve their bonuses if they accept an ambitious goal. By arguing for lower goals, employees are optimizing for getting a bonus while actually working counter to the interests of the company.

Why are large companies different? At large companies goals are not as ambitious (10% growth vs. 200% growth) and employees typically don’t have the equity potential that they have at startups. Most importantly, financial goals are much better understood and typically achievable. Startups forecast based on what’s possible. Large companies forecast based on what’s probable. It’s esier to bonus employees on the later than the former.

So bonuses aren’t a good recruiting tool. Or a good retention tool. Or a good motivation tool. For these reasons, bonuses damage culture and focus the team on the wrong objectives.

What compensation tool is effective for recruiting, retaining, and motivating employees at a startup? Equity. Pay employees a fair salary for the stage of the company and keep everyone aligned to the extraordinary equity potential of huge growth. If the company achieves a 4X plan, the company’s equity has appreciated more than if it achieves a 3X plan. When employees don’t quite achieve plan, they understand that the equity hasn’t appreciated as much, but they are still rewarded for the forward progress with assumed appreciation of their stock. Employees have no financial incentive to sandbag because trying to achieve ambitious goals is how they maximize the equity reward. Best of all, equity has the potential of paying out orders of magnitude higher than any potential bonus.

I jumped into a taxi on my way to JFK airport from Manhattan with only 90 minutes to my flight. It was the last flight out to Boston, and I was stressed about making it in time. The driver asked which way I’d like to go and suggested the Midtown Tunnel. I took out Waze on my iPhone and looked up routes. 55 minutes via Queens Blvd local roads and 75 minutes via the Midtown Tunnel. I opted for the local roads. The driver immediately protested that we really shouldn’t go that way, insisting that the Midtown Tunnel was better. I’m a zealot for Waze and told him to take the local roads.

He incessantly complained about my not trusting his experience until we arrived at JFK.  Every time we stopped at a light he decided to exclaim again that the local roads are a crazy way to go to JFK.  

My driver was wise, but blind. 

Perhaps nine out of ten times he was right that his route was better, but without real time on-the-ground data, he didn’t know which way to go.  As I became exasperated listening to his groans, I realized, he’s exactly the same as a bad Venture Capitalist.

Good investors understand their role. They know what they are good at and what they are bad at.  They know where to push and when to stay back. Good investors have some confidence that they have some wisdom to share, but also know that they are blind.

Wisdom comes as a result of experience and pattern recognition.  Good investors have years of experience and a range of current case studies informing what makes companies succeed and fail and learn they from and share these experiences.  In our view, the best investors also have operating experience and have lived through many similar pains that are facing their investments.  That helps investors see patterns that lead to good outcomes and bad outcomes and bring those learnings to the company as helpful data to influence decisions.  This is where the role of the good investor ends.

Bad investors think that based on that wisdom, they know definitively what the company should do. Unfortunately, like my taxi driver, they lack self-awareness of how blind they are.  They don’t acknowledge that they have a tiny fraction of the data that management has to make those decisions.  Management may lack the wisdom that their investors have, but at least they can see what’s happening in the business and the market. Good management teams digest the wisdom, factor it into their decision process, and then follow their own beliefs about what to do. Good investors know the importance of ground truth and are comfortable with management going against their wisdom.

We arrived at JFK in 55 minutes and I made my flight.  Best not to let the blind lead those who can see.

I had lunch recently with one of our portfolio CEOs, and he said something that really caught my attention.  I had just commented on how well they were executing and the quality of the team he put in place.  He thanked me and said that he was really proud of the team, the culture, and how hard everyone was working.  Then he said “but it really doesn’t matter, unless we win.”

I think that comment sums up the key tension between founders and their investors and is somewhat unusual to hear from a founder.  When I was a founder, I remember feeling extremely deflated when my investors would point out that we were behind our plan.  We were working so hard and making progress.  I always felt that the investors didn’t appreciate our blood, sweat, and tears; despite the speed not being as planned, the progress didn’t come without amazing effort.  I was right that the investors didn’t really appreciate it, but didn’t consider that maybe they shouldn’t.  The hard work is table stakes.

Winning in entrepreneurship is really hard.  The second a founder takes venture capital funding, they are signing up to deliver improbable outcomes and the definition of winning becomes way more ambitious.  The investors are betting on an outlier business and the founders shouldn’t take the money unless they believe they can and want to build that type of business.  By definition, there are very few outliers and the odds are against the company.

The investors spend their time thinking about whether the company is winning and what it takes to win.  Typically, the founder cares even more about winning than the investors, but founders also care about many other intangibles including passion, a great team, a great culture, hard work, engaged customers and lots of faith.  Investors care about all those things as enablers of winning, but not as ends themselves.   Seldom do investors put money in companies prioritizing passion over economic expectations.  If the company fails to meet expectations, the inputs ultimately provide little solace to anyone involved.

