Tony Wright dot com

I admit that I am a bit of a contrarian. For a long time, the contention that “if you’re doing a startup, you HAVE to be in Silicon Valley” didn’t sit well with me. Sure, talent is important– but for many startups you need only a few talented folks to prove that you’ve got something and companies like WordPress have proven that you can build a great team (literally) anywhere and everywhere (they are virtual and across the world). Sure, energy is important– but the biggest source of energy isn’t your peers– it’s the people who are finding value in your product (users and customers). And sure, you need money… Well, the Valley wins hands down here. If you need to raise money, that’s where you need to be. But more and more early stage investors seem willing to invest outside of their little patch of Californian dirt. After our stint at Y Combinator and a bit of fundraising, the decision about our startup (an employee time tracking tool) was pretty clear to us. We headed back to Seattle, where we had a rich network of geeks to work with and talk with and (more importantly) we could live cheaply and not die.

So it was with great glee that Jim Karsten took the gauntlet I threw down in my last post and mined the vaunted CrunchBase for some real live data. Now, CrunchBase is obviously NOT scientific… But it’s the biggest and most consumable dataset that I know of. Without further ado, here is a table showing startups by location and the percentage of startups in that location that have been acquired. Note: Jim has kindly put up the full scrape of data here - there are other interesting bits worth looking at.

Disclaimer: Yes, CrunchBase is flawed for this. No, ~5% isn’t REALLY your chance at getting bought if you start a company tomorrow, etc., etc. Please don’t troll about the quality of this data. It’s still thousands of records, which is better than the alternative.

At first glance, the key number (acquisition RATE) doesn’t seem markedly different. Heck, if you live in Virginia, CrunchBase tells you that you have a 4.3% shot at an exit… Why move to California for a measely 6.9%? But I think it’s better to focus on the fact that you’d be increasing your exit shot by *over 50%* with such a move. With acquisition rate being as vanishingly small as it is, nudging up a few percentage points is a huge deal.

But overall, as a contarian (AND as a resident of Washington State– the big winner by a nice margin), I was pleased by the results. The bottom line? It’s hard to quantify the COST of moving to a startup (months of distraction, expense, stress, loss of social network, etc), but my gut says (as it always has) that if you live in a technology hub like Seattle, NYC, Boston or Austin– hunker down and start building value- your success is based on how much value you can give versus how much you take.

Edit: some interesting insight from John Cook over here.

[Edit: Added the raw data in a table at the end]

Some of the smartest startup brains I’ve ever met have said that if you want to be in the startup game, you MUST be in the Valley. There are plenty of justifications out there for it, and many/most of them make a fair bit of sense. Recently, Paul Graham posted another great essay on the topic, and said:

The second idea is that startups are a type of business that flourishes in certain places that specialize in it—that Silicon Valley specializes in startups in the same way Los Angeles specializes in movies, or New York in finance. [1]

What if both are true? What if startups are both a new economic phase and also a type of business that only flourishes in certain centers?

I don’t know the truth of Silicon Valley’s gravity (or more importantly, how that gravity is trending) but the idea of it doesn’t sit right with me. Emotionally, I found myself wanting to agree with Aaron Swartz and Glenn Kelmann rather than Ron Conway, Mike Arrington, and PG (which is pretty much the only time that’s ever happened).

So as an exercise in digital outsourcing, I took some public lists of technology acquisitions in 2007 and 2008 and paid some nameless person in some nameless town a few dollars to research the locations of those companies when they were acquired. The results surprised me. Here’s the spreadsheet, if anyone wants to fiddle with it (in hindsight, I should’ve used the CrunchBase API– if someone wants to dive in and do this, I’d love to see it).

Highlights, Acquisitions in 2007 / 2008
225 total acquisitions on the list (110 in ‘07 and 115 in ‘08)
175 (77%) were in the USA
63 (28%) were in the Valley
Top states beyond CA were NY (19), WA (14), MA (11), TX (6), IL (5), NJ (5).
Israel and the UK were dominant internationally

Removing Acquisitions with Prices under $20mm or Undisclosed
(This was in response to the thought that the non-valley acquisitions were the small one)
110 total
91 USA (82%)
28 in the Valley (25%)

The Really Frakkin’ Interesting Bit
In 2007, 45 of 110 (41%) acquired companies were in the Valley. In 2008, only 18 of 115 (16%) were.

