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.