The Future of Startup Funding
paulgraham.com
paulgraham.com
Jason Mendelson, a well-known lawyer-turned-VC, took this further in a piece entitled "Why There Will Never Be a Standard Set of Seed Documents" (http://www.jasonmendelson.com/wp/archives/2010/03/why-there-...), in which he gets into more details about how people differ on what protections and terms to seek when making early-stage investments.
So if investors want to get the best deals, the way to do it will be to close faster. Investors don't need weeks to make up their minds anyway. We decide based on about 10 minutes of reading an application plus 10 minutes of in person interview, and we only regret about 10% of our decisions. If we can decide in 20 minutes, surely the next round of investors can decide in a couple days.
This 20 minute figure is missing the point. What matters here -- to founders at least -- isn't how much time YC spends on the startup. What matters is how long the startup spends on YC. I don't know how long the average group spends filling out the YC application form, but I'm sure it's quite a bit longer than 20 minutes.
(Back of the envelope calculation: Suppose a typical group spends 3 hours filling out investment-application paperwork per investor they're pitching; investors take 1 out of every 20 applicants; and a startup wants to take money from 5 investors. Then they've just spent 300 hours -- over a month -- filling out application forms, and it's probably going to be 2 months before they can focus on something other than raising money again.)
And conveniently for founders, there is a certain practice that's common among YC-like organizations that makes the cost of multiple applications low (e.g. http://www.ventures.io/apply).
But I still think that investors will need to compete not only on how quickly they can decide to fund a startup but also based on how much effort it takes to apply -- with the important difference that in the first case investors will notice if they lose ("sorry, you took too long to get back to us, and we've already got all the investors we need for this round") and in the second case investors will simply never see the deals.
I don't think it makes sense to say that because investors take 1 out of every 20 applications, a given startup has to pitch 20 investors. The average might, but that isn't necessarily a meaningful number. Some will pitch 1, others will pitch 40 before giving up.
Be more lenient on terms, let us raise less money at once but accumulate it over a few mini-rounds, and leave us to do what we do best.
<blockquote> Nearly all customers choose the competing product, a job. Why? Well, let's look at the product we're offering. An unbiased review would go something like this:
Starting a startup gives you more freedom and the opportunity to make a lot more money than a job, but it's also hard work and at times very stressful. </blockquote>
I'd say that this represents about 80% of an "unbiased review". The missing 20%? "... it's also hard work, and at times very stressful, <em>and the odds are very much against all of that hard work and stress paying off for you in any kind of direct, financial way.</em>"
E.g. it wouldn't be accurate to say in a product review of running shoes "you are going to run slow in these shoes" even if on average that's what people did.
If so, then that changes nearly everything that people understand about startups.
When I read this it reminded me of the good things that Google does to make the internet easier and faster. It's self-interested -- the better the internet gets, the more people click on their ads -- but in an inclusive way: there are auxiliary benefits that accrue to a lot of third parties (like me, using Chrome right now). In YC's case, that would be the population of startup founders and anyone who benefits from the startups they found.
I like it when companies behave this way. Maybe there are degrees of self-interest and this is a more enlightened one. It's too much to expect companies to do good things irrespective of their self-interest, but not too much to expect the above, especially if it turns out that they end up making more money this way. Then others will have a narrow and greedy reason to go down a broader and more generous path.
Lest this seem like nothing much, it wasn't so long ago that people in this position thought primarily in terms of controlling and crushing. The difference may be one of degree, but it's not just rhetorical.
To an outsider, this sounds like a small-scale version of the events that caused the Dot-com bubble: Investors race to fund ever-shorter rounds of companies that might someday be valuable, but have nothing right now but a sales pitch and a website. This arrangement would benefit a company like YCombinator, who seem to successfully fund companies based on little more than gut feel. But taking away "success as a predictor of success" from the VCs' playbook, would they have another strategy that beats random guessing? The Dot-com bubble suggests "no." Hopefully the small average investment really does turn the math on its head!
Regardless of a VCs understanding of it, if the founders can't capitalize on it, but can talk the talk, it's gonna fail.
Some successful sales actually prove a basic level of competence. It also shows the founders have a whole host of other skills, they can run a basic company, have some sort of idea how to market let alone gain traction, there really is a market for the product rather than vague projections, etc.
Has YC actually made a lot of money yet? I ask because the web does not provide a definitive answer. I see a few YC companies doing well, but there's no 100 million dollar companies there, let alone billion dollar companies.
Given that YC had to raise money last round to fund companies, one wonders.
I have a lot of respect for pg and read everything he writes, but I'm asking out interest in the actual reality of the situation, it's hard to tell.
The reason we raised money is that we've only been doing YC for 5 years (during the first of which we only funded 8 companies), and big exits usually take longer than that.
Sounds like you're right and more people should be following this model, and will lose out if they don't!
A big business would die of schizophrenia if they tried to fend off everything that attempted to disrupt them.
