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August 2010  
  
Two years ago I wrote about what I called "a huge, unexploited opportunity in
startup funding:" the growing disconnect between VCs, whose current business
model requires them to invest large amounts, and a large class of startups
that need less than they used to. Increasingly, startups want a couple hundred
thousand dollars, not a couple million.   
  
The opportunity is a lot less unexploited now. Investors have poured into this
territory from both directions. VCs are much more likely to make angel-sized
investments than they were a year ago. And meanwhile the past year has seen a
dramatic increase in a new type of investor: the super-angel, who operates
like an angel, but using other people's money, like a VC.  
  
Though a lot of investors are entering this territory, there is still room for
more. The distribution of investors should mirror the distribution of
startups, which has the usual power law dropoff. So there should be a lot more
people investing tens or hundreds of thousands than millions.   
  
In fact, it may be good for angels that there are more people doing angel-
sized deals, because if angel rounds become more legitimate, then startups may
start to opt for angel rounds even when they could, if they wanted, raise
series A rounds from VCs. One reason startups prefer series A rounds is that
they're more prestigious. But if angel investors become more active and better
known, they'll increasingly be able to compete with VCs in brand.  
  
Of course, prestige isn't the main reason to prefer a series A round. A
startup will probably get more attention from investors in a series A round
than an angel round. So if a startup is choosing between an angel round and an
A round from a good VC fund, I usually advise them to take the A round.   
  
But while series A rounds aren't going away, I think VCs should be more
worried about super-angels than vice versa. Despite their name, the super-
angels are really mini VC funds, and they clearly have existing VCs in their
sights.  
  
They would seem to have history on their side. The pattern here seems the same
one we see when startups and established companies enter a new market. Online
video becomes possible, and YouTube plunges right in, while existing media
companies embrace it only half-willingly, driven more by fear than hope, and
aiming more to protect their turf than to do great things for users. Ditto for
PayPal. This pattern is repeated over and over, and it's usually the invaders
who win. In this case the super-angels are the invaders. Angel rounds are
their whole business, as online video was for YouTube. Whereas VCs who make
angel investments mostly do it as a way to generate deal flow for series A
rounds.   
  
On the other hand, startup investing is a very strange business. Nearly all
the returns are concentrated in a few big winners. If the super-angels merely
fail to invest in (and to some extent produce) the big winners, they'll be out
of business, even if they invest in all the others.  
  
**VCs**  
  
Why don't VCs start doing smaller series A rounds? The sticking point is board
seats. In a traditional series A round, the partner whose deal it is takes a
seat on the startup's board. If we assume the average startup runs for 6 years
and a partner can bear to be on 12 boards at once, then a VC fund can do 2
series A deals per partner per year.  
  
It has always seemed to me the solution is to take fewer board seats. You
don't have to be on the board to help a startup. Maybe VCs feel they need the
power that comes with board membership to ensure their money isn't wasted. But
have they tested that theory? Unless they've tried not taking board seats and
found their returns are lower, they're not bracketing the problem.  
  
I'm not saying VCs don't help startups. The good ones help them a lot. What
I'm saying is that the kind of help that matters, you may not have to be a
board member to give.   
  
How will this all play out? Some VCs will probably adapt, by doing more,
smaller deals. I wouldn't be surprised if by streamlining their selection
process and taking fewer board seats, VC funds could do 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 are
conservative, and the threat to them isn't mortal. The VC funds that don't
adapt won't be violently displaced. They'll edge gradually into a different
business without realizing it. They'll still do what they will call series A
rounds, but these will increasingly be de facto series B rounds.   
  
In such rounds they won't get the 25 to 40% of the company they do now. You
don't give up as much of the company in later rounds unless something is
seriously wrong. Since the VCs who don't adapt will be investing later, their
returns from winners may be smaller. But investing later should also mean they
have fewer losers. So their ratio of risk to return may be the same or even
better. They'll just have become a different, more conservative, type of
investment.  
  
**Angels**  
  
In the big angel rounds that increasingly compete with series A rounds, the
investors won't take as much equity as VCs do now. And VCs who try to compete
with angels by doing more, smaller deals will probably find they have to take
less equity to do it. Which is good news for founders: they'll get to keep
more of the company.  
  
The deal terms of angel rounds will become less restrictive too—not just less
restrictive than series A terms, but less restrictive than angel terms have
traditionally been.  
  
