The future of startup financing. Paul Graham talks about making an investment decision in 10 minutes

    More and more people with large personal capital come to the understanding that investing in startups with a competent approach can become a stronger asset than banks and mutual funds. The number of business angels and those who want to become them is growing due to various courses . In addition to profit, there is another factor - investment in startups allows you to be involved in visionary work and approaching the future, and not just trade in “water with sugar”.

    Easy money still remained in the states, but the trend is on the decline - fewer angels and ventures are giving cache for powerpoint startups. In Russia, easy money ended much faster, and now the only option to attract investment is to prove at the initial stage that the project can be cost-effective, in demand by people and has a large market for growth.

    Paul Graham talked about the future of financing startups five years ago, and has been engaged in this financing even longer, so I invite you to get acquainted with his views on this issue and compare with the current state of affairs and understand in what direction business angels will develop.

    The future of startup financing

    Paul Graham, August 2010
    Original - The Future of Startup Funding
    Translation - Dmitry Pichugin

    Two years ago, I wrote about what I called “a huge and unused opportunity to finance startups” - a growing gap between venture capital funds whose business model involves investing big money lump sums, and a large class of startups that need less money than funds are used to investing in. Increasingly, new projects need only a couple of hundred thousand dollars, and not a couple of millions. [1]

    Now this feature is being used much more actively. Investors have broken into a niche and are mastering it from two directions. Venture funds began to invest more actively in small amounts than a year ago, and at the same time last year there was a sharp increase in the number of investors of a new type: “super angels” who act like ordinary business angels (Translator's note: private venture investors, providing financial support to companies in the early stages of development), but operate on the money of other people, which brings them closer to venture capital funds.

    Although many investors enter the startup finance niche, there is still room for new ones in the market. The distribution of investors must be consistent with the distribution of startups, which varies exponentially. Based on this, there should be much more among investors who are willing to invest tens or hundreds of thousands than millions. [2]

    In fact, the "angels" may also benefit from the emergence of a large number of competitors in the niche. In this case, entrepreneurs will more trust in angel investments, and will probably prefer them in the future, even if they have the opportunity to try to attract a series of “A rounds” from the venture fund (Translator's note: more about the stages of venture investment can be found here) Now, one of the reasons startups prefer A Rounds is prestige. However, if the "angels" become more active and well-known investors in the market, then one day they will be able to compete in authority with venture capital funds.

    Naturally, prestige is not the main reason why startups prefer A Rounds. Having received a series of “A rounds”, a startup is likely to attract more attention of investors than in the case of an investment from an angel. Therefore, when a startup chooses between “A round” from a good venture capital fund and “angel” money, I usually advise you to choose the first. [3]

    But I believe that as long as the A Round series remains on the market, it is the venture capital funds that have to worry about the super-angels, and not vice versa. Despite the name, “super-angels” are actually mini-venture funds, and they are clearly targeting the place of existing funds.

    I think the story will be on their side. The situation is similar to those in which startups and large companies enter a new market. As soon as online video became technically possible, Youtube broke into a niche that appeared; at the same time, large media companies slowly and reluctantly began to explore new perspectives, driven more by fear than hope, and trying to protect their sphere of influence, rather than create something that the user needs. The same is true for PayPal. The pattern repeats again and again, usually ending with the victory of the aggressors. For the investment market, the aggressors are super-angels. Their whole business is built on providing angelic investments (in the same way, online video was the main business for YouTube). And venture capital funds usually make small investments just to create a starting point, with which it will be possible to launch a flow of deals for the full-fledged series of “A rounds”. [4]

    On the other hand, financing startups is a very unusual business. Almost all profits are concentrated in several of the most successful projects. And if the “super angel” was not able to find and invest its money in them, then he will be out of work even if he invested money in all the other participants.

