53. The Path to Series A, Part 1 (Semil Shah)

The Full Ratchet Podcast on iTunesNick Moran Angel List

Semil Shah of Haystack joins Nick to cover The Path to Series A, Part 1. We will address questions including:

  • Semil Shah Path to Series ACan you walk us through your background and how you became involved in startup investing?
  • Can you first talk about why you’ve written about the path to A in the past and why it’s been a major focus area of your’s?
  • How do you think the fundraising environment of the past few years has changed the attitude or approach of Series A investors?
  • What are your thoughts on timing, seasonality and when founders should begin Series A conversations relative to the close of their seed round?
  • I’ve heard some advocate a shotgun approach while others suggest a rifle strategy when targeting VCs for an A. What are your thoughts on how a seed-funded startup should target A round VCs?
  • Will you ask for the A round investor target plan prior to closing the seed investment?
  • You’ve mentioned how messy cap tables with stacked notes and SAFEs can derail an A round. And there was an interesting twitter thread on the topic w/ Jason Lemkin, Dave McClure, Keith Rabois, Marc Andreesen and Hunter Walk discussing the problems that this creates. Can you review what the issue is here and how it may be addressed prior to an A round?
  • What are your thoughts on metrics and the role they play in securing an A round?

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*Please excuse any errors in the below transcript

NICK:  Semil Shah joins us from Menlo Park California he is a general partner at Haystack a venture partner at GGV Capital and writes great stuff over at his blog which is blog.semilshah.com. Semil thanks so much for joining us.

SEMIL: Thank you for having me Nick.

NICK: So before we jump into the topic today which is the Path to Series A, can you give us a little sense for your background and how you got involved in venture capital.

SEMIL: Yeah background is the shortest way to explain this all over the place I worked as a professional cook, professional bartender, I worked in non profits, I worked in development and strategy overseas I lived overseas and then tried some entrepreneurial things after grad school and then moved back to the Valley and thought I would be good at investing potentially and tried to do it the traditional way and everyone said nice to meet you but thanks and no thanks.

So I had a couple of friends pull me aside and kind of slap me across the face and said stop trying to ask other people to invest you just have to do it yourself so that how I got started.

NICK: How long ago was that that you moved back to the Valley and in transition to the investor side?

SEMIL: Well I lived in San Francisco from 2001 to 2006 and then I really wasn’t in this world then even though I lived in the area, I move away to grad school and then I moved back in 2010 and then I moved to Pal alto and my wife works at the university here so we moved down here and so I just kind of got involved with things.

NICK:  Got you so if you got a little background as a chef what is your favourite restaurant in the area.

SEMIL: I the Peninsula or in San Francisco or the whole bay area?

NICK: Your choice.

SEMIL: Okay so I have to give 2 answers because one category is kind of ethic hole in the wall authentic and the other category is maybe a nicer restaurant which these are apples and oranges comparison but my favourite restaurant for sentimental reasons in San Francisco is Del Feno restaurant off water park, I lived around there worked around there for years it is kind of like new Italian cuisine and then my favourite kind of hole in the wall ethnic food restaurant is Madrass café on El Camino on Sunny Vale. Nothing fancy but it is the kind of food I grew up eating and it is really good even my parents like it.

NICK: Awesome sounds good, I am in Chicago there is this whole sort of self culture of start up investors that chose different restaurants to meet up at for just to kind of connect and shoot stuff on start ups.

SEMIL: Here is a note that is kind of contrary I actually think food in general pound for pound in the Bay area is way over rated there are very few what I would say are quality restaurants.

NICK: Interesting we were out in Santa Barbara for 3 years and largely I was disappointed by the food and everyone from there doesn’t like to hear me say that.

SEMILE:  Oh yeah when I mentioned something like that people say what about this, this and this and I am like “yeah they are fancy restaurants that have cook concepts” but the food quality is not good and I would argue that the ones that actually have good authentic food quality probably over 80% of them are going to be kind of like hole in the wall one person grinding on what he or she loves whether it’s from a far off place or local but it’s not the norm.

NICK: Well I know you got investments in Insatcar and Door Dash and many others so maybe that will change the food environment a little bit in the future. Alright so today’s topic is the Path To Series A and sort of the post seed to fund raising. Semil can you first talk about why you have written about the Path to A and the Path and why it has been a major focus to real of yours.

SEMIL: Yeah there is 2 reasons, very clear 2 reasons one is that I started to observe that because the seed environment was so active and somewhat easy to raise seed funding that people started to talk about quote getting to series A with the same type of language and intonation that they would when I heard people that they would graduate from college that they were ready to apply to grad school it seems like it is the next thing you are suppose to do.

