Higher Resolution Fundraising in a Founders’ Market

“Markets always evolve towards higher resolution.” -Paul Graham - High Resolution Fundraising

I’d call this quote incomplete.  Markets evolve toward higher resolution until the return on increased resolution is no longer worth the effort to achieve it.  PG argues that “different terms for different investors is clearly the way of the future,” but that seems to be the way of the past as well, except in the past such differentiation was reserved for sophisticated investors with larger checkbooks and a more exclusive Rolodex.  With the rise of social networking and entrepreneur-oriented tools like Angelist, VentureHacks and TheFunded, the early-stage fundraising market is now sufficiently transparent to justify the work required to raise money on differentiated terms in the early rounds.  But being easy to do isn’t a justification for doing.  

Capping convertible notes at different levels for different investors sounds great—what techie doesn’t love the chance to optimize?—but it may have significant negative consequences in later rounds, especially when things aren’t flying up and to the right. I can easily imagine an A round scenario where semi-institutional super-angels fight over valuation because of the strange dynamics created by a cap table filled with differently capped notes.  Suddenly, issues that were historically the bane of later-round financings are moving up the chain. Not good.  I’ve yet to meet the founder who says “man, what I’d really like to do is make this whole fundraising process more complicated and time-intensive!”  The more time you spend negotiating with angels over where their note’s cap sits relative to your other notes, the less time you’re spending on your product.

What I think it comes down to is this: it’s a founders’ market (at least at YC).  As such, founders get to dictate terms to their angels, including such contrivances as “high resolution” caps.  But I hardly believe that high resolution financing in the angel round is here to stay.  It will be here for a while, sure, and then it won’t be a founders’ market anymore and the pendulum will swing the other direction.  At that point, we’ll be left with a collection of founders searching for their next round while trying to placate a host of debtholders who all have a slightly different idea of what an optimal term sheet looks like.  And don’t kid yourself about the lack of control rights in these converts.  If there’s money, there’s control.  What we need isn’t higher resolution, it’s optimal resolution.  I tend to think that differentiated caps go too far, overly complicating what should optimally be a clean infusion of cash at a risky phase of business by a wealthy investor to a trusted entrepreneur.  

As an attorney, I always seek to push contractual complexity into the future—I know that each additional term I put in a contract will result in 50 headaches I could never have predicted.  Clean terms, clear language, aligned incentives: that’s always the goal.  Why mess with that before it’s absolutely necessary?  Of course, I’m very new to this.  I could easily be wrong.

What We Talk About When We Talk About Digital Sky Technologies

Yesterday, Yuri Milner offered *every* new graduate of Y Combinator $150,000 in uncapped, undiscounted convertible debt. Milner did this ostensibly as an individual, rather than on behalf of his investment firm, Digital Sky Technologies, but it’s probably naive to think the gains and losses stemming from this investment won’t be absorbed by DST. Effectively, then, DST (through Milner) just purchased, for $6M (40 companies * $150k), a 3% equity stake in the Y Combinator portfolio ($150k / $5M estimated average seed round pre-money valuation for YC companies), not to mention a call option on future financings (based on goodwill and early involvement).

Most people in the tech community probably hadn’t heard of DST until its international investment arm, DST Global, invested $200M in Facebook at a $10B valuation in July 2009 (on extremely easy terms, no less). This article by Sudarshana Banerjee of VC Circle provides an extremely well-researched look at the firm, which appears likely to go public next year with help from Goldman Sachs. Owned by a Russian natural resources and media oligarch, the largest Chinese Media digital conglomerate (3rd in the world behind Google and Amazon), a South African media conglomerate, a large Russian investment bank specializing in emerging markets, an American PE/hedge fund, and, Goldman Sachs (sigh), DST is known for writing very large checks on very friendly terms to some of the best performing consumer internet companies in the United States. They also have a habit of outright buying companies in emerging markets with products that closely resemble those of their American investments.

So what does this all mean? All I’m comfortable saying is this: large business interests in Russia, China and South Africa are buying up large long positions in the highest growth sector of the American economy. And while it’s great to see outsiders go long on American innovation, I can’t help but worry that Russia, China and South Africa are proving to be better growth investors than we are. DST saw a gap in the US funding market (passive, large-volume growth equity for consumer Internet companies), and they jumped all over it, purchasing a big slice of the consumer web’s upside that American firms should’ve been smart or agile enough to capture. When it comes to the tech sector, at least, their big money is kicking our big money’s ass.