August 2010Two years ago Iwrote about what I called "a huge, unexploitedopportunity in startup funding:" the growing disconnect betweenVCs, whose current business model requires them to invest largeamounts, and a large class of startups that need less than theyused to. Increasingly, startups want a couple hundred thousanddollars, not a couple million. [1]The opportunity is a lot less unexploited now. Investors havepoured into this territory from both directions. VCs are much morelikely to make angel-sized investments than they were a year ago.And meanwhile the past year has seen a dramatic increase in a newtype of investor: the super-angel, who operates like an angel, butusing other people's money, like a VC.Though a lot of investors are entering this territory, there isstill room for more. The distribution of investors should mirrorthe distribution of startups, which has the usual power law dropoff.So there should be a lot more people investing tens or hundreds ofthousands than millions. [2]In fact, it may be good for angels that there are more people doingangel-sized deals, because if angel rounds become more legitimate,then startups may start to opt for angel rounds even when theycould, if they wanted, raise series A rounds from VCs. One reasonstartups prefer series A rounds is that they're more prestigious.But if angel investors become more active and better known, they'llincreasingly be able to compete with VCs in brand.Of course, prestige isn't the main reason to prefer a series Around. A startup will probably get more attention from investorsin a series A round than an angel round. So if a startup is choosingbetween an angel round and an A round from a good VC fund, I usuallyadvise them to take the A round. [3]But while series A rounds aren't going away, I think VCs should bemore worried about super-angels than vice versa. Despite theirname, the super-angels are really mini VC funds, and they clearlyhave existing VCs in their sights.They would seem to have history on their side. The pattern here seems the sameone we see when startups and established companies enter a newmarket. Online video becomes possible, and YouTube plunges rightin, while existing media companies embrace it only half-willingly,driven more by fear than hope, and aiming more to protect theirturf than to do great things for users. Ditto for PayPal. Thispattern is repeated over and over, and it's usually the invaderswho win. In this case the super-angels are the invaders. Angelrounds are their whole business, as online video was for YouTube.Whereas VCs who make angel investments mostly do it as a way togenerate deal flow for series A rounds.[4]On the other hand, startup investing is a very strange business.Nearly all the returns are concentrated in a few big winners. Ifthe super-angels merely fail to invest in (and to some extentproduce) the big winners, they'll be out of business, even if theyinvest in all the others.VCsWhy don't VCs start doing smaller series A rounds? The stickingpoint is board seats. In a traditional series A round, the partnerwhose deal it is takes a seat on the startup's board. If we assumethe average startup runs for 6 years and a partner can bear to beon 12 boards at once, then a VC fund can do 2 series A deals perpartner per year.It has always seemed to me the solution is to take fewer boardseats. You don't have to be on the board to help a startup. MaybeVCs feel they need the power that comes with board membership toensure their money isn't wasted. But have they tested that theory?Unless they've tried not taking board seats and found their returnsare lower, they're not bracketing the problem.I'm not saying VCs don't help startups. The good ones help them alot. What I'm saying is that the kind of help that matters, youmay not have to be a board member to give.[5]How will this all play out? Some VCs will probably adapt, by doingmore, smaller deals. I wouldn't be surprised if by streamliningtheir selection process and taking fewer board seats, VC funds coulddo 2 to 3 times as many series A rounds with no loss of quality.But other VCs will make no more than superficial changes. VCs areconservative, and the threat to them isn't mortal. The VC fundsthat don't adapt won't be violently displaced. They'll edge graduallyinto a different business without realizing it. They'll still dowhat they will call series A rounds, but these will increasinglybe de facto series B rounds.[6]In such rounds they won't get the 25 to 40% of the company they donow. You don't give up as much of the company in later roundsunless something is seriously wrong. Since the VCs who don't adaptwill be investing later, their returns from winners may be smaller.But investing later should also mean they have fewer losers. Sotheir ratio of risk to return may be the same or even better.They'll just have become a different, more conservative, type ofinvestment.AngelsIn the big angel rounds that increasingly compete with series Arounds, the investors won't take as much equity as VCs do now. AndVCs who try to compete with angels by doing more, smaller dealswill probably find they have to take less equity to do it. Whichis good news for founders: they'll get to keep more of the company.The deal terms of angel rounds will become less restrictivetoo—not just less restrictive than series A terms, but lessrestrictive than angel terms have traditionally been.In the future, angel rounds will less often be for specific amountsor have a lead investor. In the old days, the standard m.o. forstartups was to find one angel to act as the lead investor. You'dnegotiate a round size and valuation with the lead, who'd supplysome but not all of the money. Then the startup and the lead wouldcooperate to find the rest.The future of angel rounds looks more like this: instead of a fixedround size, startups will do a rolling close, where they take moneyfrom investors one at a time till they feel they have enough.