Why an investor rejection isn’t a knock on you

A few years ago, a friend asked me if I could forward an email to Abc VC.  I told him that since that Abc VC didn’t invest in my company, I wasn’t sure if Abc VC thought highly of me.

Now that I sit on the other side of the fence, I realized that my thinking was flawed.  In many cases, if a VC declines to invest in your company, it isn’t a knock against you (caveat being this is true unless you’ve acted really rude to them and/or their team).  In most cases, rejections happen well before even meeting a team, so that VC doesn’t even know you!

Here are a few reasons why an investor will reject you that has nothing to do with you.

1. Your idea is undifferentiated

Investors see thousands of businesses a year.  Your idea is the 50th social networking site this week.  Unless you have a differentiated angle and approach to the problem and/or significant traction, an investor won’t be able to understand why you stand out and why they should back your horse instead of someone else’s.  This is especially true at the early stages.

Note: by differentiation, I’m not talking about product or feature differentiation but outcome differentiation.  For example, if you’re creating a new Mailchimp competitor, you might think your product is differentiated if your product has better tracking than they do.  That’s a feature difference.  The outcome-differentiation is probably lacking; people use Mailchimp to increase revenue by selling more products and services via email.  So unless your feature can increase that outcome – and not just incrementally by 20% but a serious differential like 10x – it’s unlikely that a current, happy Mailchimp customer will want to switch to your product.  Think about it. If you’re using MailChimp and make, let’s say, $100 in sales for every send, it’s going to be a real pain in the neck to move to a new product. Your whole list is set up and everything for just an additional $20 per send.

Often as an entrepreneur, it’s hard to know whether your product is differentiated because you don’t know what other startups are out there.  This is something I personally faced when running my company LaunchBit.  There were and are so many freakin’ ad networks, ad exchanges, and ad platforms out there that LaunchBit was just undifferentiated.  A business like ours will have a really hard time raising money at the early stages, and if that’s feedback you are getting from at least 2 people, you may want to consider adjusting your plan and raise from angels and/or bootstrap for a long time.  It doesn’t mean it’s a bad business. In fact, it could be a very good business for you.  It just means VCs will shy away from it.

2. Your idea is not the right fit for the stage or industry.

Your idea is not a good fit per the investor’s thesis or mandate.  Sometimes this can be incredibly difficult to see. For example, a lot of software investors don’t invest in e-commerce companies (we do not.).  The products are physical things that cost a lot to store as inventory, and fundamentally, this makes e-commerce companies a very different profile from products that are entirely digital (software, software platforms that don’t house inventory, digital products, etc.).

A lot of investors call themselves “early stage” investors and aren’t good fits for pre-seed companies.  Many of these investors mean “series A” or “post seed” when they say “early stage,” even though they will do a handful of pre-seed deals with founders they already know or with successful serial entrepreneurs we’ve all heard of.

What I’ve found to be most annoying about the VC industry, as an entrepreneur, is that you can never pin down what VCs like.  This is because VCs are always hedging so they can see everything just in case there is that rare exception that they would potentially invest in outside of their thesis.  The best way to assess what VCs actually like is to look at their portfolio.  If a VC says that they invest without traction, you should find out when they’ve done so and whether it’s because they already had deep relationships with that team or because that team has incredible pedigree.  Play out the probabilities in your head of who will actually be likely to invest in a random company at your stage.

3a. Your business model seems flawed OR is not the right fit

I talked a lot about unit economics and sales cycles in my last post.  For me, I personally think very heavily about the unit economics of a business, and if I can’t get conviction around the potential customer acquisition, that’s an immediate pass for me regardless of the team, market size, or product.  I do understand that teams can pivot, but we are already so early in the lifecycle – often first check into a company – that I can’t count on pivots.

VCs look at unit economics in different ways.  For example, some VCs have such deep pockets that they can throw a lot of money at a company and wait out a long sales cycle. That’s not Hustle Fund.  We are currently a small fund, so when we back a company, we need to believe that we can help that company get downstream funding from other investors with deep pockets OR that the company can bootstrap its way to success.

In order to bootstrap your way to success, it largely means you need high margins and fast sales cycles.  These are companies that we can get behind as a lone ranger if we see hustle, focus, and a differentiated solution.

If you’re in a category where you have a long sales cycle or smaller margins, then I need to think that I can “sell” your deal to other investors, either people who will invest alongside us or after us.  We talk with and do try to understand what a lot of our early stage investor peers are interested in to help inform our decision.  The point is, when we are looking at companies with these type of customer acquisition qualities, we cannot make decisions in isolation.  We need to believe other investors will buy into you as well, even if we are still the first check into your company.

3b. The market size is not big enough

For a VC portfolio to work out, a VC’s winners need to compensate for all the losses of the losers plus much more to provide great fund returns.  Not only does the fund need to be net profitable, but it also needs to outperform other assets that our would-be backers could be investing in, such as other VC funds, real estate opportunities, the public stock market, etc.  No one really talks about how VCs differentiate themselves and what they need to deliver to their investors, but this is a big factor affecting how they invest in companies.

For a VC, it’s not good enough to have a winner “only return 10x” even though that would be a phenomenal outcome for a founder or even an angel.  Most VCs need their winners to return 100x (or ideally more).

This is why it seems that every VC is harping on billion dollar markets.  If you do not think you have that big of a business, VCs are not going to be the right people to raise from.  Angels might be a better fit.

For me personally, I think the problem with market-sizing exercises is that you just don’t know whether a market is big or not!  Airbnb is probably the poster child example of this.  At the seed stage, it seemed like a weird niche idea to sleep on someone else’s air mattress.  What is the market size for this?  Basically zero.  But sleeping on a bed in someone’s house is an alternative to getting a hotel room, and the hotel market is huge. It’s just very difficult to know whether the market size is big or not in the early days, especially for seemingly “weird” ideas.

This is why I don’t care to ask founders about their market size.  Their predictions will be wrong, and so will mine.  Moreover, even if a market is big, it doesn’t mean the company can grab a lot of that market share.  This is why I very much focus on a bottoms-up approach to analyzing a marketing and look at unit economics, sales cycles, and customer acquisition.  If the unit economics and sales cycles are rough, I don’t care how big the market is; it’s going to be a long and difficult slog to capture the market, and that means a very capital intensive business.  Then that goes back to the question of whether I think I can round up co-investors with me or downstream investors to fund this.

