Revisiting Paul Graham’s “High Resolution” Financing

Posted on Sep 25, 2010 | 28 comments


When I first read Paul Graham’s blog post on “High Resolution” Financing I read it as a treatise arguing that convertible notes are better than equity.  As I’m generally a believer in ‘pricing rounds’ I initially didn’t agree with the premise of the post.

Photo credit: D. Story/J. Blanchard/O’Reilly Media

I just re-read it and on second reflection, I’m surprised just how much I found myself in near TOTAL agreement with Paul.  Having re-read it, I believe his real premise instead is, “Fixed-size, multi-investor angel rounds are such a bad idea for startups that one wonders why things were ever done that way.”

On this assertion, for the reasons that Paul articulates in his post, I’m aligned.  Not that they’re “such a bad idea” but more that there are inherent problems for entrepreneurs in the process of raising angel money that need to be addressed.

Here’s where I feel common ground :

1. Most investors wait to see who else is investing.  ”Social Proof” weighs heavily on investors in making their decisions.  Perhaps it shouldn’t.  Maybe one day it won’t.  But it is.  This leads to the problem of “herding cats” for entrepreneurs raising angel money.  I talked about this in my social proof post where I gave some suggestions about how to get the early guys off of the fence.  Most early-stage entrepreneurs who have worked with me (either as an angel or as a seed VC) know that I don’t rely at all on the social proof of other investors.  When I’m in, I’m in.

Paul Graham’s assertion that “any startup founder can tell you the most common question they hear from investors is not about the founders or the product, but “who else is investing?” rings true to me.

2. Investors who commit early deserve to have a lower price. I’ve always believed this.  I argued it in my post on how social proof helps fund raising with angel investors.

“what you really need to get an angel round together are your “anchor tenants.”  These are the people who make the early commitment to you to fund your round before having any social proof.  You should seek to get people who are respected by others in your field and who will therefore make it easier to raise the rest of your angel round.”

Two strategies I talked about in the post for getting your “anchor tenants” are 1) taking them on as advisors first and 2) giving early people cheaper pricing.  On the former I mentioned a video that I shot for This Week in VC talking about how Farb Nivi solved this problem:

“Farb talks about how he got Rob Lord on board at Grockit.  He first worked hard to get him to be an advisor to the company.  From there Rob decided to make a small investment.”

On the latter:

“Another successful strategy that I’ve often recommended to people who don’t have a track record is to carve out a very small amount of seed investment (say $50,000) and offer 5 people to invest at $10,000 each at a $500,000 post-money valuation … offering the social proof you need attract great employees and ultimately venture capital investors.”

Taking it from an investor perspective (not me, angels) I think it’s totally unfair to see early angels invest, take more risk, help you get to the next level through both sweat & money, and then pay a higher price because the round had a convertible note with no cap.

Paige Craig, currently the most prolific, under-dressed, and most eligible angel in Los Angeles, sourced a hot, young startup called Gendai Games (makers of GameSalad - a platform for rapid development of mobile games).  By “sourced” I mean he: went to SxSW, saw a demo, loved the concept & team, gave them a check while still in Austin, called me & helped get them into Launchpad LA, get a local investor (DFJ Mercury) to commit, shopped the deal to a bunch of LA investors, get the CEO to move to LA and brought on LA seed investors including Disney (through Steamboat) and DFJ Frontier.  Phew.  But that’s what great angels do.

You mean to tell me that guy deserves the same price as somebody who invests six months later?  NFW. (disclosure: I’m an angel investor in Gendai Games, but not on social proof but on the relationship I built with Michael during Launchpad and the traction he’s had with major iPhone & iPad developers).

The reason I have generally been against convertible debt is that historically it was a mechanism that avoided price.  People raised rounds with “a discount to the next round” or “warrant coverage.”  Yes, these give cheaper prices to early angels but potentially not much of a discount if the company becomes hot.  Another mechanism is “convertible debt with a cap” (max price).  That’s OK, but it gives you a max (read: price!) and not a min.  Why not just price the effing round?  I wrote about convertible debt ad nauseam here.