[7]And though there's going to be one investor who gives them the firstcheck, and his or her help in recruiting other investors willcertainly be welcome, this initial investor will no longer be thelead in the old sense of managing the round. The startup will nowdo that themselves.There will continue to be lead investors in the sense of investorswho take the lead in advising a startup. They may also makethe biggest investment. But they won't always have to be the oneterms are negotiated with, or be the first money in, as they havein the past. Standardized paperwork will do away with the need tonegotiate anything except the valuation, and that will get easiertoo.If multiple investors have to share a valuation, it will be whateverthe startup can get from the first one to write a check, limitedby their guess at whether this will make later investors balk. Butthere may not have to be just one valuation. Startups are increasinglyraising money on convertible notes, and convertible notes have notvaluations but at most valuation caps: caps on what theeffective valuation will be when the debt converts to equity (in alater round, or upon acquisition if that happens first). That'san important difference because it means a startup could do multiplenotes at once with different caps. This is now starting to happen,and I predict it will become more common.SheepThe reason things are moving this way is that the old way suckedfor startups. Leads could (and did) use a fixed size round as alegitimate-seeming way of saying what all founders hate to hear:I'll invest if other people will. Most investors, unable to judgestartups for themselves, rely instead on the opinions of otherinvestors. If everyone wants in, they want in too; if not, not.Founders hate this because it's a recipe for deadlock, and delayis the thing a startup can least afford. Most investors know thism.o. is lame, and few say openly that they're doing it. But thecraftier ones achieve the same result by offering to lead roundsof fixed size and supplying only part of the money. If the startupcan't raise the rest, the lead is out too. How could they go aheadwith the deal? The startup would be underfunded!In the future, investors will increasingly be unable to offerinvestment subject to contingencies like other people investing.Or rather, investors who do that will get last place in line.Startups will go to them only to fill up rounds that are mostlysubscribed. And since hot startups tend to have rounds that areoversubscribed, being last in line means they'll probably miss thehot deals. Hot deals and successful startups are not identical,but there is a significant correlation. [8]So investors who won't invest unilaterally will have lower returns.Investors will probably find they do better when deprived of thiscrutch anyway. Chasing hot deals doesn't make investors choosebetter; it just makes them feel better about their choices. I'veseen feeding frenzies both form and fall apart many times, and asfar as I can tell they're mostly random. [9]If investors canno longer rely on their herd instincts, they'll have to think moreabout each startup before investing. They may be surprised howwell this works.Deadlock wasn't the only disadvantage of letting a lead investormanage an angel round. The investors would not infrequently colludeto push down the valuation. And rounds took too long to close,because however motivated the lead was to get the round closed, hewas not a tenth as motivated as the startup.Increasingly, startups are taking charge of their own angel rounds.Only a few do so far, but I think we can already declare the oldway dead, because those few are the best startups. They're theones in a position to tell investors how the round is going to work.And if the startups you want to invest in do things a certain way,what difference does it make what the others do?TractionIn fact, it may be slightly misleading to say that angel roundswill increasingly take the place of series A rounds. What's reallyhappening is that startup-controlled rounds are taking the placeof investor-controlled rounds.This is an instance of a very important meta-trend, one that YCombinator itself has been based on from the beginning: foundersare becoming increasingly powerful relative to investors. So ifyou want to predict what the future of venture funding will be like,just ask: how would founders like it to be? One by one, all thethings founders dislike about raising money are going to geteliminated. [10]Using that heuristic, I'll predict a couple more things. One isthat investors will increasingly be unable to wait for startups tohave "traction" before they put in significant money. It's hardto predict in advance which startups will succeed. So most investorsprefer, if they can, to wait till the startup is already succeeding,then jump in quickly with an offer. Startups hate this as well,partly because it tends to create deadlock, and partly because itseems kind of slimy. If you're a promising startup but don't yethave significant growth, all the investors are your friends inwords, but few are in actions. They all say they love you, butthey all wait to invest. Then when you start to see growth, theyclaim they were your friend all along, and are aghast at the thoughtyou'd be so disloyal as to leave them out of your round. If foundersbecome more powerful, they'll be able to make investors give themmore money upfront.