In the future, angel rounds will less often be for specific amounts or have a
lead investor. In the old days, the standard m.o. for startups was to find one
angel to act as the lead investor. You'd negotiate a round size and valuation
with the lead, who'd supply some but not all of the money. Then the startup
and the lead would cooperate to find the rest.  
  
The future of angel rounds looks more like this: instead of a fixed round
size, startups will do a rolling close, where they take money from investors
one at a time till they feel they have enough.  And though there's going to
be one investor who gives them the first check, and his or her help in
recruiting other investors will certainly be welcome, this initial investor
will no longer be the lead in the old sense of managing the round. The startup
will now do that themselves.  
  
There will continue to be lead investors in the sense of investors who take
the lead in _advising_ a startup. They may also make the biggest investment.
But they won't always have to be the one terms are negotiated with, or be the
first money in, as they have in the past. Standardized paperwork will do away
with the need to negotiate anything except the valuation, and that will get
easier too.  
  
If multiple investors have to share a valuation, it will be whatever the
startup can get from the first one to write a check, limited by their guess at
whether this will make later investors balk. But there may not have to be just
one valuation. Startups are increasingly raising money on convertible notes,
and convertible notes have not valuations but at most valuation _caps_ : caps
on what the effective valuation will be when the debt converts to equity (in a
later round, or upon acquisition if that happens first). That's an important
difference because it means a startup could do multiple notes at once with
different caps. This is now starting to happen, and I predict it will become
more common.  
  
**Sheep**  
  
The reason things are moving this way is that the old way sucked for startups.
Leads could (and did) use a fixed size round as a legitimate-seeming way of
saying what all founders hate to hear: I'll invest if other people will. Most
investors, unable to judge startups for themselves, rely instead on the
opinions of other investors. If everyone wants in, they want in too; if not,
not. Founders hate this because it's a recipe for deadlock, and delay is the
thing a startup can least afford. Most investors know this m.o. is lame, and
few say openly that they're doing it. But the craftier ones achieve the same
result by offering to lead rounds of fixed size and supplying only part of the
money. If the startup can't raise the rest, the lead is out too. How could
they go ahead with the deal? The startup would be underfunded!  
  
In the future, investors will increasingly be unable to offer investment
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 mostly subscribed. And since hot startups tend to have rounds
that are oversubscribed, being last in line means they'll probably miss the
hot deals. Hot deals and successful startups are not identical, but there is a
significant correlation.  So investors who won't invest unilaterally will
have lower returns.  
  
Investors will probably find they do better when deprived of this crutch
anyway. Chasing hot deals doesn't make investors choose better; it just makes
them feel better about their choices. I've seen feeding frenzies both form and
fall apart many times, and as far as I can tell they're mostly random.  If
investors can no longer rely on their herd instincts, they'll have to think
more about each startup before investing. They may be surprised how well this
works.  
  
Deadlock wasn't the only disadvantage of letting a lead investor manage an
angel round. The investors would not infrequently collude to push down the
valuation. And rounds took too long to close, because however motivated the
lead was to get the round closed, he was 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 old way dead, because those
few are the best startups. They're the ones 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?  
  
**Traction**  
  
In fact, it may be slightly misleading to say that angel rounds will
increasingly take the place of series A rounds. What's really happening is
that startup-controlled rounds are taking the place of investor-controlled
rounds.  
  
This is an instance of a very important meta-trend, one that Y Combinator
itself has been based on from the beginning: founders are becoming
increasingly powerful relative to investors. So if you 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 the things founders dislike about raising money are
going to get eliminated.   
  
Using that heuristic, I'll predict a couple more things. One is that investors
will increasingly be unable to wait for startups to have "traction" before
they put in significant money. It's hard to predict in advance which startups
will succeed. So most investors prefer, 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 it
seems kind of slimy. If you're a promising startup but don't yet have
significant growth, all the investors are your friends in words, but few are
in actions. They all say they love you, but they all wait to invest. Then when
you start to see growth, they claim they were your friend all along, and are
aghast at the thought you'd be so disloyal as to leave them out of your round.
If founders become more powerful, they'll be able to make investors give them
more money upfront.  
  
(The worst variant of this behavior is the tranched deal, where the investor
makes a small initial investment, with more to follow if the startup does
well. In effect, this structure gives the investor a free option on the next
round, which they'll only take if it's worse for the startup than they could
get in the open market. Tranched deals are an abuse. They're increasingly
rare, and they're going to get rarer.)   
  
