Yesterday I wrote a post about “proprietary dealflow for VCs.”

In the article I discussed the downside of raising capital at a too high of a price and referred people to a previous article I had written encouraging founders to raise “At the Top end of Normal” as opposed to stratospheric prices.

In the comments section Siqi Chen wrote a great question

“Whenever I hear advice about pricing a round too high for the next round, I can’t help but think: well, if the choice (ceteris paribus) is between

a) doing what is effectively a down round preemptively when I don’t have to, by underpricing my current round in this market vs

b) accepting the market price along with some risk of taking a down round in the future, if I don’t hit my milestones, why would I ever choose b)?”

Since it is a great question with a subjective answer I wanted to broaden the reach of my answer beyond the comments section. I would love it if other people would weigh in on the comments section below if you’ve had experiences with down rounds.

The Damaging Psychology of Down Rounds

There is an important psychology that exists in investments. I don’t make the rules so don’t shoot the messenger. But psychology DOES play a big role in investment decisions. Even when investors themselves might not realize it is at play.

The rule is, “Always be over-subscribed.”

What does that mean?

It’s far better to be raising $1.5 million and get $2 million in interest (or perceived interest) than to be raising $1.5 million and only manage to get $750,000.

“What’s wrong with them that they couldn’t raise their money?”

Damaging psychology. People want what they can’t have. They want what they must work to get. So if you’re not a sought-after commodity investors may avoid you.

I know it shouldn’t be like this. They should either believe in you and your business or not, but I promise you I’ve seen this type of behavior repeatedly over the past 15 years.

And what’s worse than being under-subscribed?

A down round. That’s why.

But why?

Well, a down round is even more complicated than having no demand for your investment round.

First, a down round sends a signal that something is wrong with your company. Something didn’t go to plan. And no amount of explanations, “we raised in a frothy market. We know that. You’re getting a great deal when we’ve made huge progress.” or whatever simply won’t erase the “something is wrong” psychology.

But here’s the kicker.

As has been pointed out by Dan Primack based on FLAG Capital data, there are fewer than 100 “real and active” tech VCs in the country. If we count seed funds and large angels maybe that number goes up by 2x?

Point is – it’s a small industry. Everybody knows everybody. And we think of it like a Prisoner’s Dilemma played in multiple games. Whatever I do now it going to affect my future deals.

Often that is a good incentive because it keeps VCs from screwing people over since a bad reputation or bad working relationships could cost you deals in the future.

But in this case it works against the founders. Many VCs would prefer to avoid having to cram down other VCs by investing at a lower price or even if it’s not a cram down they prefer not to invest in a down round that forces the VC to take a “write down” on their valuation sheets they should their LPs.

And most VCs are over-whelmed with deals. So given the choice of pissing off your VCs (and you) they simply give you a polite response and move on to the next deal (with less hair on it).

What can you do if you’re already in this situation?

I’ve written about this before. I always tell entrepreneurs, “Clean Your Own Shit Up First.” (before fund raising). It’s the one post where my wife actually complained I went too far in trying to come up with an authentic image to represent the post.

So what do others think? Have you been involved in companies with a down round? Has it been easier / harder than I describe?

Do you think there’s a case for not raising at too high of a crazy price either for psychology reasons or for restructuring reasons?

Love to debate in the comments.

Image courtesy of Daniel Moyle on Flickr.

I travel the country a lot. And I am often approached by entrepreneurs in cities which don’t have a vibrant VC community. They often ask whether they have to move to SF, NY or LA to get financed.

I have the same response always, “Where do you want to live? Where do you want to build your community, your relationships, your family?” I’m trying to get a feel for their commitment to local community versus being in a place where financing is easiest.

If their commitment to staying local is weak I normally say, “Well, it certainly would be easier on you to be in a larger community. It would be easier in terms of getting access to angels, VCs, the media, whatever. So if you’re really indifferent you might consider it.” On the other hand, if they have a strong preference to staying local I usually tell them that I believe you can build a business anywhere these days.

You can build a meaningful company just about wherever these days. Just ask the people of Portland, Seattle, Boulder, Iowa, Princeton, Dallas or countless other cities that don’t have enough venture capital.

Ask SuperCell. Or Rovio. Or UrbanAirship. NewToy, Dwolla, Pollenware or Wonga.

If you don’t live in a major VC zone, I have some tips for how to make it easier to raise Venture Capital.

Before I explain, let me give you some backgrounds why it’s harder to raise money if you live outside “the zone.”

