Key Lessons from Paul Graham’s Legendary Essay, ‘How to Start a Startup’: Part 2-of-3

 

Today, Ignitia continues its examination of Paul Graham’s legendary essay, ‘How to Start a Startup’ with the second installment in this on-going series.

What Customers Want

In the third chapter of his essay, Mr. Graham focuses on customers. According to Mr. Graham, most businesses fail because they don’t give their customers what they want. According to Mr. Graham, ‘In nearly every failed startup, the real problem was that customers didn’t want the product.’ Too often according to Mr. Graham, people spend way too much time and money developing products no one wants. Mr. Graham suggests it would be far better to merely develop a cheap and simple prototype, then see if customers respond, and adjust on the fly. In the technology market, often times pleasing customers means making your products simpler to use. According to Mr. Graham, one of the best ways to determine what customers want is to watch them; and one of the best places to watch them is trade shows. There according to Mr. Graham, you can see customers trying out products, see how they use them, and see which are most popular. It’s market research.

According to Mr. Graham, the best odds for starting a successful startup are in niche markets. ‘Since startups make money by offering people something better than they had before, the best opportunities are where things suck most.’ According to Mr. Graham, it’s easier to sell to smaller companies so they should be your first targets. Big companies already have other big companies with big budgets selling to them. As such, the opportunity lies in the niches. ‘The products that start as cheap, simple options tend to gradually grow more powerful till, like water rising in a room, they squash the “high-end” products against the ceiling.’ Mr. Graham goes on to further say, ‘If you build the simple, inexpensive option, you’ll not only find it easier to sell at first, but you’ll also be in the best position to conquer the rest of the market…If you have the cheapest, easiest product, you’ll own the low end. And if you don’t, you’re in the crosshairs of whoever does.’

Raising Money

In the next chapter, Mr. Graham deals with the heart of the matter: raising money. Mr. Graham starts this chapter by making the fairly obvious assertion that to start a company you will need money. Here Mr. Graham states that startups are like a pass/fail course. With this in mind, according to Mr. Graham, the best way to get rich is by maximizing your company’s chances of success. If this means trading stocks for something that will help those chances, the decision should be simple. According to Mr. Graham, getting investors should also be simple, and it should be tedious, not terrifying.

Seed Rounds and Angel Investors

According to Mr. Graham, the first thing you’ll need is seed capital. This is several tens of thousands of dollars to use in developing your prototype. According to Mr. Graham, because this is such a relatively small sum of money it is usually fairly easy to raise this round of funding. Usually, answers from potential investors in this round come fast, and often the ‘yes’ comes from ‘angels investors’. These are individually wealthy people. Often times, these people themselves once hit it big in a startup. As such, their round of investing tends to also come with invaluable advice and mentorship as well. These angels can help with the legal side of things and commonly make introductions to other investors who may come on board for subsequent rounds of funding. Often times, angels don’t expect you to have an incredibly in-depth business plan at the seed stage – but, they will want to see something. According to Mr. Graham, this can be as simple as a brief description of what you plan to do, how you plan to make money from it, and the resumes of the founders. According to Mr. Graham, this shouldn’t take you more than a few hours to create.

Establishing the Legal Entity

If an angel is ready to invest, you’ll then need a place for them to make their check out to. According to Mr. Graham, incorporating a business is easy, however when you do you will need to list the founders and the amount of ownership each has. This is not as easy to decide, especially if people have varying degrees of involvement. According to Mr. Graham, the time you’ll know you’ve done this right is, ‘When everyone feels they’re getting a slightly bad deal, that they’re doing more than they should for the amount of stock they have, the stock is optimally apportioned.’ There are of course many more things that should be done to properly setup a company such as insurance and business licenses, but according to Mr. Graham these things should not be viewed as deal-breakers at this point if you don’t have all of them established. Also, Mr. Graham cautions that at this point, all founding members should sign something stating the ideas of the company belong to the company so no one can take them and start a competing business. The startup should also ideally be everyone’s only full-time job. He also cautions that it’s a very good idea at this point to ask everyone what else they’ve signed to ensure no one will come after your company later on.

Additional Investors

According to Mr. Graham, after the company is setup, the next step is to raise more funding. According to Mr. Graham, you should feel no apprehension about approaching wealthy individuals about investing because as Mr. Graham puts it, ‘Mixed with any annoyance they might feel about being approached will be the thought: are these guys the next Google?’

Valuation

At this point, angels usually receive a portion of the company for their investment and the associated dollar amount for the percentage of ownership can be extrapolated to the pre-money valuation of the company on the whole. For example, according to Mr. Graham, ‘If you give an investor new shares equal to 5% of those already outstanding in return for $100,000, then you’ve done the deal at a pre-money valuation of $2 million.’ In order to set your valuation, you must decide not only what you perceive the value of your product to be, but also the value of your ideas and all the future work you plan to do.

Subsequent Rounds of Funding and VC Firms

During the next round of funding, according to Mr. Graham, you may want to approach actually VC firms. However, he cautions firms can take months to make a decision, so don’t wait until you’re almost out of money to approach them. According to Mr. Graham, VC firm deals are often rather large, so they are very much be worth it. Mr. Graham cautions however that some VC firms may want to install their own CEO as someone with more business experience but both Bill Gate and Steve Jobs proved this idea was not necessary. With regard to experienced businesspeople Mr. Graham stated, ‘We used to call these guys “newscasters,” because they had neat hair and spoke in deep, confident voices, and generally didn’t know much more than they read on the teleprompter.’ According to Mr. Graham, this is a fear that may also be realized if your company goes public. According to Mr. Graham, dealing with VC’s is a seller’s market and startups have more leverage than they usually realize. Everyone wants in on the next big thing, and even now, there is too much money chasing too few good deals. According to Mr. Graham, at the top of the VC food chain are firms like Sequoia Capital, but below them are many firms you’ve probably not heard of, and a dollar from them is worth just as much as a dollar from anyone else. Even though many VC firms will offer ‘connections’, according to Mr. Graham, ‘Basically, a VC is a source of money. I’d be inclined to go with whoever offered the most money the soonest with the least strings attached.’ According to Mr. Graham, a certain amount of discretion should also be used with VC’s, because they may one day be funding your competitor. ‘Most VCs say, they’re more interested in the people than the ideas. The main reason they want to talk about your idea is to judge you, not the idea. So as long as you seem like you know what you’re doing, you can probably keep a few things back from them.’

In closing the chapter, Mr. Graham states that it’s good practice to speak with as many VC’s as you can. He recommends this because, ‘A) they may be on the board of someone who will buy you, and B) if you seem impressive, they’ll be discouraged from investing in your competitors.’ In order to speak with them, Mr. Graham suggest the best way is by attending the conferences they occasionally organize to meet startups.

In the third and final installment of this series, Mr. Graham discusses how not to over-spend the money you raise, and how to know if starting a startup is right for you.

 

 

 

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