And so I found that cultural phenomenon interesting like you know you take your high achieving people and they say hey, I want to go from high school and I want to get in a good college and I want to do really well on my LSCT’s and I want to go law school and want to work here and do this. It is the same type of psychology and I find that interesting.

The second reason is more of a financially reason which is in seed rounds the culture is to do them in notes and so typically you are not technically investing you are lending money to a start up that’s hopefully going to give you a return in the future right, for your investment. You are not getting equity for it you are getting a convertible note and so part of it was to try and figure out well what was most important as a seed investor is try to figure out when this actually notes convert to equity and when they convert it is because a real professional investor comes in prices round and converts all the notes and so that’s trigger.

Right and so that trigger is super important not only for our founders but for the investors to take that initial risk.

NICK: Right you do investments at a seed round that’s a price round with no intention of ever doing a series A of that start up.

SEMIL:  Probably not it just wouldn’t be the type of investment I would make, generally I want to invest in something where they are going to have future rounds of financing that the business requires so probably not, the one modification I would say is there has been one case where if I were an entrepreneur I would do it on notes even though I think notes have some problems I would still do it.

There is one entrepreneur I have known for years where I wanted to symbolically want to be his first check and he was mentioning to me that he wanted to do a price round and I said hey, you know if I were co- funding this with you I would probably note this and so I gave him the pro and cons of each and he studied it for the weekend and say whatever you want to do and he came back to me and said he wanted to a price round but that was only one out of so many.

NICK: Can you talk a little bit about how the fund raising environment over the past few years have change and also the attitude or approach of series A investors.

SEMIL: I have seen two major changes or moves amongst series A investors at large there is always exceptions because some start ups are exceptional right but generally the 2 big changes that I have seen over the last 2 to 3 years are that 2 to 3 years ago there was a point where some series A realms got really, really large so because these funds are so large they want to put $10M to work because they need as a percentage of the fund these investment to matter and because entrepreneurs are entirely dilution sensitive I have seen situations which investor goes to the funder and say look we want to invest in your company here is a blank term sheet.

I just need the percentage to 20%  right like mean like we have to buy 20% of the company or else our partner will counting he feels under asked and so it is kind of crazy but that’s how all of it not all of it but a lot of it is driven.

The second big main shift that I have seen in seed investing is that relative to those last 2 years is August of this year they have slowed down they become more selective they still investing I don’t mean this to that they have stopped but relative to the last 2 years they have been more selective you can use any phase that you want they have raised the bar a little bit they are waiting a little bit more before moving.

NICK: So you feel like series A tends to have a little bit more leverage right now and that’s (8:18).

SEMIL: Series A firms you know they are traditional bread and butter series A & B firms, the only players in the eco system who if they have a chance can then enforce some type of discipline on the whole chain, that’s not to say that they always can but they are really the only ones that can modulate these things.

So seed funding can continue to grow continue to grow you will continue to see money coming from all sorts of nooks and crannies that if you can add up the little droplets could be huge amounts of money but the series A funds they are still roughly the same size the same dollar you may have a few here and there change hands but they generally modulate what ends up going throw.

So they may look at a category like start ups going after prescription drugs or the pharmacy kind of on demand model which is a daily potentially or weekly active used case from tens, hundreds or millions of merits so it is a huge market there might be by my account five six may be seven seed funded start ups you know maybe one or two make it, right and so the series A folks will modulate that bulge of seed investing and probably will not a good reason why 5 or 6 of these funded, right.

Like the models can’t be that intricate, I don’t know much about the industry I don’t see how it works and so the series A folks will then say okay one may be two of these have enough metal to keep going, right.

NICK: You talked a little bit about timing and also seasonality so when should funder start thinking about these series A conversations relative to when they are closing their seed rounds, can you talk a little bit about timing.

SEMIL:  This is a fun topic because anytime I mentioned it and I have a lot of friends who are series A investors a lot of them disagree with what I am going to say next but I think it is absolutely true and in fact every year that I lived in the valley the truth that I am about to tell you actually intensifies.

Which is there are certain moments in the year where it is a good time to start the conversation and get more introductions to these investors and if you don’t time it at these times the percentage likely hood of having a good first meeting and having things flow nicely reduce dramatically, not I can’t prove that with data so I just tell everybody that I see more of this in other people and I fully believe that.

NICK: So what are those times then?

SEMIL: I would say that starting a conversation in mid January February March April May totally good, once you start a conversation in June July August it gets a little bit dicier although there are so many more people who are investing they are still around I think it use to be in the past that there would be a lot fewer people then I use to think September and October were okay but things get so heated in the middle of October that I think it is too late.