Now, 1 year does not a trend make. And, this is some pretty amateurish research and number crunching. The numbers that I really want (which is really hard to find) are the denominators. In other words, how many valley startups spun up in these years versus the rest of the world? Does the Valley meaningfully change the chances of startup founders making it? And how have these numbers changed over the past 5-10 years?

My theory?

The core things that REALLY matters to build a v1 software startup are (in order of important):

• having the will to build one
  Silicon Valley used to have a pretty serious monopoly on people who wanted to be technology entrepreneurs. I think that’s changing– the number of people who are getting their feet wet with entrepreneurship outside of the Valley seems to be skyrocketing. People don’t want to be doctors and lawyers any more– they want to own their own companies. And as entrepreneurs in non-Valley locations see exits, it inspires a new crop in their home town.
• building something that people really freakin’ want to have
  The Valley offers no edge here– in fact, some people wonder if the “echo chamber” doesn’t actually get in the way of understanding the rest of the world.
• having the team/resources/cash to get your product to market
  THIS is where the Valley has always dominated. But I think that’s changing. We’ve all seen how cheap it is to start a software company nowadays (though you might still need VCs to GROW it).

  In terms of teams– clearly if you’re going to be recruiting lots of geeks, you want to be in the Valley. Or do you? I’ve heard that WordPress has a virtual team all over the world and they seem to be doing okay. With all of the great information on software development and startups and with the fabulous open-source projects out there, maybe it’s getting easier to get to be a great hacker outside of the Valley. And, just as the cost of building a startup has gone down, the manpower necessary to build a v1 product has gone down as well. So MAYBE you need to move your startup to the Valley when it’s time to ramp up, but I’m not convinced you need the Valley to collect two or three motivated hackers.

• Note: I think distribution magic and TAM (total addressable market) are hugely important for magnitude of startup success… But that’s a different post.

There is no doubt that Silicon Valley wins. Even a paltry 16% of 2008’s acquisitions is a staggering number for a little cluster of cities in northern California. But it’s not as big a monopoly as I might have guessed. Maybe that 1 year trend is starting to show that the institutional dollars in the Valley aren’t as important as they were in years past (or heck, maybe those funds are looking beyond their traditional borders). And maybe all of those great technologies that allow us to connect with people around the world are helping entrepreneurs connect with the energy and relationships that the valley brings the the table.

Again, Big Dislaimer: This is quickly googled data, outsourced research, and quick-n-dirty spreadsheeting. And, of course, acquisitions are an imperfect measure of success. AND, each startup/market/region is different. Bad science all around. Just a conversation starter, really.

Raw Data:

People are upset about the news industry dying/changing, and with good reason. There’s a lot of great history and romance in journalism, and it’ll be a shame to see them go. There’s a great summary of the issue by Nick Carr and some good thoughts (with a linkbait title) by Scott Karp. Karp says:

Those who argue that Google is a friend to content owners because it sends them traffic overlook the basic law of supply and demand. The value of “traffic” is entirely relative. The more content there is on the web, the less value that content has — because of the surfeit of ad inventory and abundance of free alternatives to paid content — and thus the less value “traffic” has.

He’s right that it’s a supply and demand issue, but he’s wrong that Google isn’t a friend. Newspapers got to be a VERY fat business with a huge expense line because there was a limit of supply. You want written news in your hometown? You’ve got one choice, maybe two if you’re lucky. You want to advertise to people who care about the news? Same choices.

Over the past 50 years, reporting the news SHOULD have gotten cheaper. A flood of journalism grads, word processing and desktop publishing tools, increasingly sophisticated global communication, and cheap syndicate-able news stories when it’s not practical to report it. Over the past 20 years, you’d think it’d have gotten cheaper yet. Why have a press at all? When a story is breaking in Istanbul, why not just find a freelance reporter there rather than fly one of yours over and put ‘em up in a hotel? Need to do some fact checking? Try the internet. Don”t have time to write a deeper article? Link to some content partners in a “learn more” section at the end of your article. Looking around at content startups (like TechCrunch), it’s easy to see imagine cheaply you could run a newspaper. But modern newspapers don’t have that imagination, and if they did they don’t have the agility to get there with huge debt service, huge staffs, and big infrastructure to support distributing dead trees and ink.

The problem with the industry isn’t that Google owns the middleman slot. The problem is that the news industry as we know it is fundamentally inefficient. There were local walls around the supply, and little fiefdoms of news grew fat and happy (and horribly inefficient) inside these walls. Now that innovation has removed those walls, an oversupply of news has spilled into the world and the girth of these news organizations just can’t be supported. This doesn’t mean we should pour the hate on innovation.

