The Future of Startup Funding

This is a really superb and thoughtful piece on the funding process. The only issue I would take is with the idea that funding terms will become standardized and the process routine. While, even as a lawyer, I would actually love to see this happen (we prosper right along with our startup clients and no one benefits from the waste that occurs with funding games), I have not seen this happen even as all sorts of standardized documents are now widely available to facilitate it. It can and does occur if the investors want to settle for terms protecting their basic interests but giving them no special advantages (what I call vanilla terms). That said, only the friendliest of investors will do this, and by "friendly," I mean in relation to the founders, and this usually means only friends and family or perhaps an individual angel or two that has a long history with one or more of the founders and wants above all other things to help promote the founders' interests. The rest of the angels, and most certainly the institutional ones (so-called "super angels") continue routinely to press for special advantages of one type or other. With special advantages come special terms and with this comes lawyer review, back-and-forth negotiations, and the like. In this sense, absent a <i>huge</i> shift in the balance of power toward founders, I don't see purely standardized documentation and routine processing becoming the order of the day anytime soon. Others may differ, and I may be wrong, but that's how I see this based on considerable day-to-day experience in this field. That said (for what it is worth), this is a brilliant essay that concisely encapsulates the important trends one will encounter in early-stage startup funding, and it should be widely disseminated to all who might have an interest in this field.

<i>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.<p>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.</i><p>This 20 minute figure is missing the point. What matters here -- to founders at least -- isn't how much time YC spends on the startup. What matters is how long the startup spends on YC. I don't know how long the average group spends filling out the YC application form, but I'm sure it's quite a bit longer than 20 minutes.<p>(Back of the envelope calculation: Suppose a typical group spends 3 hours filling out investment-application paperwork per investor they're pitching; investors take 1 out of every 20 applicants; and a startup wants to take money from 5 investors. Then they've just spent 300 hours -- over a month -- filling out application forms, and it's probably going to be 2 months before they can focus on something other than raising money again.)

I think this will go down as one of PG's best and most predictive essays. It feels as if these changes are all just before the tipping point but close enough that they're going to happen; if they do, it'll be a huge positive for founders and the investors that adapt.

As always, PG's done a good job of writing a thought-provoking and highly readable essay. I'm hardly qualified to comment one way or another about the ins and outs of startup financing- I'm willing to assume that he's got the facts right on those aspects of the essay- but one part of the essay stuck out at me like a sore thumb: (talking about YCombinator's "competition" with employers)<p>&#60;blockquote&#62; 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:<p>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. &#60;/blockquote&#62;<p>I'd say that this represents about 80% of an "unbiased review". The missing 20%? "... it's also hard work, and at times very stressful, &#60;em&#62;and the odds are very much against all of that hard work and stress paying off for you in any kind of direct, financial way.&#60;/em&#62;"

<i>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.</i><p>When I read this it reminded me of the good things that Google does to make the internet easier and faster. It's self-interested -- the better the internet gets, the more people click on their ads -- but in an inclusive way: there are auxiliary benefits that accrue to a lot of third parties (like me, using Chrome right now). In YC's case, that would be the population of startup founders and anyone who benefits from the startups they found.<p>I like it when companies behave this way. Maybe there are degrees of self-interest and this is a more enlightened one. It's too much to expect companies to do good things irrespective of their self-interest, but not too much to expect the above, especially if it turns out that they end up making more money this way. Then others will have a narrow and greedy reason to go down a broader and more generous path.<p>Lest this seem like nothing much, it wasn't so long ago that people in this position thought primarily in terms of controlling and crushing. The difference may be one of degree, but it's not just rhetorical.

<i>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.</i><p>To an outsider, this sounds like a small-scale version of the events that caused the Dot-com bubble: Investors race to fund ever-shorter rounds of companies that might someday be valuable, but have nothing right now but a sales pitch and a website. This arrangement would benefit a company like YCombinator, who seem to successfully fund companies based on little more than gut feel. But taking away "success as a predictor of success" from the VCs' playbook, would they have another strategy that beats random guessing? The Dot-com bubble suggests "no." Hopefully the small average investment really does turn the math on its head!

Is this not an echo chamber of 'we're doing this so everyone should'?<p>Has YC actually made a lot of money yet? I ask because the web does not provide a definitive answer. I see a few YC companies doing well, but there's no 100 million dollar companies there, let alone billion dollar companies.<p>Given that YC had to raise money last round to fund companies, one wonders.<p>I have a lot of respect for pg and read everything he writes, but I'm asking out interest in the actual reality of the situation, it's hard to tell.

I don't think it's fair to say the invaders usually win. In hindsight they appear to, because you don't remember the 10,000 startups that tried and failed for each one that succeeded. Broadcast.com was an invader in the same space as YouTube.<p>A big business would die of schizophrenia if they tried to fend off everything that attempted to disrupt them.<p>That's tangential to the point of the article though I suppose.

If you take PG's essay one step further, it would seem there might also be a need for micro-investing in the same style that Kiva does micro-loans. Something that lets small fish invest in startups that need less than, say, $250k. Investments could have a lower limit of $5k for example, and most software startups might only need 10 or 20 investors at $5k a piece.<p>Diaspora received a great deal of funding on Kickstart, but Kickstart specifically says it is not meant for investing. I think there might be a niche between well-connected, wealthy angels and simply asking family and friends for seed money. This would also alleviate the choice between risking your relationships with all your friends and family just to generate seed money. If you have a business idea, there should be an option to raise money in an open market at any scale.