So anyway we are talking about tactical things they definitely people who can start conversations and have a round habit quickly and nothing gets a ABC more ramp up than knowing that there is competition are round they want to look so that can happen. I am going to one of those right now so you know these folks are smart and have the resources to move very quickly if needs be, but in general if things aren’t obvious in the company and there is not competition around it there are some times in which to start conversation and there is a seasonality to it that a VC job is more like in terms of a managers schedule and administrative versus what an entrepreneur deals with.

And so there is very seasonal things about going on a family trip because they have kids or doing some yearend administrative tax work that are just kind of (12:22) conference season you know the end of the May and June there is all these standard conferences that all these folks go to so if you are going to pitch 7 or 8 people and you know that 5 of them in June are all going to be at this conference that they have already preordained to go to there might be hard to line things up.

NICK:  Interesting, Semil I have heard some people advocate shock and approach while others suggest more of a rival strategy when targeting VC for a round what are your thoughts on how a seed funded start up should targeted around VC.

SEMIL: I think that rifle shot is way better and a signal a few things from the funder’s point of view like an ability for precision like thinking, the desire to minimize the time spent on it because there time is more valuable elsewhere and the desire and the demonstration of doing the home work earlier to find a suitable partner. So the opposite of that and in which I see most often is hey Semil here is our Google doc spread sheet of over a hundred investors we are scoping out to try to find an interest to right, and it’s like it’s just a mess when I see that I kind of pick up the phone and I am like alright what are we trying to do.

Nobody on the other end of that want to be part of 149 pixel spread sheet process so the real way to do it is to pre screen who those people are now ideally you would have some people in your seed round who already know how to do that and intuitively. If you don’t then you need to learn it yourself so the way you do it is you say okay I want to raise around X to Y million dollars here is the proof that I am going to show to do it.

Here is why I want to work with this particular person that will join my board well put yourself in that persons shoes how do they want to be approached, they probably want to hear about you and not from one channel but a couple of channels. They probably want to do some home work on you they probably want to see some materials before they spend their meeting or an hour with you and you know the last thing they want to do is not only waste their time in the meeting or an email but then have a meeting that goes so poorly that in the end they just say thank you very much we are not interested.

So most people just think about this so scatter shot almost like a common application going back to the college and grad school analogy that they forget that the person who will be doing the series A or series B legitimately that institution will be tied to you for many, many years so people just really discount that because we have been in era easy money and so they just think you know that would be easy too and it’s not.

NICK: I hear you I wrote a blog post a few weeks ago about the proceed plant and it really was just all about very targeted focused you know pursuit of an investors as opposed to just more of a scatter shot.

SEMIL: Yeah I mean I think the other unfortunate reality that people are going to have to deal with is that from all these companies that have been seed funded a lot of the just weren’t good candidates for venture Capital to begin with, in the same way you may have a student who keep taking the L SAT 7/8 times and applying to law school you know over the course of 3 or 4 years.

It just like hey the market is telling you, you shouldn’t be doing this. The funding market is actually more efficient that what most people would want to really realize.

NICK: Right the right funders get funded and

SEMIL: The only caveat there is because there is so much activity in the bay area because the bay area and in the Peninsular specifically is an expensive place to live and there is very little housing for new people coming in and the people that don’t have this net works and I have written about it and I can absolutely see how underrepresented minority is in general may not figure out.

There is no welcome wagon here right, you may find it hard to find a play to live when they are just coming if they are coming from out of the country or whatever people still do it, it makes up for sacrifices but it is not like there is not a dynamic rental market also some people that I have met who you know that are from what I call (16:50) represented the minority groups they don’t necessarily feel totally comfortable in the bay area which I also think is very valid concern so that would be me cavit out there which is the total part of inefficiency, right.

NICK: Speaking of this targeted approach to finding investors would you actually ask for that plan from the founder before you close the seed round or is it all.

SEMIL:  Oh I won’t ask for the plan directly but I will be more monitoring fro signals that 1.) they want to go on the path, 2) they have the maturity and the intellectual curiosity and frankly the chops to go do it but I will make that decision on my own.

NICK:  Semil you have mentioned how messy cap tables and safe and notes can derail a round and there was an interesting twitter thread and on the topic with Jason Lemkin, Dave McClure Keith Rabois and Hunter Walk discussing the problems that this just creates, can you review what the issues is here and how it may be addressed prior to an A round.

SEMIL:  Yep, very good question Nick the issue is that in the culture now going back to what I am saying living in the cultural notes is that the entrepreneur can now only set the amounts that they want to raise and the evaluation caps they can back then according to whatever vagaries they want.

