Who Should—and Shouldn’t—Become A Tech Investor? Freestyle Weighs In

1/17/13Follow @wroush

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still employed by another company. We want them to be passionate. If they are not passionate enough to have left their current employer, then how are they going to be passionate about the company they’re starting?

We also have other standards that are more obvious. We only invest in “never-give-up” entrepreneurs. We had a meeting last week with two entrepreneurs who are building a company in the mobile consumer space, and we were talking about their fundraising and exit strategies, and they said, “We can totally see selling this for $30 million.” And that was it, the conversation was over. When I heard that, I said, “You should really raise money from angels, not from institutional investors,” because angels would be excited about that kind of exit, but institutions really want to invest in people who want to change the world or build something that’s going to have an impact.

DS: Josh and I are closely engaged for the first year after we invest in a company. So we want to confirm that, with their seed raise, they can prove that they are on to something big within the first year. So when we meet with entrepreneurs, we are like, “Okay, this is your product today, but what is your goal for a year from now, and is that attainable, and if you hit that goal, does that mean you can go and raise a Series A and take the company to the next level?” That is our biggest filter when we look at companies. We want to confirm that you can prove you are on to something in the first year.

X: What other types of questions do you guys ask at Freestyle that might not come up at meetings with other VCs?

JF: Most entrepreneurs will say they want to build a big, disruptive company, and they want to swing for the fences, but you have to really probe beneath that. We try to get at the validity of that statement by asking questions that aren’t as obvious. It’s important that they are honest about what they want out of the experience, because then they will choose investors who match that. For example, I think it’s great that those mobile entrepreneurs we talked to were honest about a $30 million sale being reasonable for them. The last thing you want is to be matched with an investor who is expecting you to swing for the fences and then they fight with you over your exit. That will not end well for anyone. So we try and paint scenarios for the entrepreneur to get to the bottom of what they really want.

Another area we have been focusing on more and more is, what kind of work culture are you building? Mainly, we want to see that you have thought about it. There are some wrong answers. Not necessarily wrong for the entrepreneur, but wrong for us. We want you to be able to explain why you’re choosing the work culture you’re choosing and how you are going to bring it to life. There’s one mindset where people come in at 9:00 am and work until midnight. Another is that you might want people to come in at 10:00 am and go home at 6:00 pm and exercise and then go back online from 8:00 to midnight. That can work too. But the more they’ve thought that through, the happier everyone will be. If you end up hiring people who have different work ethics, it’s going to be divisive.

X: Can you share some of your best mistakes—the errors you really learned from when you were starting out?

DS: I would say one of our main learnings was, “Don’t invest in a company just because they are on fire.” Which goes hand in hand with, “Don’t invest in a company just because there is a frenzy around that company.”

What matters is, was that traction generated because the founders were lucky, or because they were skilled? The reason that’s important is that traffic doesn’t matter if it doesn’t continue to grow. So you have to evaluate whether founders are going to be capable of turning that traction into business.

We made an investment in Formspring, for example, where they were wildly successful in the beginning. We only partially understood their product, and they had tremendous traffic, and there was a frenzy. We kind of got sucked in for all those reasons. But they had a hard time turning it into a business.

That was a learning for them and for us. Now we spend a significant amount of time checking out the entrepreneurs and getting to know them and doing our own research. If that delays the process and allows another investor to lead the round, that is okay. We can live with that outcome.

X: Are there too many people doing angel and seed investing in Silicon Valley these days?

JF: Far be it for me to judge, but for the moment the demand for capital is kind of matching the supply of capital. I think we are in a good place at the moment, at the seed stage. There was a time when demand and supply were out of balance—there was too much supply for the demand and we saw valuations rising. I think the market is more balanced now.

But what I am afraid of is that we have more lifestyle investors joining the fray who are not as concerned about valuation. Because for them, the economic return is secondary; they are insensitive to valuation. Those smaller investors start to add up in a seed round, and encourage entrepreneurs to seek a higher valuation. On the other hand, if somebody wants to invest because they want to stay current and meet interesting people and they have the cash to burn, there isn’t really any good reason, outside of my selfish interest, to keep them away.

X: But there’s a lot of talk about whether there’s a “Series A crunch” coming, as all of these seed-funded companies try to raise their next round.

JF: There is all this seed capital funding, so there are more entrepreneurs than ever. But not all of these companies can raise money at the Series A level, because the funding there is static. So I don’t know if it’s a “squeeze,” but probably a greater percentage of companies than we have seen in the past won’t make it to the Series A phase. I don’t think that’s a bad thing.

The door that is opening for us, which we are excited about, is that we’re going to institutionalize our role as a bridge funder for companies we have invested in. We are going to make it easier for the companies we believe in to raise bridge financing with us in the lead, and maybe postpone the Series A. They can go out and prove more with our financing. We are going to be more active on that.

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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