Let’s start with “oversight.” Most VCs view it as their responsibility to mentor, debate, cajole and generally assist with investments they make. They also view it as a responsibility of the money they manage on behalf of others to provide oversight of these companies. And it is significantly easier to help when you are local.

Take me for example. This afternoon (Saturday) I have a coffee meeting with a portfolio company founder. Tomorrow I’m meeting with a senior exec who is considering joining a company in which we’ve invested. He would be a very senior hire for us and filling an urgent gap. I know local talent. I know who is perceived as good and who has a fancy resume but others think didn’t perform. That’s what local allows. I know the whole ecosystem: VCs, CEOs, tech teams, founders, angels – and I know people who have worked together for 15+ years.

Local knowledge runs deep. Thus, a desire to invest more locally where I think I have a competitive advantage. Otherwise I’m just money.

But I do invest outside of LA. Examples include DataSift (San Fran & London), MyTime (SF) and awe.sm (SF).

Every year I’m in the SF Bay Area 12-14 times. I’m in NY 6-8 times. And then there are smatterings (Dallas 2x, DC 3x, Philly 3x, Austin, Boulder, Seattle not to mention San Diego 8x, Santa Barbara 8x – where I invested in RingRevenue).

This isn’t a complaint. It’s a goal to help you understand the life of a VC. And I no longer control my calendar. When DataSift sets up a board meeting (next one in London, last was in NYC) we have investors from NYC (IA Ventures), SF (Scale Ventures) and the founding team + chairman in London. So when dates & locations are set – they’re set.

So ….

Am I looking to add 8 trips / year to [name your location not already on my annual itinerary]. Not easily. Of course if it’s a company on fire I would travel to any 2-hop city from LA.

So how do you overcome that given that all VCs must have a similar pattern to me other than super-human VCs like Brad Feld or Dave McClure who have insane travel schedules but an unbelievable ability to put in the air miles and be whenever/ whenever?

Here’s what I would do if I were you. I’ll pick a mythical company in Kansas City.

• For starters I’d try to raise my initial capital locally
• Next I’d research every VC in the country and find people who grew up in or near KC. Why? Because you know they must already come back 1-2 times / year anyways. Plus, they know the local market better and therefore don’t have the uninformed biases of those that don’t. If these people work for reputable firms and have the right industry knowledge they ought to be on your pitch list
• Importantly … I would pitch investors in SF, NY, Boston, LA, etc. and say the following

“I live and work in Kansas City. I have the tremendous advantage of access to a hard-working, loyal and technical talent pool. So I want to stay here and build my business.

That said I want the best VCs in the industry and for that I know I need to be in a major VC hub.

So here’s the deal. I will commit to traveling to NYC seven times per year for board meetings. I’ll make your life easier because I know you travel all the time anyways and KC ins’t exactly on your normal path.

Heck. I need to be in NYC a lot anyways. All I would ask is that you hold 1-2 board meetings / year in KC.

You’re going to want to do that anyways to always kick the tires of the local team. Plus, we have some rocking bbq to make it worth your time.”

I know some people will cringe at this idea, “if the VC really wanted me they would come to ME.”

Maybe. But until you’ve achieved the kind of success you know you’re capable of, it’s a harder ask. And with my strategy, you take their biggest objection off the table. By the way, no VC will ever tell you, “I don’t want to come to KC 8 times / year” because it would sound bad.

But as I always tell entrepreneurs, “Better That You Deal with The Elephant in the Room.“

Note: if you’re a parent please check out their website.

Kara called me on a Tuesday. She was leaving IAC to start a company.

“Tasha, clear some space on my calendar tomorrow. OK?”

“I want you in my offices tomorrow, Kara. Does that work for you?”

Kara came. She didn’t tell me she was bringing anybody. I didn’t ask her for a deck. Or what she was working on. Or whom she was working with.

Tasha screamed. Literally.

WTF?

WTF is she going on about? Tasha! Pull it together.

It was Soleil Moon Frye. Aka Punky Brewster.

So?

I repeat. WTF? We’ve had many celebrities walk through our doors including a-list film stars. Heck, I even had Robert Downey, Jr. bang on the windows of a board meeting recently and stick his tongue out at all of us.

And Tasha never screamed before?

We’re in LA. They’re only people. It’s not much different than having Dave Morin, Dick Costolo or Sheryl Sandberg sitting next to you at lunch.

Turns out Punky was a childhood hero for Tasha. Ok. That’s cute.

They pitched on a Wednesday. I had them at my partners’ meeting the next Monday. We had them a term sheet the same week. We signed it the following week.

