November 2005Venture funding works like gears. A typical startup goes throughseveral rounds of funding, and at each round you want to take justenough money to reach the speed where you can shift into the nextgear.Few startups get it quite right. Many are underfunded. A few areoverfunded, which is like trying to start driving in third gear.I think it would help founders to understand funding better—notjust the mechanics of it, but what investors are thinking. I wassurprised recently when I realized that all the worst problems wefaced in our startup were due not to competitors, but investors.Dealing with competitors was easy by comparison.I don't mean to suggest that our investors were nothing but a dragon us. They were helpful in negotiating deals, for example. Imean more that conflicts with investors are particularly nasty.Competitors punch you in the jaw, but investors have you by theballs.Apparently our situation was not unusual. And if trouble withinvestors is one of the biggest threats to a startup, managing themis one of the most important skills founders need to learn.Let's start by talking about the five sources of startup funding.Then we'll trace the life of a hypothetical (very fortunate) startupas it shifts gears through successive rounds.Friends and FamilyA lot of startups get their first funding from friends and family.Excite did, for example: after the founders graduated from college,they borrowed $15,000 from their parents to start a company. Withthe help of some part-time jobs they made it last 18 months.If your friends or family happen to be rich, the line blurs betweenthem and angel investors. At Viaweb we got our first $10,000 ofseed money from our friend Julian, but he was sufficiently richthat it's hard to say whether he should be classified as a friendor angel. He was also a lawyer, which was great, because it meantwe didn't have to pay legal bills out of that initial small sum.The advantage of raising money from friends and family is thatthey're easy to find. You already know them. There are three maindisadvantages: you mix together your business and personal life;they will probably not be as well connected as angels or venturefirms; and they may not be accredited investors, which couldcomplicate your life later.The SEC defines an "accredited investor" as someone with over amillion dollars in liquid assets or an income of over $200,000 ayear. The regulatory burden is much lower if a company's shareholdersare all accredited investors. Once you take money from the generalpublic you're more restricted in what you can do. [1]A startup's life will be more complicated, legally, if any of theinvestors aren't accredited. In an IPO, it might not merely addexpense, but change the outcome. A lawyer I asked about it said: When the company goes public, the SEC will carefully study all prior issuances of stock by the company and demand that it take immediate action to cure any past violations of securities laws. Those remedial actions can delay, stall or even kill the IPO.Of course the odds of any given startup doing an IPO are small.But not as small as they might seem. A lot of startups that end upgoing public didn't seem likely to at first. (Who could have guessedthat the company Wozniak and Jobs started in their spare time sellingplans for microcomputers would yield one of the biggest IPOs of thedecade?) Much of the value of a startup consists of that tinyprobability multiplied by the huge outcome.It wasn't because they weren't accredited investors that I didn'task my parents for seed money, though. When we were starting Viaweb,I didn't know about the concept of an accredited investor, anddidn't stop to think about the value of investors' connections.The reason I didn't take money from my parents was that I didn'twant them to lose it.ConsultingAnother way to fund a startup is to get a job. The best sort ofjob is a consulting project in which you can build whatever softwareyou wanted to sell as a startup. Then you can gradually transformyourself from a consulting company into a product company, and haveyour clients pay your development expenses.This is a good plan for someone with kids, because it takes mostof the risk out of starting a startup. There never has to be atime when you have no revenues. Risk and reward are usuallyproportionate, however: you should expect a plan that cuts the riskof starting a startup also to cut the average return. In this case,you trade decreased financial risk for increased risk that yourcompany won't succeed as a startup.But isn't the consulting company itself a startup? No, not generally.A company has to be more than small and newly founded to be astartup. There are millions of small businesses in America, butonly a few thousand are startups. To be a startup, a company hasto be a product business, not a service business. By which I meannot that it has to make something physical, but that it has to haveone thing it sells to many people, rather than doing custom workfor individual clients. Custom work doesn't scale. To be a startupyou need to be the band that sells a million copies of a song, notthe band that makes money by playing at individual weddings and barmitzvahs.The trouble with consulting is that clients have an awkward habitof calling you on the phone. Most startups operate close to themargin of failure, and the distraction of having to deal with clientscould be enough to put you over the edge. Especially if you havecompetitors who get to work full time on just being a startup.So you have to be very disciplined if you take the consulting route.You have to work actively to prevent your company growing into a"weed tree," dependent on this source of easy but low-margin money.