High Resolution Fundraising

by anateus • 16 years ago

127 53 16 years ago

kylec• 16 years ago

Can someone post a watered-down version of this essay? I like Paul Graham's writing and I enjoy reading his ideas, but not knowing anything about the finances of investing makes this essay pretty much unintelligible for me. (I hope I'm not the only one.)

pg4• 16 years ago

This explains a lot of the concepts in more detail: http://paulgraham.com/future.html

bkrausz• 16 years ago

Paraphrasing and skipping over some important points: convertible notes are awesome because you can offer people different valuations. Investors often don't want to be the first to commit. This lets you give them an incentive to do so.

btilly2• 16 years ago

Here is a watered down version.

A convertible note is a loan that can be paid back in stock at a later date at an agreed upon price under agreed upon conditions. So if the company fails then the investor is a creditor who gets a chance to get some of the investment out. And if it succeeds then the investor stands to gain from the growth in value of the company.

The key feature from the founder's point of view is that you can effectively sell off any fraction of the company you still own at any price whenever you want this way. And you can sell to different investors at very different prices. Furthermore this type of deal is very good for smaller investments.

This is replacing the idea of a funding round where a bunch of investors put in money into a pool, decide what the company is worth, then trade their money for a portion of the ownership. The investors then divide up those shares evenly according to money invested.

The key problem with that type of funding round is that many investors would hold back until they knew that people whose judgment they trust were investing, then they'd buy a piece of the round. This forced a lot of work in coordinating a complex deal, and caused investors to be rewarded the same despite having done very different amounts of work in due diligence.

By contrast convertible notes mean that companies can raise money as they go. And it gives companies room to offer different rates to different investors. Which means, for instance, that an investor like Ron Conway might get a much better rate in recognition of the value there is in being in his network, and the fact that his having invested makes other investors more willing to invest. By contrast a random investor who knows nothing and just follows the herd can be offered much worse rates, if they even hear about the possibility before the company has enough money for their needs.

The winners are founders and the best investors. The losers are investors who mainly try to figure out where the herd is going and jump on the bandwagon.

patio113• 16 years ago

Let's see...

Startups raise money from investors to accelerate their growth into, hopefully, massively profitable businesses and/or massively large acquisitions from big companies.

One particular type of investor that invests in startups is called an angel investor. An angel investor is often an individual human being who is wealthy, frequently as a consequence of successful entrepreneurship. They invest anywhere from $25,000 to $250,000 or so.

Fundraising is painful, and requires a lot of time and focus from startup founders. To mitigate the pain, it is often structured in terms of "rounds", where the startup goes out to raise a particular large sum of money all at once. For an angel round, let's say that could be a million dollars. Clearly we're going to need to piece together contributions from a few angels here.

Traditionally, one angel has been the "lead" angel, who handles the bulk of the organizational issues for the investors. The rest just sit by their phone and write checks when required. (Slight exaggeration.) Investors are often skittish, and they require social proof to invest in companies, so you often hear them say something like a) they're not willing to invest in you but b) they are willing to invest in you if everybody else does. This leads to deadlocks as a group of investors, who all would invest in the company if they company were able to raise investment, fail to invest in the company because it cannot raise investment.

Startup founders are, understandably, frustrated by this.

One item of particular interest in investing is the valuation of the company. This gets into heady math, but the core idea is simple: if we agree that the company is worth $100 at this instant in time (the "pre-money valuation"), and you want to invest $100, then right after the company receives your investment, the company is worth $200 (the "post-money valuation"). Since you paid $100, you should own half the company.

Traditionally, the company has exactly one pre-money valuation (which is decided solely by negotiation, and bears little if any relation to what disinterested outside observers could perceive about the company). All investors receive slices in the company awarded in direct proportion to the amount of money they invest. Two investors investing the same amount of money receive the same sized slice of the company. This can be written as "they invested at the same valuation."

The thesis of PG's essay is that allowing investors to invest at the same valuation is not advantageous to the startup. Instead, by offering a discount to valuation for moving quickly, you can convince investors to commit to the deal early, thus starting the stampede from the hesitant investors who were waiting to see social proof.