3. Legal costs of early stage financing should be cheap – this is one of the final remaining arguments for convertible debt but even Paul acknowledges that this is no longer necessarily the case:

“Different terms for different investors is clearly the way of the future. Markets always evolve toward higher resolution. You may not need to use convertible notes to do it. With sufficiently lightweight standardized equity terms (and some changes in investors’ and lawyers’ expectations about equity rounds) you might be able to do the same thing with equity instead of debt. Either would be fine with startups, so long as they can easily change their valuation.

I agree on all points.  If I’m investing in convertible debt I’m fine as long as there’s a cap.  He’s fine with equity provided it’s cheap to paper it legally.  We both believe in rewarding different investors at different prices.  These days there are many lawyers that will do equity deals cheaply as long is it is a standardized, simplified term sheet, early stage, no serious investor / management debates, limited IP / customers / due diligence and as long as they perceive you as a “hot” company that’s likely to need legal services for many years ahead. (if you need advice on how to find / work with startup lawyers cheaply click that link).

4. Raising variable sized rounds – This is a hard one.  Most investors don’t want to hear teams say, “we might raise $250k.  But we might raise $1.5m.  It depends on how much appetite there is from investors and at what price they’ll invest.”

They want to hear that you have a clear plan, know what you want, know what you’re going to achieve with the money (milestones) and know when you’re going to be out again raising money.  Here’s Paul Graham again on this issue:

“… [historically] startups had to decide in advance how much to raise. I think it’s a mistake for a startup to fix upon a specific number. If investors are easily convinced, the startup should raise more now, and if investors are skeptical, the startup should take a smaller amount and use that to get the company to the point where it’s more convincing.

It’s just not reasonable to expect startups to pick an optimal round size in advance, because that depends on the reactions of investors, and those are impossible to predict.

Violent agreement.  I often counsel the following: set a minimum amount of the round  ”X” (for example $500k) and put a clause in the term sheet that allows you to do a second closing of up to “X” + 50% ($250k in this example) in up to 90 days post closing at the same price.  This gives you the ability to get the first money in the bank while giving you flexibility in size of round.

The key is making sure the second close isn’t too high (I think 50% of X sounds about right) because you’ll be adding on that dilution to yourself & “X” investors will own less of the company.  But importantly you need the “time bound” of 90 days so that “X” investors don’t feel cheated.  If you take money 180 days later then those investors get more information about how you’re performing and therefore face less risk.  It goes back to the issue of investor fairness.  Later investors shouldn’t get a “free ride.”  90 days seems about the max to me.  Often I suggest 60.

Importantly any VC investor will understand the “first close” mentality since nearly all VC funds are raised this way from our investors.

Here is where I do not agree:

1. “A startup could also give better deals to investors they expected to help them most” – That is a quote from Paul on the “high resolution financing” post.  I believe you reward investors who make an early call just like on the public stock market.  It is dangerous territory when the management starts rewarding certain investors because of a “perception” that they will add more value to you.

When I was raising money in late 1999 I had an investment team in Germany (I was in the UK) suggest that they should get a lower valuation than others because they were ex McKinsey guys and had better access to industry.  I chuckled.  We all know ex McKinsey people, don’t we? We chose not to accept their generous offer.

But the “I can help you more” argument comes often from investors.  It should be used as a mechanism to decide whether to take money from that person, not whether they should pay a cheaper price.  That is a slippery slope and believe me will piss off other investors way more than any perceived benefit of landing that one investor.  Every investor understands the concept of cheaper pricing for committing early and taking risk.  Nobody feels good about cheaper prices based on ability to help.

If somebody (excluding VCs) is truly able to help you more than others then reward them through performance-based warrants based on measurable success criteria.

