Why other hotspots need Paul Graham's binding handshakes more than the Valley

By Sarah Lacy , written on March 14, 2013

From The News Desk

Paul Graham's post this morning putting rules and parameters around something as inherently informal as a "handshake deal" may not be as philosophical or as inspiring as some of his other posts. But it's probably one of the most important things he's written -- along with the name checks at the bottom citing powerful VCs like Marc Andreessen and Fred Wilson who helped vet the post. These read as votes of support on what's essentially a new policy for early stage investing in Silicon Valley.

It may be hard to understand why this is so important if you've never raised money before. It may also be hard to understand if you've only raised money in Silicon Valley. In my experience both raising money and spending some 15 years talking to entrepreneurs who felt well treated or burned by VCs, many Valley-based VCs -- for all of their faults -- will never go back on a verbal or handshake deal.

This isn't because they are saints. It's because the potential risk to their business is too high. Entrepreneurs talk to one another and entrepreneurs talk to other VCs. That's ammo you don't want to give a potential competitor on a deal, and just generally bad mojo. A lot of these stories never show up on blogs, but people in the ecosystem hear about it.

The fear is that you never know what deals you lost because of that burned entrepreneur. It may never make a difference in your returns. It may only dissuade entrepreneurs whose deals weren't that great to begin with. But this is a home run business where outcomes for entire funds can be greatly skewed based on getting or not getting a single deal. It's common knowledge that Sean Parker's experience with Sequoia Capital when he was at Plaxo greatly influenced where Facebook went for money, for instance. How many other deals have gone bad will partners never know about?

Everyone has cash. The real currency in this world is karma. When you take an investor's money -- you are stuck with them. It's extraordinary scary, particularly for a first time entrepreneur. Everyone says the right things at the beginning. You are hungry for any signal that you are making the right or wrong move. If they treated someone you know this way when they were in the courting stage, what is going to happen when the shit really hits the fan? This is why good deals tend to clump around top firms. They seem like known quantities. And in many cases, they became top firms by not burning entrepreneurs.

And let's be clear -- even for a hot company the results of a VC going back on a verbal agreement can be disastrous. Call them lemmings all you like, there's a powerful psychology to investing, much like selling a house. The more offers there are, the more you want it. If someone is committed for a certain amount, and an entrepreneur tells other investors that, any going back on that commitment for any reason can be construed as a negative signal. Deals can fall apart. Particularly at the early stages, this is all about promise. "What does this person know that I don't?" is always going to be a nagging thought when taking a risk on such unknowns.

The best VCs are masters of the risk/reward equation. In these cases, if you made a commitment, the risk to the startup and your reputation is just too great in breaking it without an incredibly valid reason that would warrant the inevitable negative signal to the market. The social pressure is so great and the world is so small that it's not worth the risk even if a VC sours on a company that he committed $50,000 to.

The great thing about Graham's rules for handshakes is it takes out the ambiguity and the he-said/she-said. This is just as good for VCs, as frequently a young entrepreneur could misconstrue a conversation. I have no doubt that frequently VCs are unfairly tarred when an entrepreneur just can't close a deal. And that's no good either. According to the rules, there are no ranges. It has to be a specific agreement that the two are shaking hands on, with no caveats of "if you find a lead" or "if you raise X amount."

If it were my company, I'd pull out my phone at a demo day and say, "Hey, I'm just gonna clarify what we just said in an email to you real quick so we're all on the same page. I'm having a lot of conversations today, and I just want to make sure there's no crossed wires. Is that cool?" Writing is always unimpeachable, and if someone is really making you a solid offer, they will welcome the paper trail too.

The Valley will embrace Graham's suggestions, because it helps all the players clear up something that we live by anyway. But I'd encourage the major VCs and gatekeepers in other up and coming ecosystems to publicly endorse these rules, and apply the same social pressure on enforcing good behavior. Sadly, when I do hear of cases of this kind, typically it's coming from places where there are more entrepreneurs than sources of cash, and there's just not the same social pressure for people to keep to their word.

[Image courtesy Fred Seibert]