[2]Indeed, the biggest danger of consulting may be that it gives youan excuse for failure. In a startup, as in grad school, a lot ofwhat ends up driving you are the expectations of your family andfriends. Once you start a startup and tell everyone that's whatyou're doing, you're now on a path labelled "get rich or bust." Younow have to get rich, or you've failed.Fear of failure is an extraordinarily powerful force. Usually itprevents people from starting things, but once you publish somedefinite ambition, it switches directions and starts working inyour favor. I think it's a pretty clever piece of jiujitsu to setthis irresistible force against the slightly less immovable objectof becoming rich. You won't have it driving you if your statedambition is merely to start a consulting company that you will oneday morph into a startup.An advantage of consulting, as a way to develop a product, is thatyou know you're making something at least one customer wants. Butif you have what it takes to start a startup you should havesufficient vision not to need this crutch.Angel InvestorsAngels are individual rich people. The word was first usedfor backers of Broadway plays, but now applies to individual investorsgenerally. Angels who've made money in technology are preferable,for two reasons: they understand your situation, and they're asource of contacts and advice.The contacts and advice can be more important than the money. Whendel.icio.us took money from investors, they took money from, amongothers, Tim O'Reilly. The amount he put in was small compared tothe VCs who led the round, but Tim is a smart and influential guyand it's good to have him on your side.You can do whatever you want with money from consulting or friendsand family. With angels we're now talking about venture fundingproper, so it's time to introduce the concept of exit strategy.Younger would-be founders are often surprised that investors expectthem either to sell the company or go public. The reason is thatinvestors need to get their capital back. They'll only considercompanies that have an exit strategy—meaning companies that couldget bought or go public.This is not as selfish as it sounds. There are few large, privatetechnology companies. Those that don't fail all seem to get boughtor go public. The reason is that employees are investors too—oftheir time—and they want just as much to be able to cash out. Ifyour competitors offer employees stock options that might make themrich, while you make it clear you plan to stay private, yourcompetitors will get the best people. So the principle of an "exit"is not just something forced on startups by investors, but part ofwhat it means to be a startup.Another concept we need to introduce now is valuation. When someonebuys shares in a company, that implicitly establishes a value forit. If someone pays $20,000 for 10% of a company, the company isin theory worth $200,000. I say "in theory" because in early stageinvesting, valuations are voodoo. As a company gets more established,its valuation gets closer to an actual market value. But in a newlyfounded startup, the valuation number is just an artifact of therespective contributions of everyone involved.Startups often "pay" investors who will help the company in someway by letting them invest at low valuations. If I had a startupand Steve Jobs wanted to invest in it, I'd give him the stock for$10, just to be able to brag that he was an investor. Unfortunately,it's impractical (if not illegal) to adjust the valuation of thecompany up and down for each investor. Startups' valuations aresupposed to rise over time. So if you're going to sell cheap stockto eminent angels, do it early, when it's natural for the companyto have a low valuation.Some angel investors join together in syndicates. Any city wherepeople start startups will have one or more of them. In Boston thebiggest is the CommonAngels. In the Bay Area it's the Bandof Angels. You can find groups near you through the Angel Capital Association.[3]However, most angel investors don't belong to these groups. Infact, the more prominent the angel, the less likely they are tobelong to a group.Some angel groups charge you money to pitch your idea to them.Needless to say, you should never do this.One of the dangers of taking investment from individual angels,rather than through an angel group or investment firm, is that theyhave less reputation to protect. A big-name VC firm will not screwyou too outrageously, because other founders would avoid them ifword got out. With individual angels you don't have this protection,as we found to our dismay in our own startup. In many startups'lives there comes a point when you're at the investors' mercy—when you're out of money and the only place to get more is yourexisting investors. When we got into such a scrape, our investorstook advantage of it in a way that a name-brand VC probably wouldn'thave.Angels have a corresponding advantage, however: they're also notbound by all the rules that VC firms are. And so they can, forexample, allow founders to cash out partially in a funding round,by selling some of their stock directly to the investors. I thinkthis will become more common; the average founder is eager to doit, and selling, say, half a million dollars worth of stock willnot, as VCs fear, cause most founders to be any less committed tothe business.The same angels who tried to screw us also let us do this, and soon balance I'm grateful rather than angry. (As in families, relationsbetween founders and investors can be complicated.)The best way to find angel investors is through personal introductions.You could try to cold-call angel groups near you, but angels, likeVCs, will pay more attention to deals recommended by someone theyrespect.Deal terms with angels vary a lot. There are no generally acceptedstandards. Sometimes angels' deal terms are as fearsome as VCs'.Other angels, particularly in the earliest stages, will invest basedon a two-page agreement.Angels who only invest occasionally may not themselves know whatterms they want. They just want to invest in this startup. Whatkind of anti-dilution protection do they want? Hell if they know.In these situations, the deal terms tend to be random: the angelasks his lawyer to create a vanilla agreement, and the terms endup being whatever the lawyer considers vanilla. Which in practiceusually means, whatever existing agreement he finds lying aroundhis firm. (Few legal documents are created from scratch.)These heaps o' boilerplate are a problem for small startups, becausethey tend to grow into the union of all preceding documents. Iknow of