  • drorm

    “Most investors wait to see who else is investing”
    There's a good reason for that. Most people don't have the skills or the resources to do good due diligence on a company. Granted it's much easier to do due diligence on anunfunded statup than a company that's been around for a while, but there are still plenty of pitfalls that savvy investors recognize. A simple example:
    You say you have 300K visitors a month, why does compete show only 5K visitors a month (there are actually good answers to this question, for instance: most visitors come to us through mobile apps).
    So plenty of angel investors tend to be followers and wait till someone they trust invests and then they just follow them. This is all fine, as long as everyone is upfront about being a leader of a follower, so that the entrepreneur knows not to waste their time with a follower until they bag a leader.

  • http://bothsidesofthetable.com msuster

    Agreed. I talked a lot about that in my angel series.

  • dshen

    Entrepreneurs need to price correctly if they're going to raise the price as time goes on, and as early rounds of the total raise get filled up. If the later rounds are priced too high relative to the market and what the startup could get, it could stop them cold. I think that when the rise in price between the rounds is too high it could create this problem (recently saw this happen).

  • telanon

    On Fred Wilson's blog I recently explored his choice of preferred stock for seed rounds versus convertible debt with multiple conversion-price caps (which is similar to Paul Graham's “high resolution” approach). Fred responded that he uses preferred stock for seed rounds in the same way. That is, he uses one set of documents that establishes terms and conditions other than price. Then he has multiple closings within that round (A-1, A-2, etc.) with price being negotiated at the time of each closing. I now believe this is the optimum seed-stage financing structure, since it has the flexibility of the convertible-debt approach with multiple closings, plus the advantage of pricing the round to avoid the “max price but no min price” issue you identify for convertible debt using conversion-price caps.

    The discussion exploring this topic in detail is near the end of comments to Fred's post here: http://www.avc.com/a_vc/2010/08/some-thoughts-on-convertible-debt.html .

  • http://twitter.com/BrowseMob Matthew Hurewitz

    On the last part, discounts based on the perception of contribution, shouldn't you already have proof point of usefulness before you give a discount?

    I'm looking at investors the same way I looked at advisors. In regards to advisors, I started by meeting people, followed up and now I can talk to them on an as needed basis. They are all still informal and neither of us has brought up formal advisor status or the accompanying equity piece for advice. Is it naive to think that I can filter investors (specifically a lead) the same way? If an investor is interested, shouldn't they demonstrate their helpfulness during the 'dating' process?

  • http://reecepacheco.com reecepacheco

    Funny… We were lining up to shop a convertible note, but given all the discussion in recent weeks, we've switched to a priced round with the option to do a second closing within 60 days.

    It honestly feels much better to say “we're raising $x at a $x valuation,” than “we'll give you a discount later on.”

  • Aviah Laor

    But isn't it a nice way to say “Nobody got fired for buying IBM”?
    Maybe those who accept others others to adopt their investments – new, revolutionary products – at least should do it themselves?

    Ycom should be praised for that: They select good companies, period, and they seek no social proof (and maybe the whole issue is temporary, and soon Ycom companies will go directly to series A).

  • http://bothsidesofthetable.com msuster

    In my angel series I talked about how there are “lead” angels and “follower” angels and most of them are the latter. The leads tend to have great access to dealflow, strong domain knowledge and deep pockets. Or just strong conviction.

    Re: YCombinator – while they do deserve a lot of credit for what they've brought to market, it is not for the reasons you highlight in my opinion. If you run an incubator program you don't deserve credit for taking “lead” risk since that is your business model !!

  • http://bothsidesofthetable.com msuster

    Yes, which is why Paul G (and later in a Tweet Chris Dixon) said that prices shouldn't rise monotonically.

    In the examples I encourage people to “price low” for first movers not “price high” for followers. I never think it makes sense to get too far ahead of normal valuations for your stage or it becomes really difficult to do follow-on investments.

