September 2010The reason startups have been using more convertible notes in angelrounds is that they make deals close faster. By making it easierfor startups to give different prices to different investors, theyhelp them break the sort of deadlock that happens when investorsall wait to see who else is going to invest.By far the biggest influence on investors' opinions of a startupis the opinion of other investors. There are very, very few whosimply decide for themselves. Any startup founder can tell you themost common question they hear from investors is not about thefounders or the product, but "who else is investing?"That tends to produce deadlocks. Raising an old-fashioned fixed-size equity round can take weeks, because all the angels sit aroundwaiting for the others to commit, like competitors in a bicyclesprint who deliberately ride slowly at the start so they can followwhoever breaks first.Convertible notes let startups beat such deadlocks by rewardinginvestors willing to move first with lower (effective) valuations.Which they deserve because they're taking more risk. It's muchsafer to invest in a startup Ron Conway has already invested in;someone who comes after him should pay a higher price.The reason convertible notes allow more flexibility in price isthat valuation caps aren't actual valuations, and notes are cheapand easy to do. So you can do high-resolution fundraising: if youwanted you could have a separate note with a different cap for eachinvestor.That cap need not simply rise monotonically. A startup could also give better deals to investors they expected to helpthem most. The point is simply that different investors, whether because of the help they offer or their willingness tocommit, have different values forstartups, and their terms should reflect that.Different terms for different investors isclearly the way of the future. Markets always evolve toward higherresolution. You may not need to use convertible notes to do it.With sufficiently lightweight standardized equity terms (and somechanges in investors' and lawyers' expectations about equity rounds)you might be able to do the same thing with equity instead of debt.Either would be fine with startups, so long as they can easilychange their valuation.Deadlocks weren't the only problem with fixed-size equity rounds.Another was that startups had to decide in advance how much toraise. I think it's a mistake for a startup to fix upon a specificnumber. If investors are easily convinced, the startup should raise morenow, and if investors are skeptical, the startup should take asmaller amount and use that to get the company to the point whereit's more convincing.It's just not reasonable to expect startups to pick an optimal roundsize in advance, because that depends on the reactions of investors,and those are impossible to predict.Fixed-size, multi-investor angel rounds are such a bad idea forstartups that one wonders why things were ever done that way. Onepossibility is that this custom reflects the way investors like tocollude when they can get away with it. But I think the actualexplanation is less sinister. I think angels (and their lawyers)organized rounds this way in unthinking imitation of VC series Arounds. In a series A, a fixed-size equity round with a lead makessense, because there is usually just one big investor, who isunequivocally the lead. Fixed-size series A rounds already arehigh res. But the more investors you have in a round, the lesssense it makes for everyone to get the same price.The most interesting question here may be what high res fundraisingwill do to the world of investors. Bolder investors will now getrewarded with lower prices. But more important, in ahits-driven business, is that they'll be able to get into the dealsthey want. Whereas the "who else is investing?" type of investorswill not only pay higher prices, but may not be able to get intothe best deals at all.Thanks to Immad Akhund, Sam Altman, John Bautista, Pete Koomen, Jessica Livingston, Dan Siroker, Harj Taggar, andFred Wilson for reading drafts of this.