one startup that got from an angel investor what amountedto a five hundred pound handshake: after deciding to invest, theangel presented them with a 70-page agreement. The startup didn'thave enough money to pay a lawyer even to read it, let alone negotiatethe terms, so the deal fell through.One solution to this problem would be to have the startup's lawyerproduce the agreement, instead of the angel's. Some angels mightbalk at this, but others would probably welcome it.Inexperienced angels often get cold feet when the time comes towrite that big check. In our startup, one of the two angels in theinitial round took months to pay us, and only did after repeatednagging from our lawyer, who was also, fortunately, his lawyer.It's obvious why investors delay. Investing in startups is risky!When a company is only two months old, every day you waitgives you 1.7% more data about their trajectory. But the investoris already being compensated for that risk in the low price of thestock, so it is unfair to delay.Fair or not, investors do it if you let them. Even VCs do it. Andfunding delays are a big distraction for founders, who ought to beworking on their company, not worrying about investors. What's astartup to do? With both investors and acquirers, the only leverageyou have is competition. If an investor knows you have otherinvestors lined up, he'll be a lot more eager to close-- and notjust because he'll worry about losing the deal, but because if otherinvestors are interested, you must be worth investing in. It's thesame with acquisitions. No one wants to buy you till someone elsewants to buy you, and then everyone wants to buy you.The key to closing deals is never to stop pursuing alternatives.When an investor says he wants to invest in you, or an acquirersays they want to buy you, don't believe it till you get thecheck. Your natural tendency when an investor says yes willbe to relax and go back to writing code. Alas, you can't; you haveto keep looking for more investors, if only to get this one to act.[4]Seed Funding FirmsSeed firms are like angels in that they invest relatively smallamounts at early stages, but like VCs in that they're companiesthat do it as a business, rather than individuals making occasionalinvestments on the side.Till now, nearly all seed firms have been so-called "incubators,"so Y Combinator gets calledone too, though the only thing we have in common is that we investin the earliest phase.According to the National Association of Business Incubators, thereare about 800 incubators in the US. This is an astounding number,because I know the founders of a lot of startups, and I can't thinkof one that began in an incubator.What is an incubator? I'm not sure myself. The defining qualityseems to be that you work in their space. That's where the name"incubator" comes from. They seem to vary a great deal in otherrespects. At one extreme is the sort of pork-barrel project wherea town gets money from the state government to renovate a vacantbuilding as a "high-tech incubator," as if it were merely lack ofthe right sort of office space that had till now prevented the townfrom becoming a startup hub. At the other extreme are places likeIdealab, which generates ideas for new startups internally and hirespeople to work for them.The classic Bubble incubators, most of which now seem to be dead,were like VC firms except that they took a much bigger role in thestartups they funded. In addition to working in their space, youwere supposed to use their office staff, lawyers, accountants, andso on.Whereas incubators tend (or tended) to exert more control than VCs,Y Combinator exerts less. And we think it's better if startups operate out of their ownpremises, however crappy, than the offices of their investors. Soit's annoying that we keep getting called an "incubator," but perhapsinevitable, because there's only one of us so far and no word yetfor what we are. If we have to be called something, the obviousname would be "excubator." (The name is more excusable if oneconsiders it as meaning that we enable people to escape cubicles.)Because seed firms are companies rather than individual people,reaching them is easier than reaching angels. Just go to their website and send them an email. The importance of personal introductionsvaries, but is less than with angels or VCs.The fact that seed firms are companies also means the investmentprocess is more standardized. (This is generally true with angelgroups too.) Seed firms will probably have set deal terms they usefor every startup they fund. The fact that the deal terms arestandard doesn't mean they're favorable to you, but if other startupshave signed the same agreements and things went well for them, it'sa sign the terms are reasonable.Seed firms differ from angels and VCs in that they invest exclusivelyin the earliest phases—often when the company is still just anidea. Angels and even VC firms occasionally do this, but they alsoinvest at later stages.The problems are different in the early stages. For example, inthe first couple months a startup may completely redefine their idea. So seed investors usually care lessabout the idea than the people. This is true of all venture funding,but especially so in the seed stage.Like VCs, one of the advantages of seed firms is the advice theyoffer. But because seed firms operate in an earlier phase, theyneed to offer different kinds of advice. For example, a seed firmshould be able to give advice about how to approach VCs, which VCsobviously don't need to do; whereas VCs should be able to giveadvice about how to hire an "executive team," which is not an issuein the seed stage.In the earliest phases, a lot of the problems are technical, soseed firms should be able to help with technical as well as businessproblems.Seed firms and angel investors generally want to invest in theinitial phases of a startup, then hand them off to VC firms for thenext round. Occasionally startups go from seed funding direct toacquisition, however, and I expect this to become increasinglycommon.Google has been aggressively pursuing this route, and now Yahoo is too. Bothnow compete directly with VCs. And this is a