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For venture capital investors, Qualified Business Stock (QSBS) is one of the most lucrative tax benefits hiding in plain sight. It offers investors the chance to keep more of their returns by eliminating taxes on gains.

Despite being part of the U.S. Tax Code since 1993, QSBS was unused for decades—overshadowed by shifts in capital gains rates and overlooked by even seasoned investors. But today, thanks to key legislative changes, QSBS is making waves as a game-changer for venture funds, angel investors, and entrepreneurs alike.

In this post, we’ll explore the history and mechanics of QSBS, how it can transform your tax implications, and what you need to know to take advantage of it. If you’re investing in early-stage startups, this might just be the most important tax benefit you’re not fully using—yet.

QSBS first appeared in 1993, but was largely ignored

In 1993, Congress set out to incentivize investment into U.S. small businesses. As a result, Section 1202 of the IRS Tax Code was created as part of the Revenue Reconciliation Act of 1993. The goal was to give tax breaks to investors who purchased Qualified Small Business Stock (QSBS) and held it for more than five years. Initially, the tax break offered a blended tax rate of 14% on the first $10M of qualifying gains, or gains equal to 10 times the investor’s cost basis – whichever was higher. This was achieved by exempting 50% of the gains from taxes and taxing the remaining gains at a special rate of 28%.

At the time of Section 1202’s introduction, the maximum tax rate for long-term capital gains was 28%, making the effective 14% rate on QSBS gains highly attractive. However, very shortly afterwards, Congress reduced the maximum long-term capital gain tax rate to 20%, diminishing the relative impact of the QSBS benefit. By 2003, when the maximum long-term capital gains rate was further reduced to 15%, Section 1202 became virtually irrelevant. Saving 1% was not compelling enough to justify the extra complexity and tracking required.

The 2008 financial crisis sparked a QSBS revolution

The U.S. and global economies were plunged into a deep recession in late 2008 and 2009. In response, Congress incrementally expanded the QSBS tax break over the following years. Initially, these increases were temporary, lasting for short periods and sometimes applied retroactively. It wasn’t until 2015 that QSBS, as we know it today, became a permanent fixture of the U.S. Tax Code.

Key legislative changes included:

1. The American Recovery and Reinvestment Act of 2009: This act temporarily increased the tax-free exclusion from 50% to 75% for stock acquired after February 17, 2009.
2. The Small Business Jobs Act of 2010: It temporarily raised the tax-free exclusion to 100% for stock acquired after September 27, 2010, although only for a short period. This act also excluded QSBS gains from Alternative Minimum Tax (AMT) calculations.
3. The American Taxpayer Relief Act of 2012: This act retroactively reinstated the 100% tax-free exclusion and extended it forward for stock acquired through January 1, 2014.
4. The Protecting Americans from Tax Hikes (PATH) Act of 2015: This legislation permanently codified QSBS benefits, making qualifying gains 100% tax-free federally, exempt from AMT calculations, and free from the 3.8% Medicare tax. This was the true game-changer!

QSBS is now one of the best tax breaks in U.S. history

Today, QSBS stands out as one of the most impactful tax incentives in the history of the U.S. Tax Code. However, it wasn’t until the late 2010s and early 2020s that investors began to fully recognize the economic advantages of QSBS tax gains.

Here is the current tax treatment for qualifying QSBS gains:

• Tax-Free Federally: Gains are entirely excluded from federal income taxes.
• Exempt from Medicare Tax: The 3.8% Medicare tax does not apply.
• No Alternative Minimum Tax (AMT) Impact: QSBS gains are excluded from AMT calculations.
• State Tax Benefits: Gains are tax-free in 45 out of 50 states, with exceptions in Alabama, California, Mississippi, New Jersey, and Pennsylvania.

This combination of tax benefits makes QSBS an unparalleled opportunity for investors seeking to maximize their after-tax returns.

Holding Period Requirement

To be eligible for tax-free gains, Section 1202 requires that a taxpayer must hold QSBS stock for at least five years.

Limitations on QSBS gains

Section 1202 limits the amount of tax-free gain from any individual QSBS sale to the greater of $10M or 10 times the investor’s basis in the stock. Notably, this limitation applies on a per-company basis, not per taxpayer. As a result, an investor can claim up to $10M in tax-free gains for each eligible QSBS company they invest in, with no annual or lifetime cap on the total benefit.

What makes a company qualify for QSBS?

To qualify as a Qualified Small Business (QSB), a company must meet several criteria. While we won’t cover all the details here, the primary high-level requirements pertain to:

• Corporate structure: The company must be a U.S. C-corporation.
• Business activity: The company must actively conduct a “qualified trade or business.” (See definition below.)
• Asset limitation: The company must have less than $50M in aggregate gross assets immediately after the funding round in which the stock is purchased, as well as at all times prior.

What is a “qualified trade or business”?
The IRS defines it by exclusion, specifying what does not qualify. The following types of businesses are excluded:

• Businesses providing services in fields such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage, where the principal asset is the reputation or skill of one or more employees.
• Banking, insurance, financing, leasing, investing, or similar businesses.
• Farming businesses, including those involved in raising or harvesting trees.
• Businesses engaged in the production or extraction of resources for which deductions under Section 613 or 613A apply.
• Businesses operating hotels, motels, restaurants, or similar establishments.

Almost all other types of businesses qualify, meaning that the majority of U.S.-based tech startups structured as C-corporations (which is most of them) meet the criteria for Qualified Small Business status during the early years of their operations.

Can you get the QSBS tax break by investing in VC funds?

Yes. The QSBS tax benefit extends to partnerships or LLCs treated as passthrough entities for tax purposes. This means that investors in most early-stage VC funds are eligible for tax-free QSBS gains, provided the VC firm properly tracks these gains and reflects them as QSBS gains on the K-1 tax forms issued to investors each year.

In fact, a VC fund can generate well over $10M in QSBS gains from a single investment, and 100% of that gain can still pass through to its investors tax-free. This is because each individual investor in the fund has their own $10M QSBS limit per investment (as illustrated in Example 3 below).

QSBS tax benefit examples

Example 1:

An investor purchases QSBS in a qualifying company for $200k. After holding the stock for more than five years, they sell it for $5.4M, realizing a $4.4M gain. Under Section 1202 of the U.S. Tax Code, the entire $4.4M gain is tax-free federally. Additionally, the $4.4M gain is not subject to state tax in 45 of 50 states.

Example 2:

An investor purchases QSBS in a qualifying company for $1M. After holding the stock for more than five years, they sell the stock for $25M, realizing a $24M gain. In this instance, the investor exceeds the maximum $10M QSBS tax benefit. As a result, $10M of the gain is tax-free, while the remaining $14M gain is subject to long-term capital gains taxes.

Example 3:

An investor commits capital to a VC fund, which invests $1M in QSBS stock. More than five years later, the fund sells the stock for $30M, generating a $29M gain. How much of this $29M gain will investors receive tax-free? Surprisingly, it’s likely all $29M.

Here’s why: Each individual investor in the VC fund has their own $10M tax-free limit per investment. For example, if a single investor holds a 20% stake in the fund, the IRS treats them as having invested $200k in the company (20% of $1M) and as receiving $6M in liquidity (20% of $30M). This results in a $5.8M gain for that investor—well below the $10M cap—making the entire gain tax-free under QSBS.

But wait, there’s more: Investors can offset QSBS losses with Section 1244

Section 1244 is another lesser-known part of the U.S. Tax Code relevant to QSBS. It provides a unique benefit: If your investment is part of the first $1M invested in a QSBS company and the investment results in a loss, that loss can be deducted as an ordinary loss rather than a capital loss. In practical terms, this means the loss can offset ordinary income, providing a significant tax advantage.

Losses under Section 1244 are capped at $50,000 per year for individuals and $100,000 per year for married couples filing jointly.

Section 1244 has limited relevance in the traditional VC landscape since venture capital firms are rarely involved in the initial $1M invested in a company. Even Pre-Seed stage rounds typically exceed this threshold. However, individual angel investors and VC firms that focus on smaller funding rounds (such as ours) can benefit from this additional QSBS tax advantage.

How RSCM’s strategy benefits from QSBS

Although we didn’t initially design our strategy to take advantage of QSBS when we started our firm in 2012, it turns out that our focus aligns perfectly with the type of small funding rounds the government intended to incentivize. As a result, RSCM funds and investors have benefited greatly from the tax advantages provided under Sections 1202 and 1244 of the U.S. Tax Code. On average, we estimate that more than 80% of the gains from our funds will qualify as QSBS gains, and in some cases will exceed 90%. For example, over 90% of our Fund 1 distributions have been QSBS-eligible.  

When combined with the tax benefits from Section 1244 losses, the federal tax rate for most of our funds is expected to fall within the low-to-mid single digits.

QSBS: Encouraging innovation and benefitting investors

The U.S. government introduced the QSBS tax break to stimulate investment in U.S. startups and small businesses, recognizing the vital role these companies play in innovation, job creation and overall economic growth. By reducing the tax burden on successful investments, QSBS encourages more capital to flow into early-stage companies, helping to fuel entrepreneurship and economic progress.

Although it took years for QSBS to gain traction, it is now recognized within the small business and early-stage venture investment communities as a significant advantage. QSBS has come to fulfill its intended purpose, becoming a powerful tool for investors while supporting the broader goal of a dynamic and growing economy.

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This blog post is NOT professional tax advice

This blog exists to summarize the history and benefits of the QSBS tax breaks. It should NOT be construed as a complete or exhaustive overview, nor should it be considered tax advice. There are additional criteria not mentioned in this post that can disqualify a company and its investors from receiving QSBS tax benefits. Please consult a tax professional before making any personal investment decisions.

For pre-seed and seed stage startups, investor updates are a challenge. Often, founders try to make them too ornate and end up getting behind. Similarly, investors don't always have the time to fully digest a finely crafted narrative and lose track of what's happening. At RSCM, our portfolio of pre-seed and seed-stage investments is at about 2000 today, so we have lots of experience with updates. Not only do we read them all, we write a 3-7 line internal summary and each one goes into our CRM system so we have a complete history at our fingertips.In my opinion, useful investor updates have three requirements: they must get done, they must be easy to produce, and they must be easy to consume.

Anatomy of an Update

You can deliver on all three requirements by breaking updates into modules and putting the most important modules first. That way, you need only produce the modules you have time for and we need only consume the modules we have time for. Everybody wins.Here are the modules and order I recommend:

[Company Name] Investor Update for Month Ending [Last Day of Month]

• Metrics
• Highlights (Optional)
• Asks (Optional)
• Thank Yous (Optional)
• Commentary (Optional)

Notice that the only required module is "Metrics". This should be easy to produce because, at any given moment, you should have a handful of Key Performance Indicators (KPIs) you track anyway. This should be easy to consume because most investors have lots of experience absorbing tabular business data. This should be easy to get done because, in our modern software-driven world, KPIs are at your fingertips. Most importantly, if they are the metrics you are actually tracking to run your business, then they will be reasonably informative to investors. Requirements satisfied!More detail on metrics in a minute, but first some quick notes on Highlights, Asks, and Thank Yous. If you opt to include these modules, do them as bullets. Easier to produce and easier to consume. But, as with PowerPoint slides, no more than 7 bullets per section! Even then, only go to 7 on rare occasions. No more than 5 most of the time. It's easy for people to get saturated and when they get saturated, they flush the entire list from their attention. If you've got more to say, put it in the Commentary.Everything after Metrics really is optional. Better to get the update out the door quickly than wait until you come up with points for every section. If you ever find yourself thinking something like, "I'll crank out the Asks later," stop! Just hit send. Then if you do think of important items later, put them in a notes file and include them in the next update. Or send out a specific Asks email.