Technology innovation is often about making markets smaller/more efficient. It’s taking something that used to cost $50 and making it available for $5, which tends to make innovators rich and incumbents flounder and die. It’s about making music sharing cheap and easy so record-labels can’t get drunk off of the insane profits they’ve been enjoying. It’s about sites like Kayak and Faracast making the market for airline tickets more efficient and less inscrutable.

Google *IS* a friend to the news business. They are giving them a free/huge distribution channel that they don’t have to pay for. There are plenty of small/nimble news startups from the Huffington Post to the West Seattle Blog (my neighborhood rag) that are happily growing and collecting advertising revenue.

There’s clearly a need/demand for news and a clear path to making money with content on the Internet. There’s not much we can do but sit back and watch most of the dinosaurs die, rot or evolve, and watch the nimble little mammals grow up to fill the niches they leave behind.

As a business with public contact information, we are inundated with sales calls. The process generally runs roughly like this:

1. We get a phone call from a number that is often “blocked” for caller ID. We’ve learned to screen those calls. Some leave a voicemail, some do not. If they aren’t blocked, we’ll answer the call, and we’ll generally get blasted with a run on sentence. If it’s a short introduction, I’ll politely decline. If it’s a long monologue, I’ll hang up.
2. We get a followup email from the caller describing their service. They will ask for a 15-30 minute introductory discussion/presentation. Depending on how good the email is (in terms of grammar and presentation), I’ll drop a reply saying that we’re not interested or ignore it entirely.
3. I’ll often get a 2nd email saying something like, “when would be a good time to follow up with you. How about I drop you a line in 3 months to see how things are going?” Um, no thank you.
4. The really well-trained salesfolks will often also say, “Do you know of anyone else who might be looking for our services?” The answer to this is always no. I’m not going to make an introduction (which is often tantamount to an endorsement).

5. I don’t want to be a jerk to salesfolks. I’m sure they are by and large good folks and are just trying to do their job. But we NEVER BUY ANYTHING THIS WAY. Between a few Google queries and a few “lazyweb tweets or emails”, I can drum up a short list of vendors who are thought well of by SOMEONE, and perhaps can get a list that are actually recommended by people that I know and trust. Why would I ever buy from the salesperson who happens to be calling me? Even if they were introducing me to a class of software/service that I wasn’t aware of and really wanted, the first thing I’d do is thank them for the info and start googling.

   As people get smarter about searching and social networking (and thus social recommendations) go mainstream, I continue to wonder at the future of outbound lead generation via phone/email.

   So, I’ve got a new canned response in Gmail:

   Thanks for your inquiry.

   RescueTime does not respond to unsolicited sales requests and we’d prefer to not receive them.

   When we’re interested in software or services, we prefer to do some combination of searching on the Internet and asking trusted people in our network for their recommendations.

   If you’re interested in earning our business, your best bet is to serve the customers you have well so that when we ARE looking for what you offer, you’ll be highly recommended in our network and across the web.

   Thanks for your understanding.

   Cheers,

   -Tony Wright, founder of http://rescuetime.com

   http://blog.rescuetime.com (company blog)
   http://tonywright.com (personal blog)

I saw Brad Feld speak last night at Beer, Brad, and Boulder (you can see the recorded stream and chat here) and was really struck by something that he said.

In response to the question: "How broken is venture capital?" he said (paraphrasing, among other things): "It's not broken, but it is saturation.  It's absolutely cheaper to build companies nowadays, but it's not necessarily cheaper to build them and scale them.  Venture Capital is still necessary to scale businesses from the prototype stage, but no longer quite so valuable to get to that prototype stage."

(note: this is a test using Posterous to automagically post to this blog– sorry for the brevity!)

Posted via email

On Friday I spoke at a “Business Bootcamp” in Corvallis, Oregon. The event was fabulous (big thanks to John Sechrest) and I was pretty impressed to see that kind of passion for startups in Corvallis.

I wanted to follow up with that community with a few thoughts (that might be interesting to a broader audience, so I’ll post it here).