    Venture capital funds
    Why won't venture capital funds start using smaller A rounds? A stumbling block is the fund’s participation in the management of every startup funded by it. Usually, during the “A round", the investor who provided the financing receives a seat on the board of directors. Suppose that an average startup lives for about 6 years and the partner responsible for the transaction can take part in managing no more than 12 startups at a time. In such a situation, an investment fund can only conclude two transactions per year for each partner.

    It always seemed to me that the solution to the problem was to refuse the foundation's policy to have a place on the board of directors of each startup. You don’t need to be on the board to help a startup. Perhaps venture capital funds consider the power received with a seat on the board of directors a certain guarantee that their money will not be wasted. But did they test this theory? Unless they tried to reduce their participation in startup management and afterwards did not find a decrease in profit, we can conclude that they did not even try to change the situation.

    I do not claim that venture capital funds do not help startups. Good funds help, and greatly. I’m just trying to say - in order to provide substantial assistance, it is not necessary to have a place on the board of directors. [5]

    How will it all end? Some venture capital funds will be able to adapt, increasing the number of small investments. I won’t be surprised if, by streamlining the selection process and reducing the number of seats on boards of directors, funds will be able to conclude 2-3 times more A series of rounds without losing quality.

    Other venture capital funds will be limited only to superficial changes. The threat is not fatal, and these organizations are very conservative. Such funds will not be brutally expelled from the market, but gradually, without realizing it, they will transfer to another business. These funds will continue to invest and even call it the “A round” series, but de facto they will be the “B round” series. [6]

    In these rounds, they will no longer be able to count on 25-40% of the startup, as it is now. Except for very bad situations, the founders do not need to sell such a large share of the company in the late stages of financing. Since non-adaptive funds will provide financing at a later stage, their profits from each successful startup will decrease accordingly. However, the number of failed transactions will also decrease. Because of this, the ratio of risk to profit may remain the same, or even improve. These funds will simply become investors of a different, more conservative type.

    Now in large "angel investments", which are increasingly competing with the series of "A rounds", investors are not taking as much startup capital as venture capital funds. Funds trying to compete with the "angels" by making more smaller deals will probably find that they will have to settle for less capital. And this is great news for startup founders: they will retain most of the company's capital under their control!

    The terms for the provision of angel rounds will also become less stringent. Not just less stringent than for the A rounds, but less stringent than the conditions for the angel rounds that they have ever been.

    In the future, Angel Investments will increasingly be limited to a certain amount or have a lead investor. Formerly, the usual course of action for any startup was to search for one angel who would act as a leading investor. With a leading investor who provides some (but not all) of the money, the startup will subsequently discuss the company's market value and size of the round. After that, the startup and the leading investor cooperate to find the rest of the investors.

    Rather, the future of angel investments looks like this: instead of a fixed round size, a startup will look for money, negotiating with each investor individually (the so-called “rolling close”). This will continue until the founders decide that there is enough money. [7]

    And although there will be one, the very first investor, and his help in finding and negotiating with investors, of course, will be welcomed, this investor will not be the "leader" in the old sense of managing the round. Now the startup will do this on its own.

    The so-called “Leading investors” who will take on the role of helping startups with business advice. These investors can also make the largest investment in startups, but now they will not always be the only negotiating party or the first to write a check. The unified documentation will end the need to agree on something other than a market assessment of the project. And it will simplify this process.

    If several investors start from the same market value of the project, this will be the amount that convinces the first one to write a check. However, you need to consider whether this value will scare off other investors. It is not necessary to dwell on a one-time assessment of the cost of a startup. Startups are increasingly attracting money with the help of convertible bonds, which do not give a share in the company, but define a “limit for assessing market value”: when converting a debt into capital (during a subsequent revaluation or privatization, whichever comes first), such an investor will receive a share of capital from discount determined by convertible bond. This is a very important difference, because it gives a startup the opportunity to make several loans with different restrictions. At the moment, this method is only gaining ground, but I guess that he will become more popular. (Translator's note: Read more about convertible )

    The reason for the current events is that for startups, the old ways were frankly bad. Leading investors could use and use a fixed round size to justify the position that all startup founders hate: “I invest if others invest.” Most investors are not able to evaluate startups on their own - instead, they rely on the opinions of other investors. If other investors participate, then they will be, and if not, then no. Founders of startups hate this attitude because it leads to a stalemate and a delay, and this is the last thing a startup can afford. Most investors understand that such a course of action is ineffective, and very few openly admit that they work according to this scheme. The most inventive of investors achieve the same effect, offering fixed rounds and providing only a fraction of the amount needed to finance. If the startup can not find the missing, then they exit the transaction. How can you succeed with such a deal? Startup will be underfunded!