    I'm encouraged that every time you've ever commented we've been in 100% agreement. We should work together more ;-)

  • http://bothsidesofthetable.com msuster

    Yes, I had read his post and actually wrote several times in the comments section there. Fred & I are in near total agreement on this. I keep telling entrepreneurs that “converts with no cap are unfair to investors. converts with a cap have a maximum price but no minimum. that's the worst kind of price for an entrepreneur.”

    regarding preference vs. common stock – I prefer preference stock and there is also a reason for the company. if you issue preference stock then it's easier to give out restricted stock at 25-40% of the price of the preferred stock, which is a hugh favor to your employees that you're hiring at a critical phase in your company.”

    that said, for only $250-500k I'm willing to do convertible debt if there is a cap. and I'm willing to do it with common stock rather than preferred if required. i prefer not to. but at the end of the day I'm only investing $250-500k in a deal with the hope of being able to invest more as the company grows and in this case it will for sure be preference stock.

  • http://bothsidesofthetable.com msuster

    Yes. They should. And even then they should only get a discount if they move early.

  • http://bothsidesofthetable.com msuster

    hallelujah! tell everyone you know how much easier it is to tell investors that. i always counsel local entrepreneurs with that fact. i wish more people got it.

  • http://reecepacheco.com reecepacheco

    haha… let me get those transfers in the bank before i start giving advice

    on fundraising!

  • http://www.victusspiritus.com/ Mark Essel

    Glad to see you found some patten matching points in Paul's philosophy with your own optimal strategy for early stage startup fund raising. Why doesn't the price fluctuate dynamically based on the time of investment? If the price of an app based startup (perceived value) doesn't change in 90 days of developing there's likely a problem.

    I keep reading raise money when you can, enough to prove your startups worth and make it to the next round/revenue, an probably more than you thing you'll need. If the seed market is flat next year you may have to go a long time between closing more financing. 200k gets your team x months, 1 million can make it a LONG way for a modest sized team (5-7) of high performance people.

  • Frederick Cook

    Mark, you address the “don't have a fixed-sized round” issue for the case of a larger-than-expected demand by investors, but not an under-subscribed round. With your example above, if the company puts together a term sheet as you describe, but isn't able to fill out that $5ook, that still puts them in a very bad position. Can you address?

    “…if investors are skeptical, the startup should take a smaller amount and use that to get the company to the point where it’s more convincing.” -PG

  • Aviah Laor

    Got you. This is what happens when you deal with angel investment problems when you need to get the dime for your startup. I'll bookmark it for 2013. :)

  • http://bothsidesofthetable.com msuster

    OK, so 2 strategies – one I've talked about one I haven't.

    1. Mini round. Close a small round $100k with your “anchor tenants” and give them a super low price (sub $1m). Example, if you ask 5 people for $20k each at a $1m post money valuation you've raised $100k for 10% of your company. They each own 2% (which is enough to be meaningful). Your goal is to raise the next round at $1.5m-2.0m pre but now you have some cash to help develop plus some social proof to land new investors.

    You obviously only do this when you can't raise that “real” round. I also have told some entrepreneurs to do this at $500k. I know 20% of your company is expensive money at this stage, but if you're stuck on financing, need money and need social proof sometimes it is the only way to get “unstuck.” Also, you could just try to land THE anchor tenant for $25k at a $500k post. He/she owns 5% (hugely meaningful to them and rightly so for the risk they're taking being first and only money) and you have an anchor.

    Anyways, these are all just mitigating strategies if a bigger round doesn't seem like it's likely to come together quickly enough or at all. I must tell you – this is the norm rather than exception. We all read about the funded companies. I see many that struggle to get the first $500k raised.

    2. The other obvious thing is to have the “first close” of your round be for a smaller amount. Maybe first close is $150k and your round size is for max $450k. I know that this is only 33% of the round, which should make the $150k nervous but doesn't hurt to try. Also, you might offer the $150k 10% warrant coverage for being in the first closing (only if you need another carrot to close them).