In short, these are 3 reasons why a VC might reject your business when they haven’t even looked at your team or anything else about your company.  It doesn’t mean you necessarily have a bad business; it just might not be the right fit for that particular firm or the VC industry in general.  In most cases (caveat being you were rude to someone on our team), when we decline to invest in companies, we would very much welcome seeing a different business that the founder starts later and would be honored if the founder wanted to take the time to refer a friend who is working on a different startup.

11 Things I’ve learned from running a micro VC in the last year

It’s been about a year since I started working on Hustle Fund with my business partner Eric Bahn.  People often ask me what it’s like to start a micro VC and whether they should do one too.  (Hunter Walk just wrote his perspectives here)

Here are some of my learnings from the last year.

1. It is absolutely the best job in the world for me.

I enjoy learning about new technologies and ideas – and you get to see a lot of them in this business, especially in early stage investing.  I enjoy working with founders immensely, but most importantly, I love fundraising.  I know – that isn’t what you thought I was going to say  (more on this later).

Much like running a product-startup, you’re your own boss, so you sometimes end up working really hard and at all hours depending on where you are in your fund life cycle. If it’s work you enjoy, then it doesn’t feel like work.  There’s also a lot of flexibility, and I’ve definitely taken advantage of that.  You can whimsically pick the most powdery day of winter and go up to Tahoe to ski.  Or go to the beach or lake midweek in the summer, and no one will be there.  It’s great.

2. Starting a micro VC is just like starting a product company.  Except harder.

Probably 10x harder.  If you go in knowing that with eyes-wide-open, then it’s totally fine, but most people don’t do enough homework before deciding to start their funds.  I would talk with at least 10 micro VCs before deciding to do this.

3a. In particular, there is no money in micro VC!

Hah – this seems ironic, but I’ll explain.

Most people think VCs have a lot of money.  That’s if you work for an existing large established VC.  If you are starting a VC, this is definitely not true.  I’ll break this down across a few points, but the gist is that you have to be willing to make no money for 5-10 years.

If you are not in a solid financial situation to do that, this business can be terrible for your personal life.

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Originally posted by auroras-boreales

3b. Micro VC’s have no budgets.

This is surprising to a lot of people.  Even if you have, say, a $10m fund, most of that money needs to be used for investing – not for your livelihood or for other things.

In fact, the standard annual budget that VC funds have is 2% of the fund size for the life of the fund (typically 10 years).  If your fund is, say, $10m, then that means you have a yearly budget of $200k.  To be clear, this isn’t your salary; this is your budget to run your company.  Your salary does come from this number, but you also need to cover the salaries of everyone else on your team (if there are others on your team).  If you travel, those costs come from this number, too.  If you have an office, that cost also fits in here.  Health care and benefits also fit under this.  Marketing – t-shirts, watches, swag, parties – all of this fits under this budget.  There are also fund ops costs that need to be factored into this number, too.  When you factor in all these costs, $200k actually doesn’t go far.  To give you some perspective, my salary today is less than what I made at my first job out of college… in 2004.

You need to be willing to bootstrap for about 5-10 years.  In contrast to building a product company where most people bootstrap for maybe 2-3 years and then either raise some money or build off of profits or throw in the towel, when you sign up to do your own VC, you are committed for 10 years (the standard life of a fund).  You can’t throw in the towel.  And if your fund does well – i.e. your companies either raise more money or they grow their revenues a lot – you also don’t make more money because your salary is based on a percentage of your fund size.  Your salary (or lack of salary) is stuck for years – until you raise your next fund and have new budget from that fund.

Some Micro VCs write into their legal docs that they will frontload all of their budget in the first few years.  Under this model, instead of taking, say, a $200k budget per year for 10 years, some funds will do something like frontload the budget – say, $400k per year for 5 years.  This can help increase your budget, though there are still fund ops costs every year for 10 years, so I’m not sure how these funds end up paying for those costs in years 6-10 if they are taking the full budget up front.  This is not something we do at Hustle Fund.

Other micro VCs will try to make money in other ways by selling event tickets or whatnot.  In many cases, depending on how your legal docs are written, consulting is discouraged.  It actually is very hard to bootstrap a micro VC because on one hand, you get virtually no salary but are also mostly prohibited from making money outside of your work.

3c. You also will make General Partner contributions to your fund.

At most funds, you will also invest in your fund as well.  This allows you to align with your investors and have skin in the game, and this is standard practice.  In many cases, fund managers invest 1-5% of the fund size.  So, if you have a $10m fund, you’d be expected to invest at least $100k to the fund.

Not only are you not making money on salary, you are also expected to contribute your own money to the fund.

There are some funds that don’t write this requirement into their legal docs, but it’s something that a number of would-be investors always ask about (in my experience).  They want you as a fund manager to be incentivized to make good investments because you are staking your own cash too.  And this makes sense.

3d. Sometimes you need to loan money to your fund.

There have been several cases over the course of the last year where either Eric or I have had to loan Hustle Fund money interest-free to do a deal that needed to be done now (before we had the fund fully together).

One thing that is different about raising money for a fund (vs a product-company) is that when investors sign their commitment, they don’t actually send you the money right away.  So, let’s say we raise $10m; we don’t actually have the $10m sitting around in a bank account.  This surprises a lot of people – VCs don’t actually have cash on hand!

The way investors invest in a fund is they sign a paper committing to invest in the fund.  Later, when the fund needs money, the fund does a capital call.  Typically, capital calls are done over the course of 3 years.  So, if an investor commits to investing $300k into a fund, then on average, that fund will call 1/3 of the money each year over the course of 3 years.  In this case, that would be roughly a $100k investment each year from this individual.  The capital calls are not done on a perfectly regular cadence because sometimes a fund will need money sooner than later.  Most funds try as best as they can to do regular capital calls.

This also means that there’s a lot of strategy and thinking that needs to go into capital calls.  For example, when you’re first starting to raise money and have very little money committed – say $1m – it can be tempting to call 50% of the money right away to start investing $500k into a couple of deals.  However, as you continue to raise, subsequent investors will be required to catch up to that 50% called amount.  Let’s say you round up another $6m in capital; this means that all of a sudden, you have $3m that you’re automatically calling to catch up to the proportionate amount that the first set of investors contributed.  And if you’re writing small checks out of your fund, much of that $3m will then just sit around in your bank account, not earning interest, and will negatively affect your rate of return.  Instead of doing a capital call, loaning your fund money is a way to ensure that you don’t have capital just sitting around in your bank and counting against your rate of return.

