Should Investors in the Same Round of Financing Ever Get Different Prices?

Posted on Sep 8, 2012 | 35 comments


If you were on Twitter on Saturday you might have noticed a lively discussion with Dave McClure, Fred Wilson, Chris Dixon and myself. And a few others.

Luckily there are tools like Storify – so you can actually see a synopsis here.

I recently wrote about my views that startups rounds should be priced.

If you do an uncapped note it’s bad for the investor. If you do a capped note it’s bad for the entrepreneur. I’m not sure why people don’t see that. It has both a “full rachet” and “multiple liquidation preferences.”

I wrote about it here.

Fred, who also wrote his views about convertible debt (significantly more succinctly than I) believes that the price of a single round should be the same for everybody.

For the most part I agree with Fred. I would never as a VC fund a round and then expect somebody else to pay a higher price right after me. I also would never expect another VC to do that to me. We’re either “all in the round together” or we’re not.

But Paul Graham really did have a point in his “high resolution fundraising” post – that there is a problem – particularly in angel financing – with herding cats.

Since 2009 I have been counseling people to offer discounts to the first angel investors. It is part of my stump speech across the country,

With the tagline something like,

“Most investors are sheep. They hate making decisions. They’re looking for “social proof.” It shouldn’t be – and most people deny it – but I have found it to be true.

The trouble is, nobody has an incentive to agree to write the first check. And no matter how rich people are – they still want a good deal. That’s probably how they became rich in the first place.

So you need an anchor. But how to get one?”

If you remember the three rules of sales: it’s

  • why buy anything?
  • why buy me?
  • why buy now?

The last one kills all deals. There is simply no reason for the first angel to write you a check until you have the whole round secure, which is why people herd cats. Here is what I recommend very often – privately – to startup entrepreneurs for angel funding.

1. Price the round. Everybody deserves to know how much they’re paying and the people who commit when you are at your most risky deserve to pay less for that risk.

2. You need an anchor. Two ways to get one. First, you can make somebody an advisor and get them working with you. And after you feel they’re bought in intellectually and emotionally you can ask them to make a small investment. This can be time consuming.

The second way is to pitch them like normal but offer them a discount. The pitch is really simple:

“We’re going to be raising $750,000 – $1 million. We plan to raise at a $5 million pre-money valuation.

We know how hard it is to get the first people committed. And we know it’s a challenge to herd cats. So we’ve reserved the first $150,000 at a $2.5 million pre-money.

We would be honored if you would consider being one of our first angels.”

3. You can do it with equity & a price. You simply draft up a series seed term sheet. In the document it outlines that you will issue stock at a $5m pre-money valuation and in recognition of the additional risks and commitments of early money you have allocated warrants to the first $150,000 of investors. You outline that you need at least $150k to do your first close and that your maximum round size will be $1 million in total. The  way it works structurally is that you issue stock (let’s say it’s at $1 / share) and for the first 150,000 shares you also grant a warrant of common stock equal to $1 for every share they buy. That means they get a 50% discount to the round [25,000 shares of preferred stock at $1 / share and 25,000 warrants at $0.01 / share equals around $0.50 / share – a 50% discount].

Another easy way to do it is the term sheet create Series Seed A-1 and Series Seed A-2. The first is priced at $0.50 / share and the second at $1.00 share. They share in liquidation preferences pari passu and they vote as a single class. This is occasionally how convertible notes are structured at the time of conversion anyways. You’re just doing it up front.

I don’t believe that VCs or professional seed investors ought to get this discount. It’s bad precedence for the reasons Fred outlined. But nobody would care if a high-profile (or not so high-profile) angel got it. Especially if it was memorialized in the documents why you were doing it.

That should offer enough “resolution” to do multiple closes. The next people who close pay full price and since you’ve already hit the minimum raised they can just close as you collect checks. So rolling closes are not a problem.

By the way, this is EXACTLY how VCs close their funds.

And if you absolutely HAD to do an interim funding at a mid-way point you could always issue a 1/2 a share in warrants for every full share purchased for the second $150,000.

I’ve seen it done several times. It works. The fact that some people tell you that you can’t do it without convertible debt is a canard.

Think about it … once you DO convert your debt to equity in the future … what I’ve outlined above (or some variation) is exactly what you’re eventually going to do anyways.

And finally, in my opinion – that first investor IS taking real risk. The rest of the round might not close. They might have all of their money smoked. I’m ok with their getting a discount on this basis. And you should be, too.

  • Almost every startup needs an anchor
  • Almost every wealthy angel wants a deal

  • http://avc.com fredwilson

    i understand that this is done all the time in the angel round but i don’t like it. it feels like you are buying a lead.