    Normally people find safety in numbers, which is why the “first close” strategy sometimes is hard. They are nervous it will be your “only close” and lead to a “goose egg” for them. Ultimately you need two things: 1) risk tolerant angels and 2) persuasive closing skills. Most founders lack the latter.

    I did two angel deals specifically because the entrepreneurs wouldn't relent (respectfully) until I wrote the check. I liked the founders / concepts but wasn't looking for more angel investments. They persisted and convinced me otherwise. It took them many meetings, much patience & persistence … but that's what it takes.

  • http://www.Spidvid.com Jeremy Campbell

    Sounds like a deal is either hot for investors, or completely cold. Entrepreneurs need their investment deals to tip amongst investors.

  • Frederick Cook

    Thanks, Mark. Good to hear the acknowledgement that this is closer to the “norm rather than the exception”. There are no TC articles on companies raising $100k at $1M post, but it must be quite common, given the sharp increase in seed investments in the last few years. (All those companies starting with $20k rounds aren't all going straight to $500k rounds, clearly.)

    It also seems that when raising money in these circumstances, convertible notes do make a lot of sense because you can simply modify the cap and use the same documents for that first $100-$200k as with your $500k-plus “real round” a few months later.

  • dshen

    ha funny! let's talk about when we have our coffee!

  • Mingchang Wu

    Hi Mark,
    Thanks for this interesting and informative blog. I am gonna do an internship in a venture capital fund of funds in China and very interested to know about how VC funds raise money from their investors. Is there any difference compared to startups?

  • http://twitter.com/IBAssociate Entreprenuer TechIB

    When you say “at $x valuation” are you giving investors your price or are you giving investors the price of committed “lead” investors?

    I find trying to tell investors a price is a bad strategy

  • http://reecepacheco.com reecepacheco

    price.

  • http://1000markets.com Matthew_Trifiro

    Convertible notes are an entrepreneur's friend. They are fast, low-cost, and help build momentum in a startup. They also help entrepreneurs focus on execution even while in the midst of fundraising, as they can accelerate their spending in meaningful ways. Moreover, by removing some of the near-term cash pressures the entrepreneur is afforded some space and time to carefully pick her seed investors and thoughtfully negotiate a priced round.

    VCs who categorically avoid convertible notes (e.g., “we aren't lenders”) are offering a less attractive product to their entrepreneurs. VCs who offer convertible notes aren't being lenders (nobody really expects the loan to be paid back); they are being smart competitors, offering a turbo-charged product to entrepreneurs.

  • host4more

    Mark, and how do you solve ( if it is possible ) the Social Proof issue as a first time entrepreneur, i know it is hard but how to go about it? From my experience i can say that on the second project, even if there is no social proof, angels start to feel more secure about you and your team because they can base their analysis on previous work, but how about when you are first time entrepreneur. Any suggestion highly appreciated.

  • http://twitter.com/TylerBeerman Tyler Beerman

    This article is soooo money…. As an entrepreneur, I'm not really interested in issuing convertible debt… but I think you made excellent points about rewarding certain investors who come-in early on.

    Mark thanks for writing such wonderful posts, I got a collection of my favorite posts and these will most certainly be handy in the near future….

  • http://www.emergingenterprisecenterblog.com/ Dave Broadwin

    I am a little late to the conversation, but here is a question: If your next round is $5mm on $5mm pre, will you still feel good about it?

  • http://reecepacheco.com reecepacheco

    I'll only be disappointed that I didn't raise the valuation of my company as I expected.

    I won't sit around saying “I wish we'd gone with that convertible note.”

    It's about doing what's right for the business. In this case, we have potential investors who prefer priced rounds, who are good people, who want to see this be a successful business and they're willing to invest at a fair price.

    If I fuck it up between now and the next round, then it's my fault. So be it.