Universal Metrics

Now for some depth on metrics. There are really two types: (1) those that are universal to all pre-seed/seed startups and (2) those that are particular to your business. Investors need both. The first type gives us a general sense of how things are going for you relative to the typical startup lifecycle.  Kind of like the vital signs that all doctors want to know regardless of patient or condition.  They help us triage our attention. So start with them:

• Revenues: [revenues | date when you plan to start selling] (+/- ?% MoM)
• Total Expenses: [expenses] (+/- ?% MoM)
• Net Burn: [total revenues - total expenses] (+/- ?% MoM)
• Fundraising Status: [not raising | planning to raise | raising | raised]
• Fundraising Details: [how much, what structure, valuation/cap, who]
• Ending Cash: [last month's Ending Cash - this month's Net Burn + this month's Amount Raised] (+/- ?% MoM)
• Full Time Employees: [FTEs, including founders] (+/- # MoM)

Note 1: we strongly encourage a monthly update cycle. Anything longer means we get data that's too stale. Anything shorter, and the financial metrics don't really make sense. Though if you're part of an accelerator that encourages weekly updates, we'd love to see them. Just make sure we also get the monthly metrics!Note 2: always put the percentage or absolute month-over-month changes in parentheses next to each entry. It turns out that highlighting the deltas make updates dramatically easier for us to absorb by drawing immediate attention to the most volatile areas.A couple of quick explanations. Always have a Revenues line. If your product isn't finished or you aren't actively trying to generate revenues, just put the target date for when you do plan to start selling. Either piece of information is enormously helpful to us. Also, provide an FTE number that logically reflects the labor resources at your disposal. A full time contractor is a unit of full time labor that you can call on. Two half-time employees are also one unit. An intern may or may not be a unit or fraction of a unit depending on how much time he/she is putting in and whether the output is roughly equivalent to what a regular employee would produce. Don't exclude people based on technicalities, but don't pad your numbers either.Now, some detail about fundraising status. This topic turns out to be pretty important to existing investors. First, it lets us know that you're on top of your working capital needs. Second, some investors like to participate in future rounds and even the ones that don't are a great source of warm leads. Third, it makes us feel good to know that other people have or will be validating our previous investment. Here are a couple of example fundraising bullets:

• Fundraising Status: planning to raise in 4Q2015
• Fundraising Details: $750K - $1M Series Seed at a $5M-$6M pre-money from a small fund and/or local angels

• Fundraising Status: raising
• Fundraising Details: $300K - $500K on a convertible note at a $2.75M cap with $175K soft committed from [prominent angel name] and other local angels

• Fundraising Status: raised and raising
• Fundraising Details: $400K closed of a $600K convertible note at a $4M cap from [small fund name], [AngelList syndicate name], and local angels.

Custom Metrics

At any point in time, there should be a handful of top-level KPIs that you monitor to help run your particular startup. Of course, they vary across lifecycle stage, technology area, and business model. Just pick the most important 2-6 and give them to us. Feel free to change them as you pivot and mature.Here's an example for a pre-product enterprise SaaS company:

• Projected Alpha Delivery Date: 11/30/2015 (+15 days)
• Alpha Access Wait-list: 47 Companies (+8)

And one for an enterprise SaaS company that recently shipped private beta

• Max Queries/Minute: 1,201 (+29% MoM))
• Outstanding Critical Bugs: 3 (-2)
• Inbound Inquiries: 481 (-17% MoM)
• Qualified Prospects: 19 (+2)
• Paid Pilots: 3 (New Metric!)

And finally one for a consumer Web company in full operation

• Max Concurrent Users: 1,006 (+30% MoM)
• Registered Users: 23,657 (+13% MoM)
• Monthly Actives: 3,546 (+4.5% MoM)
• Users Making Purchases: 560 (+21% MoM)
• Total Purchase Value:$17,993 (+28% MoM)
• CAC: $12.55 (-7% MoM)

That's it. We estimate that, if you keep your accounting system up to date and use MailChimp, producing an update with metrics and a few extra bullets should take about 15 minutes (with some practice). And you'd be heroes in our book.  Well, all entrepreneurs are already heroes.  So you'd be superheroes!

This post originally published on 10/15/2015 and was last updated on 11/10/24.

I see a lot of pitch decks. Hundreds per year. Almost every one is wrong. Not the startup idea. Not the slide layout. Not the facts per se. But which facts and in what order. Nearly all founders use a structure guaranteed to kill their “conversion rate”.

The common flaw stems from a fundamental mismatch in the way our brains create versus consume content. Each engages a different rms of reasoning. I studied this general topic in graduate school under one of the pioneers in the field. I kept up with the literature over the years. And I observed a huge number of pitches. But it still took me years to realize what was happening (repeating the same mistake in my own pitches, of course). Once I did, I couldn’t help appreciating the ironic beauty of the situation.

First, some background in cognitive psychology. Your brain has two completely different reasoning systems. System 1 is the fast, associative pattern-matching module—good for sitting in the background while you walk the plains and then rapidly determining whether a rustle in the bushes signifies mortal danger or a tasty dinner. System 2 is the slow, logical alternative-weighing module—good for deliberately figuring out whether it’s best to make camp by the river or on the hill. (If you want the full general audience explanation of System 1 and System 2, read Thinking Fast and Slow by Daniel Khaneman, who was the partner of my late professor, Amos Tversky.)

Now, when you build a pitch deck, you have to call on System 2 to develop the content. System 2 is logical so you can’t help but try to construct a deductive proof of why someone should invest in your company. That’s why most pitches have 3-7 slides setting the stage: here’s the problem, here’s the size of the problem, here are the current solutions, here are the drawbacks of current solutions, here are the requirements for a better solution…” I refer to this pattern as “In the Beginning”.

However, when investors consume that pitch deck, either at Demo Day, in an email, or face-to-face, they call on System 1. For most people in most situations, System 1 is the default. System 2 takes much more energy and operates much more slowly, so it only gets called on when something special happens. Thus, unless your pitch quickly triggers investors' System 1s to recognize your company as a tasty dinner, their System 2s will never wake up and no amount of logic can help you. And then when you use your System 2 to try and improve your pitch, you'll be blind to the problem.

You may be wondering why none of your advisers notice this problem when they reviewed your deck or watched a practice pitch? Here's another ironic bit. People who sincerely want to help with your pitch will expend the effort to use System 2, also blinding them to the lack of System 1 appeal.

Perhaps the worst case of “In the Beginning” I’ve seen was at a pitch event several years ago with a brutal schedule of 12 fifteen-minute slots. A company in the last hour really started at the beginning: the last generation of technology, quotes on recent shortcomings of that generation, market sizing for the next generation, the founders’ previous experience designing this type of system, technical architecture of their new solution, and performance metrics versus the primary incumbent. Logical, but not engaging. Ran over his time and had to rush through the last slide, which was something along the lines of logos for 5 blue chip enterprise customers, an average annual contract value of $60K/year, and current $MRR of $35K/month with 20% MoM growth for 6 months.

WTF? By the time that slide flashed on the screen, 80% of the audience members were fiddling with their cellphones or chatting with their neighbors. Talk about a missed opportunity! Better to just show that last slide, drop the mike, and walk off the stage!

Luckily, identifying the problem suggests an obvious solution—focus on triggering System 1 to flag you as interesting. So without further ado, here’s Kevin’s “Hey, tasty dinner right here!” pitch template:

• ^‍Title Slide
• Context Slide: super high-level explanation of what you do, 5 bullets max
• BOOM! Slide: the most impressive thing about your company
• Ask Slide: what the next BOOM will be and what you need to get there‍
• Why Slides: details on how you made the first boom happen and why you’ll make the next boom happen too

Putting the Ask right after the Boom is key. The Boom triggers alertness and primes for action. Then you’ve got to give the investors something to pursue. Otherwise, you may lose their interest. Also, telling them about good stuff that will happen in the future right after good stuff that has already happened in the past naturally gives your good-stuff-forecast more credibility. Your investment ask will seem maximally reasonable at this point.

You may wonder why you need the Why slides at all? Well, once you wake up System 2, it needs to eat too. But keep the Why section as small as possible. The more facts you present, the more chance that System 2 will find a strong objection and dismiss you so it can go back to sleep—remember, System 2 requires a lot of energy. The goal is to just satisfy System 2 and get to the next step in the process. where you can bring other cognitive mechanisms into action. Oh, and when delivering the Why, keep referring back to the Boom as much as possible to maintain alertness. For example: “[Supporting Evidence]… which is why X customer loves us so much and is paying us so much money.”

My guess is that most founders’ pitch decks already contains 80%+ of this content. It’s just in the wrong order and probably too much detail on Context and Why. The big question you probably have is, “What should my Boom be?” Sorry, no blanket advice here. It’s situation dependent. But guess what? By simplifying the problem to one question, we’ve made it amenable to A/B testing. If your Boom isn’t obvious, generate 3-7 alternatives and test them against several investors each. Also, if you can’t come up with a decent Boom, it might be a signal that you haven’t made enough progress to fundraise with much success. So your near term goal becomes to make something Boom-worthy happen.

That's my preliminary diagnosis and treatment. I’ve given this advice face-to-face to many startups over the past two years and have received a lot of positive feedback. But it’s an inherently limited sample. So if you read this post, try out the approach, and learn anything interesting (positive or negative), please drop me a line and let me know! Maybe someday we'll be able to develop a thoroughly researched system of Evidence Based Pitching (EBP).

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This post was originally published on 05/10/2016 and was last updated on 10/14/24.

People sometimes ask us, "What's the #1 mistake startup founders make?" Based on our 2000 pre-seed portfolio companies, one of the prime candidates is: "Planning for Series A."I don't mean the way you plan for Series A. I mean the fact that you do it at all. We see a lot of pre-seed pitch decks. A decent fraction have a "Comparables" section that list the Series A raises for companies with similar models in the same industry. In these cases,  Series A has become an explicit planning goal, despite the fact that these companies are at least two rounds, and probably three or four, away from that milestone. But the prevalence in pitch decks vastly understates the issue. From systematically interviewing 800+ founding teams in accelerators, it's clear that Series A expectations play a substantial role in most founders' planning.

While completely understandable, even considering Series A at the accelerator stage is usually a huge mistake. As I've written before, taking Series A at the point where it's appropriate decreases your success rate (though increases your expected value). Unsurprisingly, actually working backward from a future Series A can create all sorts of planning pathology. Yes, TechCrunch makes a big deal out of Series As. Yes, lot of cool VCs blog about Series A. Yes, VC investment leads to pretty fantastic story lines on "Silicon Valley". But these sources of information inherently screen for outliers. It's still the exception. Even among successful tech startups. Fundamentally, you're trying to engineer an extreme outcome in a highly uncertain environment. On first principles, this is problematic, as Nassim Taleb so beautifully explains the The Black Swan. But let's work through the steps.

Start with a modern Series A of roughly $10M as your goal. OK, those VCs will want evidence that you can quickly grow past the $100M valuation mark. That means you'll probably need about a $3M Series Seed 12-24 months beforehand to build the necessary R&D, sales, and customer success scaffolding, as well as prove out a huge addressable market. This in turn implies a $1M angel round coming out of an accelerator to complete the full-featured version of the product and establish a firm beachhead market over the next 12-18 months.