For example, take the company from earlier. We said it was worth $100 prior to receiving investing, but that is not tied to objective reality. Say instead we'll agree that it is worth $80... but only with respect to the 1st investor. He commits $20. $80 + $20 = $100, so he gets $20 / $100 = 20% of the company for $20, or $1 = 1%. This convinces a second investor to invest. He says "Can I get 20% for $20, too?" Not so fast, buddy, where were you yesterday? The company isn't worth $80 any more. We think it is worth $105 now. (Did we just get through saying $100? Yes. But valuations are not connected to objective reality.) So you get $20 / ($105 + $20) = 16% of the company for your $20. Think that is fair? You do? OK, done.

This continues a few times. The startup raises money -- possibly more money, depending on how much the angels want in -- with less hassle for the founders.

We've been talking about just dollars so far, and alluding to control of the company as if it were equity like stocks, but there is a mechanism called "convertible notes" at play here. A convertible note is the result of a torrid affair between a loan and an equity instrument. It looks a bit like Mom and a bit like Dad. Like a loan, it charges interest: typically something fairly modest like 6 to 8%, much less than a credit card.

The tricky thing about convertible notes is that they convert into partial ownership of the company at a defined event, most typically at the next round of VC funding or at the sale of the company. So, instead of the first investor getting $20 = 20% of the company, he loans the company $20 in exchange for a promise like this: "You owe me $20, with interest. Don't worry about paying me back right now. Instead, next time you raise money or sell the company, we're going to pretend that I'm either investing with the other guy or selling with you. The portion of the company which I buy or sell will be based on complicated magic to protect both your interests and my interests. If you want to sweeten the deal for me, sweeten the magic."

Do we understand why this arrangement works for both parties? It incentivizes investors to commit early, which lets startups raise more money with less pain. Because startups are in the driver's seat, it also lets them avoid collusion among investors ("We decided we'd all invest in you, but we don't think the company is worth $100. We think it is worth $50. Yeah, that has no basis in objective reality, but objective reality is that your company is worth $0 without the $100 in our collective pockets. What is it going to be? Give up 2/3 of the company, or go broke and get nothing."

OK, back to complicated magic. When the company takes outside investment, the convertible notes magically convert into stock, based on a) the valuation the company receives for the investment round b) a negotiated discount to the valuation, to reward the angel investor for his early faith in the company, and c) possibly, a valuation cap.

For example, continuing with our "low numbers make math comprehensible" startup, let's say it goes on a few months and is then raising a series A round, which basically means "the first time we got money from VCs". We'll say the VC and startup negotiate and agree that the company is worth $500 today, the VC is investing $250, ergo the VC gets a third of the company.

How much does our first $20 angel investor get? Well, he gets to participate like he was investing $20 today, plus he gets a discount to the valuation. So instead of getting $20 / $750 = 2.67% of the company, maybe he got a 20% discount to the valuation, so he gets $20 / (.8 * $750) = 3.33% of the company. (We're ignoring the effect of interest here for simplicity, but he probably effectively has $21 and change invested by now in real life.)

After this is over, the convertible note is gone, and our angel investors are left with just shares (partial ownership of the company), which they probably hold until the company either goes IPO or gets bought by someone. So if the company later gets bought for $2,000 by Google, our intrepid angel investor makes $66 on his $20 investment.

We haven't discussed valuation caps yet. Valuation caps are intended to prevent the startup dragging its feet on raising money, thus building up lots of worth in the company, and then the angel investor getting cheesed. For example, if they had just grown through revenues for a year or two, they might be raising money at a valuation of $1,250. In that case, $20 only buys you 2% of the company (remember, he gets a 20% discount : $20 / (.8 * $1250) = 2%), which the angel investor might think doesn't adequately compensate him for the risk he took on betting on a small, unproven thing several years before. So we make him a deal: he gets to invest his $20 at the same terms as the VCs do if, and only if, the valuation is less than $750. If it is more than $750, for him and only him, we pretend it was $750 instead. This means that under no circumstances will he walk away with less than $20 / (.8 * $750) = 3.33% of the company, as long as the company goes on to raise further investment. (Obviously, if they fold, he walks away with nothing. Well, technically speaking, with debt owed to him by a company which is bankrupt and likely has no assets to speak of, so essentially nothing.)

I think that just about covers it. Make sense? Anybody feel free to correct me if I botched something here, this is not quite my bag.

tjmc• 16 years ago

Excellent explanation Patrick. Perhaps PG should run his finance related posts past you in future! IMHO he's assuming more of a financial background than his usual hacker audience has.