Thought #1: The Valley is a Unique Animal

After the Y Combinator experience, we dove into fundraising in the Valley as well as Seattle (where we ended up settling). It didn’t take long to give focus our efforts largely on Silicon Valley. Don’t get me wrong– there are some great Seattle investors. But there just aren’t many of them, and as Paul Graham points out, investors outside of the Valley just aren’t very bold. At the Business Bootcamp, a local angel investor spoke for a bit after I did about what he looks for in a company and he seemed even less “Valley-like” than Seattle investors. The big differences that stuck out to me were:

• A strong emphasis on patents/IP (in 20+ meetings with VCs and angels before we were funded, not a single one asked us for our thoughts on this).
• A strong emphasis on written business plans and financial forecasting (we never were asked for anything beyond an executive summary and never were asked for any financial projections except by a single angel group in Seattle).
• A desire for a big equity stake. The Corvallis angel had a an equity floor that was a third more than the premium “household name” angels in the Valley. Presumably, this is because the Corvallis angels aren’t too plentiful and have a captive audience.
• A desire for a more fully formed team. He wanted a 4-7 person team before he invested.

For the record, I don’t think ANY of this is bad. I just think it’s SAFE. I imagine a methodology likes this results in far fewer failures, but also results in fewer hits and disqualifies all sorts of non-traditional teams. I think many of the startup home-runs in the last decade or two would’ve been shown the door rather quickly in Corvallis. Boldness might not be a virtue from an investor’s perspective (the landscape is littered with the financial corpses of bold early stage investors, I’m sure), but it certainly is from an entrepreneur’s perspective.

Thought #2: Audience Questions

The third presenter gave a fabulous presentation called “Do you have what it takes to be a Startup CEO?”. It was chock full of info and I certainly learned a lot. Unfortunately, there were two questions from the audience that I felt weren’t answered very well, so I’m going to take a shot at ‘em.

“I’m hearing that we need a team of 5-7 people, paying customers, provision patent applications, and mess of other things before we can even begin to ask for money. That seems inherently contradictory with the idea of angel investment.”

It does, doesn’t it? Smart angels seek to mitigate/minimize risk and most angels are pretty smart. There’s nothing more wonderful than a startup with 5-7 great team members, growing revenue numbers, a pile of great patent apps, etc. Unfortunately, angels who are looking for this kind of company are really “later stage” angel investors. Unless you, as an entrepreneur, have a million bucks to get to that point, you have two options. One, find a bolder seed-stage investor (in Corvallis or move the the Valley where bolder investors are more plentiful). Two, get some freakin’ traction. Seriously, dial back your idea to the most basic offering you can manage that people will use/buy and build it with a co-founder or two (in your off-hours if you have to). If you can launch SOMETHING that people really love (and if the TAM is big enough), investors will listen. You’ve reduced two of the main risks that they are worried about; That you are a screw-up who can’t launch a product and that what you build ends up not being particularly interesting to your target audience. The better your traction and the steeper your growth curve (in terms of usage or dollars), the easier fundraising is.

If you don’t have a gold-plated team (read: previously made an investor lots of money), a pre-existing relationship with an investor, or TRACTION, I seriously advise not trying to raise money from anyone but friends and family. Given that most entrepreneurs aren’t gold-plated (I sure as hell wasn’t) and building relationships with investors is a hard to do from scratch, your only option is launching and building traction.

“I’m a college student here. What advice would you give to an aspiring entrepreneur with a notebook full of ideas?”

The speaker quite literally responded with a long answer that amounted to, “Not everyone is CEO material. You should consider that you likely aren’t CEO material.” Really? Is that what we want to tell aspiring entrepreneurs?

The right answer (IMO) is this.

First, pick the idea that you’re going to attack. I’d say, focus on tractability with a strong bias to the ideas you are most passionate about as well as the ideas that have some built in marketing (SEO or viral– relying on word-of-mouth and salespeople is difficult and expensive).

Second, figure out what you’re good at that a startup needs. Hopefully, you can code things, design things, or sell things because the vast majority of the first months of a startup is comprised of that kind of work and precious little else.

Third, read everything here: http://ycombinator.com/lib.html

Fourth, save money or borrow a few bucks from family/friends so you can work on it full-time for 3 months. If you can’t do that, do it half-assed (it can be done!).

And finally, don’t listen to people who tell you that you might not be CEO/startup material until you’ve taken a stab at it. The world is full of unlikely CEOs from Steve Jobs to Bill Gates to Mark Zuckerberg. Roll the dice and dive in– when you’re on your deathbed, I’m betting you won’t be saying, “Gosh, I wish I could go back and take fewer risks.”

In the past two months I’ve been on two different panels with other entrepreneurs. The first was at WTIA in Bellevue, WA (”Cashing in on Web Services“)– the other panelists were very clearly what I’d call “business entrepreneurs”. All of them had relatively successful funded startups, but not a one of them had probably written a line of code, moved a pixel, wrangled a server, or written a line of copy in months or years (some probably never had).