Now, I can tell you from reading the investor updates for 2000+ pre-seed startups that such rounds are very hard to raise... unless you're a strongly pedigreed founder, have obviously anti-gravity level technology, or have crazy traction in a hot space. We like to say rounds at this stage have a "geometric" difficulty curve. A round that is twice as large is four times as hard to raise.

Even if you manage to raise that round, the failure rate at each subsequent stage is high because you're continually striving to achieve outlier levels of growth. There's not much room for error or setbacks.  It's like trying to run up a ridge that just keeps getting steeper and narrower, with a sharp drop into the abyss on either side.

So what's the alternative? We recommend you ask yourself, "What's the smallest early acquisition (but not just acqui-hire) that I'd be satisfied with?" Unless you have a significant previous exit, are already very wealthy, or have unusual risk preferences, this number is likely somewhere between a $10M and $35M acquisition where the founders still own about 1/3 to 1/2 the company. Then work backwards from that.

Now, you may be saying to yourself, "Wait a minute! If I could get acquired for $10M to $35M, I could get a Series A. It's the same thing." Not exactly. $20M is a typical Series A pre-money these days, at least from a traditional name firm. But you would also need to be able to demonstrate that you could quickly grow to be worth $100M+. And you usually get a bit of a premium on acquisitions. So it's only at the upper end of the range where a Series A would be a fit, and then only some of the time.

Importantly, acquirers mostly want to see a great business or great technology and Series A investors mostly want to see enormous growth potential, which often aren't quite the same thing.

Finally, Series A investors usually want to see extremely rapid past growth, as an indicator of rapid future growth. Acquirers care much less how much time it took you.Also, the cost of being wrong is asymmetric. Say you aim for Series A from the outset. If at any point it doesn't work out, you either fold or do a fire sale. In a fire sale, liquidation preference will kick in and founders will get zilch anyway. Conversely, say you go the smaller route and things go much better than expected. You can still "upgrade" to the Series A path. And if you go the smaller route and fail, there's some chance you'd still make a modest amount in a fire sale or acqui'hire.

So now let's work backwards from the acquisition. We'll assume that revenues, rather than technology capability, is the relevant metric because it makes the reverse induction more clear cut.

1. In most tech sectors, a $10M to $35M acquisition means $1M to $3M per year in margin (not gross revenues, though in some sectors, the margins are so high, it's the same thing). That's low $100Ks of margin per month.
2. Next, we like to think in terms of the "straightforward scaling factor". This is the multiple by which you can grow with straightforward scaling of your product development and sales machines. No major overhauls of the product, no completely new channels, and no huge breakthroughs. Basically keep doing what you're doing, but with more resources. In most segments, this factor is 3-4X for a target in the $100K/month order of magnitude. Obviously, it's not a sure thing. Bad things can still happen. It can turn out that you've made a mistake. But it's the difference between needing circumstances not to go strongly against you and needing circumstance to go strongly for you. That works out to $20K to $80K per month, depending on scaling factor and target outcome. Thus, your near-term goal becomes, "Build a business doing $20K to $80K per month in margin."
3. If your minimum acceptable exit is on the higher end and your scaling factor is on the lower end, you might want to break this stage into two (though your might want to ask yourself why your minimum is higher given the lower scaling factor). In most cases, the first step therefore reduces to, "Build a business doing $20K to $40K per month in margin."

This is often a very achievable goal with a very modest amount of capital. How do you go about raising a round to support achieving this goal? Well, we have a post for that.

It's worth noting that, in terms of our expected returns, it doesn't matter too much to us one way or another whether founders follow this plan. Our funds have many hundreds of companies, so we're expected value decision makers. Though there is also some argument to be made for preserving option value by having companies survive longer. But it's not a huge difference either way at our level of diversification.

However, for founders who can only do a handful of startups in their career, understanding the difference between success probability and expected value could be literally life altering. And don't forget, once you have a modest exit under your belt, you've got the pedigree! So it's much easier to command the resources and attention necessary to go big from the start on the next one.

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This blog post originally published on 12/10/2020 and was last updated on 10/14/2024.

Investor updates can feel like just another task on a founder’s endless to-do list, but they’re actually one of the most powerful tools in your startup toolkit. Done well, regular updates strengthen relationships with investors, unlock new opportunities, and ensure your company stays top-of-mind when it matters most. Done poorly—or not at all—they risk creating frustration or missing out on crucial help when you need it.

This post is your guide to writing updates that are not just sent but read, valued, and acted upon. From building a sustainable habit to crafting updates that inform and engage, we’ll cover the dos and don’ts to help you get the most out of every email.

Getting It Done

• Do Start Small. A lot of founders, riding a wave of initial enthusiasm, start off writing huge, detailed missives… for a couple of months. But few can keep up that pace while running a high growth business. Then, in their own minds, they’ve set the bar too high and struggle to meet those self-imposed expectations. Better to start with a small, core update. Build the habit. Add to it incrementally. Same advice as for starting an exercise program if you want to get long-term results.
• Don’t Let Perfect Be the Enemy of Adequate. Founders tend to be goal-oriented, and those goals tend to be big. Many seem to have a vision of the perfect update in their minds--capturing all the excitement, possibility, and heartache they’re experiencing. That’s a lot of pressure to put on yourself every month while staring at a blank page, especially with all the other demands on your time. Let yourself off the hook and come up with a very basic template you can fill out in 10-20 minutes (see our Minimum Viable Investor Updates post for ideas).
• Don’t Fall into a Shame Spiral. Often, it seems founders miss an update, then feel like the next one has to be even better. Which makes the chance of delivering it lower. Which means the next one has to make up for two missed updates. And so on. Again, let yourself off the hook. Offer a brief apology, go back to Step One, and Start Small.

Getting It Read

• Do Send as Email. Email is the least common denominator. All investors have it. Nearly all investors have evolved a system for organizing email that works for them. There are lots of tools for managing email lists. Don’t use Slack. Don’t try completely new platforms. Feel free to use other platforms in addition to email. But put your core updates in email. (We could provide detailed reasons why each alternative platform is inferior but they all essentially boil down to standard least common denominator platform arguments.)
• Don’t Put the Content in an Attachment. Honestly, I don’t understand why founders attach updates as PDF, Word, and PowerPoint. Sure, supplementary material is fine in those formats. But we receive a lot of updates where the founder has clearly written a specific update document and attached it as a file. Forcing the opening of a file just introduces friction and attachments break/slow some forms of searching. One founder said he felt it was more secure. As our founder Kevin Dick, a former security guy, puts it: “Uh, no.”
  Note: There is an exception here. If the choice is between not sending a useful update at all and sending a pre-existing file like a board deck or pitch deck traction slides, go ahead and send the file.
• Don’t Rely Solely an Online Service Like Reportedly. Anything that requires a login introduces friction. But it also causes particular problems where partners in a firm jointly help portfolio companies and/or have a process for actively synthesizing a view of each portfolio company’s state. You don’t want a process that makes it hard for multiple people at a firm to look out for you. If you really want to use something like Reportedly, perhaps to manage discussions, copy the body of the update into the email as well.
  Note: if you want to centralize your detailed financial reporting as part of your accounting system, that’s fine. Just link to it from your update emails.

Maximizing Usefulness

• Do Put Metrics Up Front. Most founders seem to think the metrics are the punchline, but they should be the preamble. First, for the same psychological reasons that you want to put your traction up front in a pitch deck, as we explained in Your Pitch Deck is Wrong. Second, purely from a practical standpoint, if an investor is short on time, the metrics give the most information. Third, the metrics provide useful context for absorbing all the other information. Traffic shot up? I’m looking forward to finding out why. Burn spiked? I’ll expect an explanation. CAC and LTV both went up? This should be interesting.
• Do Include Financial Metrics. Financial metrics are your startup’s basic vital signs, like pulse and blood pressure. It’s really hard to maintain situational awareness of how things are going without them. Always provide Net Burn and Ending Cash. If you’re generating revenues, provide revenues. Better yet, break it down as applicable: recurring vs one time; COGs vs margin, inbound vs outbound, etc. Whatever is most relevant to your current situation. But please don’t use non-standard or ambiguous terms without defining them. If you’re not generating revenues, provide some indication of what the timeline is, whether it’s a target shipping date for revenue generating product, details of where prospective customers are in the pipeline, etc.
  Note: some founders think that financial metrics should be confidential. Not from people who gave you money! If there are people on your update list who are not investors and you don’t want them to know, split the distributions. If this sounds like a hassle, go to Step One and Start Small.
• Never Just Provide a Percentage Change. Perhaps even more frustrating than no financial metrics at all is seeing just a percentage change. Again, the motivation here seems to be confidentiality, but the same response applies. Statements like, “User acquisition costs dropped by 30% last month,” or, “Revenue rose 30% last month” are not only useless to your investors, they are extremely frustrating. The goal of your update is probably not to frustrate your investors.
• Do Provide Values as Well as Graphs. Graphs are great! But often the graphs will have weird scales or multiple scales or be generally hard to read. So if you graph a quantity, be sure that each point is either clearly labeled with the corresponding value or also put the values for the most recent period in text below the graph.
• Do Provide Fundraising Details. Investors can often help with fundraising. If not this round, then maybe the next one. We also like to get validation that our previous investment is appreciating! So knowing exactly where you are in a raise or where you ended at close is important. If you’re raising, report the target amount, the target valuation (a range is fine), how much you have committed, how much closed, and from whom. If you’ve completed a raise, report the final total, final terms, and final participants. And again, don’t use non-standard or ambiguous terms like, “We secured $500K from [firm].” What does that mean? A verbal promise, a written commitment, signed investment documents, a check?
• Do Organize Content into Digestible Chunks. Paragraphs of unbroken prose or lists of unbroken bullet points are hard to digest. Use descriptive and logical headings to group related information together. Never have more than three consecutive paragraphs of prose--and only then if the paragraphs are reasonably short. Never have more than seven consecutive bullet points. Only have more than three consecutive graphs if they’re all closely related and seeing them together is necessary to provide a coherent picture. For reference, here are the sections we use in our internal app for summarizing company updates: Metrics, Fundraising, Team, Business Model, Product/Engineering, Customers/Sales/Channel, Miscellaneous

What Investors Need from Your Updates

You may have specific circumstances not addressed by this list. In general, it helps to have a model of what your investors are looking to get out of the updates. First, remember that they are looking at your company mostly from the outside and can’t possibly have all the context you have, and there’s no way you can load it into their heads in a reasonable period of time. Second, investors want to be helpful if possible. But you don’t necessarily know if you need help or the best way each investor could help. Experienced investors actually have more context than you on how startups in general develop and the challenges they encounter. They obviously have more context about their own capabilities. So the best path is to give them a high-level and reasonably transparent view that both maintains consistency over time but also notes “inflection points” when you think you hit them. You should always feel free to ask investors what they want to see.

The Power of Staying Top of Mind

The absolutely most important thing is to send out an update regularly. Your investors and their extended networks are a valuable asset--but only if they are up-to-date on your company. If you have six investors, and they each give you just a single strategic introduction every other year, that’s three extra opportunities per year for good things to happen. You could be missing out on introductions to acquirers, channel partners, next-round funders, experienced potential hires, relevant advice, and much more. All because your investors don’t know what’s going on with your business. Can you really afford not to put this free upside in play?