smart move. Why waitfor further funding rounds to jack up a startup's price? When astartup reaches the point where VCs have enough information toinvest in it, the acquirer should have enough information to buyit. More information, in fact; with their technical depth, theacquirers should be better at picking winners than VCs.Venture Capital FundsVC firms are like seed firms in that they're actual companies, butthey invest other people's money, and much larger amounts of it.VC investments average several million dollars. So they tend tocome later in the life of a startup, are harder to get, and comewith tougher terms.The word "venture capitalist" is sometimes used loosely for anyventure investor, but there is a sharp difference between VCs andother investors: VC firms are organized as funds, much likehedge funds or mutual funds. The fund managers, who are called"general partners," get about 2% of the fund annually as a managementfee, plus about 20% of the fund's gains.There is a very sharp dropoff in performance among VC firms, becausein the VC business both success and failure are self-perpetuating.When an investment scores spectacularly, as Google did for Kleinerand Sequoia, it generates a lot of good publicity for the VCs. Andmany founders prefer to take money from successful VC firms, becauseof the legitimacy it confers. Hence a vicious (for the losers)cycle: VC firms that have been doing badly will only get the dealsthe bigger fish have rejected, causing them to continue to do badly.As a result, of the thousand or so VC funds in the US now, onlyabout 50 are likely to make money, and it is very hard for a newfund to break into this group.In a sense, the lower-tier VC firms are a bargain for founders.They may not be quite as smart or as well connected as the big-namefirms, but they are much hungrier for deals. This means you shouldbe able to get better terms from them.Better how? The most obvious is valuation: they'll take less ofyour company. But as well as money, there's power. I think founderswill increasingly be able to stay on as CEO, and on terms that willmake it fairly hard to fire them later.The most dramatic change, I predict,is that VCs will allow founders to cash out partially by sellingsome of their stock direct to the VC firm. VCs have traditionallyresisted letting founders get anything before the ultimate "liquidityevent." But they're also desperate for deals. And since I knowfrom my own experience that the rule against buying stock fromfounders is a stupid one, this is a natural place for things togive as venture funding becomes more and more a seller's market.The disadvantage of taking money from less known firms is thatpeople will assume, correctly or not, that you were turned down bythe more exalted ones. But, like where you went to college, thename of your VC stops mattering once you have some performance tomeasure. So the more confident you are, the less you need abrand-name VC. We funded Viaweb entirely with angel money; it neveroccurred to us that the backing of a well known VC firm would makeus seem more impressive.[5]Another danger of less known firms is that, like angels, they haveless reputation to protect. I suspect it's the lower-tier firmsthat are responsible for most of the tricks that have given VCssuch a bad reputation among hackers. They are doubly hosed: thegeneral partners themselves are less able, and yet they have harderproblems to solve, because the top VCs skim off all the best deals,leaving the lower-tier firms exactly the startups that are likelyto blow up.For example, lower-tier firms are much more likely to pretend towant to do a deal with you just to lock you up while they decideif they really want to. One experienced CFO said: The better ones usually will not give a term sheet unless they really want to do a deal. The second or third tier firms have a much higher break rate—it could be as high as 50%.It's obvious why: the lower-tier firms' biggest fear, when chancethrows them a bone, is that one of the big dogs will notice andtake it away. The big dogs don't have to worry about that.Falling victim to this trick could really hurt you. As oneVC told me: If you were talking to four VCs, told three of them that you accepted a term sheet, and then have to call them back to tell them you were just kidding, you are absolutely damaged goods.Here's a partial solution: when a VC offers you a term sheet, askhow many of their last 10 term sheets turned into deals. This willat least force them to lie outright if they want to mislead you.Not all the people who work at VC firms are partners. Most firmsalso have a handful of junior employees called something likeassociates or analysts. If you get a call from a VCfirm, go to their web site and check whether the person you talkedto is a partner. Odds are it will be a junior person; they scourthe web looking for startups their bosses could invest in. Thejunior people will tend to seem very positive about your company.They're not pretending; they want to believe you're a hotprospect, because it would be a huge coup for them if their firminvested in a company they discovered. Don't be misled by thisoptimism. It's the partners who decide, and they view things witha colder eye.Because VCs invest large amounts, the money comes with morerestrictions. Most only come into effect if the company gets intotrouble. For example, VCs generally write it into the deal thatin any sale, they get their investment back first. So if the companygets sold at a low price, the founders could get nothing. Some VCsnow require that in any sale they get 4x their investment backbefore the common stock holders (that is, you) get anything, butthis is an abuse that should be resisted.Another difference with large investments is that the founders areusually required to accept "vesting"—to surrender their stock andearn it back over the next 4-5 years. VCs don't want to investmillions in a company the founders could just walk away from.Financially, vesting has little effect, but in some situations itcould mean founders will have less power. If VCs got de factocontrol of the company and fired one of the founders, he'd lose