That's tangential to the point of the article though I suppose.
b) that doesn't change the hindsight bias at all, it just shifts it from individual companies to individual industries. For instance the invaders in grocery retail have done very little.
b) Grocery retail is an established market. PG was talking about new markets: "The pattern here seems the same one we see when startups and established companies enter a new market."
b) you're not an invader if it's in a new market. you're more of a pioneer then.
b) <shrug> PG chose the term, not me. The point is that you have a startup and an established company competing in a market that recently didn't exist. PG's point was that very often the startup wins. He may be wrong, but grocery retail is not a counter example.
Diaspora received a great deal of funding on Kickstart, but Kickstart specifically says it is not meant for investing. I think there might be a niche between well-connected, wealthy angels and simply asking family and friends for seed money. This would also alleviate the choice between risking your relationships with all your friends and family just to generate seed money. If you have a business idea, there should be an option to raise money in an open market at any scale.
Angels exist because there's a big legal distinction between offering stock to ordinary people and offering stock to millionaires.
From http://www.sec.gov/info/smallbus/qasbsec.htm#eod6
"Section 3(b) of the Securities Act authorizes the SEC to exempt from registration small securities offerings. By this authority, we created Regulation A, an exemption for public offerings not exceeding $5 million in any 12-month period. If you choose to rely on this exemption, your company must file an offering statement, consisting of a notification, offering circular, and exhibits, with the SEC for review. Regulation A offerings share many characteristics with registered offerings. For example, you must provide purchasers with an offering circular that is similar in content to a prospectus. Like registered offerings, the securities can be offered publicly and are not "restricted," meaning they are freely tradeable in the secondary market after the offering."
Disagree here. Dealing with investors is a source of stress, but there are many reasons why startups are stressful. A friend put it this way: "As a startup founder, every day you're eating glass and staring into the abyss."
There is the stress of product-market fit, dealing with the fact that no one knows who you are or cares, endless hours, etc.
But the best startup founders, I think, do it because they simply can't do anything else.
While I hope that fundraising becoming more efficient will help create more great startups - I think the battle against cushy jobs at established companies is at the very, very beginning.
I'm puzzled because I thought investing successfully was all about doing exactly this.
The few new things that startup then will not be worth having a lot of angels for.
More things surely would have before, but there was no way for investors to ensure they weren't cheated by the managers skimming the profits. The reason venture funding worked for trading voyages was that when the ship returned, it was very hard to conceal what was in it.
The way railroads ensured that investors got paid was to fund themselves with bonds that paid a fixed rate. Managers were free to do what they wanted with the cash flow, but if they failed to make their bond payments they'd be in default.
The risk and cost factor in websites is rapidly reducing. As the risk reduces, so will the need to go to people dedicated towards giving money. It will be easier to raise money locally and in your environment, as has been done for a long time.
In human society, it's my observation that there are two types of capital being raised:
-- Risky and big money: These is the type of money that gets raised from venture capitalists nowadays and from rich dudes back in the shipping days
-- Less risky and smaller money: This type of money is raised from savings, bank loans and borrowed from family.
Websites and many of these simple technology things are rapidly moving out of the first category and into the second category. Cost is dropping and risk is dropping. Things like robots or electric cars are now in the first category.
The same holds true for long-tail content generation. If you want to build a better Demand Media, you need to spend like they spend.
As transaction costs in general decline, it will make less and less sense to rely on friends and family, the way I don't rely on friends and family to make my shoes, even though shoes are (adjusted for inflation), much cheaper than they have been in the past.
Your "Two types of capital" division is arbitrary, both because you're turning a continuum into a binary decision, and because that's just one way to divide things. I could divide capital-raising businesses into those with limited scale and those with unlimited scale. There are more and more businesses with unlimited scale, and the optimal way to run such a business is to maximize risk, and to use someone else's capital to place bigger bets.
The first companies issuing tradable stock were shipping/trading companies. 1/64th shares seems to be about the size that would start to require some more sophistication.
I'd actually argue the opposite. Business has traditionally needed outside funding, but the incredible cheapness of software startups is decreasing that need.
Finally, you say that investment "is only neccessary because technology is changing so quickly...but this will end soon enough." That definitely seems wrong. Technological change is accelerating.
By that I mean raising money with a larger number of smaller inputs from a marketplace or similar. Potentially still in exchange for equity though also possibly for debt or just belief, as with Kickstarter.
Diaspora and Kickstarter are a recent successful example, though that was something of a black swan event in my opinion.
I do think this type of exchange could solve some of the things founders dislike about raising money, but it certainly raises other problems.
I heard a while ago of a company called Sprowtt planning to do something like this, but researching again just now, they appear to have "hit the deadpool" http://www.crunchbase.com/company/sprowtt-marketplace
I love the idea of a startup-controlled round and would definitely love to do my first round (coming soon hopefully) this way but... how exactly do I go about setting something like this up? Is there somewhere that explains how to do this or do I have no recourse but retaining a lawyer who has experience with this sort of deal (which I don't have the money for right now).