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This post originally published on 08/07/2018 and was last updated on 8/10/24.

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The venture market bottomed out from historic highs last year. Total deal volume slumped roughly 50% from 2021’s peak, exit activity hit a ten-year low, and venture fund performance dropped across the industry. These rapid changes have created a new landscape for venture capital, and it’s affected how VCs are investing.

Right Side Capital surveyed 110 Pre-Seed and Seed VCs from February 2024 to May 2024 on their investment activity and strategies in 2023 and their plans for 2024, with a focus on Pre-Seed Rounds and Seed Rounds. VCs revealed that they are optimistic about the funding landscape in 2024 and that they have high expectations for revenue levels and growth rates from portfolio companies.

Below we share what we learned.

VCs Were Active in Pre-Seed Rounds in 2023

Surveyed VCs revealed that they were fairly active in Pre-Seed investment last year. Of the VCs surveyed, 87.0% made at least one investment in round sizes of $1M to $2.5M, and 35.2% made more than five investments at this stage.

Seed Round Deal Volume Was Less Than Pre-Seed Round Deal Volume in 2023

VCs reported less deal volume in Seed Rounds in 2023 as compared to Pre-Seed Rounds during the same period. Only 12.1% of surveyed VCs made more than five investments at this stage, and 25.9% made no investments at all. The majority (62.0%) made between one and four investments at this stage.

Investment Outlook Is Optimistic in 2024

Nearly half (45.4%) of respondents plan to make five to nine new investments in 2024, which is a significant increase from 2023, and 24.1% said they planned to make 10 or more investments this year. All respondents planned to make at least one investment, which indicates a more positive outlook from 2023.

Pre-Seed Fundraising: What VCs Expect from Founders in 2024

At the Pre-Seed fundraising stage, only 46.3% of surveyed VCs will invest in a pre-revenue startup, 27.4% will invest in a startup with sub-$150K annual recurring revenue (ARR), and 14.7% require $150K – $499K in ARR. For some surveyed VCs, revenue expectations can be even higher: 11.7% said they required startups to have $500K or more in ARR.

Growth expectations are high for Pre-Seed Rounds, with 34.8% of surveyed VCs expecting startups to double year over year at this stage, and 37% expecting startups to triple year over year.

Seed Fundraising: What VCs Expect from Founders in 2024

Expectations vary a lot for startups raising their seed rounds. At this stage, 17% of surveyed VCs will invest at pre-revenue, but 24% want to see ARR of $1M or more. That’s a big change from four years ago, when $1M or more in ARR was the criteria for Series A funding.

Surveyed VCs expect aggressive growth at this stage, with 47% investing in startups that are doubling year over year and 34% investing in startups that are tripling year over year.

Most VCs Recommend 6-12 Months of Runway

The majority (53.7%) of surveyed VCs advise their portfolio companies to maintain six to twelve months of runway before raising their next round. Only 29.6% of VCs advise startups to have over 18 months of runway.

Capital Efficiency Is More Important Than Ever

VCs reported that, in this leaner landscape, they are placing a greater emphasis on capital efficiency for portfolio companies. For 81.5% of respondents, capital efficiency is more important than ever before. The survey included an option for respondents to indicate that capital efficiency was unimportant, but not a single respondent selected it.

Roughly One Third of VCs Have Changed Their Investment Thesis

We asked respondents to write in answers about how their firm’s investment thesis has changed in 2024. Below we break down the results of those write-in answers.

Summary of Investment Thesis Changes in 2024

No Change (58%) The majority respondents indicated that their investment thesis has not changed significantly from 2023.

More Focus on Specific Areas (15%) Some VCs have an increased focus on specific sectors such as health, cyber, AI, and cybersecurity. They’re putting a greater emphasis on software, particularly AI-powered applications, and avoiding certain sectors like consumer and hardware.

“Like everyone else, [we have] more interest in AI-powered applications.”

– Survey respondent

Adjustments in Investment Strategy (10%) Some VCs are shifting to smaller check sizes. They indicated more capital allocation for Pre-Seed and they are rightsizing investment amounts to achieve more significant ownership.

Greater Sensitivity to Valuations and Due Diligence (7%) VCs are more sensitive to valuations, ensuring companies have more runway, and conducting more thorough due diligence. They’re also focusing on financing risk, revenue, traction KPIs, and efficient use of capital.

“[We’re] thinking more about financing risk and making sure companies have more runway.”

– Survey respondent

Increased Sector Preferences and Deal Dynamics (5%) A small subset of VCs have a growing preference for companies with experienced founders, significant revenue, and efficient burn rates. They’re avoiding overinvested spaces like sales-enablement software and sectors that are seen as high risk for next-round funding.

“[We’re] rarely taking pre-product risk unless the team has prior operating experience.”

– Survey respondent

No Specific Answer or N/A (5%) Some responses were “N/A” or did not specify a change in investment thesis.

Final Conclusions from the RSCM 2024 VC Survey

The venture capital landscape in 2024 has adapted to a leaner and more cautious environment. Right Side Capital’s survey reveals a higher bar for revenue expectations and a greater emphasis on capital efficiency than in more bullish periods.

Despite the challenges of 2023, VCs are optimistic about 2024 and plan to increase new investment volume. Overall, VCs are adopting a resilient and forward-looking approach, emphasizing sustainability and capital efficiency to navigate the transformed economic landscape.

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Founding a company is challenging enough without also heading your sales process. But Kelvin Johnson, the CEO and co-founder of Brevity, believes that leading sales is an opportunity for founders to get to know their customers. He’s developed a five-step sales process that tailors to a prospect’s pain points and adapts to his customer’s needs, while also allowing him to learn his Ideal Customer Profile (ICP) and build trust.

In a recent webinar for Right Side Capital Managment’s portfolio companies, Kelvin sat down with RSCM’s “Sales Doctor” Paul Swiencicki to share how he’s used his founder-led sales process to drive $600K in annual recurring revenue (ARR) for Brevity’s core product, an AI-powered sales role playing tool.

Below, we outline Kelvin’s sales process and highlight some of his key insights.

Step One: The Qualification Call

Kelvin uses a qualification call to kick off his relationship with a prospect to determine if his product will be a good fit for them. He makes sure the call takes place before any additional time is spent on the sales process. “We start off these conversations by asking, ‘What piqued your interest to even take this call?’ and ‘What will a successful outcome look like at the end of our 30 minute conversation?’ So at least we have an anchor point as to what’s important to them,” says Kelvin. “We may have our own agenda, but I really want to figure out what is important to this prospect. And I want to make sure we maximize our time.”

Qualifying leads is a critical part of sales success. A founder’s time is best spent on  prospects where their product can make a big impact. “At first, we weren’t doing a great job of qualifying our leads. But over time, we ended up discovering that our best ICP is somebody that’s at the sales manager level or above, who oversees at minimum 10 sales reps. That’s where it starts to make sense for us,” says Kelvin. “You’ve got to qualify hard to close easy.”

Step Two: The Custom Test Drive Demo

Kelvin has learned that a demo is much more effective when he caters to a prospect’s specific pain points. He schedules a “call before the call” in advance of a demo to gather information. “In the call before the call, we’re trying to figure out where a prospect is experiencing the greatest friction, what initiatives they have in place to alleviate that friction, and what have been the results of those initiatives,” says Kelvin. “We’re also trying to get into the weeds of what key success metrics matter the most to them, a.k.a., ‘How do you plan to justify this investment internally?’”

Once he knows what’s important to his prospect, he can give them a customized demo. Demonstrating he paid attention is also a great way to build trust and strengthen his relationship with the prospect. “You have to shut up, listen, and then here’s the most important part: As soon as you hear what the customer says, that’s the only thing you demo,” says Paul. “What I find is that everyone just does a spray and pray demo. It’s all just one size fits all. That’s not what prospects want. The first thing you have to demo is what they said their problem is. Otherwise, they’re not going to listen.”

Step Three: The Business Justification Review

After the demo, Kelvin sends the stakeholders a document that captures everything he’s learned about them thus far. The document outlines their problem, what they’ve already tried, the outcomes and results of those past solutions, what they stand to gain by using Kelvin’s product and, most importantly, what they stand to lose if they do nothing. “One of the most important sections in the document is about the cost of inaction – the lost revenue calculator,” says Kelvin. “The biggest thing we’re all competing with is doing nothing.”

He then schedules a call to go over the document with the stakeholders, so he can put all of the relevant information in front of the prospect in one tidy package. “This makes our champions look so good when they present to their CFO along with a supporting Excel sheet that shows them the cost of doing nothing, of not buying our product. That shows them why they need to start now,” says Kelvin.

Step Four: The Kick-Off Call

Kelvin is thinking about retention before he’s even closed the deal, which ultimately leads to higher ARR. Research has shown that retaining customers is cheaper than acquiring new ones and that improving retention by just 5% can drive profits up over 25%.

Kelvin sends the prospect a plan for implementation that sets expectations and shows clear milestones and goals. “We understand how overwhelming new software can be,” says Kelvin. “I’m trying to break it down into very digestible pieces.” He asks his new customer two questions: “Before the end of our renewal process, what are you going to brag to your board about?” and “What is one high-impact scenario where we can deliver first value?” Kelvin and his team can then have a kickoff call that caters to these primary objectives.

Step Five: The First Value Check-In

About one month after closing the deal, Kelvin schedules a call with his new customer to ensure they’ve hit their initial goal. “Our average customer is getting to first value within 17 days. Not because they’re focusing on uploading their entire sales playbook into our roleplaying software. No, no, no. We’re focusing on one high impact, high stakes, high frequency scenario,” says Kelvin.

From there, Kelvin can work with the customer to expand Brevity’s usage and ensure the customer is getting what they need. “I tell them, ‘It’s our job to make this simplified for you and your team,’” says Kelvin. “Everybody learns how to maximize the utility of the software within the first month. And then once we’ve nailed that, then we get to show ongoing value.”

A Repeatable Process for Building Revenue and Trust

Kelvin’s five-step sales process is a testament to the power of personalized engagement. It emphasizes active listening, customized demonstrations, and transparent communication that not only fosters trust but also ensures alignment between Brevity’s solution and the customer’s needs. By implementing Kelvin’s strategies, you can not only increase your chances of closing deals but also establish credibility, laying a solid foundation for a long-term, successful partnership.

Want to get more expert advice for your startup? Apply for funding from Right Side Capital to gain access to take part in our community of 1800+ founders and gain access to a host of free services including go-to-market, sales, marketing and fundraising advisory.

About Right Side Capital

Right Side Capital is one of the most active VC firms investing in the Pre-VC stage, partnering with 100+ capital efficient tech companies in the USA & Canada every year at an average round size of <$500K.

As a team of former founders and operators, we know that founders tackle problems that are equal parts challenging and inspiring. Building on our 12 years of experience with 1800+ portfolio companies, we’re changing how early stage startups receive funding and support.

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RSCM is different from the vast majority of startup investors.

We are one of the only ones that is completely transparent on our Web site about our criteria and completely open access to any founders that think they meet them. Then we are fast. We make decisions in days and fund in weeks

If you’re familiar with how other investors work, you might find our behavior confusing. But once you understand our perspective, you’ll hopefully appreciate the rationality of our approach.