    In the future, investors will no longer be able to offer investments with such uncertain conditions as the participation of other people. More precisely, such an investor will be the last in line. A startup will resort to their money only if it is necessary to supplement an already almost funded round. And considering that there are usually more money than necessary for "hot" startups, being the last in the line means that they are likely to miss the hottest deals. Hot deals and successful startups are not the same thing, but they strongly correlate with each other. [8] Based on the foregoing, non-self-investing investors will be the losers.

    Surely investors will find that getting rid of this crutch, they will do better. The pursuit of attractive deals does not force the investor to choose more carefully, but makes them feel better about their choice. I have seen the birth and extinction of more than one investment fever and, as far as I can tell, they are usually random. [9] If investors can no longer count on herd instinct, they will be forced to carefully analyze each startup before investing. They will probably be surprised how well this works.

    Stalemate is not the only unpleasant consequence of transferring angel investment management to a leading investor. Investors often conspire to push the market value of a startup down. Or a round of raising funds for too long, because an investor in search of money does not have a tenth of the motivation of the founders of a startup.

    Increasingly, startups themselves manage their "angel rounds." So far, only a few have gone so far, but I think that this is sufficient reason to declare the former method dead, because some of them are the best startups. They are the ones who can impose their vision of the round on the investor. And if the startup you want to invest in works according to a certain principle, then what's the difference, how do the others work?

    In fact, to say that “angel investments” are increasingly supplanting the “A rounds” series is a misconception. In fact, rounds controlled by startups are starting to replace rounds controlled by investors.

    This is an example of a very important general trend on which Y Combinator was founded from the very beginning: founders are becoming more influential compared to investors. Therefore, if you want to predict how venture financing will develop, then just ask: “How do founders of startups want to see it?” Anything that did not suit the founders in the financing process will be eliminated one by one. [10]

    Having resorted to heuristics, I will predict several things. Firstly, investors will no longer be able to wait until the startup “gains momentum” before they begin to invest significant amounts in it. It is difficult to predict in advance which of the startups will fire. Therefore, now the strategy of most investors is to wait until the startup succeeds, and then quickly come up with an offer. Startups also hate this approach, because it can create a stalemate, and also because it seems like a scam. If you are a promising, but still not sufficiently developed startup, then most investors will be your friends in words, but you won’t get any work done from them. They will loudly declare that they support you, but they will keep the money with them. However, when the startup starts to grow, they will claim to have supported you all this time and they’re just horrified by the thought, you’ll be so ungrateful that you leave them out of your “round”. If the founders become more influential, they will be able to get a large amount of money in advance from investors.

    (The worst manifestation of this approach is tranche financing. In this case, the investor makes a small initial investment with the intention of investing more in the future, but only if the startup is successful. In fact, this approach allows the investor to freely exit the next round of financing And the investor will use it if he finds a better option on the market. A transaction that includes tranche financing is clearly an abuse. Such transactions are very rare and will be used in the future. is smaller.) [11]

    Although investors do not like to predict which of the startups will be successful, they will have to do this more often. However, it is not a fact that the current situation will make them change. Perhaps they will simply be replaced by investors with a different attitude to startups - investors who understand startups well enough to cope with the problem of predicting the project's trajectory. These new investors will gradually supplant those dealers whose skills lie mainly in the plane of receiving money from other investors.

    Another side of the fundraising process that the founders hate is the sheer amount of time it takes. Therefore, with the growing influence of startup founders, rounds will be gained in less time.