When things aren’t going as planned, the founder naturally takes pride in everything the team built and all the intangibles that have been created to pursue the outcome.  As tough feedback comes from investors, it is natural for founders to be defensive and emphasize how much has gone into the business.  I certainly felt that way during our more challenging moments.

From the investor viewpoint, none of it matters if the company doesn’t win.  Understanding this difference in perspective is the key to overcoming the natural tensions between investors and founders.  Some founders, like the one I was having lunch with, seem to innately understand this better than I did when I was in the same seat.

One of my favorite founders in Boston is Jason Jacobs of Runkeeper.  Every time I see Jason, I mention to him how impressed I am with what I’m hearing about the progress of Runkeeper.  Without fail, Jason graciously thanks me for the encouragement and then shares the many challenges they are facing how much work there is to do to achieve his vision.

When I was starting out as a first time venture-backed CEO, I was way more insecure than Jason.  I was afraid to talk about the challenges with my team or board, for fear of seeming incompetent or dampening enthusiasm for the company.  Instead I harbored the challenges internally and always talked about how well things were going, until someone would point out the inconsistency of how far behind plan we were.  In reality, overselling the progress is what made me look incompetent.  I really wasn’t effective as a leader until I started focusing with everyone around me on the problems, while using the vision to build enthusiasm for the company.

Now that I have a portfolio of terrific founders, I have consistently seen this as the operating mode of the very best ones and particularly of successful repeat entrepreneurs and great operational CEOs.  Ask the typical entrepreneur how things are going and they feign a smile and say “terrific.”  Most founders feel the need to constantly convince their investors and everyone in the ecosystem that the company is doing extremely well; that the operational plan is well within hand, and the company is consistently outpacing it’s own aspirations.  This is not a characteristic of great entrepreneurs.

My best portfolio founders spend their board meetings telling the investors what is wrong with the business and how they are trying to solve those problems.  They don’t feel that they need to oversell the progress, because the ambition of the vision is the reason that they are so passionate and the reason that all of their constituents are committed to the venture.  The good news is either in the numbers or it isn’t in the numbers.  Hand waiving undermines credibility.  By putting the challenges on the table great leaders demonstrate how on top of the issues they are.  Most board members hear the bad news and think that at least they have someone excellent who is completely on top of solving the problems.

I have way more confidence in those that spend their time unearthing and focusing on the problems than those who pretend they don’t exist.  Sharing the challenging realities doesn’t demonstrate incompetence; instead it demonstrates the exact opposite.  Keep everyone energized by the big vision, but don’t oversell the progress in achieving it.

In late 2008, in the midst of the financial crisis, a small band of founders got together and started imagining the fund that we all wished existed when we started our own companies. We felt that there was a gap in the market for a fund that was dedicated to the seed stage and run 100% by founders and for founders – we called it peer-to-peer venture capital.

Founder Collective I was an exciting experiment.  We had all been actively angel investing for several years before we started the fund, but would it work for two of us to be full-time while five of our partners ran startups day-to-day and worked for the fund part-time? Would smart entrepreneurs appreciate the unique elements of our offering and want to work with us?

Founder Collective has now been in business for a little over three years.  We strive every day to live up to our mission of being the most aligned fund for founders at the seed stage.

We’re delighted today to announce that we’ve closed Founder Collective II – a $70MM fund continuing the work that was started by FCI and based on the same founder-centered vision.

We support this vision by looking at the world from a founder point of view and focusing our investments at the seed stage.

Every person involved in Founder Collective is an entrepreneur.  FCII, like FCI, will be managed full time by the two of us, with our other partners working part time for FC while primarily focusing on their day jobs of running companies. We are proud Founder Collective has had the privilege to back our own partners, Zach, Bill, Caterina, Chris, and Micah, on their startups. We feel that keeps us uniquely connected to the day-to-day challenges of running a fledgling company.

By dedicating ourselves to seed, we deliberately avoid the misalignment of being a net buyer round after financing round, while our founders are net sellers.  We are not buying an option on the future. Our founders don’t feel compelled to constantly oversell to make sure we keep buying. We invest at the beginning and then sit on the same side of the table.  That makes it easy for founders to talk to us about the ground-truth of their businesses, without fear that we’ll lose enthusiasm, and hopefully puts us in a better position to help.

Founder Collective is committed to backing exceptional founders and their visions of the future.  We don’t seek out founders that validate our particular thesis within a defined set of themes.  Show us a big business that can be transformed by technology and great people eager to prove it, and we want to be part of the journey whether it’s democratizing text books, fundraising for medical care, automating agriculture, rapid testing for food safety, or rethinking ground transportation.
 

We are deep believers in the entrepreneurial ecosystems of our home turf of NY and Boston.  This will remain our focus, while we’ll continue to invest in the Bay Area where three of our partners now live.  