We look at the investment process like engineers:

• There are very large numbers of both startups and investors.
• The probability of any particular startup and any particular investor overlapping in their requirements is small.
• Startups and investors both want to find the best match.
• Time is valuable.

Conclusion: as an investor, (1) you want to be very up front with your target profile so startups outside this target don’t waste their time with you and (2) if you’re going to pass on a deal, you want to do so as quickly as possible. The later in the process you pass, the higher the cost to you and the startup. If you fail a high percentage of deals near the finish line, you’re doing it wrong.

When we analyzed and observed other investors, it seemed like two large sources of rejection frequently occurred at the very end of the process: outside of scope and disagreement on valuation. Investors would spend an enormous amount of time learning about a startup’s technology, business, and team, only to say, “No,” because they didn’t feel the investment ultimately matched their thesis or the founders wanted too high of a valuation.

Ideal Profile

To address the first category of failure, we made a list that defined our ideal profile and stuck to it. That may sound simple in theory, but it turns out to be extremely difficult in practice due to “fear of missing out”. Our goal was to come up with a set of criteria so crisp that we would never invest outside its boundaries and would invest in anything within its boundaries at the right price. Obviously, such perfection is impossible, but we are far closer to this ideal than everyone else.

Our list is not very long:

1. Must be a “technology startup”.
2. Must be “capital efficient”.
3. Must be looking for an investment of no more than our maximum round size.
4. Must be looking for a valuation of no more than our maximum valuation.
5. Must be located within our investment geography.
6. Must not be in one of our excluded business areas.
7. Must meet our minimum traction bar.
8. Must have a minimum number of FT founders..

Obviously, the parameters of each requirement can evolve. But it’s easy to declare them at any point in time, at least for (3)-(8).

Defining a “technology startup” is more subtle. For example, Internet auction sites and bookselling sites were “technology” in 1995. In the 2020s, not so much. What about a company that makes clothing from advanced materials manufactured by someone else and then sells it on Amazon? We would look at this business and conclude that their value add is the design of the clothing, so it’s fashion not technology. A similar analysis applies to resellers, who may sell extremely technical products, but their specific value-add is not the technology in those products.

Then there’s the issue of “technology-enabled” businesses–ones that apply technology internally to deliver a non-technology product such as car repair or temporary workers. In these cases, we consider how much technical advancement the startup has achieved and whether its business is likely to scale dramatically better than it would without the technology enablement. For example, if the technology enablement were superficial and easy to imitate, we would be a no. If the business required building or customizing specialty facilities at scale, also a no. If the differentiation were branding or fashion, no.

In general, we try to predict whether the business would scale rapidly due to its technological advantage and whether the exit market would treat the business as technology, with its associated high valuation multiples. Obviously, these touchstones are imprecise, but at least they provide a framework for making a determination.

The definition for “capital efficient” is also fuzzy. The underlying issue is that, the more capital a company needs to prove out its business, the more vulnerable it is. Also, when you’re an early investor that doesn't follow on, there can be structural challenges with large subsequent rounds that occur before a company has achieved product-market fit. The question we ask ourselves is, “Could this business reasonably get to breakeven, if necessary, with only $1M to $2M in total investment?” That doesn’t mean we don’t want companies to take more money; we just want them to have the choice and negotiating power of not needing large future rounds.

Valuation Up Front

Addressing the second challenge of avoiding mismatched valuation expectations is trickier. Any solution requires calculating at least a narrow range for the acceptable valuation up-front and at low cost. Initially, we developed a basic algorithm using parameters like founder experience and stage of technical development. This algorithm worked well enough to make us far more nimble than other investors, but required substantial qualitative judgment to determine the input value for each parameter. 

Then, a few years after we started investing, startups in our price range started routinely having initial revenues. We quickly realized that we could key valuations off these revenues. While more objective than our first algorithm, this path presented two sub-challenges.

The first sub-challenge was determining whether focusing on revenues would produce “negative selection”. It’s theoretically possible that the startups with the most potential to have very high returns are those working on groundbreaking products that take longer to reach a salable stage. In fact, there was also some conventional wisdom to this effect. However, there was also conventional wisdom from the “Lean Startup” movement that advocated getting some version of the product into the hands of customers as soon as possible.

When we analyzed our portfolio up to that point, we determined that several factors argued strongly for early revenues being a net positive:

• Burn. Startups at our stage seemed to typically burn $10K to $20K per month. Revenues of even $5K per month could extend runway 33% to 100%. Because we fundamentally believe that the earliest startups represent option value, revenue that extended runway should increase this value.
• Business. Having some customers willing to pay something is a positive sign that the startup is in a general area that might be a good business. Also, founders that are able to convince people to pay now is some indication that they’ll be able to convince people to pay more in the future. Finally, achieving initial revenue quickly and at relatively low cost is a signal of capital efficiency.
• Innovation. Having customers to test new features on and ask about broader needs is a valuable source of insight. People who pay money are a more reliable source of opinion because they have skin in the game.

The second sub-challenge was how to deal with different revenue models. Obviously, a company that sells a piece of hardware at 50% margin and then a bunch of professional services is quite different from a SaaS company with customers on annual contracts at 90% margin. After reviewing our portfolio to that point, we were able to construct a set of rules that accounted for these differences:

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1. Only revenues from the technology product or service count. No professional services revenues.

1. Only gross margins count. 
2. Growth path matters. A startup that reaches $10K/month in three months since launch is more attractive than one who took a year to grow from $1K to $10K.
3. Recurring matters. Customers on annual contracts are better than ones on month to month contracts, which in turn are better than those who pay once. Generating revenues from a spot market, such as an ad or affiliate network, is the least attractive.
4. Price point matters. At low price points, the sales channel must be very scalable and the acquisition costs pretty low. At higher price points, there is more room for error.
5. Sales channel matters. The lower cost and more scalable the channel, the better.
6. Acquisition cost matters. The less it costs to acquire a given amount of revenue, the better.
7. Revenue concentration matters. Having more than one enterprise customer or customer segment is more attractive.

With these rules, we can look at a startup’s revenues in the context of our historical deal flow and determine our valuation tolerance. Obviously, if we happen to have several recent deals with identical revenue characteristics, we can determine the valuation easily. But the above rules also allow us to make tradeoffs versus recent deals with different characteristics. For example, a company that is otherwise similar at half the price point would be worth a modest amount less. But if it had achieved revenue more quickly then grown much faster, that could make up the difference. In practice, we seem to be able to make these tradeoffs for most startups we encounter.

Importantly, we distinguish between the “market” price and the price we are willing to pay. While we may determine that the market price for a startup is X, that price is based on the startup going through the much lengthier, haphazard, and opaque process other investors use. So we typically ask for a price that is 20-30% below market. Conversely, we acknowledge that startups can likely get a 20-30% higher price if they are willing to go through that longer haphazard process. Note that this position makes us a more competitive choice for startups that don’t have a lead investor or a substantial fraction of the round closed. Startups that already have a chunk of working capital coming in obviously don’t get as much benefit from us moving quickly.

Logical Process

These two innovations, sticking to an ideal profile and aligning valuation expectations up front, lead to a straightforward, efficient investment process. We simply apply the concept of failing as fast as possible.

1. Receive request. We funnel all funding requests through our Web site to ensure we get a relatively consistent set of information that we can process quickly. Sometimes, we receive an electronic or verbal inquiry where we can “look ahead” to identify an obvious mismatch and save a founder the trouble of going to the site.
2. Screen for profile fit. Based on a company’s description, Web site, and deck, we try to determine if a company fits our ideal profile. Occasionally, making this determination may require a few emails.
3. Screen for valuation fit. Based on a company’s revenue model, current revenue level (including firm contracts going active soon), and capitalization structure, we calculate our valuation tolerance. Sometimes, making this determination may require a few emails. 
4. Make an estimated offer. If a company’s valuation expectations are far outside our tolerance, we often reject the deal out of hand. If there’s potentially some room for overlap, we will provide our estimated offer to the company. Sometimes, exploring whether there is overlap may require a few emails.
5. Review initial diligence documents. If there’s a profile fit and valuation alignment, we’ll review an initial set of diligence documents. We usually want to see a capitalization table, current balance sheet, monthly P&L spreadsheet, and some breakdown of customers.
6. Phone call. If the documents don’t present any red flags, we schedule a phone call to review the business in general and dig down on specific issues. Often we proactively schedule a phone call for a few days after the company’s estimated date for delivering the documents.
7. Make confirmed offer. Within 2 business days of the phone call, we make a confirmed offer or final rejection. We almost always make our offer based on a YC post-money SAFE with a cap set to our pre-money valuation plus the round size and a discount of 20%. In cases where there is a specific reason to use a different type of instrument, we can be flexible.
8. Final diligence. If the company accepts our offer, we proceed to final diligence. Unlike some investors, final diligence is not about figuring out whether there’s a good fit. Rather, it’s about verifying the information previously provided, as well as generally making sure the company is legally and financially squared away.
9. Execute investment. Once final diligence is complete, we generate investment documents, execute them, and then wire.

Typically, steps 1-4 take hours to days. The whole process requires 3-4 weeks from first contact to wire–if the company is responsive, has the necessary documents at hand, and there are no scheduling issues. 2 weeks is sometimes possible. The most common causes of delays are the company not having all the necessary initial and final diligence documents or there being some sort of circumstance that needs correction before we can proceed, such as converting to a C corporation. 

We often see other investors taking 3-4 months, sometimes longer, even in the good case. Moreover, we often see those investors saying, “No,” several months in. 

Internally, because our process always has a well-defined next step with a well-defined decision making scope, we rarely find ourselves getting bogged down. If we do, or if we end up having to say, “No,” late, we try to identify the underlying cause and fix it if possible.

Given this approach, we’ve found that it helps for founders to keep the following in mind:

• Meetings are late in our process. Just because we don’t take a meeting early, doesn’t mean we’re not seriously evaluating an opportunity. Scheduling introduces calendar delays and limits the number of startups we can work with at any one time. Luckily, we can collect the vast majority of information we need for a decision without a meeting. When we take a meeting (usually by Zoom), you have already checked off many of our boxes and we have concluded a fit is likely. 
• We care about the details of your revenues and unit economics. Because revenue is our number one metric, we tend to dig pretty deeply into the details of each revenue stream and its associated economics. We’re essentially trying to build a model of how your business generates gross margin.
• We care less directly about your vision and team. Other investors will often spend a lot of time trying to assess your vision and entrepreneurial spirit over several meetings. While we do care about vision and team, we are humble about our ability to assess them just by talking to you, so let the early results mostly speak for themselves.
• The more organized you are, the faster the process will go. However, we are patient. If, for whatever reason, you don’t have everything nicely organized, it usually won’t stop the deal. With a well-defined process, we can hold an investment at any stage while issues get resolved. In fact, we often help companies overcome obstacles during the process. But we would sincerely prefer to complete the process as quickly as possible so founders can start putting our investment to work in their businesses!
• We care about speed. We want to be fast so you can be fast. First, we want to get you back to the business of building your business. Then, once we’ve invested, we want you to have the resources for faster sales, marketing, and future fundraising.

In general, we see ourselves as less judgemental and more process driven than other investors. The goal is not to holistically assess each company and pronounce it a “good deal” or not. Rather, the goal is to systematically build a large portfolio of companies in a very specific area of the market. Just because a company isn’t in our target area doesn’t mean we don’t think it will succeed.

This post is by John Eng, RSCM's Director of Funding Ecosystem. He stays in constant contact with other investors so that we can effectively advise our portfolio companies on their subsequent rounds.