There are bank loans you can get once you are fully closed and up and running, but very few banks will loan you money in the very beginning when you have raised nothing – hah.

3e. And even if your fund does well, you still make very little money at the end of 10 years!

First, most VC funds are failures.  In fact, much like startups, I’ve heard that 9 in 10 VCs will not even get to 1x returns!

But, if you happen to be in the lucky 10%, there’s a range even here.  The “gold standard” for profitable VCs is a “3x return” benchmark.  If you’re above it, you’re considered excellent.  This is very hard to do.  Just getting into the profitable category is an accomplishment in itself.

Let’s suppose for a moment that your fund is excellent (because we all believe that our funds are excellent), and let’s say that we return 5x on our fund. On a $10m fund, a 5x fund return means the fund will return $50m.  Using a standard 20% carry formula, and after returning most of the gains to the fund’s investors, it means that the team will receive $8m.  If you have 2 managing partners, that’s $4m per person – but 10 years later.  Considering that you’ll make no salary for much of that time, there are many other professional, tech, and established VC jobs at big Sand Hill firms that will make you more money or the same amount of money on salary alone (not including benefits or stock) with greater certainty.  You don’t have to be a 90%+ performer as a Director of Product at Google to accomplish the same outcome as an exceptional micro VC manager.  Think about that – you risk so much, much like a startup, but your upside is equivalent to working a steady job at Google for 10 years!

For all of these reasons, microfund managers who are able to raise more money on subsequent funds end up doing so because for the same amount of work and risk, you’d much rather be paid more in salary and in carried interest later.

4. You should love fundraising.

I think most people think that, as a VC, you spend most of your time looking at deals.  The breakdown of a given week for me is something like:

  • 50% fundraising-related (preparation of materials , meeting potential future investors, networking, etc.)
  • 20% marketing-related (content, speaking, etc.)
  • 5% ops (legal, audit, accounting, deal docs, etc)
  • 15% looking at deals (talking with co-investors and referrers, emailing with founders, looking at decks, talking with founders)
  • 10% working with portfolio companies

Of course, it varies a bit if you’re at the beginning of a raise or if you have closed your fund.  The point is, you will spend a solid chunk of your time as a micro VC on fundraising activities.  Even if your fund is closed and you don’t have a deck to pitch, you are always in fundraise-mode.

If you have never fundraised for anything before, you will probably think that this process is horrible.  Having raised money before for my startup and having coached a lot founders on fundraising over the last few years, I’ve grown to love it.  And part of that is just lots of practice. The more you practice, the better you get, the more you like doing something.

5. Fundraising for a micro vc is exactly like fundraising as a product-startup.  Except more involved.

Prior to raising a fund, it never occurred to me to ask where fund managers raise their funds.  That was just not something I had thought about before.  For the big Sand Hill VCs, most of them raise money from institutionals.  These are retirement and pension funds at government entities, endowments at universities, or similar.  As you can imagine, these entities are pretty conservative, and rightly so. The pension check that granny is counting on for her retirement shouldn’t be frivolously thrown away on a fund that invests in virtual hippos recorded on some blockchain.

As a first time manager, often it can be difficult to convince these types of institutional funds to invest.  It can be done if you have a strong brand already.  Even if you are an experienced angel investor or worked at a well-known VC fund, you’re still starting a new fund with a new brand, and there are still questions about whether you can repeat your past success on this new brand.

This means that much like product-startups, you end up raising primarily from individuals, family offices, and corporates.  Much like with raising money from angels and corporates for a product-startup, angels and corporates don’t have websites announcing that they are funding vc funds.  You have to hunt for these folks.  Often these “angels” whom you can access are folks you know or folks who are 2-3 degrees away from you whom you don’t know yet (see my post on raising from friends and family).

And much like a product-startup, the check sizes are going to be smaller if they are from individuals (unless you know lots of very, very wealthy individuals).  When we first started fund 1, our minimum check size was $25k – much like the minimum investment amount for a typical product-startup.  Except we were raising tens of millions of dollars, not $1m.  $25k doesn’t go far on say a $10m fund.

This means you need to be doing lots of meetings, and this takes time.  The average time for a microfund manager to raise a fund is ~2 years.  We felt fortunate and incredibly thankful to our investors to be able to raise our fund in < 1 year.  When you think about it, that’s still months of active fundraising  (see point #4).

6. And you have a limited number of investors you can accept.

Per SEC rules, you can only accept 99 accredited investors into your fund.  This means that if you want to raise a $10m fund, you need the average check size to be above $100k.

When product-startups set a minimum check size, it’s usually arbitrary.  If you’re raising $1m for your product-startup, it won’t hurt you to take some investors at $1k or $5k checks here and there, especially if they are value-add.  With a fund, every slot counts.

So when we started with $25k as a minimum check size for some friends, we knew we needed to quickly raise that bar in order to raise a significant enough fund and still maintain 99 investors.  We ended up having to turn away a lot of great value-add, would-be investors who could not do a higher investment.  I would have absolutely loved to bring in more investors if I didn’t have this restriction.

In other words, you cannot just accept $5k here and there from friends and claw your way to momentum.

To get around this, some funds set up a “1b” fund.  For example, Hustle Fund 1a and Hustle Fund 1b split startup investments equally between the two.  That would be one way to get bring in more investors, but because the costs of this setup start to go up, we decided not to do this.

7. Ok, so there’s no money.  You also cannot change the world on fund 1.

If you can get past all of the above, and you’re still “yay yay yay – I want a life of making no money and want to fundraise all day and night for whatever cause I am trying to support,” the last piece is that you should know that you cannot change the world overnight.

I know so many aspiring micro VCs who go into this because they want to fund more women or minorities or geographies or some vertical that is underfunded.  I think those are all awesome worthy causes.  And me too – the reason I’m doing this is that I don’t believe the early stage fundraising landscape is a meritocracy, and I want the future of funding to be much more about speed of execution rather than about what you look like or how you talk.

But, you absolutely need to go into this with a 20-30 year plan.  If you’re a small little microfund with, say, $5m, you won’t be able to change the numbers in any of these demographics because impact happens at the late stages when VCs pour tens of millions of dollars into companies – not $100k here and there.  What does affect change is having lots of money under management.  That happens by knocking fund 1 out of the park.  And then fund 2.  And then fund 3.  And growing your fund each step of the way.  And growing your believers who start to hop onboard your strategy – not only your investor base but other VCs.  That is a 20+ year plan.