Investors don't like trying to predict which startups will succeed, but
increasingly they'll have to. Though the way that happens won't necessarily be
that the behavior of existing investors will change; it may instead be that
they'll be replaced by other investors with different behavior—that investors
who understand startups well enough to take on the hard problem of predicting
their trajectory will tend to displace suits whose skills lie more in raising
money from LPs.  
  
**Speed**  
  
The other thing founders hate most about fundraising is how long it takes. So
as founders become more powerful, rounds should start to close faster.  
  
Fundraising is still terribly distracting for startups. If you're a founder in
the middle of raising a round, the round is the top idea in your mind, which
means working on the company isn't. If a round takes 2 months to close, which
is reasonably fast by present standards, that means 2 months during which the
company is basically treading water. That's the worst thing a startup could
do.  
  
So if investors want to get the best deals, the way to do it will be to close
faster. Investors don't need weeks to make up their minds anyway. We decide
based on about 10 minutes of reading an application plus 10 minutes of in
person interview, and we only regret about 10% of our decisions. If we can
decide in 20 minutes, surely the next round of investors can decide in a
couple days.   
  
There are a lot of institutionalized delays in startup funding: the multi-week
mating dance with investors; the distinction between termsheets and deals; the
fact that each series A has enormously elaborate, custom paperwork. Both
founders and investors tend to take these for granted. It's the way things
have always been. But ultimately the reason these delays exist is that they're
to the advantage of investors. More time gives investors more information
about a startup's trajectory, and it also tends to make startups more 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 the advantage of investors, who
have in the past been the ones with the most power. But there is no need for
rounds to take months or even weeks to close, and once founders realize that,
it's going to stop. Not just in angel rounds, but in series A rounds too. The
future is simple deals with standard terms, done quickly.  
  
One minor abuse that will get corrected in the process is option pools. In a
traditional series A round, before the VCs invest they make the company set
aside a block of stock for future hires—usually between 10 and 30% of the
company. The point is to ensure this dilution is borne by the existing
shareholders. The practice isn't dishonest; founders know what's going on. But
it makes deals unnecessarily complicated. In effect the valuation is 2
numbers. There's no need to keep doing this.   
  
The final thing founders want is to be able to sell some of their own stock in
later rounds. This won't be a change, because the practice is now quite
common. A lot of investors hated the idea, but the world hasn't exploded as a
result, so it will happen more, and more openly.  
  
**Surprise**  
  
I've talked here about a bunch of changes that will be forced on investors 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 more power would
be better or worse for the world. I was surprised, because I'd never
considered that question. Better or worse, it's happening. But after a
second's reflection, the answer seemed obvious. Founders understand their
companies better than investors, and it has to be better if the people with
more knowledge have more power.  
  
One of the mistakes novice pilots make is overcontrolling the aircraft:
applying corrections too vigorously, so the aircraft oscillates about the
desired configuration instead of approaching it asymptotically. It seems
probable that investors have till now on average been overcontrolling their
portfolio companies. In a lot of startups, the biggest source of stress for
the founders is not competitors but investors. Certainly it was for us at
Viaweb. And this is not a new phenomenon: investors were James Watt's biggest
problem too. If having less power prevents investors from overcontrolling
startups, it should be better not just for founders but for investors too.  
  
Investors may end up with less stock per startup, but startups will probably
do better with founders more in control, and there will almost certainly be
more of them. Investors all compete with one another for deals, but they
aren't one another's main competitor. Our main competitor is employers. And so
far that competitor is crushing us. Only a tiny fraction of people who could
start a startup do. Nearly all customers choose the competing product, a job.
Why? Well, let's look at the product we're offering. An unbiased 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 reforming the
investment process removed that stress, we'd make our product much more
attractive. The kind of people who make good startup founders don't mind
dealing with technical problems—they enjoy technical problems—but they hate
the type of problems investors cause.  
  
Investors have no idea that when they maltreat one startup, they're preventing
10 others from happening, but they are. Indirectly, but they are. So when
investors stop trying to squeeze a little more out of their existing deals,
they'll find they're net ahead, because so many more new deals appear.  
  
One of our axioms at Y Combinator is not to think of deal flow as a 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 this principle very useful,
and we think as it spreads outward it will help later stage investors as well.  
  
"Make something people want" applies to us too.  
  
  
  
  
  
**