In contrast, the most recent panel I was on (at the O’Reilly Web 2.0 Summit) was with what I’d call “builder entprepreneurs”… All startups with great traction, some funded, but all of the founders were directly engaged with the creation of the product. They designed, coded, played sysadmin, and played all sorts of other production roles for their startups.

The contrast was startling, and it made me think hard about my earlier contention that the “business guy” doesn’t really have a useful role to play in the very earliest stages of a software startup. The first panel had a pile of examples of business guys leading startups to some significant (sometimes dramatic) success.

At one of the other panels at the Web 2.0 conference, Dave McClure (master of 500 hats and 473 font colors– and one of the smartest guys in the game) summed up the life-cycle of a startup in a great way. “There’s the product development phase, the market development phase, and the revenue development– or revenue optimization– phase.” Rings true to me.

So with this in mind, let’s track the value of a “product entrepreneur” over the early life of a company:

Now let’s track the value of a “business entrepreneur” over the early life of a company:

(note: I’m talking about one person’s ability to make a major impact with a startup– I’m not saying that either person is useless at any stage of the startup… And, of course, exceptions abound)

As I’ve said before, the business guy often doesn’t have a lot to do in the early stage of product development– especially if the builders are building something that they actually want themselves. If you’re a bunch of hackers building a simple photo sharing, you don’t need a business guy telling you what the market wants. Of course, if you’re a bunch of hackers building business time management software, you might well need that. Your mileage may vary.

But what I haven’t said before (and what I’m coming to learn) is that the product entrepreneurs have an increasingly marginal role as a startup evolves and becomes more successful. In fact, I’d argue that they are in a rude awakening– they either need to evolve into business entrepreneurs (as Gates and Jobs did, for example– both shrewd business guys) or hire people to play that role (a la Eric Schmidt at Google). Building an asset is the first (and most important) challenge. But finding the customer for that asset and maximizing the revenue/profit is also a challenge (and one that many builders are ill-suited to handle).

It feels like product entrepreneurs are oftentimes “cowboys”. Flying by the seat of their pants, they rally a small team to build a product that people want. It’s no surprise that this is really freakin’ hard and requires a mythical combination of brute force time and effort, insight, customer empathy, and a huge pile of luck. Saddling the product team with a biz guy who chases big customers and locks in the product direction too early can be deadly, as the Wizard points out:

This is one reason I hate to see very early stage companies sign a big customer before the product is baked. You are encumbered by product commitments and customer support before you truly know what the market wanted. You have to be passionate about a customer and the product when you should be laser focused on the product. The customer’s needs and your goals vis a vis the market may diverge. In an effort to show progress, however, the marquee customer is attractive in the belief it will help attract investment (and this may indeed be true). In a previous life before FeedBurner, my founders and I made the mistake of signing a big name customer to a paid monthly contract before we really knew what the product’s place in the market should be. Won’t ever do that again.

The product development phase of company needs product development people and precious little else.

But as the market development phase sets in, builder entrepreneurs are oftentimes increasingly obsolete. It’s no longer time to hurl features willy nilly at your users– you’ve already built something that they like. No you need to measure the hell out of it and turn it into something that they love. You need to iterate on it and turn it into something that confuses 4% of your new users instead of 7%. It means finding a way to tune your viral loop and conquer your SEO enemies to increase the organic flow to your product. And you need to start expoloring the market to figure out who they hell is going to pay for all of this. That means crafted adwords campaigns. That means cold calling. That means price experimentation. That means exploring the world of direct ad sales. Well, it can mean all sorts of things, depending on whether you are a free web service, a freemium product, a pure b2b play or some combination thereof.

But you are firmly out of the world of building products and drifting into the world of iterating a product and exploring a market. And, likely, you’re in the world of sales, marketing, and instrumenting the hell out of your app/site.

As Papa PG says, if you look at the leaders of successful tech companies you see more CS degrees than you see MBAs. That makes sense– geeks are critical to conquer the first (and most important) problem of a startup… Building a badass product. But if you look at these same tech companies, you see CS geeks who’ve actually set aside their geeky roots (though maybe not their geeky instincts) and become very very shrewd business guys. And you also see inferior products kicking the crap out of superior products through better sales/marketing/and distribution.