  • http://cafepeople.com/ Pete Meehan

    There seems to be different ‘rules’ and standards of engagement for angels then.

    But I can imagine that getting someone to cross the line can be tough for the entrepreneur. And no doubt some investors play their hand and hold back until they see the carrot.

    Whatever works.

  • Luke Deering

    Do you think this would lead to the following angles,in the same round, feeing unappreciated… maybe even pulling out of the round, just through pride?
    It just seems to me that it could be an easy way to put a bad taste in the mouth of too many involved at the ground level. At the end of the day if you have a good company and the right contacts to get in-front of a lot of angels,
    someone will go first without that additional incentive. I might be wrong, but
    it feels like its founders throwing away a bit of ownership while making some
    of the early investors feel like they got a raw deal. Hope you guys dig into this more!

    Luke – Not an investor, just a guy in a small town in England
    Co-Creator of the startup interview site HowToWriteABusinessPlan.com

  • http://www.charliecrystle.com/ Charlie Crystle

    Much more complicated than a priced convertible w a date-based discount, but the same notion at least.

  • http://avc.com fredwilson

    hard to say. it all depends on the circumstances and the people involved.
    i just don’t like it. doesn’t mean it isn’t an important part of how angel deals get done.

  • http://twitter.com/leoalmighty Leo Chen

    We just did a priced round with a lead and it actually made the rest of the round simpler because the price was set and there wasn’t room for negotiation. Few of my friends raising on notes are negotiating the cap with every investor — some think they should get a lower cap and know it’s easy to do with a note. I’m glad I didn’t have to deal with that. The synchronization issue was also less problematic than I had expected, our lawyer had committed investors wire into a trust account, then did a single wire to the company upon closing. Just one data point FWIW.

  • http://www.startupmanagement.org/ William Mougayar

    Mark- I know you covered this topic to death in your other post, but why “If you do a capped note it’s bad for the entrepreneur.”? If the company is valued higher at the Series A and is moving in the right direction, then it all works out, right? It’s when the valuation doesn’t move enough that it could be bad for the investor, right?

  • http://jbp3.com/ John Petersen

    As a VC, are you ever an anchor where you are the ahead of the herd? I would assume you do some rallying to try to get the round filled and just closing the round is enough of a benefit that no discount is needed. Is that right?

  • http://www.justanentrepreneur.com Philip Sugar

    I’m with you. I never like it when it seems like you paid for an introduction. I don’t know how to reward that person who got you into the dance other than to always remember it.

    It really does come back three fold, but it seems my view is not in vogue, its old school, because it takes time.

    Mark certainly has a point with why now…that is the hardest part of sales.

  • http://www.crunched.com/ Sean Black

    Mark, while your alternative warrant model is interesring, why complicate a deal with a new model if “once you DO convert your debt to equity in the future … what I’ve outlined above (or some variation) is exactly what you’re eventually going to do anyways.” Like it or not, everyone understands convertible debt. By introducing a new model that has the same net effect all you do is introduce more friction, longer sales cycles and higher legal costs. IMHO.

  • http://bothsidesofthetable.com msuster

    Why? For the reasons I wrote in my previous post.

    On the way up (2009-2012) convertible debt with a cap feels great. One day we’ll be on the way down. In that period, full ratchets won’t feel quite as nice.

  • NowEntrepreneur

    I believe this argument has cropped up because to many angels and VCs have recently started co-investing either in seed or Series A.

    Typically angels should invest in convertible notes with a healthy discount (setting cap & floor for investor) in the next round. The valuation of a company should always be a function of its performance. Investors should also demand higher valuation for their value add and not risk taking ability. IMHO.

  • http://bothsidesofthetable.com msuster

    I know. And I understand *why* you don’t like it. Still, there often is a problem of getting a round going and for many startups (perhaps not the hottest) this can be a real issues. I’ve seen it work very successfully for some. And especially for small companies that struggle to ever get big name VCs. But getting $1.5m in funding can be all the difference between them getting a business off the ground or not.

  • http://bothsidesofthetable.com msuster

    Happens all the time, Luke. And I haven’t seen a single deal fall apart because of it.

    Think for a moment about public investors. Are you not willing to buy Apple stock just because your neighbor bought last month at a cheaper price? I know that’s a bit of a stretch in terms of how angel rounds come together, but the principle is the same. Early risk deserves to be rewarded.

  • http://bothsidesofthetable.com msuster

    Thanks, Leo. You bring up a great point. The nice thing about getting your first investor over the line and priced is that it makes it easier for everybody else to consider the deal. The terms are set and they can more easily react and decide whether or not to commit.