That happens, right?

Well, sort of. Remember, it’s about Lines, Not Dots.

I first met Kara 5 years ago. I considered her one of LA’s great talents. You can imagine the narrative … Native Angelino. Competitive sportswoman. Princeton. Stanford MBA. Ex Venture Capitalist with Battery Ventures. Leaves to work in Corp Dev at IAC. Tells me she wants to do operational stuff so she joins a small team of people running City Search. She learns how to ship product, how to deal with merchants, how to hire product managers. She had previously acquired UrbanSpoon. Now she was tasked with running it.

She was a young mom back then. 2 kids. Sheryl Sandberg leans in? Kara perfected that. Somehow she was always on a flight up to Seattle or San Francisco. Always meeting her product ship dates. Getting involved with political events and fund raisers. And still able to make it out to LA networking events. She was always able to get into the weeds on product or biz dev discussions.

She was everything I was looking for in an entrepreneur to back.

Still.

What was she doing with Soleil Moon Frye?

Didn’t I make myself clear about celebrities & startups?

Ok. ladies, show me what you got.

It was magic at first meeting for me.

Kara on one side of the table showing me market sizes, competitive dynamics, product roadmaps, pricing plans for physical products with COGS and gross margins.

Soleil on the other side getting out sticker packages. Showing me designs. Talking about how to inspire moms to get their children engaged with iPads and physical activity sets customized for their kids and based in part on their digital lives. She speaks about ethical sourcing of eco-friendly products. She’s passionate about near-shore manufacturing in places like Haiti where we can do good and do well. About the need to be careful about being the low-cost provider of physical products but risking not providing products that mom’s can feel safe using with their children.

She is a brand ambassador at Target. She runs a mom segment on the Today Show. 1.5 million Twitter followers. Nearly all probably moms. Plus me. She won me over at first meeting.

Soleil returns emails at 1.30am. She flies from LA to NY every two weeks. She helps write press releases. She debates manufacturing strategies. She talks about creative design of websites and physical products – in our case – stickers.

Turns out she’s done this startup thing before. Who knew?

Kara & Soleil are hard-working powerhouses. Great moms, both. But passionate about building businesses.

Soleil is paranoid about leaking design & product information because she’s been burned. Kara is showing me GANTT charts, wireframes, user stories and ship dates.

They are yin & yang. In the most perfect sense of the definition. And they’re both full time committed to their startup – Moonfrye. Kara as CEO. Soleil at Chief Creative Officer.

When I told them I really wanted to work with them and lead their funding round they each had their, “but can you please save some space for …” moment.

Unsurprisingly for Kara is was the VC connections. So we have the pleasure of working with Dana Settle at Greycroft, whom I have a blanket offer with that any entrepreneur that wants to create room for Dana in a deal that I’m involved with has a free pass. She’s awesome to work with. As are her partners.

And for Soleil it was her entrepreneur friends: Dan Rosensweig, Tim Ferriss, Kevin Rose, Shervin Pishevar, Randi Zuckerberg, Gina Bianchini, Erik Lammerding and Rick Marini.

At one point she actually reached into her pocket and allocated some of her personal shares in the company to be sure that the people who advised her up to this point had enough advisory stock – she felt they had contributed to her success to date. I wonder if she even ever told them. That is Soleil. And part of the secret of her success.

So, Mark, enough entrepreneur love. What the eff are they actually building?

Turns out it’s something that instantly resonated with me. They have designed a digital, mobile product that engages parents and kids. It’s something you’d imagine working best on a tablet where the parents take digital assets (think: photos & stickers) and engage with their children in story telling, arts-and-crafts, scrap-booking and the like. They are designing physical products that will be shipped to kids and become both activities to do with friends & parents as well as collectibles.

When you think about physical stickers and activity books every parent can understand. I drove 45 minutes across LA to The Grove to a specialty sticker shop when my boys were young – so obsessed with stickers were they. At every holiday: Thanksgiving, Passover, etc. my wife bought activity sets to put together little collages of turkeys and Pilgrims and talk about Thanksgiving.

And I’m a huge believer in the merging of our digital and physical lives but mostly in preserving our physical ones. I’m passionate about personalization. Kids love stories that involve people they know: Aunts, uncles, cousins. They love looking at pictures PapaKay. And Bubbie.

But mostly I’m a believer in Kara & Soleil. I’m excited to take this journey together. And watch the magic of what they produce working together.

Now ladies, get back to work. Don’t think I’m going to be Mister Nice Guy if you miss that next product release date. Grrrr.