How has the recent tech downturn affected early stage VCs investment? Undoubtedly, all startups are asking themselves this question. Should they go for the seed or Series A round now or should they buckle down and raise a smaller round from existing investors? Our poll of Seed and Series A VCs reveals that these stages remain relatively robust, though tempered by more historically realistic expectations.

As I’m writing this, VC Twitter is foreshadowing doom and gloom. Is a recession imminent? Does it feel more like the dotcom bubble of 2000 or the housing bubble of 2008? Some big high-flying growth stocks have dropped by 75% to 90%. Public SaaS multiples dropped from a high of 17x to a low of 5.6x. When will we see tech stocks bottom? What’s the right valuation to pay for growth?

Based on VC Twitter, it sure seems like the sky is falling. Many well-known later-stage and growth-stage VCs have published “crucible-moment memos” about operating during a downturn–extending runway, get to default alive, get to default investable, expect valuations to come down, etc.

But what about early-stage companies? At Right Side Capital Management, we invest at the earliest stages. Our portfolio companies are typically concerned more about the early-stage investment climate, rather than later-stages that feel a more direct impact from public market turmoil. 

Can startups still get Seed or Series A investments? Well, we tried to answer this question. We conducted an informal survey of Seed and Series A investors the week of May 21 2022. Roughly 70 responded. We asked questions like:

• Are you still investing in new portfolio companies? If so, is your rate of investment higher, lower, or the same as it was prior to the recent tech downturn?
• Have there been any changes in your investment themes / strategy that I should be aware of? For example, are there any new sectors you are focusing on or avoiding, or have there been any changes to the traction levels you are looking for at different stages (ie. Seed, Series A, etc.)?
• Are there any other ways the recent downturn has affected your investing?

The results didn’t surprise us. The sky does not appear to be falling (at least yet) in early stage fundraising.

Key takeaways:

• Early stage investors are still very active. Everyone responded that they are indeed still investing and busier than ever. Some (20%) are more cautious and are slowing down their pace of investment. And a few (6%) are opportunistically increasing their pace of investment.
• Not many have changed their investment criteria. Those that have are just moving to earlier stages (i.e., to seed from Series A) and moving away from cyclical businesses.
• The bar is higher now. Investors are being more selective–a higher bar in terms of both revenue and unit economics. Investors are taking more time for due diligence now that deals are less competitive, digging more into business fundamentals before committing. They are asking companies how their businesses will be impacted by an economic downturn–growing inflation, higher interest rates, slowing consumer demand.
• Early stage investors are expecting lower valuations in Seed and Series A and are excited by it. They are already seeing a slow-down and lower valuations in Series A. They anticipate the same for seed-stage fundraising before long. Many investors who have been passing on high valuation deals are anticipating a faster pace of investment as valuations normalize. Some startups seeking Series A rounds may end up being disappointed in the valuations they receive (or don’t receive) and will need to raise bridge rounds to stay funded.
• Reserving more capital for follow-ons. They expect bridge rounds to become more common and are therefore shifting their allocation to accommodate that need within their existing portfolio companies. That means less capital available for new investments, which has to mean either less Seed and Series A rounds get done or that round sizes are smaller (or both).
• Spending more time advising their portcos. Startups that used to go 12 to 18 months between rounds are now expected to go 18 to 24 months before their next funding round.  As a result, investors are more engaged than normal with their portfolio companies helping them plan and adjust for this new reality. Survival, runway extension, and optimizing for unit economics is now the primary focus for most existing portfolio companies.

We understand that the changes at later stages should eventually trickle its way to earlier-stages. Some say it might happen in a month or two. Some say it might take longer.. However, the good news is that, for now, the early stage funding environment is still alive and open for business. VCs still want to meet founders. They still want to invest. The bar is higher. Valuations are lower. Due diligence is stricter. The Seed and Series A markets are not dead, they have just quickly reverted to what used to be considered normal conditions. This means early stage founders will need to adjust and become more realistic. 

We will continue to keep our eyes and ears open. I’d welcome your comments and news.

Have you ever finished an arduous task and thought to yourself, "Argh! I went about that all wrong. Why didn't anyone warn me?" Well, if you're thinking about raising a seed round, here's me warning you :-)When faced with a challenge, most entrepreneurs seek out as much data as possible, then wade in and start trying to make things happen. For fundraising, that probably means poring over TechCrunch, listening to as many "founder stories" as possible, and dissecting the top VCs' blogs.Of course, every one of these channels suffers from massive selection bias--only unusual events are noteworthy enough to make it through their filters. And fundraising is one of those processes where, if you optimize for the unusual case, you hurt yourself in the typical case.At RSCM, we've either observed our portfolio companies raise or directly participated in 100s of seed rounds over the last 4.5 years. We are intimately familiar with the typical case and have developed a corresponding "small seed playbook". And, should you be lucky enough to find yourself in the right tail of the fundraising curve, there's any easy upgrade path.

Too Much Money, Obsession with a "Lead"

The most common mistakes in raising a seed round are: a headline amount that's too large and getting anchored on the concept of a "lead" investor.Raising seed is rarely easy. But there's a very steep gradient in difficulty as you move from a $500K to $1M target. In that range, you usually need substantial revenues, a clearly pedigreed team, or anti-gravity class technology. Sure, there's some chance you could find investors who simply fall in love with you and your idea (most likely if you're in the SF Bay Area or NYC), but the probability is low and the expected search effort is high.Even if you satisfy one or more of the extreme requirements, as you get towards $1M, a lead investor becomes more and more necessary. Now, you may be thinking to yourself, "That's OK; I want a lead!" Hmmm. If you're an engineer, what would you think if someone said, "I want an architecture with a single point of failure!" Or in marketing, "I want a campaign targeted at users with low conversion rates!" Or in sales, "I want prospects with long sales cycles!" Yes, there are cases where that is in fact what you want, because there are other factors that balance out the obvious drawbacks. But as a rule of thumb, it's a mistake.Suppose you plan your round around a lead from the outset. If you don't end up finding one, you have precisely zero dollars to show for your efforts. Moreover, the universe of lead investors is much smaller than that of all investors, so the prospecting job is correspondingly much harder. Finally, it typically takes a lot longer to get a first serious meeting with a potential lead investor, let alone close the deal. You're probably in for a much longer fundraising cycle, which has tremendous opportunity cost in terms of building your business, especially at the seed stage.Unless you truly meet some of the aforementioned extreme criteria, this path is probably not optimal. Our recommendation is that you don't start a seed raise by looking for a lead unless you have at least $20K in monthly revenues, a dozen professional investors who have proactively expressed interest, or your business simply cannot move forward without a large chunk of capital.

Modest Raise, Brick-by-Brick, Graduated Price

So what do you do if you have zero to small revenues and don't have a lot of VCs on speed dial? Start with a modest headline amount, $250K to $500K. Your plan will have to show you making decent progress with this amount of money. Make sure your development schedule and cash burn support you hitting a reasonable milestone with that much runway. And be prepared to tighten your belt; fundraising almost always takes longer than expected.Then get your first commitments from your most enthusiastic supporters and members of their immediate networks. Usually, when I ask a company who is planning or trying to raise if they have anybody close to the company (friends and family, advisor, early customer, etc.) who could write a small check, the answer is yes. When I ask them why they haven't tried to close the money yet, the answer is usually some combination of, "It doesn't really move the needle," and "We don't know what terms to use."At the very beginning of a raise, pretty much no check is too small. You need to get the ball rolling. You also need to show momentum. So use attractive terms that lead to a quick close. I recommend a convertible note with the standard 20% discount and 5% interest, plus a very compelling cap. If you have an attractive valuation, people will not mind so much that you don't have a lead investor. The plan is to start the cap low and raise it gradually as you build momentum.Now, a lot of founders worry about dilution and lose sleep over getting "fair" value. Don't. $100-200K worth of dilution at a valuation even 30 or 40% below what you think is market just won't make very much difference in the long run--I assure you that there are much worse dilution potholes on the road to liquidity. And fundraising is a terrible distraction from operating your business, so an investor willing to move quickly is valuable.You must make clear that you're offering the earliest investors the great deal partly in return for moving quickly (the other part is due to the special relationship and/or value-add of the investor). Otherwise, most investors will dither. Sometimes it helps to tie the great deal to some sort of natural deadline like an accelerator Demo Day, a significant software release, or a large customer close. Creating a sense of urgency is much easier said than done, but you need to try.Somewhere after $100-200K, you bump the cap up. "The great deal" becomes "the good deal". The size of the bump depends on what the market tells you. If you closed the first chunk really fast and you have a big pipeline of prospects, bump the cap two notches. If the first chunk was still a fair bit of work or your pipeline seems thin, only bump it one notch. But keep the time pressure on to the extent you can. "The good deal" is also a limited time offer, perhaps tied to yet another natural deadline.Once you have the first two chunks in, you can start to play a little more strategically. Getting half the the round closed often generates psychological momentum. You'll also have money in the bank, which helps your negotiating position. And you'll hopefully have made further engineering and customer progress, which makes you less risky. You can bump the cap again. You can also start trying to work AngelList and look to bigger geographies like San Francisco or NYC (if you're not based there already). You can event start seriously probing small funds who lead rounds. This is where the upgrade path comes in.

Sidebar: Process Is Key

Before I get to upgrading a small seed round to a big seed round, I need to make a point about process. Like achieving any other company objective, fundraising works better if you impose some structure on it. You absolutely must track prospects, either in a spreadsheet or a CRM.I recommend a couple of prospect categories: first checks, second checks, later checks, and round leads. Initially, focus on developing lists for the first two categories. You will also naturally generate names of people within your network that fall into the second two categories, but don't devote too much energy to extending those lists until you're ready to actively pursue those categories.Now, start talking with all the first check prospects, focusing on two initial objectives. First, qualify each prospect. There are three basic qualification states: (1) does in fact appear to be a potential first check writer, (2) doesn't appear to be a first check writer but may be a second or later check writer, or (3) doesn't appear to be a check writer at all.Second, try to expand you lists through the prospects' networks. Ask class (1) prospects if they know anyone else who is as decisive as they are or investors that tend to follow their lead. Ask class (2) prospects if there's anyone who they like to follow or people they typically participate alongside. In my experience, members of class (3) rarely make good referrals.After you work through the first check prospects, move on to the second check ones, with parallel qualification and list expansion objectives.If you have time during the first check and second check prospecting, do some modest scouting of the later check and round lead prospects. Go ahead and schedule some first meetings. These prospects probably have long scheduling lead times and require multiple stage-setting meetings anyway. The goal here is not to close them (though if they fall in your lap, seize the opportunity). Rather, the goal is gather intelligence on what they're looking for and start building a relationship. Try to keep detailed notes in whatever tracking system you use.