    The search for investments is still very distracting for a startup. If the founders are in the middle of the process of finding financing, then it is a priority in their minds, which negatively affects the main field of the startup’s activity. If the search process takes two months (which is acceptable by today's standards), this means that for 2 months the campaign actually pushes water in the mortar. And this is the worst thing a startup can do.

    Therefore, if investors want to make better deals, then they will have to provide funds much faster. Investors do not need weeks to make a decision. We make a decision based on 10 minutes of reading the application and 10 minutes of interviews with the candidate and regret only 10% of the decisions. If we are able to make a decision in 20 minutes, then future investors will be able to do the same in a few days. [12]

    There are many established delays in the financing of startups: a week-long nuptial dance with investors; differences between the initial dates and the actual duration of the transaction; the need for complex work with documents for each series of “A rounds”. They are taken for granted by both investors and founders - simply because it has always been so. However, the initial reason for these delays is that they are beneficial to investors. More time gives investors more information about the development of the project, and besides, time usually makes strataps more negotiable, as they need money.

    Initially, these customs were not intended to delay the financing process, but only because of this effect they are still used. The slowness of the process plays into the hands of investors, the parties more influential in the past. But as soon as the founders realize the optionality of these delays, the rounds will no longer take months or even weeks. This will be true not only for “angel investments”, but also for the series “A rounds”. The future lies in simple transactions with standard conditions that will be concluded in the shortest possible time.

    Another minor abuse that will be fixed in the process is the option pool. In the traditional “A rounds” series, before investing, the venture fund forces the company to postpone 10-30% of the total number of shares in the company. This unit is intended for future employees of the company. The point is to maintain the division of the company for already invested shareholders. This practice is not dishonest (the founders understand what is happening), but unnecessarily complicates the transaction. As a result, market value is estimated in two different numbers. There is no reason to continue using this method. [thirteen]

    And the last opportunity that the founders want to achieve is the right to sell part of their own shares in subsequent “rounds”. This will not change much, since this practice is already quite common. Many investors are not enthusiastic about this idea, but the world will not stop turning from their discontent, so this will happen more and more often.

    I have already spoken about the many changes that investors will be forced to accept due to the increased influence of the founders. And now for the good news: as a result, investors can earn even more money.

    A couple of days ago, a reporter asked me whether the growth of the influence of the founders will be for better or for worse. I was surprised because I never asked myself this question. Now this is happening: for better or for worse. However, after a second reflection on the question, the answer seemed obvious. Founders better understand their companies than investors, and usually the situation is better when people with more knowledge have more power.

    One of the common mistakes of inexperienced pilots is that they control the device too carefully. They are too energetically making adjustments. Because of this, the plane oscillates around the desired course, instead of approaching it asymptotically. It seems that so far, investors have been too diligent in controlling companies in their portfolio. In many startups, the most stress for the founders was not competitors, but investors. That was definitely the case for us in Viaweb. And this is not a new phenomenon: even for James Watt, investors were the biggest of the problems. If the loss of influence prevents excessive control of startups by investors, it will be for the best not only for the founders, but also for the investors themselves.

    For investors, everything will probably end with a decrease in their share in each individual startup, but for startups themselves, increased control by the founders will probably benefit projects and will provoke the emergence of new startups. Investors compete with each other, but they are not direct competitors to each other. Our main opponent is employers. And while they are crushingly winning - only a small number of people who have the opportunity to create a startup really create it. While almost everyone chooses a competing product - a permanent job. What is the reason? Let's take a look at the product we offer. An unbiased review will look something like this:

    Creating a startup will give you more freedom and a chance to earn much more money than a permanent job, but it is also very hard work, often causing great stress.

    A lot of stress comes from investor relations. If reforming the investment process relieves this stress, then we can make our product even more attractive. The type of people who create great startups don't worry about technical issues. They even enjoy the process of solving them. However, they hate the problems posed by investors.