So to all of you builders out there… Beware! When you reach a challenge in the evolution of your business, the most natural thing in the world is to frame it as a product problem. “If we just build this new feature/product, we’ll be off to the races and we’ll never have to do any of that business crap!”. Keep your eyes peeled for the time when you have to personally evolve and start tackling business problems, or step out of the way and let someone else do it for you.

This will be a small post, but I stumbled onto some interesting data that I thought I’d share. As a background, we’re currently searching for a great C++ dev to work at our startup here in Seattle. I decided to do a bit of research to see other job postings, compensation packages, etc.

I was startled to find that (in Seattle) C#, C++, and Java jobs are hotter than everything. Period. By a monstrous margin. Take a look (numbers in parentheses are the results counts as I write this):

Jobs with C# in the title (759)
Jobs with C++ in the title (537)
Jobs with Java in the title (307)
Jobs with ASP in the title (209)
Jobs with Ruby in the title (85)
Jobs with PERL in the title (50)
Jobs with PHP in the title (46)
Jobs with Python in the title (26)

Wow. C++ jobs almost end up being more plentiful than all of the major scripting languages combined. C# jobs are even more plentiful. Toss the word “startup” into your search query and it reduces all of the results, but the big-iron languages still win by a wide margin. Really interesting to contrast these numbers with San Francisco, where you see fewer C++ and C# jobs (predictably as you move away from Microsoft-country), more Java jobs as well as a few more Rails and PHP jobs (but Java wins in SF by a landslide).

So if you could snap your fingers in Seattle and be a rockstar/ninja programmer in one of these languages, which would you pick (from a career perspective)?

(nota bene: recruiters who use the word “rockstar” or “ninja” in a job posting deserve to be flogged. While we’re at it, anyone using the phrase “FAIL” or “EPIC FAIL” deserves a healthy thrashing as well.)

My first experience with stock options was at the ripe age of 34 years old, when I was selling Jobby (retired) to Jobster (Gah, make the Web 2.0 names STOP!). Before that, I’d been running my own business for close to a decade– with good success, but there really wasn’t any sense in setting up an options plan.

So when selling our company and getting presented with a cash/stock options package, I was damn excited about the options. I dutifully did a bit of research to try to understand how they worked, asked some smart questions, and was a proud new owner of startup equity. 365 days later, I left Jobster– on good terms, but I chose not to exercise my options.

Now, as RescueTime is expanding its team, I’m on the other side of the equation– putting together stock option plans for new hires. So I figured it might be useful for folks we’re talking to for me to put together so thoughts and resources about startup compensation, particularly in the area of stock options. A big part of my motivation here is that I think most startups are QUITE content to let employees think that options are this magical ticket to wealth and prosperity… It feels dishonest.

3 Harsh Realities of Startup Options

1. Employees with decent salaries and options will almost NEVER get rich in a liquidity event. The people who might get rich with startup equity are the founders and the investors (not coincidentally, the people who took significant risks). There are obviously exceptions here– I read that Google minted 900 new millionaires when they IPO’d. Good for them. But when you do the math on probably exits for most startups, it’s good– but it’s not quite so rosy. VentureHacks has a breakdown of what startup employees might expect in terms of equity. Assuming you don’t get diluted with further investment down the road, a lead dev or director might expect 1% ownership (vesting over 4 years). So in the event of a $50,000,000 exit, they’d walk away with a cool $500k, IF they’d been there for 4 years or longer.

2. Options vest over 4 years. Everyone loves the idea of the overnight success with a quick-flip to Google. It’s vanishingly rare, but it does happen. When it does, the founders generally do okay, but what happens to the late-comers with unvested options is a question mark. Those unvested shares COULD accelerate (meaning they could all vest when the buy happens). Or they could convert to options in the purchasing companies stock (par value). That’s all part of the negotiation and it all depends on the leverage you have with the buyer.

3. How the options are set up very much effect how attractive the company is to a buyer. We’d LOVE to offer 100% acceleration upon change of control to our hires– that’d mean that all options would immedietely vest and our whole team would be rich and happy– but not particularly incentivized to stay and work for the buyer.

So are Options a Crappy Deal?

The best way to look at options are as a high-risk investment– it’s important to look at the cost of the investment, the chance that the investment will “hit”, the likely magnitude of the return on investment, and the percentage you’ll likely have in your pocket at the time of a liquidity event. Here’s the best way to look at the math.