anyunvested stock unless there was specific protection against this.So vesting would in that situation force founders to toe the line.The most noticeable change when a startup takes serious funding isthat the founders will no longer have complete control. Ten yearsago VCs used to insist that founders step down as CEO and hand thejob over to a business guy they supplied. This is less the rulenow, partly because the disasters of the Bubble showed that genericbusiness guys don't make such great CEOs.But while founders will increasingly be able to stay on as CEO,they'll have to cede some power, because the board of directorswill become more powerful. In the seed stage, the board is generallya formality; if you want to talk to the other board members, youjust yell into the next room. This stops with VC-scale money. Ina typical VC funding deal, the board of directors might be composedof two VCs, two founders, and one outside person acceptable to both.The board will have ultimate power, which means the founders nowhave to convince instead of commanding.This is not as bad as it sounds, however. Bill Gates is in thesame position; he doesn't have majority control of Microsoft; inprinciple he also has to convince instead of commanding. And yethe seems pretty commanding, doesn't he? As long as things are goingsmoothly, boards don't interfere much. The danger comes when there'sa bump in the road, as happened to Steve Jobs at Apple.Like angels, VCs prefer to invest in deals that come to them throughpeople they know. So while nearly all VC funds have some addressyou can send your business plan to, VCs privately admit the chanceof getting funding by this route is near zero. One recently toldme that he did not know a single startup that got funded this way.I suspect VCs accept business plans "over the transom" more as away to keep tabs on industry trends than as a source of deals. Infact, I would strongly advise against mailing your business planrandomly to VCs, because they treat this as evidence of laziness.Do the extra work of getting personal introductions. As one VC putit: I'm not hard to find. I know a lot of people. If you can't find some way to reach me, how are you going to create a successful company?One of the most difficult problems for startup founders is decidingwhen to approach VCs. You really only get one chance, because theyrely heavily on first impressions. And you can't approach some andsave others for later, because (a) they ask who else you've talkedto and when and (b) they talk among themselves. If you're talkingto one VC and he finds out that you were rejected by another severalmonths ago, you'll definitely seem shopworn.So when do you approach VCs? When you can convince them. If thefounders have impressive resumes and the idea isn't hard to understand,you could approach VCs quite early. Whereas if the founders areunknown and the idea is very novel, you might have to launch thething and show that users loved it before VCs would be convinced.If several VCs are interested in you, they will sometimes be willingto split the deal between them. They're more likely to do this ifthey're close in the VC pecking order. Such deals may be a net winfor founders, because you get multiple VCs interested in yoursuccess, and you can ask each for advice about the other. Onefounder I know wrote: Two-firm deals are great. It costs you a little more equity, but being able to play the two firms off each other (as well as ask one if the other is being out of line) is invaluable.When you do negotiate with VCs, remember that they've done this alot more than you have. They've invested in dozens of startups,whereas this is probably the first you've founded. But don't letthem or the situation intimidate you. The average founder is smarterthan the average VC. So just do what you'd do in any complex,unfamiliar situation: proceed deliberately, and question anythingthat seems odd.It is, unfortunately, common for VCs to put terms in an agreementwhose consequences surprise founders later, and also common for VCsto defend things they do by saying that they're standard in theindustry. Standard, schmandard; the whole industry is only a fewdecades old, and rapidly evolving. The concept of "standard" is auseful one when you're operating on a small scale (Y Combinatoruses identical terms for every deal because for tiny seed-stageinvestments it's not worth the overhead of negotiating individualdeals), but it doesn't apply at the VC level. On that scale, everynegotiation is unique.Most successful startups get money from more than one of the precedingfive sources. [6]And, confusingly, the names of funding sourcesalso tend to be used as the names of different rounds. The bestway to explain how it all works is to follow the case of a hypotheticalstartup.Stage 1: Seed RoundOur startup begins when a group of three friends have an idea--either an idea for something they might build, or simply the idea"let's start a company." Presumably they already have some sourceof food and shelter. But if you have food and shelter, you probablyalso have something you're supposed to be working on: eitherclasswork, or a job. So if you want to work full-time on a startup,your money situation will probably change too.A lot of startup founders say they started the company without anyidea of what they planned to do. This is actually less common thanit seems: many have to claim they thought of the idea after quittingbecause otherwise their former employer would own it.The three friends decide to take the leap. Since most startups arein competitive businesses, you not only want to work full-time onthem, but more than full-time. So some or all of the friends quittheir jobs or leave school. (Some of the founders in a startup canstay in grad school, but at least one has to make the company hisfull-time job.)They're going to run the company out of one of their apartments atfirst, and since they don't have any users they don't have to paymuch for infrastructure. Their main expenses are setting up thecompany, which costs a couple thousand dollars in legal work andregistration fees, and the living expenses of the founders.The phrase "seed