I'd love a nuts and bolts type answer if possible.
Or is this process even possible (yet) for a startup founder to lead?
http://venturehacks.com/articles/no-lead
If you're going to take 10s to 100s of thousands of dollars from private investors, there's no getting around having a lawyer with experience in such deals.
Is it because there profitable exists which are bringing more money in? I have been following the news and while the number of buyouts seem to be increasing, many of them are at valuations which would not indicate much profit for the investors.
Also VCs keep telling me that they have trouble getting funds as their traditional institutional investors have soured on the VC investment class. So that would indicate something other than a seller's market.
Or do you think that because there is so much activity with start-ups, investors have already decided that some companies that have not yet reached an exit (e.g., Twitter, Foursquare) are defacto winners, so that there is an assumption of high profitability even without the exits.
Or do you think it is a sellers market because more money is going to silicon valley now that many of the wall street profit making schemes have stopped working.
Or is it possible that it only seems like a seller's market to you because Y-combinator is so successful and popular that investing in Y-combinator startups is indeed a seller's market, while this may not be the case overall.
I think one reason for the trend is that a number of rich people have soured on the idea of paying someone at BigCo finance to manage their money for them in the stock market. A lot of portfolio's have recovered most of the losses from the past 2 years of stock market craziness, and a lot of them are seeing the benefit of diversifying their investments with angel investing.
Multiply that trend times 500 to 5000 millionaires in Silicon Valley, and you have a sellers market in angel investing. That is, there are a lot of angel investors looking for startups to invest in early.
YC companies get a lot of publicity. And so their chances of raising another round of capital or getting bought out are very good. This is not the case with most startups. So a rolling close with convertible notes may not be the best option from investor point of view - no?
(With an equity deal, the startup can get an exit until it goes out of business. With a convertible notes deal, you have a fixed timeframe and you (as an early stage investor) lose out if the exit happens beyond that time period...
...So I thought one never did a convertible notes deal unless they knew there was a very very good chance of an exit within the specified time frame... am I missing something?
My point is - I don't see rolling closes with convertible notes getting too popular with most angels.)
I think there is an assumption the VC agreement is structured without any sharing of operating profits, but I'm not sure why it has to be this way... anyone care to enlighten?
If a profit sharing component was added to this model, you could significantly reduce investor risk, possibly offer better terms to founders and create an added incentive for finding businesses that have a monetizable product or service. Maybe YC is trying to avoid founders that bow to these constraints in favor of startups focusing purely on the product? There is nothing wrong with this, but it might just be delaying the inevitable; someone, somewhere will need to make a profit from it or the business will surely die.
If the company reaches a point where it will need no outside capital (nor pursue acquisition/IPO), it could have a 'round' that simply converts the debt to equity at some agreed-upon value. Then, perhaps, the original investors can at least start the capital-gains clock, collect dividends, sell shares on a private market, etc.
Convertible notes are loans that can be converted into equity if some predetermined event takes place (usually you raise another round of money or you get a buy out offer.)
You're not selling X shares at Y price. You're issuing a loan that may get converted into X shares. Every investor who gets these convertible notes usually will end up getting the same valuation in the future if the note converts to equity.
So with rolling round, you're just taking on debt. And you can take as much debt as you want to (unless you've added a clause in any of the notes that determines that you can't go over a certain amount of debt.)
that's not true, most of the convertible notes we're seeing include a valuation cap in them i.e. the investor never converts their debt at a valuation higher than the cap. the cap addresses the main criticism of convertible notes, namely they misalign the incentives of the founders (who want a high valuation for their next funding event) and investors (who want a lower valuation for the next round so they get more stock).
The exception to this would be e.g. I intend to raise $150k, i get this amount of money in the bank and then more investors want to participate. I can bring them in but I could argue for a higher valuation since they're coming in once I have money in the bank i.e. at less risk than the investors who initially put in $150k and therefore deserve the lower valuation.
Other exceptions might be where an investor brings particular value that warrants a lower price e.g. you're working on payments and Max Levchin wants to invest
series A rounds, additional rounds of funding, fixed size rounds, convertible notes, changes in valuation, stock dilution, etc.
The first year of a startup can be incredibly cheap. Cheap enough that you simply don't need any outside cash to make it happen. For me, the only reason I'd ever consider taking VC if for the side benefits that come along with the money.
When you have an entity like YCombinator backing your thing, you get a huge boost from their connections (and the fact that they're inclined to use those connections for your benefit). That's orders of magnitude more valuable than the lousy six grand they give you, and if I could get that help without the money attached or the requirement to move to the bay area, I'd jump at it for my latest project.
Now imagine the scenario with Random No-Name Angel with $100k to give you. All you get out of that deal is money. No influence. No guaranteed TechCrunching, no introductions to Important People, no Inc Magazine cover story about you and the latest crop of young entrepreneurs. Unless you actually need money (which if you're smart, you shouldn't), there's just no advantage there.