Moreover, you need to be contrarian to have a good fund, and at the same time, you cannot be too contrarian on fund 1 because you need to work with other VCs in the ecosystem.  You need your founders to get downstream capital.  To a good extent, I do care a lot about what downstream investors think and how they think about things.  You can only start to be very contrarian once you have more money under management (i.e. have proven out the last couple of funds) and follow on into your companies yourself.

In short, you will not make any money on fund 1.  You might need to loan money to your fund.  You will need to have money to invest into your fund.  You will constantly be selling your fund as an awesome investment opportunity for this fund and the next fund and the fund after that, etc…  You will not change the world on fund 1.  But, if you still love all of this and go in with eyes-wide-open on all of these things, and if you believe you want to do this for the next 20-30 years, then I would highly encourage you to go for it.  I think it is the best job in the world.

How to raise money from friends and family

Most VCs won’t invest in startups super early.  There are some exceptions: my company Hustle Fund tends to invest quite early, and so do a few of our peer funds at the pre-seed level.  However, there are only a handful of us, and 99%+ of startups won’t be able to raise money at this stage.  Alternatively, if you are a successful entrepreneur or have great connections, multi-stage VC funds will also invest super early in these types of founders.

For the vast majority of entrepreneurs, doing a friends and family round of funding during the earliest stages of a company is the primary way to raise money.  I know for many people, raising from friends and family doesn’t come naturally.  Many entrepreneurs may feel like they don’t know enough rich people to raise money from their network.  Many people – would be investors – whom you ask to invest may also feel like investing is only for the really rich.  It can also be confusing and awkward to ask people close to you to invest.  How do you even broach the topic?  Will the person be taken aback?  Will it ruin your relationship?

Here are some tactical tips from my personal experience that might be helpful:

1. Dedicate lots of time to fundraising.

Fundraising, in general, takes a lot of time, and, raising from friends and family is no different.  As I’ve written about previously, one of the biggest challenges in fundraising is that it just takes so much time to balance running a company and raising money.

2. Set up “catch-up” meetings with friends and family.

It’s really hard to know who will be interested in investing in your new venture.  Set up “catch-up” meetings with everyone who is smart, has means, and/or is well-connected.  In each of these meetings, you’ll certainly “pitch” your new venture, but you are not necessarily looking to raise money from each of the people you meet with.  In some cases, you may only be looking to get introduced to more people who may be good to meet.

Pack these meetings into a limited period of time to maximize FOMO as well as maximize the efficiency of your fundraise.

3. Be creative about your meetings.  

Your meetings could be coffee catch-ups, but in other cases, maybe you cook brunch at your home and invite people over. Maybe you invite a lot of people over at the same time.  In other cases yet, you may want to do a group social activity; it could even be bowling!  Whatever works for you and what you think your friends, friends-of-friends, and family may like doing to make your meeting less formal.

Your meetings don’t have to be stiff coffee meetings.

4. You are always “pitching” even if not formally.

You should always have a deck ready to show on your phone or computer, but you don’t always need to use it.  I find that at the earliest stages, people are mostly investing in you.

Make sure that at some point in all your catch-up meetings you mention:

  • You are starting a new company
  • One line about why it will change the world – think very high level here
  • You are raising money for the company
  • You are raising only from friends and family
  • Casually ask if he/she would like to invest or if he/she knows 1-2 people who might be interested in potentially investing or may know other potential investors

It is important to get each person you talk to very excited about your business.  I find that one of the biggest mistakes entrepreneurs make in pitching their high level ideas is that they say too much about what their product idea does. For example: “I’m starting a new social network that will combine Facebook, Snap, Instagram, WhatsApp, WeChat, and LINE all in one place.”  Or, “I’m starting a new AirBnB for retired people.”  This isn’t very exciting.  The only person excited about your product mechanics is you.  However, you can get people excited about outcomes: “I’m building a new social network that will bring people globally closer together – so that people in India can talk with people from Japan.” Or, “I’m starting a new type of housing platform so that older people don’t need to live in stodgy sad retirement homes and can live a vibrant independent life.”

When pitching to people who do not invest for a living (i.e. non fund managers), it’s important to explicitly mention that you are raising money and that you want their help.  This could mean that they could help introduce you to other people and/or that they could invest.

There are a lot of people on the internet who say you should ask for advice and not money.  IMO, this is really awful advice.  Most people who do not invest for a living – even active angels – don’t realize they are being asked to consider your idea as an investment if you don’t ask for their help in raising money.  If you are talking with your dentist about your new startup, his/her first thought is not, “Oh I wonder if I can invest?” or even, “I would never invest in this.”  His/her first thought will be, “Oh cool, John/Jane Doe has a new career.  I’m going to make a mental note that he/she has left Cisco and is now working for himself/herself.”  They don’t see themselves as investors, and so you need to explicitly make the ask if you want an investment.  You cannot just assume that people will volunteer to invest.

Your conversation might end up going something like this:

“So yeah, lots of new changes.  I left Cisco, and I’m now starting a company.  We are trying to do ABC in the world, and if we’re successful, DEF will happen.  Right now I’m raising some money from friends and family to achieve XYZ goals.  I wanted to see if you might be interested in potentially investing or know 1-2 individuals who might be interested and good to talk with?”

(Please don’t monologue. Those are only the rough talking points that you need to bring up.)

At this point in the conversation, you are making the ask only to see if the person will consider investing (or knows someone who might be good to talk to). You are not asking for a commitment.

It is important to mention that you are raising money from friends and family.  A lot of people have in their heads that entrepreneurs raise money from funds and don’t realize that at the earliest stages, friends and family have the opportunity to invest in your company and also get the best deal.  This is what you need to communicate to would-be investors.

A lot of people also think that investors need to be super rich in order to invest.  This is also not true and also what you need to inform people about.

When you are first starting to raise money, my personal strategy is to set a lower minimum check size and generate momentum.  This makes investing very accessible to many professionals.  I know lots of “angels” who invest $1k-$10k per deal.  I think many people think that angels need to put in at least $25k per deal, but that is simply not true anymore.  Now, you as an entrepreneur may not want a lot of people to put in less than $25k because it will mean you have to do a lot of meetings.  However, when you are first starting out and you don’t have a strong investor network, it may be worthwhile to accept some smaller checks to get the flywheel going and also to say Bob or Mary has invested in your company to generate buzz with subsequent conversations.  Once you start to get checks in the door, you may want to increase the minimum.  As a result, investing in startups is actually accessible to many people in your network.  They just don’t think about it that way, and it’s your job to change that mindset.