I once read that the road to mastery of a subject is:

1. No knowledge and a lack of awareness of the knowledge you need (eg. I don't know how to drive and I don't even know what I need to learn)

2. No knowledge, but conscious of what needs to be learnt (I don't know how to drive but the instructor has told me what I'm going to learn)

3. Knowledge and still conscious of what needed to be learnt to get there (I've learnt how to drive but I have to consciously think about changing gears)

4. Knowledge without awareness of application (Driving is now part of my kinesthetic memory and I can concentrate on my phone calls instead)

The point is - an expert can't teach from level 4. They have to go back to 3. If they can't do that they're still an expert, but a bad teacher.

My brother's like that with chemistry - dare to ask a question and you'll get a PhD level answer. I think pg's like that with finance. So thanks again!

trominos• 16 years ago

Thanks for the explanation. One thing that's confusing me: if the company gets a Series A round, convertible debt is worse than the equity you would've gotten because you've essentially chosen to invest as a VC rather than an angel (which means you're investing, in all likelihood, at a higher valuation). This isn't true if the valuation cap is sufficiently small, but then why not just get equity out the door?

If the company goes bust convertible debt is worth nothing, like equity.

Where's the upside? Convertible debt seems like a strictly worse investment than stock.

subbu3• 16 years ago

I think this is worthy of a blog post. That way its indexed by Google and Co and is more searchable. Otherwise this gem will be buried deep down in the comments.

yason• 16 years ago

Convertible notes are a financial instrument that allow the startup to raise money in a more flexible way than traditional fixed rounds.

First, convertible notes help offer the first investors cheaper price. Investors that come later will pay more because it's easier and less risky to invest in something that other people have already invested in.

Second, the startup can use convertible notes to raise money more gradually. It used to be that they don't know how much they need and investors don't want to borrow large sums of money to early startups. Now the startups can more easily raise smaller amounts until they become credible enough and actually need to raise larger amounts.

noverloop• 16 years ago

http://www.khanacademy.org/#Finance

I understood all of it since I had watched these videos for the past 2 days.

alexophile• 16 years ago

In addition to some of the great summaries here, you should check out Sal Khan's videos on capital and funding

http://www.khanacademy.org/video/raising-money-for-a-startup

http://www.khanacademy.org/#Venture Capital and Capital Markets

axiom2• 16 years ago

"Raising an old-fashioned fixed-size equity round can take weeks"

Weeks? Jesus, do things really move that much faster in the valley? Even the hot startups in our area (Waterloo, Ontario) take months at minimum to raise a round. Probably the biggest factor is just that there aren't all that many active investors.

twidlit2• 16 years ago

Our very tiny funding from a foreigner investor is taking almost 6 months now in the Philippines. we suck.

axiom2• 16 years ago

It's funny, the very first piece of advice I got after starting my company was that we should find a way to move to the valley. At the time, I remember thinking "I'm sure it would help, but it's not worth the hassle." How wrong I was.

Granted we're doing pretty well, but my god has it been brutal. And not the good kind of brutal - as in building the product and finding customers - the bad kind of brutal, where you lose good developers because no one wants to live in friggin' Waterloo, and there's maybe 10 active investors in the whole damn city (and we already have 3 of them!)

joshu2• 16 years ago

For an ultra-hot startup, yes.

Generally it takes at least two months.

pg4• 16 years ago

That quote is about angel rounds, not series A. It doesn't take 2 months to raise an angel round.

ra2• 16 years ago

We're in Sydney and it took us 7 months to raise a modest Angel round. And even then the Angels only matched our pain money dollar for dollar.

jgrahamc• 16 years ago

When John Ousterhout and I started Electric Cloud we raised a $7m series A on the back of a PowerPoint presentation and some half written code in less than two months.

We were highly organized about how we approached VCs and we had prepared well before the first meeting, but ultimately it came down to one partner at USVP clicking with the idea and running with it. They called us back for a second meeting and gave us a term sheet.

MediaSquirrel2• 16 years ago

I had a conversation with my lawyer on this very topic TODAY, and she said different valuation caps would require us to create different securities filings for each investor, and that the additional fees were bad and this was a bad idea...unless we were only raising money from people in California, in which case it didn't matter because the rules made it easy.

Anyone know what the legal ramifications are for this? I'm trying to figure this out as we may be raising money in the near future.

davidu2• 16 years ago

Get a new lawyer. You can definitely do a round with different investors getting different share prices. At the very least, your lawyer can structure a Series A-1, A-2, A-3, each with a different share price, but otherwise being identical in terms and structure and everyone signing the same docs. Just make sure preferences are clear that the classes get liquidated pari pasu, if that's what you want.

