Convertible? Equity? What kind of coin should you use to scratch off a lottery ticket?

There’s been a lot of debate recently in the market about what kind of investment structure is best for angel and seed arounds.  Mark Suster, Seth Levine, Fred Wilson, and Chris Dixon have all weighed in and there’s more on RWW.

Here’s my own personal take, not any kind of official First Round take:

You should read all of these posts, instantly forget everything you read, and then do what it takes to go out and find the investors who are most passionate, most willing, and most able to help you create a huge business.

According to Paul Graham, “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.

Don’t think for a second that what happens in YCombinator is indicative of the whole seed funding market.  Paul has been able to create (and transfer to the companies in YC) a valuable, and unmatched brand.  Moreover, because of his investor relationships, YC has immense momentum around Demo Day.  Seed investors trip over themselves to get a look at the latest YCombinator deals and the entreprenuers in the hottest companies are in the drivers seat on terms.

Unfortunately, that’s really not the case for most startups.  Sure, if you’re Jack Dorsey, creator of Twitter, you can dictate your terms, but last I checked, most of the entrepreneurs First Round and most of the seed stage firms back don’t have that same kind of track record.  Many, if not the majority, are first time CEOs.  Most deals aren’t obvious winners and have lost of risk still left on the table.  There are the no-brainer winners, the no-brainer passes (which a brain often screws up the ability to distinguish between the two), but most are somewhere in the middle. 

That’s why, for the most part, the first investor willing to commit to your deal is usually in a good position to influence the terms.  In all four deals that I’ve worked on, we were the first ones to the table.  We negotiated fair deals—all equity—in a timely manner.  I think the entrepreneurs were just happy to close and move on to building great companies.  Sure, there will always be another investor who hears that you’ve got a term sheet that is willing to one-up it on price, but it’s really hard to get that first one in the pool. 

When you see all these seed stage investors debating on Twitter and blogs what structures they support, take it for what it is—a marketing exercise.  The investor water cooler occasionally falls victim to reputation racketeering.  An investor says something that makes them *seem* entrepreneur friendly, and then, because the early stage is very competitive, every other investor playing in that space has to follow suit—otherwise they look bad.  At best, they can counter with some thoughtful points, but saying nothing often makes them seem absent from the conversation.

The truth is, for most of you actually reading this, it simply doesn’t apply to you—similar to most of the prescriptive stuff about fundraising written by the top investors.  You’re out there scratching and clawing just trying to cobble together enough angel investor money to feed yourself while you code into the wee hours of the morning, and there’s a debate going on as to what kind of paper stock you should use to print out your legal docs on.  There’s another debate somewhere else going on about which impossible to get into restaurant you should take a supermodel to.  Nice work if you can get it.

What you really should be concerned about is who is in your deal—and who’s really going to help you drive value.  Too many entrepreneurs I see are concerned about optimizing around price.  Sure, you don’t want to get screwed—but if I was building a SaaS tools company that sold to sales teams or plugged into Salesforce, I’d be an idiot not to take money from Mark Suster.  (If you’ve turned down money from Mark, I’m not calling you an idiot—I’m just saying that *I’d* be the idiot)  Similarly, if you’re doing something in eCommerce, and you get a term sheet from Josh Kopelman (ok, so I’m biased there), I can’t imagine another person more able to build value in that area.  I just saw a network effect driven reputation company and immediately sent it over to Chris Dixon to try and get him as a sydicate partner because of his SiteAdvisor experience.  Of course all of these investors add lots of value to a wide variety of companies, but sometimes it’s pretty obvious when an investor is in a unique position to really drive a company forward.

Not all investors add the same amount of value and entrepreneurs need to think long and hard about who they include in a deal if they have that luxury.  There are a lot of folks out there that write small checks and aren’t really as active in the formative stages in a company.  That’s fine if you’re looking to fill out a round—but someone needs to be depended upon to drive value as an active investor—because management teams need all the help they can get to achieve success.

In fact, I’d venture to say that perhaps getting people on board who are purely momentum driven, who ignore terms and are willing to sign up for any term sheet recardless of whether its an uncapped convertible note, might actually be adverse selection.  They may have unlimited tolerance for pricing, but you don’t have unlimited resources as a startup.  Will this investor help you show prudence as a decision maker?  Can you afford to play the “pay up to move ahead at all costs” game as a startup with just 9-12 months of capital in the bank? 

It’s a bit like dating.  You absolutely want to feel special, even fawned over, by the person you’re with—but there’s a limit.  You don’t want the person most desperate to date you—the one who is willing to put up with any terms (like only showing up at their house at 1am, never introducing them to your family or friends, etc). 

There’s nothing wrong with entrepreneurs trying to get the best deal they can—but the “best” deal invovles assembling the best supporters.  Price is a relatively small piece of that at this stage, and professional investors shouldn’t get dinged for trying to negotiate a price that is reflective of the kinds of risks they’re taking.  When Fred Wilson was an angel investor in my company, he told me that he didn’t want to take equity risk and get debt in return—and so we changed over to equity from a convert to make sure he was in. 

Was that entrepreneur unfriendly?  Not at all.  Writing the check was the friendliest thing he ever did.

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