investment" covers a broad range. To some VC firmsit means $500,000, but to most startups it means several months'living expenses. We'll suppose our group of friends start with$15,000 from their friend's rich uncle, who they give 5% of thecompany in return. There's only common stock at this stage. Theyleave 20% as an options pool for later employees (but they setthings up so that they can issue this stock to themselves if theyget bought early and most is still unissued), and the three founderseach get 25%.By living really cheaply they think they can make the remainingmoney last five months. When you have five months' runway left,how soon do you need to start looking for your next round? Answer:immediately. It takes time to find investors, and time (alwaysmore than you expect) for the deal to close even after they sayyes. So if our group of founders know what they're doing they'llstart sniffing around for angel investors right away. But of coursetheir main job is to build version 1 of their software.The friends might have liked to have more money in this first phase,but being slightly underfunded teaches them an important lesson.For a startup, cheapness is power. The lower your costs, the moreoptions you have—not just at this stage, but at every point tillyou're profitable. When you have a high "burn rate," you're alwaysunder time pressure, which means (a) you don't have time for yourideas to evolve, and (b) you're often forced to take deals you don'tlike.Every startup's rule should be: spend little, and work fast.After ten weeks' work the three friends have built a prototype thatgives one a taste of what their product will do. It's not whatthey originally set out to do—in the process of writing it, theyhad some new ideas. And it only does a fraction of what the finishedproduct will do, but that fraction includes stuff that no one elsehas done before.They've also written at least a skeleton business plan, addressingthe five fundamental questions: what they're going to do, why usersneed it, how large the market is, how they'll make money, and whothe competitors are and why this company is going to beat them.(That last has to be more specific than "they suck" or "we'll workreally hard.")If you have to choose between spending time on the demo or thebusiness plan, spend most on the demo. Software is not only moreconvincing, but a better way to explore ideas.Stage 2: Angel RoundWhile writing the prototype, the group has been traversing theirnetwork of friends in search of angel investors. They find somejust as the prototype is demoable. When they demo it, one of theangels is willing to invest. Now the group is looking for moremoney: they want enough to last for a year, and maybe to hire acouple friends. So they're going to raise $200,000.The angel agrees to invest at a pre-money valuation of $1 million.The company issues $200,000 worth of new shares to the angel; ifthere were 1000 shares before the deal, this means 200 additionalshares. The angel now owns 200/1200 shares, or a sixth of thecompany, and all the previous shareholders' percentage ownershipis diluted by a sixth. After the deal, the capitalization tablelooks like this:shareholder shares percent-------------------------------angel 200 16.7uncle 50 4.2each founder 250 20.8option pool 200 16.7 ---- -----total 1200 100To keep things simple, I had the angel do a straight cash for stockdeal. In reality the angel might be more likely to make theinvestment in the form of a convertible loan. A convertible loanis a loan that can be converted into stock later; it works out thesame as a stock purchase in the end, but gives the angel moreprotection against being squashed by VCs in future rounds.Who pays the legal bills for this deal? The startup, remember,only has a couple thousand left. In practice this turns out to bea sticky problem that usually gets solved in some improvised way.Maybe the startup can find lawyers who will do it cheaply in thehope of future work if the startup succeeds. Maybe someone has alawyer friend. Maybe the angel pays for his lawyer to representboth sides. (Make sure if you take the latter route that the lawyeris representing you rather than merely advising you, or hisonly duty is to the investor.)An angel investing $200k would probably expect a seat on the boardof directors. He might also want preferred stock, meaning a specialclass of stock that has some additional rights over the common stockeveryone else has. Typically these rights include vetoes over majorstrategic decisions, protection against being diluted in futurerounds, and the right to get one's investment back first if thecompany is sold.Some investors might expect the founders to accept vesting for asum this size, and others wouldn't. VCs are more likely to requirevesting than angels. At Viaweb we managed to raise $2.5 millionfrom angels without ever accepting vesting, largely because we wereso inexperienced that we were appalled at the idea. In practicethis turned out to be good, because it made us harder to push around.Our experience was unusual; vesting is the norm for amounts thatsize. Y Combinator doesn't require vesting, because (a) we investsuch small amounts, and (b) we think it's unnecessary, and that thehope of getting rich is enough motivation to keep founders at work.But maybe if we were investing millions we would think differently.I should add that vesting is also a way for founders to protectthemselves against one another. It solves the problem of what todo if one of the founders quits. So some founders impose it onthemselves when they start the company.The angel deal takes two weeks to close, so we are now three monthsinto the life of the company.The point after you get the first big chunk of angel money willusually be the happiest phase in a startup's life. It's a lot likebeing a postdoc: you have no immediate financial worries, and fewresponsibilities. You get to work on juicy kinds of work, likedesigning software. You don't have to spend time on bureaucraticstuff, because you haven't hired any bureaucrats yet. Enjoy itwhile it lasts, and get as much done as you can, because you willnever again be so productive.With an apparently