5. You are selling more than your company

At the earliest stages, people are investing in you.  There are other things you can do to sweeten the deal.  One of the things that we do at Hustle Fund is host a meetup for all of our investors in our fund multiple times a year.  It’s an opportunity for them to meet and get to know each other.  In general, well curated and exclusive networking events are a really good draw for people to participate in things (as I wrote about here as a tip for getting speakers for a conference).  People always want to get to know other rich and well-networked people.  If your initial minimum is, say, $10k, then not only is someone buying a stake in your company, but he/she could also potentially be buying into a network.  And you can facilitate this for free or really cheap.  You can host these in an office space for free.  Plus, pizza, wine, and cheese and crackers are pretty cheap.

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Originally posted by hyenadip

People who invest in you – especially friends and family – are buying an experience.  They are not just buying a transaction.  Make that experience a good one.

6. Do a formal pitch & call-to-action if someone is interested

From the catch up meeting, if someone is interested in learning more, you can either dive into details right then and there (preferable if you all have the time) or set up another time to talk.

This is where it’s important to have a pitch deck and materials ready.  At the end of this pitch, try to push for a yes or a no.  In many cases, people will need to think about your deal, but, if the person you’re speaking with is ready to commit, have a SAFE or convertible note ready to sign.

7. Be transparent

If an investor has committed but hasn’t invested in a startup before, it’s important that you clearly outline the risks.  I would say something like this: “I am flattered that you are going to join our round.  And I think this is a great opportunity.  But I really want to emphasize that investing in a startup like this is an incredibly risky endeavor.  I could potentially lose all your money, and there is a high probability of failure.”  People usually appreciate this level of transparency, and I’ve never known anyone to back out.  I think that it’s important to highlight this in case/when things go awry down the road.  Moreover, psychology suggests that in many cases, when things are slightly pulled away from you, you only want them more.

8. Re-assure friends/family that it’s ok not to invest

If you sense that someone feels awkward when you’re asking for his/her help, it’s important to re-assure him/her that it’s OK to not participate.  You might find yourself in a dialogue like this:

“Oh…oh.  Well, I don’t really have any money to invest.”
“A couple of thoughts – 1) First off, I value our friendship/relationship above all else.  So, I don’t want to put you in a tough position.  If this isn’t a good fit, that is totally cool.  I just wanted to give you an opportunity that I think is great.  2) I also want to mention that since this is a friends/family round, we have a low-ish minimum of X.  I don’t know if that changes things, but just wanted to highlight that.”

It’s really important for the sake of your relationship with the person to re-assure him/her that it’s OK to not invest.  You are presenting and opportunity, and that’s it.

9. Don’t run out of leads

The best piece of advice that I received when I was raising money for Hustle Fund was from Charles Hudson, who also runs a pre-seed fund called Precursor.  He said, “Don’t run out of leads.”  This is very good advice. If you have infinite leads (and time), you won’t have to worry about being rejected as you go along, and that is exactly the mentality you should have going into and throughout your fundraise.

When I was a first time entrepreneur years ago, I remember being incredibly afraid of rejection.  I didn’t push people to a yes or a no for most of my raise.  By having the attitude that you have infinite leads, you will force all potential investors you’re talking to into a “yes” or “no” answer.  This is a good thing.  A “no” means you can stop wasting your time with someone who isn’t going to commit.

It also means that you need to keep generating leads to have enough potential investors fill your round.  As you go along, this gets harder because you’ll start with people in your network who are closest to you and then work outwards and chat with people who may be friends of friends of friends who don’t know you at all.  This is why it’s so important to constantly ask everyone you talk with for introductions or 1-2 names of folks they would recommend talking with… because you can’t run out of leads.

Now another typical piece of advice that you often hear is, “Never take an intro from someone who doesn’t invest.”  I would say this is true of VCs.  This is NOT true of non-professional investors: angels, friends, and family.  VCs have funds to invest from, and it’s their job to invest money.  If they pass, then they didn’t like something about your business, and that’s a negative signal.  If I were running a startup, I would not take an intro from a VC who passed.  But angels are different.  They don’t necessarily have pools of money that they need to invest.  If an angel passes, it could be because he/she wants to set aside money to repair the roof on his/her house.  Or save some extra money for his/her kid’s private school.  Or take a fancy vacation.  Or buy a new car.  Angels can do whatever they want with their money, including not invest.  So, if an angel passes, that isn’t a knock on your business per se, and most people understand that.  Also, angels run out of money all the time. They may have been active before, but until that portfolio becomes liquid, an angel may be tapped out of funds even if he/she wants to invest in your business.  So, definitely ask for intros to other potential investors from individuals.

I usually try to ask for 1-2 introductions because it’s a small but anchored request.  If the ask is too broad, such as, “If you can think of anyone who might like to invest…”, then no one will think deeply about it.  Try, “Can you think of 1 person who might be interested in taking a look at this?”  Asking for just 1 or 2 leads is a small task, and almost everyone can think of one specific person he/she knows who may be interested in chatting with you.

Pulling together a friends and family round is a bit of a crapshoot and takes a long time.  Part of the challenge is in identifying which people are interested in investing in you and has some money to do so.  I’ve found that it’s hard to predict who will end up joining your round.  The richest people are not necessarily the most bought into the opportunity nor are they necessarily investing a lot into startups.  In fact, many super rich people are a bit risk-averse because they want to preserve their wealth.  Conversely, many people whom you may discount as not having much money may actually be really bought in. In fact, I’ve found that people who are not super rich tend to also be more risk-taking because they want to become super rich. In the end, you’ll just need to meet with a ton of people.  You’ll need to do a lot of meetings, but raising a friends and family round even if you’re not well-connected can be done.

 

Cover photo by rawpixel on Unsplash

Seed rounds are dead

This is my second post (albeit later than I’d hoped!) on the state of Q2 2018 seed-stage fundraising.  The first one focused on crypto is here  (although it’s changed even more since I last wrote; altcoins are starting to moon again, and I’m sure everyone will leave Consensus this week on a high).