• The COST of the investment is the difference between what you could be making (your market value) minus the salary that you are offered. So if you’re worth $85k/yr and the offer is $75k/yr, you’re investing $10k per year in this high-risk opportunity. If you’re getting paid market value, then… Well, there’s no risk– and you shouldn’t be expecting much reward.
• The CHANCE the investment will hit is a huge question mark. Think hard about the market for such a company. Who would buy it? Can you imagine Google and Microsoft fighting over the company?
• The MAGNITUDE of the return is another question mark. If it’s a web startup, there’s lots of data out there about sale prices. The question is: how big is the opportunity? What are companies in your space getting bought for? It’s easy to test a few scenarios.
• The PERCENTAGE of ownership is a bit of a moving target, but you can at least know where you start. Again, take a look at VentureHacks for a reality check.

So to boil it down in an example, let’s say we have an engineer who is getting .5% of the company vested over 4 years. He’s making $80k, but probably could make $90k at a company with limited equity opportunity. Let’s assume a target exit price of $50,000,000 (oh, happy day!).

Our engineer is spending $10k per year to have a shot at a $62,500 per year. If he spends the full four years there, he’s “invested” $40k for a shot at $250k (a 6x+ return– not bad). When you run the same scenario with a billion dollar exit, it’s starting to look a lot prettier. When you run it at a Flickr-sized exit ($20m), it’s not looking like that great of a bet. If you want to get into the finer points, you should probably consider the benefits as well as the cost of the options.

The only way to buy more reward is with more risk. Some founders will be willing to give up lots more equity if you’ll work for less, but it’s honestly fairly rare if they’ve reached the point where they have enough cash to hire people for them to be terribly eager to part with lots of equity. There’s obviously a small army of “idea guys” out there who would happily give you huge piles of equity if you’ll work for free. And, of course, the best way to get rich with equity is to start your own company.

If you don’t fancy rolling the financial dice by “investing” in a startup, most startups are probably happy to pay you market rate and dial down your options… But either way, there are lots of career perks that you’re buying by working in a startup. Which brings me to…

You’re Buying More than Just a High Risk Investment

Needless to say, most options aren’t a very good investment. A chance at a 5x return is great, but most startups are facing longer odds than 5 to 1– so you should be damn sure that you believe in the company, the team, and (most importantly) your ability to influence the outcome.

I think it’s important to note that our engineer in the above example is buying a heckuva lot more with his $10k… Though they are things with a very subjective value.

• He’s buying startup experience. If you plan on spinning up your own thing someday, there is no substitute for working in a startup to learn what works and what doesn’t. You don’t have to sign on with a experienced startup founder… It’s good enough to get paid to watch them make mistakes that you can avoid when it’s your turn.
• He’s buying a “clean slate”. If you get to a startup early enough, there is lots of blue sky. The early days of product development (for many people) are the most rewarding.
• He’s buying startup cred. When it comes time to spinning up his own thing or getting his next gig, it’s a big plus to have that background. It’s obviously a HUGE plus to be part of a winning team (if an exit happens).
• He’s buying relationships. One of our investors says that 99% of his deal flow comes from people he’s previously invested in or people on their teams. Working at an early stage startup is an opportunity to meet investors and other important startup folks– good leads for future endeavors.
• He’s buying a work environment that is comparatively bullshit-free. Little bureaucracy, few meetings, flexible work schedule/environment, etc. If you’ve ever had an environment like this, you know how addictive it is and how elusive it is in larger companies.
• He’s (hopefully) buying a chance to work on a product he likes/wants to use.

Obviously, all of these perks are really only perks for people who see themselves working on/in startups in the future… For people like this, the $10k price tag (when you roll in the high-risk investment op) is a great investment. For folks who are just chasing the idea that they are going to get rich taking decent-paying jobs with post-funding startups, they are in for a long series of disappointments.

(note: if other folks have insights on startup compensation/options, please chime in. Despite writing a Newbie’s guide, I am, admittedly, a bit of a newbie! )

Last night I spoke at Seattle Tech Startups. Given that lots of people who go to these meetings tend to be wantrepreneurs (aspiring startup folks), I focused on early decisions that need to be be made. Do you shoot for a great lifestyle business or do you aim for a grandslam? Services biz or product biz? Bootstrap it, find angels, or court VCs? And when you answer all that, how do you settle on an idea when you have lots of them bounding around in your head (for this part, I liberally borrowed from Ev Williams’ great post on evaluating startup ideas, which I posted a riff on a while back).

After my short presentation, there were some really fabulous questions. Two of ‘em kept me thinking and I wanted to expand on the answers a bit. Here they are.