(The worst variant of this behavior is the tranched deal, where theinvestor makes a small initial investment, with more to follow ifthe startup does well. In effect, this structure gives the investora free option on the next round, which they'll only take if it'sworse for the startup than they could get in the open market.Tranched deals are an abuse. They're increasingly rare, and they'regoing to get rarer.) [11]Investors don't like trying to predict which startups will succeed,but increasingly they'll have to. Though the way that happens won'tnecessarily be that the behavior of existing investors will change;it may instead be that they'll be replaced by other investors withdifferent behavior—that investors who understand startupswell enough to take on the hard problem of predicting their trajectorywill tend to displace suits whose skills lie more in raising moneyfrom LPs.SpeedThe other thing founders hate most about fundraising is how longit takes. So as founders become more powerful, rounds should startto close faster.Fundraising is still terribly distracting for startups. If you'rea founder in the middle of raising a round, the round is the top idea in your mind, which means working on thecompany isn't. If a round takes 2 months to close, which isreasonably fast by present standards, that means 2 months duringwhich the company is basically treading water. That's the worstthing a startup could do.So if investors want to get the best deals, the way to do it willbe to close faster. Investors don't need weeks to make up theirminds anyway. We decide based on about 10 minutes of reading anapplication plus 10 minutes of in person interview, and we onlyregret about 10% of our decisions. If we can decide in 20 minutes,surely the next round of investors can decide in a couple days.[12]There are a lot of institutionalized delays in startup funding: themulti-week mating dance with investors; the distinction betweentermsheets and deals; the fact that each series A has enormouslyelaborate, custom paperwork. Both founders and investors tend totake these for granted. It's the way things have always been. Butultimately the reason these delays exist is that they're to theadvantage of investors. More time gives investors more informationabout a startup's trajectory, and it also tends to make startupsmore pliable in negotiations, since they're usually short of money.These conventions weren't designed to drag out the funding process,but that's why they're allowed to persist. Slowness is to theadvantage of investors, who have in the past been the ones with themost power. But there is no need for rounds to take months or evenweeks to close, and once founders realize that, it's going to stop.Not just in angel rounds, but in series A rounds too. The futureis simple deals with standard terms, done quickly.One minor abuse that will get corrected in the process is optionpools. In a traditional series A round, before the VCs invest theymake the company set aside a block of stock for future hires—usuallybetween 10 and 30% of the company. The point is to ensure thisdilution is borne by the existing shareholders. The practice isn'tdishonest; founders know what's going on. But it makes dealsunnecessarily complicated. In effect the valuation is 2 numbers.There's no need to keep doing this.[13]The final thing founders want is to be able to sell some oftheir own stock in later rounds. This won't be a change, because the practice is now quite common. A lot of investorshated the idea, but the world hasn't exploded as a result,so it will happen more, and more openly.SurpriseI've talked here about a bunch of changes that will be forced oninvestors as founders become more powerful. Now the good news:investors may actually make more money as a result.A couple days ago an interviewer asked me if founders having morepower would be better or worse for the world. I was surprised,because I'd never considered that question. Better or worse, it'shappening. But after a second's reflection, the answer seemedobvious. Founders understand their companies better than investors,and it has to be better if the people with more knowledge have morepower.One of the mistakes novice pilots make is overcontrolling theaircraft: applying corrections too vigorously, so the aircraftoscillates about the desired configuration instead of approachingit asymptotically. It seems probable that investors have till nowon average been overcontrolling their portfolio companies. In alot of startups, the biggest source of stress for the founders isnot competitors but investors. Certainly it was for us at Viaweb.And this is not a new phenomenon: investors were James Watt's biggestproblem too. If having less power prevents investors fromovercontrolling startups, it should be better not just for