Here’s what’s happening in the equity world (from my perspective):

1. Token sales in the crypto-world do affect “equity” raises.

(I put “equity” in quotes because I include convertible notes and convertible securities in this category.)

Part of this is driven by the fact that VCs who can buy into tokens were spending a lot of time looking at token deals for a while, removing some investors from the “equity market.”

2. As blockchain companies are moving back to the equity world to do their pre-seed fundraises, this has shifted investor attention back into the equity world.

A number of companies that would have done a token sale a few months ago are now doing equity rounds instead.  Part of this is driven by how the SEC is thinking about regulations in this space.  Part of this is driven by the traction bar rising amongst blockchain companies – the bar is now higher in order to do a large token sale.  In other words, last year, you didn’t really need anything to do a token sale and this year you do!  (wow, what a concept…)

Now that there are more companies flooding the equity market (via all these blockchain ideas),  there is increased competition for startups seeking investor-dollars in the traditional equity world.  This leads me to point #3.

3. The bar for raising a seed round is increasing and so is the bar for raising a pre-seed round.

I allude to this here,  and Charles Hudson did as well here.  Because the gap between pre-seed and seed levels is increasing, there are a couple of approaches to this.  For some funds, it makes more sense to come in at the same entry point, but they need to be willing to carry their companies longer (i.e. inject more capital into the company) before their companies get to the next stage.  This is both greater risk and reward – pre-seed funds can gain more ownership in companies by putting more money into the businesses at lower valuations.

For other funds, it might mean waiting until there are more investors who are interested in the opportunity.  For others yet, it might mean waiting longer for results or traction.

For us, we are not increasing our check size to carry our companies,. Effectively, when we do bet very early as first check-in, we are now investing at lower valuations.  This is because there is increased risk that these companies will not make it to the next stage, so the price is affected accordingly.  In other cases, if companies are looking for the pre-seed valuations of last year, we’re often investing alongside investors or they’re further along.  In other words, we are not changing our strategy to accommodate changes in the market, but price is reflected in these deals.

Caveat: this is different for blockchain companies.  As these start to enter the equity market, there are a lot of investors who will fund these companies at a very early stage – even seed investors who typically don’t do other pre-seed deals will bet here.  This is great for blockchain entrepreneurs, so we see higher valuations in this space.  That being said, because there is also a LOT of competition amongst blockchain companies now, we are also passing a lot, too.  While we are open to paying up a bit, we won’t pay up as much as other investors.

In general, given how cheap it is to start a company and how few pre-seed investors there are, I think it makes sense to bootstrap to some level of revenue traction before fundraising.  At least, this is what I would do if I were starting a product-company today.

4. Seed rounds are dead

These days, pre-seed, seed, and post-seed stages all kind of blend together, honestly.  While each has different traction “requirements,” investors will often invest in multiple stages of these. Even though many people say the post-seed round is the old A, the interesting thing is that these rounds are not being done by series A investors.  Series A investors are still doing series A rounds even if they are much larger rounds that require more traction now.  Post-seed rounds are being done by seed investors.

This is interesting because it means that “seed” investors will look at a broader stage than they used to.  In fact, Hunter Walk wrote about this greater seed stage here.

In looking at this phenomenon, though, we see that seed rounds are dead (in most cases).

Certainly, if you raise early stage money from a large fund, then you’ve pulled together a round; so, yes, that is a round.  But, the vast majority of startups these days will not be able to raise money from large seed funds who lead  (And that’s ok!).  Most companies these days will be doing party rounds with some permutation of angels, friends & family, and microfunds and at multiple times.

Because most startups will end up raising tranches of money from multiple parties, many startups will use convertible securities (SAFEs / KISSes) or  convertible notes.  And often, these tranches here and there are done at different valuation caps, e.g. $200k on $3m.  Then, you make some progress and raise another $400k on $5m. And this continues.  Effectively, there’s no such thing as a “round” anymore.  These are seed tranches.  

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Originally posted by zechs

Now, a lot of big funds will tell you not to do tranches.  The truth is that spending a lot of time trying to raise bits of money here and there is not ideal and takes a lot of time. Frankly speaking, sometimes you have no choice and are not able to raise a big chunk all at once.  And that’s life!  The best entrepreneurs will try every avenue for fundraising – big funds, small funds, angels, friends & family – and will roll with their best options and will keep making progress until they either don’t need investors anymore OR they are able to raise a big round once they’ve proven out the business.  Sometimes the most value-add investors are only able to write small checks.  There are a bunch of angels and microfunds I really respect and from whom I would take money any day, even though they are only writing small checks.

Being able to raise in tranches is actually a good option to have because it gives entrepreneurs more flexibility in how they raise.  Gone are the days where you need to sit around for a lead to decide in 2 months if they want to put $500k into your company.  In many cases if you raise $100k here and there, it may even be faster for you to raise $500k from smaller parties on convertible notes and securities than to wait around for a large fund (depending on the fund).  Tranches also create a forcing function for investors; if you only have $200k available at $3m, then that makes an investor move faster than raising a $1m round at $5m when you’re just starting your raise.

To me, it’s a good thing for entrepreneurs that seed rounds are dead.

There are also a bunch of investors who will push back on raising in tranches saying, “Yeah, but entrepreneurs end up giving away a lot of their cap table because they don’t know how much they are actually being diluted down with their various SAFES and notes.” I’ve heard this argument many times from friends of mine at big firms.  Frankly speaking, whether you’re raising in tranches or not, you should ALWAYS know what you are signing before you sign (valuation aside, there are many other terms you should be aware of).  You should always know what percentage of your company you’re selling to investors.  Take the time to do the calculations or find someone who can help you with this.  This is not rocket science, and being unable to use a spreadsheet (or find someone to use a spreadsheet) is a poor argument for why someone should not raise in tranches.

I think this increased optionality for entrepreneurs is always a good thing.

RIP seed rounds.

5. Crowdfunding is starting to take off

This is less of a Q2 observation and more of a 2018 observation.

A question I often get is whether crowdfunding is looked down upon by VCs at later stages.  In general, from what I’ve seen, no.  I’ve backed a handful of startups who have done crowdfunding before us, and they’ve gotten funding later from well known VCs.  Building on my overall point in #4, your job as a CEO is to keep the lights on however you can.  If it means that you’re going to raise money from crowdfunding, then that’s great.