Oversubscribe, Entertain a Lead, Convert if Necessary

OK, back to upgrading. Please keep in mind this is no longer the base case. Most no-to-low revenue startups never get to this point.Suppose first-check demand justified a two notch bump in your cap, second-check demand seems strong even at the higher price, and later-check and lead scouting has yielded a promising pipeline. Further suppose that you've made good operational progress in the meantime. If all these stars align, you can attempt the upgrade.In this everything-goes-smoothly scenario, you should be having lots of positive meetings with later-check prospects. At some point, it may look like you've got more "soft-commits" from later-check writers than you have room (assuming you stick to your original target amount). Or you may receive strong buying signals from some of your lead prospects. If either of these conditions are true, do one of two things:

1. Force a quick close and oversubscribe if desired. Tell all interested investors that it looks like you might be oversubscribed. Make it clear that you need to get firm commitments so you can figure out if there is any room left. In other words, use scarcity and social proof to get investors to move. You can then decide whether you want to raise a larger amount than your original target.
2. Move to close any viable professional funds as "leads". The term “lead investor” is confusing. You naturally assume they come first. In $1M+ rounds they usually do, but in seed rounds they often just take everything left at the end. A situation that often arises is you're talking to a potential “lead” investor that only writes $250K+ checks, but moves very slowly. At the same time, you have several later check writers that you feel you can pretty quickly and you probably don’t have room for everyone. In this situation, you need to force the action with the potential lead investor. Give them a deadline and tell them you need a term sheet in 7-10 days or you will close your existing pipeline. Absolutely do not risk losing other investors because you want to hold out for the "lead". When you are a low revenue company, always take the bird in the hand.

The goal in both cases, obviously, is to create a sense of both scarcity and urgency. As a low revenue startup you rarely have leverage when fundraising. Anytime you do find some, use itMost institutional investors these days are comfortable leading a seed round with a convertible note structure. There are still a few that have a strong preference for priced rounds. If you run into one that insists on a preferred equity financing and you’ve already close a bunch of investors on notes, don’t sweat it. You can always convert all the other notes into the preferred round.

Parting Wisdom

Remember, it's usually pretty easy to adjust and pivot when things go better than expected. So you don't need to plan much for those scenarios. This playbook is targeted at the usual case. Oversubscribed and led seed rounds are the exception rather than rule.Depending on market conditions, I would say only 10-20% of seed rounds are "led" in any meaningful sense and another 10-20% are oversubscribed from a modest original target. So 60-80% are just ordinary, every day seed rounds that take a while to close and have no real lead investor. Which is totally fine. Fundraising is really hard. $250K to $500K is a win. That's roughly a year of runway and I'm continually blown away at what entrepreneurs manage to accomplish in a year.

I have posted quite a bit of analysis that is (hopefully) useful to startup investors. But as someone noted to me privately, I have not provided much direct advice for startup founders. This post is a first step toward reducing the imbalance.Face-to-face, the number one tip I give to founders is: think very carefully before taking any round of funding. No, not because of dilution. Because funding closes off exit opportunities. "What?" you say, "But an investment will give me the resources to make my company more attractive for an exit."That's true, but it will also raise your asking price... by a lot! And as basic economics tells us, demand drops with price. In this case, it drops a lot! I'll actually work through the detailed math and data for Series A in my next post. But here I want to make the more general point.Remember that investors want a return. They have mental anchor points for exits they consider a "win". This anchor typically varies from 5X to 10X. Professional investors usually get legal stock preferences that allow them to block exits that they don't like, i.e., that are out of line with their anchors. Now, they also have mental anchor points for how much of the company they want to buy in the round. This anchor typically varies from 20% to 30%.Let's consider the midpoints of those two anchors, 7.5X and 25% to do a quick estimation of how taking a round of funding reduces exit opportunities. Say your company is worth Y today. If investors want to own 25% of your company, the post-money will be 1.33Y. If investors want a 7.5X return, the required exit price will be 10Y.

Every round of funding you take increases your required exit price by an order of magnitude!

So if you take an angel seed round at a $3M pre-money, you now need a $30M exit. Not too bad. Then a Series A at a $10M pre-money pushes that up to $100M. Pretty steep. Series B at $25M means $250M. Whoa. How many $250M exits happen per year? About 50 to 100. There are about 1,000 early stage VC investments per year. Not good odds.As we'll see in the next post, there's a huge cliff at Series A. But in general, the number of exit opportunities goes down exponentially with each round of funding. So consider whether an exponential reduction in the number of prospects is worth the progress you'll make.

One of the questions I most frequently answer about RSCM is how we value seed stage startups. Apparently, being not only willing, but eager to set equity valuations sets us apart from the vast majority of investors. It's also the aspect of our approach that I'm most proud of intellectually. Developing the rest of our process was mostly a matter of basic data analysis and applying existing research. But the core of our valuation system rests on a real (though modest) insight.

We've finally accumulated enough real-world experience with our valuation approach that I feel comfortable publicly discussing it. Now, I'm not going to give out the formula. Partly, this is to preserve some semblance of unique competitive advantage. But it's also for practical reasons:

• Our precise formula is tuned for our specific investment theses, which are based on our larger analysis of exit markets, technology dynamics, and diversification requirements.
• The current version of the formula doesn't communicate just how adaptable the fundamental concept is (and we do in fact adjust it as we learn).
• There's a lot of truth in the wisdom about teaching a man to fish rather than giving him a fish.

Instead, I'm going to discuss how we constructed the formula. Then you can borrow whatever aspects of our approach you think are valid (if any) and build your own version if you like.The first part of our modest insight was to face the fact that, at the seed stage, most of the value is option value not enterprise value. Any approach based on trying to work backwards from some hypothetical future enterprise value will be either incredibly expensive or little more than a guess. But how do you measure a startup's option value from a practical standpoint?The second part of our modest insight was to ask, "Is there anyone who has a big stake in accurately comparing the unknown option value to some other known dollar value?"  The answer was obvious once we formulated the question: the founders. If the option value of their ownership stake were dramatically less, on a risk-adjusted basis, than what they could earn working for someone else, they probably wouldn't be doing the startup. Essentially, we used the old economist's trick of "revealed preference".We knew there could be all sorts of confounding factors. But there might be a robust relationship between founders' fair market salaries and their valuation. So we tested the hypothesis. We looked at a bunch of then current seed-stage equity deals where we knew people on the founder or investor side, or the valuation was otherwise available. We then reviewed the founders' LinkedIn profiles or bios to estimate their salaries.What we found is that equity valuations for our chosen segment of the market tended to range from 2x to 4x the aggregate annual salary of the founders. The outliers seemed to be ones that either (a) had an unusual amount of "traction", (b) came out of a premier incubator, or (c) were located in the Bay Area. Once we controlled for these factors, the 2x to 4x multiple was even more consistent.Now, the concept of a valuation multiple is pretty common. In the public markets, equity analysts and fund managers often use the price-to-earnings ratio. For later stage startups, venture capitalists and investment bankers often use the revenue multiple. Using a multiple as a rule-of-thumb allows people to:

• Compare different sectors, e.g., the P/E ratios in technology are higher than in retail.
• Compare specific companies to a benchmark, e.g., company X appears undervalued.
• Set valuations, e.g., for IPOs or acquisitions.

Obviously, 2x to 4x is a big range. The next step was to figure out what drives the variance. Here, we relied on the research nicely summarized in Sections 3.2-3.6 of Hastie and Dawes' Rational Choice in an Uncertain World. In high-complexity, high-uncertainty environments, experts are pretty bad at making overall judgements. But they are pretty good at identifying the key variables. So if all you do is poll experts on the important variables and create a consensus checklist, you will actually outperform the experts. The explanation for this apparent paradox is that the human brain has trouble consistently combining multiple factors and ignoring irrelevant information (such as whether the investor personally likes the founders) when making abstract judgements.

So that's what we did. We asked highly experienced angels and VCs what founder characteristics are most important at the seed stage. (We focused on the founders because we had already determined that predicting the success of ideas this early was hopeless.) The most commonly mentioned  factors fell into the general categories you'd expect: entrepreneurial experience, management experience, and technical expertise. Going to a good undergraduate or graduate program were also somewhat important. Our experts further pointed out that making initial progress on the product or the business was partly a reflection on the founders' competence as well as the viability of the idea.We created a checklist of points in these categories and simply scaled the valuation multiple from 2x to 4x based on the number of points. Then we tested our formula against deals that were actually in progress, predicting the valuation and comparing this prediction to the actual offer. This initial version performed pretty well. We made some enhancements to take into account location, incubator attendance, and the enterprise value of progress, then tested again. This updated version performed very well. Finally, we used our formula to actually make our own investments. The acceptance rate from founders was high and other investors seemed to think we got good deals.Is our formula perfect?  Far from it. Is it even good? Truthfully, I don't know. I don't even know what "good" would mean in the abstract. Our formula certainly seems far more consistent and much faster than what other investors do at the seed stage. Moreover, it allows us to quickly evaluate deal flow sources to identify opportunities for systematically investing in reasonably valued startups. These characteristics certainly make it very useful.

I'm pretty confident other investors could use the same general process to develop their own formulas, applicable to the particular categories of startups they focus on—as long as these categories are ones where the startups haven't achieved a clear product-market fit. Past that point, enterprise value becomes much more relevant and amenable to analysis, so I'm not sure the price-to-salary multiple would be as useful.

I privately received a couple of interesting comments on my diversification post:

One of RSCM's angel advisors wrote, "I would think most smart people get it intellectually, but many are stuck in the mindset that they have a particular talent to pick winners."

One of my Facebook friends commented, "VC seems to be a game of getting a reputation as a professional die thrower."

I pretty much agree with both of these statements. However, even if you believe someone has mad skillz at die-rolling, you may still be better off backing an unskilled roller. Diversification is that powerful! To illustrate, consider another question:

Suppose I offered you a choice between the following two options:

(a) You give me $1M today and I give you somewhere between $3M and $3.67M with 99.99% certainty in 4 years.

(b) You give me $1M today and a "professional" rolls a standard six-sided die.  If it comes up a 6, I give you $20M in 4 years. Otherwise, you lose the $1M. But this guy is so good, he never rolls a 1 or 2.

The professional's chance of rolling a 6 is 25% because of his skill at avoiding 1s and 2s. So option (b) has an expected value of $5M. Option (a) only has an expected value of $3.33M. Therefore, the professional has a 50% edge. But he still has a 75% chance of losing all your money.I'm pretty sure that if half their wealth were on the line, even the richest players would chose (a).  Those of you who read the original post probably realize that option (a) is actually an unskilled roller making 10,000 rolls.  Therefore:

Diversifying across unskilled rolls can be more attractive than betting once on a skilled roller.

Of course, 1 roll versus 10,000 hardly seems fair.  I just wanted to establish the fact that diversification can be more attractive than skill in principle.  Now we can move on to understanding the tradeoff.To visualize diversification versus skill, I've prepared two graphs (using an enhanced version of my diversification spreadsheet).  Each graph presents three scenarios: (1) an unskilled roller with a standard 1 in 6 chance of rolling a 6, (2) a somewhat skilled roller who can avoid 1s so has a 1 in 5 chance of rolling a 6, and (3) our very skilled roller who can avoid 1s and 2s so has a 1 in 4 chance of rolling a 6.First, let's look at how the chance of at least getting your money back varies by the number of rolls and the skill of the roller:

The way to interpret this chart is to focus on one of the horizontal gray lines representing a particular probability of winning your money back and see how fast the three curves shift right.  So at the 0.9 "confidence level", the very skilled roller has to make 8 rolls, the somewhat skilled roller has to make 11, and the unskilled roller has to make 13.