  • http://500startups.com/ Dave McClure

    maybe not a bad way to go, but currently this isn’t how the market works on the ground… at least right now. warrants are used, but infrequently. and I don’t know anyone who would price a seed round on just a $100-150k investment.

    the market standard is currently to use capped notes. until we establish a new best practice that is widely accepted by founders & investors, this prob won’t change much.

    perhaps Adeo’s new “convertible equity” docs are a step in the right direction.

  • http://bothsidesofthetable.com msuster

    Please read my previous post on convertible debt. A convert with a cap is the same as a “full ratchet” and this will be more obvious to founders in the next downturn.

  • http://bothsidesofthetable.com msuster

    Yes. That’s right. As a VC I’m a professional investor with enough money to properly get behind deals. I don’t believe professional VCs ought to get discounts for doing our job.

  • http://bothsidesofthetable.com msuster

    I know that convert with cap is what is accepted and that’s not easily changed. Still, people are constantly saying you “can’t” do equity and my goal was to show that this is hogwash. It’s not the majority of cases, but it certainly is possible.

    In fact, the way you do it is similar to how some rounds are ultimately constructed at the time of conversion. Either you convert all into the same round of preferred stock (and that investor gets a 2x liquidation preference, or you do series a-1, series a-2 each at different prices or you give them some stock as preferred and some as common (which is the same as giving them warrants).

    re: “I don’t know anyone who would price a seed round on just a $100-150k investment.” … I don’t see why not. As an entrepreneur you’re just trying to establish market terms. If you think your company is worth $6m pre, then state it. If you say I’m doing $1m convert with a $6m cap … investors writing a check are baking in the $6m price. With convert with cap this is your max … but you have no min. If you just priced it at $6m you’d have no full ratchet for the next round.

  • http://bothsidesofthetable.com msuster

    “Investors should also demand higher valuation for their value add and not risk taking ability” Exact opposite of how it should be. Think about public markets – should “value add” investors get cheaper prices? Investing is about taking risk. That’s why your A round is cheaper than your B round if you succeed.

    And everybody HATES when some investors try to get discounts because “they will be more value add than others.” That is the surest way to scare off potential other investors.

    re: “The valuation of a company should always be a function of its performance” – sure, in later stages when there is enough performance to judge. But that’s not how it works in early-stage markets.

  • http://www.startupmanagement.org/ William Mougayar

    I have read it, but the issue is only a problem if the next valuation is lower than the one at which the convert was done.

  • ruchitgarg

    I agree Mark! putting incentives for early investors is a great way to have them right check. Most of them are on borderline of to-do or not-to-do and better deal would help them move faster than others.

  • http://www.ringrevenue.com/ Jason Spievak

    A lot of good discussion here about differential economics for early investors. One subtlety re anchor angels that’s not discussed here is that your earliest angel investors often have a personal connection to the company that can have the effect of making them less valuation/term sensitive. The extreme example of this is a family member. I’m not at all advising someone to take money from family. I’d strongly advise not to, in fact, for reasons Mark has covered before. Just making the point.

    A real-world example to illustrate with our current company. We self-funded for about a year and then did an angel round in the form of a convertible note. Our first angel investor was a friend who had a 25x return on our last company. No negotiation there. Our second was a friend who owed me money, and I offered him the chance to invest in the round with that money rather than repay me. A third was a cash investment where we then used some of that money to pay rent to that investor over the next 18 months. Importantly, none of that had any real bearing on valuation when we did a VC-led round just a few months later. In fact, we needed to modify the angel terms slightly in order to close the round. Is this method of valuation-setting unfair to anyone?

    Bottom line: there are lots of creative ways to get that anchor angel, and the terms and valuation will likely not have much effect on the VCs’ decision making … unless you gave anti-dilution protections to your angels, in which case you probably missed a couple of Mark’s earlier posts and shouldn’t be playing this game. ;-)

  • Luke Deering

    Mark, I totally feel what you’re saying. My concern is just whether or not something like this would mess with the ego’s and the dynamics of a first angel round. But, like Fred said, it depends on the people involved, and it’s not going to hurt if the round was led
    by someone who is well known and respected such as yourself or Fred. I don’t know any VC’s really, but I do know a lot of non-professional investors, that are simply wealthy individuals who also like to invest in a project every now and then. They might not be the first to jump in the round but they don’t care, sadly I can’t see any of the individuals that I know not minding if the lead investor gets a better deal than they do… come to think of it, maybe that is a good indicator in itself that they are not the right people to have involved in a startup at it’s roots… but then.. ahhh i think i just went cross-eyed.