MediaSquirrel2• 16 years ago

Thanks for this. Not sure I totally understand all the legalese. What about the filing fees? Will each note be counted as a separate offering?

Thanks again. I really appreciate it.

deltapoint• 16 years ago

Small typo, the word "with" is repeated.

"Bolder investors will now get rewarded with with lower prices"

pg4• 16 years ago

thanks; fixed

rumpelstiltskin• 16 years ago

Someone should create a comprehensive A-Z guide/wiki to this whole niche of startup investing with the assumption that it's readers have no finance background whatsoever. That someone will then earn a lot of goodwill for explaining in detail all the variables and in-and-outs of this complicated field.

Eliezer• 16 years ago

Let me know when you're done!

kapitalx2• 16 years ago

Great article. What does HN think about large initial rounds. In my opinion raising large amounts of money can distract one from building an efficient business, and can potentially distract from the core vision while giving up more control. But I always hear recommendations to raise as much as you can!

gojomo• 16 years ago

Is it only the valuation cap that could vary for different investors? (Would a conversion discount or even interest-rate-until-conversion ever vary as well?)

How often does the valuation cap actually prove relevant? (I'd thought they were picked to handle outlier successes; a healthy company might still do its first formal round below any caps.)

Does having many different caps make the next equity round any more complicated?

davidw• 16 years ago

> competitors in a bicycle sprint who deliberately ride slowly at the start so they can follow whoever breaks first.

This generally happens either in track racing (where they have a small oval track to race around) or in small groups. Usually the track, though - in the small group, the guys who are not good sprinters will try and take off before things get too slow. If there's a big group, there'll be guys working to pull their sprinter to the line going as fast as possible.

Tactics in road bike racing can be quite complex and are part of what make the sport more interesting than a simple contest of athletic ability.

dpifke• 16 years ago

Does YC have a standard template for the convertible notes being used this round?

Would you mind making it public, as you did with the Series AA documents (http://ycombinator.com/seriesaa.html)?

pg4• 16 years ago

Yes. Ok, we will.

anmol• 16 years ago

Hi Pg-- were you going to do this soon? we're looking to close on a small round this week...

BrashInsight• 16 years ago

The YC note format seems to suit modern deals. Still planning to publish?

nadam3• 16 years ago

Last time, when pg was speaking about the trend of efficient markets, I was wondering how incredibly the tech startup funding is NOT an efficient market. We are in the internet age. Anybody can start a startup from anywhere in the world. Despite this, you have to travel to Silicon Valley to be considered to be funded in the first place. Most people cannot even have an American visa I guess. Imagine a world, where you could just login to a site, and start there a startup by a mouse click, like a project in sourceforge. Imagine a self-serve system, like Adwords: anyone could invest any amount into any startup, even $1. It would be so much more efficient. The competition would be so much bigger. And Sillicon Valley and being a U.S citizien would be so less important anymore.

daliusd2• 16 years ago

I must say that I strongly disagree with you. There should be enough local VCs where are rich people having too much money or having problem how to get best result from them. E.g. they are not satisfied with what they get from bank.

BTW I think http://www.kickstarter.com/ is what you described.

nadam3• 16 years ago

There is no local VC for example in Eastern Europe at all. There are no people understanding technology AND having money. Really almost zero. Lots and lots of talent is wasted. This is not an efficient market at all. Anyone can read all the startup advice on the internet from anywhere in the world. But at most part of the world, the only option is bootstrapping. And I think it is not an efficient market even in the Sillicon Valley. You are funded with a lot of money or no money at all even there. If individuals could fund you with any small amount (like on the stock exchange) it would be an efficient market like the stock exchange, which is incredibly efficient. (I am in an Eastern Europian country, and I can buy stocks of a big American company for $10 if I want anytime 24/7. This is efficient market I must say.)

joeag• 16 years ago

Convertible notes, in smaller amounts and in sequential offerings just make so much sense if you combine them with customer development and lean startup strategies.

It's simple, fast and allows investors to measure their risk.

I believe it's good for the startup as well because it really keeps you focused on what's important to most startups - finding product/market fit.

If you don't have "extra" money you don't go off on tangents and you stay focused on finding the customer that will pay for your product or service.

The faster you find this, the faster your value goes up and the cheaper the next round of capital is.

High Resolution Fundraising

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