Chris mentioned in his original blog announcing FC that the word “Collective” may sound a bit radical, but it is intended to emphasize our focus on peer-to-peer investing.  Over the last three years we’ve tried hard to honor our name.  Our founders actively help each other and help our fund.  We learn from them every day.

We see Founder Collective II as the next step in building a sustainable collective that will contribute to the startup world for many years to come.

- David Frankel & Eric Paley

I remember a very strange moment during my college interview where my obsession with baseball came into the conversation.  The interviewer asked me what I loved so much about baseball.  I listed several things that I love and then threw in a deeply held belief, “I find that baseball provides a metaphor for nearly everything in life.”  He seemed to find that amusing and quizzed me for some examples.  I offered many examples relevant to my life then and still have many relevant to my life now.  When dealing with lots of complexity, I often find baseball metaphors clarify things for me.  A recent metaphor has been coming to mind when thinking through our investment selection as venture capitalists.

First a bit of philosophical background – I’m a deep believer that companies are made and not born.  They can be born with terrific DNA and fail, and they can be born with terrible DNA and succeed.  All things considered, I’d take the terrific DNA every time, but this belief defies the way that most Venture Capitalists talk about companies.  I frequently hear VC’s say things after being pitched like “that’s a bad investment” or “that’s not an interesting company” or proudly state to others “we passed on that deal.”  Those are judgmental statements of DNA, but those comments don’t acknowledge that the company is dynamic and will change over time.  Not to mention that a good VC can make an impact on a company by helping focus its direction or introducing a key employee that becomes a catalyst to recreating the DNA of the company.

We see lots of companies that we think have very high merit, but we choose not to invest.  We see others with similar merit and pull the trigger on an investment.  At the moment we invest, we do believe that the new portfolio company is stronger than the interesting company in which we didn’t invest, but the future isn’t written yet and it’s all about the future, not the DNA. 

This leads me to my clarifying baseball metaphor – I’ve begun to think of investing much like a batter selecting pitches.  Pitch selection reflects a hitter’s estimation of the quality of that pitch for hitting, but it doesn’t define the outcome.  Some hitters dive for pitches out of the zone and hit it out of the park.  Other hitters swing at their perfect pitch and miss.  Pitch selection also reflects a hitter’s personal biases.  One hitter may just be more comfortable swinging at a high pitch than another hitter who likes to swing at low pitches; it all depends on what type of pitches the hitter or investor is most comfortable swinging at.

No doubt some pitches are better to swing at than others; much like funding startups with better DNA.  At Founder Collective, we are trying to swing at the best pitches that we can, but will swing and miss with some.  We’re also not swinging at lots of good pitches that other funds will hit out of the park.  I’m very happy with our overall pitch selection and think we’re going to have a terrific slugging percentage.  However, founders should understand that we don’t view the pitches when we don’t swing as bad pitches or the pitches when we do swing as probable homeruns.  We just have to keep looking for our pitch and take the best swing that we can.  It’s all about what happens next.

Startup founders have boundless ambition.  Most founders can imagine their platform concept having broad appeal and meeting the needs of many customers, with numerous products, often across many markets.  Investors love to hear about platforms and big visions for success.  This ambition is contagious but also very dangerous.

Repeat after me: “Startups Rarely Do Anything Well.”  I believe this mantra is the key to startup success.  The sooner a founder gets realistic about the need to focus, the more likely the founder will be successful.  To succeed, a startup needs to become world class at something that a large enough group of customers value.  Becoming world class at something is non-trivial.  It is very challenging for a small group of people to create something that is world class.  It is nearly impossible for that group to create multiple things that are world class.

Think of most of the fastest scaling startups of our time and how they started. Twitter, Groupon, Gilt Group, Dropbox, AirBnB etc.  They didn’t start with multiple products or even multiple target audiences.  Over time, they may have grown into broader platforms, but even today those platforms have limited capabilities that most people would refer to as world class.  Given the billion plus dollar valuations of these startups, one might expect that many of them would now offer multiple products and broaden their platforms, but looking back at the list, the range of products offered from each of these companies is highly focused.

Ultimately, the reason this is such an important mantra for startups is that success is so dependent on focus and prioritization.  A music student who wants to become a world class cello player needs to practice for hours a day.  That almost definitely prevents the same student from also being a world-class soccer player or even a world class piano player for that matter.  Being good at both pursuits is possible, but being world class at either activity requires an incredible amount of focus and prioritization of which activity to be practicing many hours per day.  The same is true of startups.  Division of extremely scarce resources among multiple goals is highly detrimental to becoming among the best in the world at something customers greatly value.  The challenge is deciding which of these goals is truly the big opportunity and justifies all the resources.  Hedging or multi-pronged ambition is almost never an outcome maximizing option.

I encourage startups to dream big, but to focus small.  While having a huge vision of the future, remember that if you are among the best in the world at solving one problem, you’ve achieved something rare. Aspiring to this goal alone is likely a multi-year rollercoaster pursuit.