Question (paraphrased): “Given that takinghuge piles of VC money both has the dangers you describe and and firmly closes the door on most early acquisition opportunities, why are people still going after big VC?”

My response was two-fold at the time. First, there are some ideas that require a lot of money– as an example, I mentioned a local northwest guy who is working on a really cool electric motorcycle… It’d be hard to imagine getting that business off the ground with $500k of angel money. I also mentioned that some entrepreneurs look at their valuation as a score. Taking $4m on $12m post-money is essentially saying that, on paper, your company is worth $12m. Feels pretty cool, I suppose.

Two more things to add here.

First, I think people chase VC because it’s available. Angels are purposefully elusive– they don’t exactly hang out a shingle saying, “I’ve got $50k burning a hole in my pocket”. VCs, on the other hand, have a web site, and processes to handle/process deal flow. They almost always want to lead the investment by negotiating terms and putting in a big chunk of the money, while angels sometimes shy away from leading/negotiating, but are happy to pile on with other investors.

I think there is a big hole to be filled here by institutional investors who aim at a larger number of smaller deals (something that most VCs can’t handle because they have too much money under management, take too long to do the deals, and have too few people to sit on boards). There are smaller funds out there that are starting to fill the “early/small” niche (with $250k-$1m investments) but they are rare and (from an outsider’s point of view) are buried in interesting startups to invest in. The good news is that they’re seeing great success, so more are popping up every day. If you want to see a good list of folks who are really looking at early-stage/lower-dollar deals, here’s a great article profiling a few. You’ll notice a decided lack of ‘em in the Northwest. Madrona is mentioned but I think they very rarely do a deal less than $1m.

Second, B2B. Despite Web 2.0 hype, there is tremendous money to be made with B2B software. Going the B2B route requires a sales engine or some clever distribution innovation. If you’re spinning up a sales team, that requires LOTS of money flowing out of your business (salary, commissions) before you recognize revenue for their efforts.

Question #2: “Can you talk about how to decide whether a business/idea should fall into the “lifestyle” category or the “get funding a go big” category?

My answer last night centered around overall magnitude of the idea. Could you imagine it being the next Google/Facebook/Salesforce.com? Is it that ambitious? Can you set out milestones where you end up selling for $100 million? I also mentioned that how much you NEED is important. If you can “run the experiment” for $500k to see if your market/team/idea are as good as you think, raising $10m is silly. If you can roll those same dice taking no funding and working on weekends, raising ANY money might be silly.

What I want to add: Think about how you fit into recent investment trends. Investors closely follow trends. Most seem to focus on trends and recent acquisitions that you’re already reading about– the top tier ones often try to anticipate what’s going to be the next trend. Imagine yourself pitching your idea to someone who religiously follows and tries to anticipate trends. Will their eyes light up? To my amateur eye trends that are important out there right now are: Ad networks, widgets, casual gaming, video advertising, iPhone/mobile apps, Facebook/MySpace apps, social aggregation, and (of course) anything that could credibly take a shot at killing Google. Am I missing any? There are a few tired trends that probably still have legs with some investors like niche social networks, social news sites, photosharing, etc.

If you’re outside these trends, that’s okay (we certainly are, though we think that productivity/information overload is a meme that is growing like gangbusters). It just means that you’re going to have a harder time raising money and you’ll need a bit more traction to pique VC interest. We’re just about ready to close our angel round with a fairly platinum-plated group of investors, so it’s certainly do-able. I’m just glad our founders all had hefty personal bank accounts to allow us to grow the business over the 3 months of fundraising. I know plenty of people who’ve needed 6-10 months to raise a round, so be prepared for that if you’re bucking trends.

Remember, Google came to a market that had well-funded mature players at a time when a lot of really smart people were saying that search was a dead business where you couldn’t make any money.

Another thing to consider on this front is this: Do you have some unique aspect of your business that allows you to acquire new users/customers for zero or near-zero cost? SEO, viral marketing, user-generated content are all fabulous ways to get an organic flow of visitors to your product. VCs love clever distribution wrinkles, and most successful startups have a fabulous (if sometimes accidental) story to tell here.

And finally– the best way to decide whether it’s a small biz opportunity or a huge business opportunity is to launch. If you’ve got something big, the market will start dragging you down the growth path. If it’s a big opportunity and you’re growing like gangbusters out in the wild, funding isn’t hard.

Anyhoo– hope folks enjoyed the talk– I’ll post the video if STS puts it up.