From the perspective of getting your money back, being very skilled "saves" you about 5 rolls at the 0.9 confidence level. Furthermore, I'm quite confident that most people would strongly prefer a 97% chance of at least getting their money back with an unskilled roller making 20 rolls to the 44% chance of getting their money back with a very skilled roller making 2 rolls, even though their expected value is higher with the skilled roller.Now let's look at the chance of winning 2.5X your money:

The sawtooth pattern stems from the fact that each win provides a 20X quantum of payoff.  So as the number of rolls increases, it periodically reaches a threshold where you need one more win, which drops the probability down suddenly.Let's look at the 0.8 confidence level.  The somewhat skilled roller has a 2 to 5 roll advantage over the unskilled roller, depending on which sawtooth we pick.  The very skilled roller has a 3 roll advantage over the unskilled roller initially, then completely dominates after 12 rolls. Similarly, the very skilled roller has a 2 to 5 roll advantage over the somewhat skilled roller, dominating after about 30 rolls.

Even here, I think a lot of people would prefer the 76% chance of achieving a 2.5X return resulting from the unskilled roller making 30 rolls to the 58% chance resulting from the very skilled roller making 3 rolls.But how does this toy model generalize to startup investing? Here's my scorecard comparison:

• Number of Investments. When Rob Wiltbank gathered the AIPP data set on angel investing, he reported that 121 angel investors made 1,038 investments. So the mean number of investments in an angel's portfolio was between 8 and 9. This sample is probably skewed high due to the fact that it was mostly from angels in groups, who tend to be more active (at least before the advent of tools like AngelList).  Therefore, looking at 1 to 30 trials seems about right.

• "Win" Probability. When I analyzed the subset of AIPP investments that appeared to be seed-stage, capital-efficient technology companies (a sample I generated using the methodology described in this post), I found that the top 5% of outcomes accounted for 57% of the payout. That's substantially more skewed than a 1 in 6 chance of winning 20X.  My public analysis of simulated angel investment and an internal resampling analysis of AIPP investments bear this out. You want 100s of investments to achieve reasonable confidence levels. Therefore, our toy model probably underestimates the power of diversification in this context.

• Degree of Skill. Now, you may think that there are so many inexperienced angels out there that someone could get a 50% edge. But remember that the angels who do well are the ones that will keep investing and angels who make lots of investments will be more organized. So there will be a selection effect towards experienced angels. Also, remember that we're talking about the seed stage where the uncertainty is the highest. I've written before about how it's unlikely one could have much skill here. If you don't believe me, just read chapters 21 and 22 of Kahneman's Thinking Fast and Slow. Seed stage investment is precisely the kind of environment where expert judgement does poorly. At best, I could believe a 20% edge, which corresponds to our somewhat skilled roller.

The conclusion I think you should draw is that even if you think you or someone you know has some skill in picking seed stage technology investments, you're probably still better at focusing on diversification first.  Then try to figure out how to scale up the application of skill.

And be warned, just because someone has a bunch of successful angel investments, don't be too sure he has the magic touch. According to the Center for Venture Research, there were 318,000 active angels in the US last year. If that many people rolled a die 10 times, you'd expect over 2,000 to achieve at least a 50% hit rate purely due to chance! And you can bet that those will be the people you hear about, not the 50,000 with a 0% hit rate, also purely due to chance.

In science, there isn't really any such thing as a "fact".  Just different degrees of how strongly the evidence supports a theory. But diversification is about as close as we get. Closer even than evolution or gravity. In "fact", neither evolution or gravity would work if diversification didn't.So I've been puzzled at some people's reaction to RSCM's startup investing strategy.  They don't seem to truly believe in diversification. I can't tell if they believe it intellectually but not emotionally or rather they think there is some substantial uncertainty about whether it works.In either case, here's my attempt  at making the truth of diversification viscerally clear.  It starts with a question:

Suppose I offered you a choice between the following two options:

(a) You give me $1M today and I give you $3M with certainty in 4 years.

(b) You give me $1M today and we roll a standard six-sided die.  If it comes up a 6, I give you $20M in 4 years. Otherwise, you lose the $1M.

Option (b) has a slightly higher expected value of $3.33M, but an 83.33% chance of total loss. Given the literature on risk preference and loss aversion (again, I highly recommend Kahneman's book as an introduction), I'm quite sure the vast majority of people will chose (a).  There may be some individuals, enterprises, or funds who are wealthy enough that a $1M loss doesn't bother them.  In those cases, I would restate the offer.  Instead of $1M, use $X where $X = 50% of total wealth. Faced with an 83.33% chance of losing 50% of their wealth, even the richest player will almost certainly chose (a).Moreover, if I took (a) off the table and offered (b) or nothing, I'm reasonably certain that almost everyone would choose nothing. There just aren't very many people willing to risk a substantial chance of losing half their wealth. On the other hand, if I walked up to people and credibly guaranteed I'd triple their money in 4 years, almost everyone with any spare wealth would jump at the deal.

Through diversification, you can turn option (b) into option (a).

This "trick" doesn't require fancy math.  I've seen people object to diversification because it relies on Modern Portfolio Theory or assumes rational actors.  Not true.  There is no fancy math and no questionable assumptions. In fact, any high school algebra student with a working knowledge of Excel can easily  demonstrate the results.Avoiding Total LossLet's start with the goal of avoiding a total loss. As Kahneman and Tversky showed, people really don't like the prospect of losing large amounts. If you roll the die once, your chance of total loss is (5/6) = .83.  If you roll it twice, it's (5/6)^2 = .69.  Roll it ten times, it's (5/6)^10 = .16. The following graph shows how the chance of total loss rapidly approaches zero as the number of rolls increases.

By the time you get to 50 rolls, the chance of total loss is about 1 in 10,000.  By 100 rolls, it's about 1 in 100,000,000.  For comparison, the chance of being struck by lightning during those same four years is approximately 1 in 200,000 (based on the NOAA's estimate of an annual probability of 1 in 775,000).

‍Tripling Your Money

‍Avoiding a total loss is a great step, but our ultimate question is how close can you get to a guaranteed tripling of your money.  Luckily, there's an easy way to calculate the probability of getting at least a certain number of 6s using the Binomial Theorem (which has been understood for hundreds of years).  One of many online calculator's is here. I used the BINOMDIST function of Excel in my spreadsheet.

The next graph shows the probability of getting back at least 3x your money for different numbers of rolls.  The horizontal axis is logarithmic, with each tick representing 1/4 of a power of 10.

As you can see,  diversification can make tripling your money a near certainty. At 1,000 rolls, your probability of at least tripling up is 93%. And with that many rolls, Excel can't even calculate the probability of getting back less than your original investment. It's too small. At 10,000 rolls, the probability of less than tripling your money is 1 in 365,000.So if you have the opportunity to make legitimate high-risk, high-return investments, your first question should be how to diversify. All other concerns are very secondary.

Now, I will admit that this explanation is not the last word. Our model assumes independent, identical bets with zero transaction costs. If I have time and there's interest, I'll address these issues in future posts. But I'm not sweeping them under the rug. I'm truly not aware of any argument that their practical effect would be significant with regards to startup investments.

What do you do when you have to make decisions in an uncertain environment with only mediocre data?  Startup founders and investors face this question all the time.I had an interesting email exchange on this topic with Brad Feld of Foundry Group. First, let me say that I like Brad and his firm.  If I were the founder of a startup for whom VC funding made sense, Foundry would be on my short list.

Now, Brad has an Master's in Management Science from MIT and was in the PhD program. I have a Master's in Engineering-Economic Systems from Stanford, specializing in Decision Theory.  So we both have substantial formal training in analyzing data and are both focused on investing in startups.

But we evidently take opposing sides on the question of how data should inform decision-making. Here's a highly condensed version of our recent conversation on my latest "Seed Bubble" post (don't worry, I got Brad's permission to excerpt):

Brad: Do you have a detailed spreadsheet of the angel seed data or are you using aggregated data for this?... I'd be worried if you are basing your analysis... without cleaning the underlying data.

Kevin:  It's aggregated angel data....   I'm generally skeptical of the quality of data collection in both... data sets.... But the only thing worse than using mediocre data is using no data.

Brad: I hope you don't believe that. Seriously - if the data has selection bias or survivor bias, which this data likely does, any conclusions you draw from it will be invalid.

Kevin: ...of course I believe it....  Obviously, you have to assess and take into account the data's limitations... But there's always some chance of learning something from a non-empty data set.  There's precisely zero chance of learning something from nothing.

Brad: ... As a result, I always apply a qualitative lens to any data (e.g. "does this fit my experience"), which I know breaks the heart of anyone who is purely quantitative (e.g. "humans make mistakes, they let emotions cloud their analysis and judgement").

I don't want to focus on these particular data sets.  Suffice it to say that I've thought reasonably carefully about their usefulness in the context of diagnosing a seed investment bubble.  If anyone is really curious, let me know in the comments.Rather, I want to focus on Brad's and my positions in general. I absolutely understand Brad's concerns.  Heck, I'm a huge fan of the "sanity check".  And I, like most people with formal data analysis training, suffer a bit from How The Sausage Is Made Syndrome.  We've seen the compromises made in practice and know there's some truth to Mark Twain's old saw about "lies, damned lies, and statistics." When data is collected by an industry group rather than an academic group (as is the case with the NVCA data) or an academic group doesn't disclose the details of their methodology (as is the case with the CVR angel data), it just feeds our suspicions.I think Brad zeroes in on our key difference in the last sentence quoted above:

...which I know breaks the heart of anyone who is purely quantitative (e.g. "humans make mistakes, they let emotions cloud their analysis and judgement").

I'm guessing that Brad thinks the quality of human judgement is mostly a matter of opinion or that it can be dramatically improved with talent/practice.  Actually, the general inability of humans to form accurate judgements in uncertain situations has been thoroughly established and highly refined by a large number of rigorous scientific studies, dating back to the 1950s.  It's not quite as "proven" as gravity or evolution, but it's getting there.At Stanford, I mostly had to read the original papers on this topic.  Many of them are, shall we say, "difficult to digest." But now, there are several very accessible treatments.  For a general audience, I recommend Daniel Kahneman's Thinking Fast and Slow, where he recounts his journey exploring this area, from young researcher to Nobel Prize winner.  For a more academic approach, I recommend Hastie's and Dawes' Rational Choice In an Uncertain World. If you need to make decisions in uncertain environments and aren't already familiar with the literature, I cannot recommend strongly enough reading at least one of these books.

But in the meantime, I will sum up.  Human's are awful at forming accurate judgements in situations where there's a lot of uncertainty and diversity (known as low validity environments).  It doesn't matter if you're incredibly smart.  It doesn't matter if you're highly experienced.  It doesn't even matter if you know a lot about cognitive biases.  The fast, intuitive mechanisms your brain uses to reach conclusions just don't work well in these situations. If the way quantitative data analysis works in practice gives you pause, the way your brain intuitively processes data should have you screaming in horror.

Even the most primitive and ad hoc quantitative methods  (such as checklists) generally outperform expert judgements, precisely because they disengage the intuitive judgment mechanisms. So if you actually have a systematically collected data set, even if you think it almost certainly has some issues, I say the smart money still heavily favors the data rather than the expert.

By the way, lots of studies also show that people tend to be overconfident. So thinking that you have a special ability or enough expertise so that this evidence doesn't apply to you... is probably a cognitive illusion too. I say this as a naturally confident guy who constantly struggles to listen to the evidence rather than my gut.

My recommendation: if you're in the startup world, by all means, have the confidence to believe you will eventually overcome all obstacles. But when you have to make an important estimate or a decision, please, please, please, sit down and calculate using whatever data is available.  Even if it's just making a checklist of your own beliefs.