Crowdfunding especially works well if you have a consumer product and you have built up an audience who loves you.  When you think about it, this is the best form of funding – taking money from customers both as customers and investors.  I’ve seen some of our companies raise a few hundred thousand dollars from their customers in just 2 days.  Crowdfunding is legit and can move big money and also be valuable in shaping your product.

Just my purview.

The state of Q2 2018 pre-seed/seed-stage fundraising: Part 1 – Crypto version

This year has been crazy in the fundraising landscape.  The fundraising landscape in 2018 for pre-seed and seed-stage companies has changed a lot, even in just the first few months of this year.

This is what I wrote in Q1 2018 about the fundraising landscape.

Now in Q2, things are a bit different.  I’m breaking this down into two blog posts. Part 1 (this one) is about the token-based fundraising landscape.  Part 2 will be for pre-seed/seed companies raising traditional equity, debt, and convertible security rounds.

Even though most of my audience is probably more interested in Part 2, it’s important to cover what is happening in the crypto fundraising landscape first because investor behavior in this world affects the pre-seed/seed landscape.

Drivers

  • A boatload of VCs are trying to get exposure to cryptocurrencies.  (Sorta)
    • Some VCs are doing token buys.
    • Some VCs are not set up to do token buys per their legal docs for their funds.  Or their investors in their funds (their LPs) are not keen on their doing token buys.
    • Some VCs who were not set up to do token buys before per their legal docs are now making amendments in their legal docs to be able to do so.
  • Some VCs are less interested in token buys now than a few weeks ago, as alt cryptocurrencies are down in value.

Trends and Takeaways

1) Investors who are able to do token buys are active, but they are not “the usual suspects” (mostly).

In some cases, you see well known Sand Hill VC firms doing token buys – Sequoia, for example. In most cases, however, traditional VCs are not participating (much) for the reasons above.

There are new VCs who are specialized and focused solely on cryptocurrency buys.  Some of these are pulling away and building brands in the crypto space.  My hypothesis is that there will be a real shake up in how deals are done in startups, and you’ll see turnover as some of these new brands overtake older, well-established VC firms (this is an aside for another blogpost).

And then there are also syndicates.  These are groups of angel investors, individuals who are pooling their money together to purchase tokens.  These syndicates are often a bit “underground,” so you won’t be able to find them by researching via Google. One good place to find these groups is actually at tech companies.  Just about every tech company has a club of cryptocurrency enthusiasts.  From there, you can find various syndicates.  Syndicates also know other syndicates.  Even though syndicates are comprised of angels, you’d be surprised how much money a syndicate call pull together. It’s not uncommon for some of these syndicates to pull together a few million dollars in a given deal and do deals regularly (perhaps less so now that it’s crypto winter).

2. These cryptoinvestors are not buying tokens at the ICO

Most cryptoinvestors I know are trying to buy tokens pre-ICO and often in companies who are doing token sales discreetly.

I think there’s an assumption that VCs are participating in ICOs.  They aren’t.  They want to buy tokens before the public does at a better price.  Moreover, most companies I’m seeing these days who are doing token sales are not even doing ICOs.  They are just doing private sales directly to various investors and/or investor groups.

This is because it’s pretty involved to do an ICO. You have to worry about SEC compliance A LOT as well as any potential hacking or fraud issues that could arise.  These companies are publicly announcing their upcoming token sale (without committing to dates) and are using those announcements to generate interest, which is then converted into private direct sales of tokens.

3. You now need some “traction” to successfully do a token sale (sorta)

Unlike last year when you could raise $50m on more or less just an idea, the “traction bar” has increased for doing a token sale.  We’re still not talking about loads of traction – and it depends on whether you are launching a protocol or an app – but there is a bar.

The bar for protocols is basically a solid idea with some development and a really reputable team (even if it will take a long time to fully build).  In contrast, the bar is incredibly high to build an app (decentralized or not).  In many cases, you need a community of users already (in addition to a product) to have a successful token sale.  These days, many investors are very much leaning towards funding protocols with potential strong tech over apps.  Here’s a good paper on why this is (though I don’t entirely agree with his conclusions; that is also for another blog post).

4. Larger established companies are doing token sales

Interestingly enough, part of the reason the bar for apps is increasing is that I’m now seeing centralized apps, existing startups that are at the series A through enterprise level prepare their token sales.  If given the choice to buy into a token of a company that is already thriving vs a new app, many investors would choose the former, right?  A series C marketplace that has millions of users is a lot more de-risked than an idea-stage marketplace.

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Originally posted by trapstrblog

5. Centralized apps are doing token sales

Continuing from point 4, companies that are doing token sales today are not necessarily decentralized.  Rather, their projects may technically be decentralized, but the tokens will be used in a very centralized use case.  A lot of blockchain enthusiasts may find this appalling.  After all, one of the drivers of blockchain is this notion that large, centralized companies should NOT hold your data (technically they are not, but their blockchains are for the purpose of furthering a centralized, for-profit company).

This is an interesting concept.  I think moving forward, we will see many companies do token sales, even companies where blockchain is not at the core of the business.  My prediction – and I could be totally wrong – is that we will see a new type of crowdfunding of utility tokens for centralized apps.  Basically, early customers buy into a new startup’s token at a special price, and those customers benefit from that price if the company does well.  This is just my prediction of where I think the market is headed.

6. Because the bar for token sales has increased, blockchain companies are raising equity-based pre-seed rounds

Funnily enough, in 2017, a number of companies who could not raise from VC did successful ICOs.  Now in 2018 (Q2 specifically), a number of companies who cannot raise on a token sale are running to VCs to do pre-seed raises!

What I’m seeing here is that a lot of VCs who are not able to get into token sales (i.e. are not able to legally do token buys or their investors don’t want them to) are investing in blockchain companies on a convertible note or convertible security and then are receiving promises of X number of tokens during a later token sale.

This has become a common way for pre-seed blockchain companies to raise money.

7. Token-sale raises are becoming smaller

Investors are becoming more wary of large raises.  Startups are doing much smaller token sales (and I’m glad)!  I think that discipline in a startup is important.  If you are basically at the beginning of your startup, and someone gives you infinite resources, you still would not be able to increase your progress substantially.  The adage that 9 women cannot incubate a baby in 1 month is apt here.

That being said, raises still have to be substantial in the crypto world because there are a lot of additional considerations that don’t apply to the equity world.