I have been involved in something where I actually asked to be removed from the company because I found out that they did caps at 4/5/6/8/10 and then they did like $5M uncapped notes and then they wanted to recap everyone that is uncapped I guess that was so fundamentally opposed to that kind of behaviour that I just ask for my money back.

We are going to see a lot of that here and so generally if you see firms will fall into 2 buckets some of them will just say and parson my French, “I don’t want to deal with that” you clean it up and bring it to me I don’t want to clean your crap table right, and also the funders in that case often have to do some pretty harsh maths and have to realises how diluted they could be.

There are some firms that will actually go in and say look I want to make this investment I like the founder I understand why they did these messy notes I understand why the cap table is messed up we will go fix it right, but there are few people who want to go do that, few people who want to do that.

And so one thing here as a foot note that I will mentioned a lot of A &B series investors will monitor in the negotiation when they meet an entrepreneur how high that they are aiming and if they feel like they are aiming almost 2 ridiculously high as if they are negotiation tactic they will not only disengaged from the meeting.I actually see this happen like so many times they will not only disengage from the conversation or like hey congrats on all your success but there is no way in hell that I would ever even talk to you about that kind of round they actually lose respect for the entrepreneur they actually think I am not sure if I want to work with them.

NICK: Wow just questioning sort of their decision making approach fundamentally.

SEMIL: Yeah, I only just heard some people put it that way and I picked up on it absolutely.

NICK: So in this world that we are living in now sort of under capitalizing maybe get seed round in a lot of these start ups that are doing seed extension how do you avoid sort of this stack notes situation in getting in some of this problem.

SEMIL: In politics it is called the bridge to nowhere when you start shoving pork into a project, in starts ups it is a run way to nowhere and I have seen it I have been invited to once I figured out what the round was I said wait a minute what are we talking about here and he said this is kind of our series seed too series seed extension 2 and I was like wait a minute this is the 3rd round of finance they have done.

So I still look at it and there still can be some things that takes awhile to bake so I don’t want to be dismissive but it does strike me in general as kind of strange what seed entrepreneurs do not in general respect enough is that there is a time element when the series BBC comes in and let’s say they get a good recommendation to the funder or something they come ask when did you start the company.

When did the company form when did the people start coming and then if the answer is over 18 months 2 years 3 years they start to look at it like a milk carton and look for expired date and so people have to be careful and there is romanticized notion of no overnight success and I agree there are many things that have done very well that have been started many, many years ago that people do like to see progress early progress and momentum and they can’t be discounted.

NICK: What are your thoughts on metrics and the role that they play in securing the A round?

SEMIL:  Here I would just like a parent imitate someone I have learned a ton from Keith 3 months earlier. Keith is someone I observed his pontificating over the last 5 years as a matter to learn and I would say that of all the predictions that he had made I think over 80% or 90% of them have prove right, so he just has an unusual ability to dissenter size information I can’t take credit for this but I use this to say team first, vision and market second and then your metrics third and then and it’s not like a eco way.

So I think people still want to invest in great teams partially because physiologically the VC enjoys it they learn, I think they feel that the plans could change these morphis stage of the company so what I have is a good team that can move with the wind and they don’t want to sit there and be a recruiter right if they don’t have to they might want to one or two people but they don’t want to sit around doing it all day.

In terms of the vision in market what is the market that you are in how do we know that you know the market, right how do we know that the market is not only big but is grown in dynamic and that you can actually compete in it and then what’s the vision, product vision, market vision whatever vision, right.

The VC doesn’t want to invest in someone with better vision for the company than the founder does they want to be blown away by a vision that is back up by the founder founding teams personality and DNA that there interest are hypnotized by and then the metrics I think it just depends on the category in The metrics are pretty standardized you got to hit some certain things to look legit in other categories they may not metrics but the market or the team they would be so interesting that they trumped everything else.

I would like to say the metrics are kind of disproved illusion right so if somebody comes in with a great team and they have a great vision and great market position and the metrics maybe earned they have some metrics but they are not there that at least look like they are crazy or delusional right, there is something there, there is a little more leap of faith there.

NICK: Yeah we had Tom Tunguz and he mentioned Peter Thiel’s term The Secret you know every funder has to have that vision and they have to have the secret that transcends what other peoples vision would look like.

SEMIL: I think Chris Dixon also wrote a post on the similar topic about maybe you call it the idea maze it’s like one of his great topic of 100 post it is probably in the top 20 called the idea maze where he likes it where the founder walks him through this kind of labirent showing him the way to get from A to B he kind of enjoys that.