The reason startups used convertible notes when attracting angel investing is because it allowed them to close deals quickly. By providing different investors with different prices, startups have broken the deadlock where investors wait and see who will be the first to invest in the startup.
By far, the opinion of other investors has the greatest influence on the opinion of investors about a startup. Very, very few investors who themselves decide to invest in a startup. Any startup founder will tell you that most investors are not asking about the founders or the product, they are asking, "Who else is investing?"
This leads to a dead end. A traditional investment round can take weeks, because all business angels sit and wait for the first to take the risk, just like in a sprint bike race at the start, participants go slowly to get behind the one who fails first.
Convertible bills allow startups to break out of these deadlocks by giving investors who want to invest first with a lower (efficient) rate. The first investors deserve such a rate, as they risk more. It is much safer to invest in a startup that Ron Conway has already invested in; the next person must pay the higher price.
Convertible bills of exchange provide more flexibility in price because bill valuation is not tied to the actual price and the bills themselves are easy to use. Thus, you can raise funds under different conditions: if you wish, you can have different contracts with different conditions with different investors.
These differences are not limited to simple rate hikes. Startups can provide better terms for those investors who are expected to provide more help. It's just that different investors have different values for startups, either because of the help they provide or because of their willingness to take risks, and that different value should be reflected in different terms of the deal.
In the future, different conditions for different investors will become commonplace. Markets are always moving towards greater differentiation. And convertible bills aren't the only way to do this. Transparent standardized terms will be needed (and some changes in investor and legal expectations for rounds of shares) to be able to achieve the same for equity as opposed to debit. It would be great for startups to change their financial valuation.
Deadlocks were not the only problem with equal terms investment rounds. Another problem was that startups had to decide in advance how much to grow. I think it's wrong to set any number. If investors are easy to convince, the startup should grow now, and if investors are skeptical, it should take less and use that money to put the company in a position where investors can be more easily convinced.
It is simply unreasonable to expect startups to decide in advance the optimal size of the investment round, because this size depends on investor behavior and cannot be predicted.
Investment rounds with a fixed size and a large number of investors are such a bad idea for startups that it begs the question: why has everything always been done this way? One possible explanation is that investors tend to collude if they get away with it. But I think the real reason is less sinister. I think business angels (and their lawyers) organize investment rounds this way, just mindlessly imitating
Series A venture capital rounds. In Series A rounds, a fixed size makes sense, because there is usually one large investor among others who is clearly the leader. Serie A rounds are already quite differentiated. But the more investors participate in the round, the less sense it makes for everyone to get the same price.
The most interesting question is: How will differentiated fundraising affect the investor world? More daring investors will now be rewarded with lower prices. But more important to a pioneering business, courageous investors can do deals with the companies they want. Investors of the sort that ask, “Who else is investing?” Will not only pay a higher price, but they will not be able to conclude a good deal at all.
Thanks to Immad Akhund, Sam Altman, John Bautista, Pete Koomen, Jessica Livingston, Dan Siroker, Harj Taggar, and Fred Wilson for reading drafts of this article.
Translation: finik
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