inexhaustible sum of money sitting safely in thebank, the founders happily set to work turning their prototype intosomething they can release. They hire one of their friends—atfirst just as a consultant, so they can try him out—and then amonth later as employee #1. They pay him the smallest salary he canlive on, plus 3% of the company in restricted stock, vesting overfour years. (So after this the option pool is down to 13.7%). [7]They also spend a little money on a freelance graphic designer.How much stock do you give early employees? That varies so muchthat there's no conventional number. If you get someone reallygood, really early, it might be wise to give him as much stock asthe founders. The one universal rule is that the amount of stockan employee gets decreases polynomially with the age of the company.In other words, you get rich as a power of how early you were. Soif some friends want you to come work for their startup, don't waitseveral months before deciding.A month later, at the end of month four, our group of founders havesomething they can launch. Gradually through word of mouth theystart to get users. Seeing the system in use by real users—peoplethey don't know—gives them lots of new ideas. Also they findthey now worry obsessively about the status of their server. (Howrelaxing founders' lives must have been when startups wrote VisiCalc.)By the end of month six, the system is starting to have a solidcore of features, and a small but devoted following. People startto write about it, and the founders are starting to feel like expertsin their field.We'll assume that their startup is one that could put millions moreto use. Perhaps they need to spend a lot on marketing, or buildsome kind of expensive infrastructure, or hire highly paid salesmen.So they decide to start talking to VCs. They get introductions toVCs from various sources: their angel investor connects them witha couple; they meet a few at conferences; a couple VCs call themafter reading about them.Step 3: Series A RoundArmed with their now somewhat fleshed-out business plan and ableto demo a real, working system, the founders visit the VCs theyhave introductions to. They find the VCs intimidating and inscrutable.They all ask the same question: who else have you pitched to? (VCsare like high school girls: they're acutely aware of their positionin the VC pecking order, and their interest in a company is afunction of the interest other VCs show in it.)One of the VC firms says they want to invest and offers the foundersa term sheet. A term sheet is a summary of what the deal termswill be when and if they do a deal; lawyers will fill in the detailslater. By accepting the term sheet, the startup agrees to turnaway other VCs for some set amount of time while this firm does the"due diligence" required for the deal. Due diligence is the corporateequivalent of a background check: the purpose is to uncover anyhidden bombs that might sink the company later, like serious designflaws in the product, pending lawsuits against the company,intellectual property issues, and so on. VCs' legal and financialdue diligence is pretty thorough, but the technical due diligenceis generally a joke. [8]The due diligence discloses no ticking bombs, and six weeks laterthey go ahead with the deal. Here are the terms: a $2 millioninvestment at a pre-money valuation of $4 million, meaning thatafter the deal closes the VCs will own a third of the company (2 /(4 + 2)). The VCs also insist that prior to the deal the optionpool be enlarged by an additional hundred shares. So the totalnumber of new shares issued is 750, and the cap table becomes:shareholder shares percent-------------------------------VCs 650 33.3angel 200 10.3uncle 50 2.6each founder 250 12.8employee 36 1.8 unvestedoption pool 264 13.5 ---- -----total 1950 100This picture is unrealistic in several respects. For example, whilethe percentages might end up looking like this, it's unlikely thatthe VCs would keep the existing numbers of shares. In fact, everybit of the startup's paperwork would probably be replaced, as ifthe company were being founded anew. Also, the money might comein several tranches, the later ones subject to various conditions—though this is apparently more common in deals with lower-tier VCs(whose lot in life is to fund more dubious startups) than with thetop firms.And of course any VCs reading this are probably rolling on the floorlaughing at how my hypothetical VCs let the angel keep his 10.3 ofthe company. I admit, this is the Bambi version; in simplifyingthe picture, I've also made everyone nicer. In the real world, VCsregard angels the way a jealous husband feels about his wife'sprevious boyfriends. To them the company didn't exist before theyinvested in it. [9]I don't want to give the impression you have to do an angel roundbefore going to VCs. In this example I stretched things out toshow multiple sources of funding in action. Some startups could godirectly from seed funding to a VC round; several of the companieswe've funded have.The founders are required to vest their shares over four years, andthe board is now reconstituted to consist of two VCs, two founders,and a fifth person acceptable to both. The angel investor cheerfullysurrenders his board seat.At this point there is nothing new our startup can teach us aboutfunding—or at least, nothing good. [10]The startup will almostcertainly hire more people at this point; those millions must beput to work, after all. The company may do additional fundingrounds, presumably at higher valuations. They may if they areextraordinarily fortunate do an IPO, which we should remember isalso in principle a round of funding, regardless of its de factopurpose. But that, if not beyond the bounds of possibility, isbeyond the scope of this article.Deals Fall ThroughAnyone who's been through a startup will find the preceding portraitto be missing something: disasters. If there's one thing allstartups have in common, it's that something is always going wrong.And nowhere more than in matters of funding.For example, our hypothetical startup never spent more than halfof one round before securing the next. That's