foundersbut for investors too.Investors may end up with less stock per startup, but startups willprobably do better with founders more in control, and there willalmost certainly be more of them. Investors all compete with oneanother for deals, but they aren't one another's main competitor.Our main competitor is employers. And so far that competitor iscrushing us. Only a tiny fraction of people who could start astartup do. Nearly all customers choose the competing product, ajob. Why? Well, let's look at the product we're offering. Anunbiased 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.Much of the stress comes from dealing with investors. If reformingthe investment process removed that stress, we'd make our productmuch more attractive. The kind of people who make good startupfounders don't mind dealing with technical problems—they enjoytechnical problems—but they hate the type of problems investorscause.Investors have noidea that when they maltreat one startup, they're preventing 10others from happening, but they are. Indirectly, but they are. Sowhen investors stop trying to squeeze a little more out of theirexisting deals, they'll find they're net ahead, because so manymore new deals appear.One of our axioms at Y Combinator is not to think of deal flow asa zero-sum game. Our main focus is to encourage more startups to happen,not to win a larger share of the existing stream. We've found thisprinciple very useful, and we think as it spreads outward it willhelp later stage investors as well."Make something people want"applies to us too.Notes[1]In this essay I'm talking mainly about software startups.These points don't apply to types of startups that are still expensiveto start, e.g. in energy or biotech.Even the cheap kinds of startups will generally raise large amountsat some point, when they want to hire a lot of people. What haschanged is how much they can get done before that.[2]It's not the distribution of good startups that has a powerlaw dropoff, but the distribution of potentially good startups,which is to say, good deals. There are lots of potential winners,from which a few actual winners emerge with superlinear certainty.[3]As I was writing this, I asked some founders who'd takenseries A rounds from top VC funds whether it was worth it, and theyunanimously said yes.The quality of investor is more important than the type of round,though. I'd take an angel round from good angels over a series Afrom a mediocre VC.[4]Founders also worry that taking an angel investment from aVC means they'll look bad if the VC declines to participate in thenext round. The trend of VC angel investing is so new that it'shard to say how justified this worry is.Another danger, pointed out by Mitch Kapor, is that if VCs are onlydoing angel deals to generate series A deal flow, then theirincentives aren't aligned with the founders'. The founders wantthe valuation of the next round to be high, and the VCs want it tobe low. Again, hard to say yet how much of a problem this will be.[5]Josh Kopelman pointed out that another way to be on fewerboards at once is to take board seats for shorter periods.[6]Google was in this respect as so many others the pattern forthe future. It would be great for VCs if the similarity extendedto returns. That's probably too much to hope for, but the returnsmay be somewhat higher, as I explain later.[7]Doing a rolling close doesn't mean the company is alwaysraising money. That would be a distraction. The point of a rollingclose is to make fundraising take less time, not more. With aclassic fixed sized round, you don't get any money till all theinvestors agree, and that often creates a situation where they allsit waiting for the others to act. A rolling close usually preventsthis.[8]There are two (non-exclusive) causes of hot deals: the qualityof the company, and domino effects among investors. The former isobviously a better predictor of success.[9]Some of the randomness is concealed by the fact that investmentis a self fulfilling prophecy.[10]The shift in power to founders is exaggerated now becauseit's a seller's market. On the next downtick it will seem like Ioverstated the case. But on the next uptick after that, founderswill seem more powerful than ever.[11]More generally, it will become less common for the sameinvestor to invest in successive rounds, except when exercising anoption to maintain their percentage. When the same investor investsin successive rounds, it often means the startup isn't gettingmarket price. They may not care; they may prefer to work with aninvestor they already know; but as the investment market becomesmore efficient, it will become increasingly easy to get market priceif they want it. Which in turn means the investment community willtend to become more stratified.[12]The two 10 minuteses have 3 weeks between them so founderscan get cheap plane tickets, but except for that they could beadjacent.[13]I'm not saying option pools themselves will go away. They'rean administrative convenience. What will go away is investorsrequiring them.Thanks to Sam Altman, John Bautista, Trevor Blackwell,Paul Buchheit, Jeff Clavier,Patrick Collison, Ron Conway, Matt Cohler, Chris Dixon, Mitch Kapor,Josh Kopelman, Pete Koomen, Carolynn Levy, Jessica Livingston, ArielPoler, Geoff Ralston, Naval Ravikant, Dan Siroker, Harj Taggar, and Fred Wilsonfor reading drafts of this.