  • http://500startups.com/ Dave McClure

    what I mean is unless the founder has leverage / confidence in pricing, setting a price on the first $100k or so is rather dangerous. you don’t know if the rest of the participants in the round will line up with that price, and prematurely setting it too high or too low is NOT a good idea that could fuck up the round. this is why the practice of targeting a range, rather than a specific #, is best practice and standard in the industry, at least or until a majority of investors line up, or a notable investor signs on who is willing to stand behind the cap / price. again, being able to collect funds as you go while this process is formalizing / settling on a price, is exactly why notes are being used. jumping to a price immediately is not usually helpful, and in fact could upset the whole apple cart if you or your first investor choose the “wrong” price…. choosing the “wrong” cap is much less damaging, and can be adjusted up or down as the round comes together. this is not the case if you sign docs for a priced round with the first investors in the deal, especially if they aren’t notable and/or your pricing is fuzzy.

  • davidshore

    would you agree to different equity splits for founders? sure. different comp plans for management? of course.

    if you are raising angel funds and really looking for value from investors, why not price it according to value add? just for one or two investors and perhaps that includes the lead, who are doing more work, not being rewarded for leading the sheep. most angel stage companies really need the help, would the discount help to incent them? i guess you could say it might hurt!

    I’d like to know your thoughts on this, relative to angel rounds where the team needs more help and the number of investors in the party is often so large and the investment so low that the investors are less individually committed. i understand how Fred thinks all should be at the same price but that seems to make more sense when a couple of series A investors are investing millions each.

  • http://avc.com fredwilson

    Good points

  • http://bothsidesofthetable.com msuster

    every angel thinks they are going to help the most. So you’d have an argument over that. And every other angel would be offended “he gets a cheaper price for being more helpful? I already introduced you to a,b,c and I haven’t even invested yet.”

    but everybody knows that early risk gets paid a premium so less room to argue / debate.

    the problem with your analogy … if one member of management gets more equity / options but doesn’t perform they can be removed and some of the equity comes back to the company (and thus the performing management). If the angel doesn’t perform the same doesn’t exist.

  • davidshore

    good point
    you cant vest the equity

  • http://walkercorporatelaw.com Scott Edward Walker

    Hey Mark, solid post (just catching-up on my reading) — but there are significant tax and accounting issues that need to be addressed. In short, not as easy as it sounds — that’s why notes are generally utilized. Cheers, Scott

  • Chris Yeh

    I’m fine with different prices for different investors, IF the criteria are clear and fairly applied.

    Providing a discount for early money is fine. It’s granting a secret deal to other investors that annoys me.

    I’ve been in deals where I only found out later that other investors had received warrants or other considerations. These things need to be disclosed up front, or the investors who don’t get a special deal will feel like you took advantage of them.

    If you really want an investor in the deal, find another way to compensate them, such as with advisory shares.

  • http://www.mentortechventures.com Brett Topche

    Great post, Mark. One thing to consider is whether or not that initial angel actually puts up the cash before everyone else, as opposed to simply making a commitment to the round. If they put the money in first (and thus their cash is at risk if the rest of the round doesn’t come together), it’s a very easy case to make. If they are making a commitment, even if they have signed documents, but don’t put up the cash until the round comes together, the risk isn’t really there.

  • http://www.eFuneral.com/ Mike Belsito

    Mark, I *love* your stuff. But the nonchalant “you will issue stock at a $5M pre-money valuation…” is why this post doesn’t exactly ring true for me. If you’re a first-time entrepreneur who hasn’t had multiple successful exits under your belt, it may be nearly impossible to assume you’ll get a valuation of $5M pre-money when you’re raising your first $100K. If you live outside of the valley? The odds are even worse.

    You may have been simply using $5M as a placeholder or assuming that the person doing a raise *is* a multi-exited founder in SV, but in the situation I described above — it may be a real struggle to get a valuation that’s even a fraction of that. And if that’s the case, are convertible notes with *warrant coverage* really that bad for everybody?

  • Jim A.

    I am a HUGE fan of using a trust account maintained by Company counsel. People can wire and send sigs whenever it’s convenient for them, eliminating drama and stress. It also gets “committed” investors more committed: while an investor can still back out, it’s MUCH less likely once money has left their bank account. I’m honestly surprised that I have to so routinely suggest this.

  • Jim A.

    Mike, I think it’s just for illustrative purposes. Easy to divide everything by two if you feel it’s more appropriate. Re: your last comment, IMO it makes no sense to grant everyone warrant coverage. Just cut the price (increase the discount), which has the same effect without a whole bunch of accounting hassles.

    Off topic, but people underestimate the mundane accounting hassles of warrants, which have to be revalued every accounting period. Can be a useful tool in some situations, but I like to keep things simple and solve for the same desired outcome by other means.