  1. It takes millions of dollars to get your token listed on an exchange, which people need for liquidity.  For top exchanges, it could be as much as $2m-$5m per exchange.
  2. Operations costs more.  More legal, accounting, and other service providers related to tokens means your bill will be substantially higher.

Even if the net you want to raise is, say $5m, you’re probably looking at raising $10-$15m to cover your other costs.

8. It’s crypto-winter, so investors are a little more shy to move forward even if you have some progress

There’s still a lot of crypto money floating around, but investors are a little more shy to move forward since alts are not doing well right now (and you now have competing token sales from larger companies – see #4).

9. Companies raising on a token need a concrete liquidity and currency plan

In 2017, investors were willing to take a flyer on projects that had built some semblance of a community.  In 2018, liquidity had proven to be very important.  It’s important to have exchange-connections, money to get on an exchange (or if you are really good friends with people at exchanges, you can get prioritized for free), and a plan or timeline for when your token will become liquid.  In addition, thinking through the offering (number of tokens, release of tokens, etc.) is also really important.

In some sense, your success here will be based on whether you can play mini-fed.  It’s not about your white paper.

This is something we’ve been talking about with a number of companies – both big and small.  How you run your token sale is something that isn’t core to people’s businesses but is really important!  I’m happy to chat with more companies thinking about doing this if they want (time permitting).

If I were starting a blockchain startup today, I would at a minimum get a prototype or early version of my tech working (for a protocol idea). For an app, I would get a full v1 product and start pulling together a community.  For the former, you can probably raise if the tech is strong.  For the latter, you may need to do a pre-seed round with traditional investors and give investors future tokens if you cannot jump straight to a token sale.  I would plan for any token sale to take months, partly to raise but partly to make sure that you are fully in compliance. It is also important to have strong legal counsel and think through the costs of this legal counsel (plus the cost of getting on exchanges) as part of planning a fundraise.

This is just my $0.02, and I’m sure my thoughts will change as we move towards Q3 of this year.

Cover photo by Thought Catalog on Unsplash

What early stage fundraising in 2018 looks like

I thought it might be useful to do a high level overview of what fundraising in 2018 will look like at the pre-seed and seed stages.  Of course, this is just my prediction; only my $0.02.

It will be hard to raise a pre-seed round through traditional methods

If you are raising money through traditional methods (such as through angels, micro VCs, or VCs) via a convertible note, convertible security, or equity deal, it will be a lot harder to raise pre-seed money in 2018.  I’m seeing a number of investors pull back on investing through traditional means.  This means that traction bar has gone up for both pre-seed and seed stage companies.

In the late summer/early fall of 2017, we were investing in companies that were quite early.  For founding teams we did not already know, they all had a product built and all had early customers.  The companies we were investing in at the pre-seed level were doing as low as $1k revenue per month (non-repeatable) though we also invested in many companies with much higher revenue, too.

Towards the end of 2017, we noticed that downstream investors were slowing their investment pace, and we felt that it would be incredibly difficult to get our companies to the next point if we were investing only $25k at such an early stage.  The market had definitely shifted.  For your “typical” software deal, the stage after us (seed-stage) is probably around $30k-$50k per month in revenue as of writing this post  (this will depend A LOT on the idea and vertical).  So from my perspective, our entry point needs to be close enough to this rough benchmark for our companies to get to the next round of funding.  This has caused us to shift a bit downstream, too.  And in fact, in 2018, we have not yet done a single software deal even though last year we were averaging about one deal per week.

Raising money via an ICO is the exact opposite experience right now

However, if you are raising via an ICO, at least at this moment, you are probably having the opposite experience as a pre-seed company.  In fact, the median raise I’m seeing in the ICO markets is $20-30m or thereabouts, and you need very little developed to raise a lot of money!

For me, I personally think ICOs, at this time, only make sense if you’re building a blockchain company that uses utility tokens as currency for your decentralized product or service.  However, the frenzy is so nuts now, there are so many centralized/non-blockchain related companies that are successfully raising via ICO.

I do think in the long run, ICOs or some variation of today’s ICOs will disrupt traditional VC, and I plan to help this process along (this is what I’ve alluded to here).  I’ll be bringing thought leaders to this blog who can talk more about ICOs in later posts.

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Originally posted by we-love-gaming

Crowdfunding is also more mainstream than you might think

Beyond traditional methods of fundraising (e.g. convertible notes, convertible securities, equity) and ICOs, there are other ways to raise money, too.  Crowdfunding can be incredibly effective if you already have customers and/or have built up an audience.  Companies like The Hustle raised $300k from their customers in just a couple of days.

Pros and cons of different funding methods in 2018

This is going to be an evolving analysis, but as of today, here’s a quick set of pros and cons for various fundraising methods:

“Traditional” fundraising on a convertible note, convertible security, or equity round:

Pros: Tried and true.  Professional investors understand how this works.  There should be no surprises with this type of raise.

Cons: Slow.  Investors can be annoying and obnoxious to deal with.  Power is in the hands of investors.

Crowdfunding and pre-sales:

Pros: Customers are the perfect audience for raising money because they already understand your product or service.  This works well if you’ve amassed a huge user base or audience or have a large mailing list.  If you have a media company or do a lot of content marketing, for example, this could be a great path.  And quick.  And online so you can get investors from anywhere.

Cons: Each investor will likely write only a small check.  So, you might have lots of people to deal with even if you go through a 3rd party platform (e.g. if people have lots of questions).  And, this is most effective if you have something already and/or already have investors – in other words, you’re already in business and have raised some money.

ICOs:

Pros: Once you get all the pieces in place, quick to raise money.  You don’t give up equity or control.  Power is in the hands of the entrepreneur.  Completely online so you can get investors from anywhere. Can raise on just an idea.  And can potentially raise lots and lots of money.

Cons: Logistics can be challenging.  Handling the security of ETH (cryptocurrency) is quite involved.  If you don’t handle this correctly, you can get hacked and lose everything.  If your ICO is not in compliance with SEC regulations, you can get shut down by the SEC.  The value of ETH can fluctuate wildly (unlike the dollar).  Generally makes sense at this point in time only for blockchain related companies that utilize a token that can be used for decentralized services and products.

I’m also seeing variations of the above – various combo deals with equity and tokens…the fundraising landscape has been changing a lot in the last couple of months, so who knows, this entire blog post might be obsolete in another 2 months.  It’s an exciting time…