"Much of the stress comes from dealing with investors."<p>Disagree here. Dealing with investors is a source of stress, but there are many reasons why startups are stressful. A friend put it this way: "As a startup founder, every day you're eating glass and staring into the abyss."<p>There is the stress of product-market fit, dealing with the fact that no one knows who you are or cares, endless hours, etc.<p>But the best startup founders, I think, do it because they simply can't do anything else.<p>While I hope that fundraising becoming more efficient will help create more great startups - I think the battle against cushy jobs at established companies is at the very, very beginning.

Oops. I was supposed to review this but ended up being too busy fundraising.

<i>Investors don't like trying to predict which startups will succeed, but increasingly they'll have to.</i><p>I'm puzzled because I thought investing successfully was all about doing exactly this.

Business has traditionally not needed outside funding. Funding has mostly come from revenue or from family. This angel/small scale investment is only neccessary because technology is changing so quickly and there are many opportunities at the moment. But this will end soon enough and the market will stabilize.<p>The few new things that startup then will not be worth having a lot of angels for.

What are people's thoughts on peer-to-peer startup funding? Is it ever going to happen?<p>By that I mean raising money with a larger number of smaller inputs from a marketplace or similar. Potentially still in exchange for equity though also possibly for debt or just belief, as with Kickstarter.<p>Diaspora and Kickstarter are a recent successful example, though that was something of a black swan event in my opinion.<p>I do think this type of exchange could solve some of the things founders dislike about raising money, but it certainly raises other problems.<p>I heard a while ago of a company called Sprowtt planning to do something like this, but researching again just now, they appear to have "hit the deadpool" <a href="http://www.crunchbase.com/company/sprowtt-marketplace" rel="nofollow">http://www.crunchbase.com/company/sprowtt-marketplace</a>

This is a question for pg and anyone else who can chip in:<p>I love the idea of a startup-controlled round and would definitely love to do my first round (coming soon hopefully) this way but... how exactly do I go about setting something like this up? Is there somewhere that explains how to do this or do I have no recourse but retaining a lawyer who has experience with this sort of deal (which I don't have the money for right now).<p>I'd love a nuts and bolts type answer if possible.<p>Or is this process even possible (yet) for a startup founder to lead?

This is a great article, Paul. I have one question, if you do not mind setting off on a tangent. You said that start-up investing is a seller's market now. Why is that? In general "a sellers market" would indicate that there a lot of investor money in comparison with startup opportunities.<p>Is it because there profitable exists which are bringing more money in? I have been following the news and while the number of buyouts seem to be increasing, many of them are at valuations which would not indicate much profit for the investors.<p>Also VCs keep telling me that they have trouble getting funds as their traditional institutional investors have soured on the VC investment class. So that would indicate something other than a seller's market.<p>Or do you think that because there is so much activity with start-ups, investors have already decided that some companies that have not yet reached an exit (e.g., Twitter, Foursquare) are defacto winners, so that there is an assumption of high profitability even without the exits.<p>Or do you think it is a sellers market because more money is going to silicon valley now that many of the wall street profit making schemes have stopped working.<p>Or is it possible that it only seems like a seller's market to you because Y-combinator is so successful and popular that investing in Y-combinator startups is indeed a seller's market, while this may not be the case overall.

So question: in a rolling close with convertible notes, what happens if the startup neither gets a buy out offer nor raises another round of capital?

In a rolling round, is each investment negotiated at a different price? Or does the company sell X shares at Y price, first-come, first-served? The former sounds like a lot of work; the latter gives people an incentive to delay even more (they'll have made an investment with more information than the prior investors. And, of course, they'll have cash on hand in the interim.)

OT: That's weird, I didn't see this and just posted a dup - <a href="http://news.ycombinator.com/item?id=1579024" rel="nofollow">http://news.ycombinator.com/item?id=1579024</a> - but it didn't get caught. The only difference seems to be in the www in the url.

Some angel groups have some steep fees just to pitch and luckily there is counter movement to that. I hope with the shift towards more angel investment in the long run that this attitude of paying a high fee for presenting is not getting to a norm.

Could someone please guide me towards a "startup funding 101" resource that explains what all this means? Ideally something that walks you through the process instead of just defining the vocabulary. I've searched but I haven't found anything good.<p>series A rounds, additional rounds of funding, fixed size rounds, convertible notes, changes in valuation, stock dilution, etc.

"it's usually the invaders who win." Let's aim, launch &#38; invade!

May I suggest the use of the word archangel instead of super-angel?

I think there's a missing word in this sentence: "What I'm saying is that the kind of help that matters, you may not have to be a board member to give."

The essay makes sense as far as it goes, but if it's true, there's going to be a change in both board of directors and advisors as well.

This sounds wonderful, but a bit too much wistful thinking.

I think that adding more VCs and Angels to the ecosystem would actually make me less likely to consider raising money.<p>The first year of a startup can be incredibly cheap. Cheap enough that you simply don't need <i>any</i> outside cash to make it happen. For me, the only reason I'd ever consider taking VC if for the side benefits that come along with the money.<p>When you have an entity like YCombinator backing your thing, you get a huge boost from their connections (and the fact that they're inclined to <i>use</i> those connections for your benefit). That's orders of magnitude more valuable than the lousy six grand they give you, and if I could get that help without the money attached or the requirement to move to the bay area, I'd jump at it for my latest project.<p>Now imagine the scenario with Random No-Name Angel with $100k to give you. All you get out of that deal is money. No influence. No guaranteed TechCrunching, no introductions to Important People, no Inc Magazine cover story about you and the latest crop of young entrepreneurs. Unless you actually <i>need</i> money (which if you're smart, you shouldn't), there's just no advantage there.