    Investors have no idea that by treating one startup brutally, they prevent the appearance of 10 others. However, this is so. Therefore, when investors do stop trying to squeeze “even a little more” out of existing projects, they will find themselves in the gain, because there will be more new deals.

    One of our axioms in Y Combinator is not to consider the flow of transactions as a zero-sum game. Our main task is to contribute to the emergence of new startups, and not to snatch a larger piece from them. In our opinion, this principle is extremely useful, and if it spreads outward, it will help investors who invest money at later stages.

    The principle of “do what people need” applies to us.

    [1] In this essay, I mainly discuss startups related to software development. This point of view does not apply to startups that need a large start-up capital, such as startups in the field of energy or biotechnology.
    Even cheap startups will require a lot of investment when they hire a large number of employees. The difference is how much they manage to do before this point.

    [2] Not only the number of good start-ups is determined by the exponent, but also the number of potentially good start-ups, in other words, good deals for investors. There are many potential winners, of which only a few will reach the end.

    [3] In the process of writing this article, I asked a few entrepreneurs whose startups attracted A Rounds from the best venture funds. The question was: "Was it worth it?" They unanimously agreed what was worth it.
    However, the investor's reputation is clearly more important than the type of round. I would prefer an “angel round” from a good angel, “A round” from a mediocre venture capital fund.

    [4] Founders of startups are also worried that getting the initial investment from the venture capital fund will mean that their project is worthless if the fund refuses to participate in the next round. The initial investment trend from venture capital funds is still so new that it is difficult to say how justified these fears are.

    Another danger noted by Mitch Kapor is that venture funds provide small investments only as a starting point to initiate a flow of transactions for the next series of “A rounds,” then the goals of the founding founders and founders do not match. Founders want the market value of a startup in anticipation of the next round to be high, while the fund wants to keep it low. I repeat, it is still difficult to say how serious this problem can become.

    [5] Josh Kopelman (Josh Kopelman) noted another way to reduce the labor costs of funds in startup management - to reduce the time of participation in the board of directors of each of the projects.

    [6] From this point of view, Google, like many others, was a template for the future. It would be great for venture capital funds if the similarity extended to profits, but I think these are too optimistic expectations. However, their profit is likely to be higher. I will explain the reason for this later.

    [7] Following the “rolling close” scheme does not mean that a startup is always in search of funding. That would be too distracting. The point here is to make the search for financing take as little time as possible, and not more. The classic “round” of financing means that you will not receive money until all investors come to an agreement. Often this leads to a situation where all investors are inactive and expect activity from other players. Following a rolling close strategy usually prevents this outcome.

    [8] There are two mutually exclusive reasons for the appearance of “hot deals”: ​​the quality of the company and the domino effect among investors. The first is obviously the best harbinger of success.

    [9] Part of the fact of chance is masked by the fact that investing is essentially a self-fulfilling prophecy.

    [10] At the moment, the shift in power towards the founders is somewhat exaggerated, since the market is in the hands of sellers. At the first decrease in the trend, it will seem that I overestimated the degree of shift, but already at the next increase in the trend after it, the founders will find themselves more influential than ever.

    [11] In general, a situation will become less common when one investor is invested in several consecutive “rounds”. An exception is an attempt to maintain a percentage of the company. When the same investor invests in successive rounds, this usually means that the startup does not receive a market price. Perhaps this will not bother the founders. Perhaps they will prefer to work with an already well-known investor. But with increasing the efficiency of the investment market, it will be easier to get the market price for a startup, provided that the founders want it. In turn, this means an increasing differentiation of the investor community.

    [12] Usually 3 weeks pass between these ten minutes. This allows founders to rely on cheap plane tickets. However, with the exception of this, ten minutes can pass without a break.

    [13] I do not presume to say that option pools will completely disappear. They are a convenient administrative advantage. What will disappear is investors requiring their use.

    The author thanks : 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, Ariel Poler, Geoff Ralston, Naval Ravikant, Dan Siroker, Harj Taggar, and Fred Wilson for their help in writing this article.

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