

High Resolution Fundraising - anateus
http://paulgraham.com/hiresfund.html

======
dpifke
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>)?

~~~
pg
Yes. Ok, we will.

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

~~~
chris123
Hey PG, Any ETA on this? Know you're busy, but it's been a while and releasing
this will be so helpful to so many people. Thanks.

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axiom
"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.

~~~
joshu
For an ultra-hot startup, yes.

Generally it takes at least two months.

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

~~~
joshu
Not everybody has the benefit of being a yc-backed startup.

~~~
simonista
This actually raises the point that YC acts like the "first-mover" that pg
talks about in the essay.

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kylec
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.)

~~~
patio11
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.

~~~
subbu
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.

~~~
patio11
Your wish is my Excel-jockey command. Now with graphs:

[http://www.kalzumeus.com/2010/09/02/new-trends-in-startup-
in...](http://www.kalzumeus.com/2010/09/02/new-trends-in-startup-investing-
explained-for-laymen/)

~~~
subbu
Thank you.

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rumpelstiltskin
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
Let me know when you're done!

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MediaSquirrel
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.

~~~
davidu
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.

~~~
MediaSquirrel
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.

~~~
davidu
No, it will not. I'm not sure what filing fees you are referring to. Your
Schedule D with the SEC? There's not much else that needs to be filed. This
can all be done in one 409A evaluation immediately after the financing.

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davidw
> 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.

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deltapoint
Small typo, the word "with" is repeated.

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

~~~
pg
thanks; fixed

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kapitalx
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!

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nadam
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.

~~~
daliusd
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.

~~~
nadam
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.)

~~~
daliusd
I'm from Eastern Europe (Lithuania) and there are local VCs here. Here in
Lithuania we are constantly attacked with startup event's: BarCamps, Open
Coffee Clubs, competitions that tries to find out those talents and etc. I'm
ignoring them actually but for my own reasons.

As far as I know Poland is place to look if you need bigger money. If money
really is the only reason not to make your own startup.

~~~
nadam
Here in Hungary I don't know about any VC which would consider funding small
software startups with realistic terms or would have the competency to
understand this market. (An if I don't know about them that means they are
incredibly incompetent marketing themselves on the internet, which simply
means they are incompetent.) I am bootstrapping anyway. I just mentioned that
it would be a bit easier if funding would be a more efficient market. And it
would be a cool thing not only for startups but also for people who are not
professional investors and would want to invest directly into startups only
small amounts.

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joeag
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.

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gojomo
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?