more ideal thantypical. Many startups—even successful ones—come close torunning out of money at some point. Terrible things happen tostartups when they run out of money, because they're designed forgrowth, not adversity.But the most unrealistic thing about the series of deals I'vedescribed is that they all closed. In the startup world, closingis not what deals do. What deals do is fall through. If you'restarting a startup you would do well to remember that. Birds fly;fish swim; deals fall through.Why? Partly the reason deals seem to fall through so often is thatyou lie to yourself. You want the deal to close, so you start tobelieve it will. But even correcting for this, startup deals fallthrough alarmingly often—far more often than, say, deals to buyreal estate. The reason is that it's such a risky environment.People about to fund or acquire a startup are prone to wicked casesof buyer's remorse. They don't really grasp the risk they're takingtill the deal's about to close. And then they panic. And not justinexperienced angel investors, but big companies too.So if you're a startup founder wondering why some angel investorisn't returning your phone calls, you can at least take comfort inthe thought that the same thing is happening to other deals a hundredtimes the size.The example of a startup's history that I've presented is like askeleton—accurate so far as it goes, but needing to be fleshedout to be a complete picture. To get a complete picture, just addin every possible disaster.A frightening prospect? In a way. And yet also in a way encouraging.The very uncertainty of startups frightens away almost everyone.People overvalue stability—especially youngpeople, who ironically need it least. And so in starting a startup,as in any really bold undertaking, merely deciding to do it getsyou halfway there. On the day of the race, most of the other runnerswon't show up.Notes[1]The aim of such regulations is to protect widows and orphansfrom crooked investment schemes; people with a million dollars inliquid assets are assumed to be able to protect themselves.The unintended consequence is that the investments that generatethe highest returns, like hedge funds, are available only to therich.[2]Consulting is where product companies go to die. IBM is themost famous example. So starting as a consulting company is likestarting out in the grave and trying to work your way up into theworld of the living.[3]If "near you" doesn't mean the Bay Area, Boston, or Seattle,consider moving. It's not a coincidence you haven't heard of manystartups from Philadelphia.[4]Investors are often compared to sheep. And they are like sheep,but that's a rational response to their situation. Sheep act theway they do for a reason. If all the other sheep head for a certainfield, it's probably good grazing. And when a wolf appears, is hegoing to eat a sheep in the middle of the flock, or one near theedge?[5]This was partly confidence, and partly simple ignorance. Wedidn't know ourselves which VC firms were the impressive ones. Wethought software was all that mattered. But that turned out to bethe right direction to be naive in: it's much better to overestimatethan underestimate the importance of making a good product.[6]I've omitted one source: government grants. I don't thinkthese are even worth thinking about for the average startup.Governments may mean well when they set up grant programs to encouragestartups, but what they give with one hand they take away with theother: the process of applying is inevitably so arduous, and therestrictions on what you can do with the money so burdensome, thatit would be easier to take a job to get the money.You should be especially suspicious of grants whose purpose is somekind of social engineering-- e.g. to encourage more startups to bestarted in Mississippi. Free money to start a startup in a placewhere few succeed is hardly free.Some government agencies run venture funding groups, which makeinvestments rather than giving grants. For example, the CIA runsa venture fund called In-Q-Tel that is modelled on private sectorfunds and apparently generates good returns. They would probablybe worth approaching—if you don't mind taking money from the CIA.[7]Options have largely been replaced with restricted stock, whichamounts to the same thing. Instead of earning the right to buystock, the employee gets the stock up front, and earns the rightnot to have to give it back. The shares set aside for this purposeare still called the "option pool."[8]First-rate technical people do not generally hire themselvesout to do due diligence for VCs. So the most difficultpart for startup founders is often responding politely to the inanequestions of the "expert" they send to look you over.[9]VCs regularly wipe out angels by issuing arbitrary amounts ofnew stock. They seem to have a standard piece of casuistry forthis situation: that the angels are no longer working to help thecompany, and so don't deserve to keep their stock. This of coursereflects a willful misunderstanding of what investment means; likeany investor, the angel is being compensated for risks he tookearlier. By a similar logic, one could argue that the VCs shouldbe deprived of their shares when the company goes public.[10]One new thing the company might encounter is a downround, or a funding round at valuation lower than the previousround. Down rounds are bad news; it is generally the common stockholders who take the hit. Some of the most fearsome provisions inVC deal terms have to do with down rounds—like "full ratchetanti-dilution," which is as frightening as it sounds.Founders are tempted to ignore these clauses, because they thinkthe company will either be a big success or a complete bust. VCsknow otherwise: it's not uncommon for startups to have moments ofadversity before they ultimately succeed. So it's worth negotiatinganti-dilution provisions, even though you don't think you need to,and VCs will try to make you feel that you're being gratuitouslytroublesome.Thanks to Sam Altman, Hutch Fishman, Steve Huffman, JessicaLivingston, Sesha Pratap, Stan Reiss, Andy Singleton, Zak Stone,and Aaron Swartz for reading drafts of this.
