Paul Graham’s Prescription For VCs: Move Fast, Take Less Equity

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At the 500 Startups’ PreMoney Conference last week, Y Combinator’s Paul Graham gave a presentation in which he suggested a new way for Series A investments to get done. Graham provided a few suggestions for innovative early stage investors to differentiate themselves. It basically comes down to: move fast, and don’t over-invest in startups just to get a certain percentage of equity.

“One of the biggest things investors do not get about the fund raising process is what an immense cost talking to them imposes on the startups that are raising money, especially when a startup consists just of the founders. Everything completely grinds to a halt during fundraising,” Graham said at the conference.

Graham suggested that as a result, there’s room for an investor to undercut the competition by moving more quickly with early stage investments. If there existed a reputable investor who would invest $100,000 on market terms within 24 hours, they would be able to corner the market on the best startups, he said. That firm would be approached by all the worst startups as well, Graham said, but at least they’d see everything. In contrast, firms which have a reputation for taking a long time to make their investments would be approached last.

Another way that venture firms could differentiate themselves is by breaking from the typical 20 percent in equity that they ask for during Series A investments. VCs are investing too much and startups are raising too much during that fund raising period, but that could change if someone were willing to break ranks and actually invest less, but for less equity.

“I think the biggest danger for VCs, and also the biggest opportunity is in the Series A stage,” Graham said. “Right now, VCs knowingly invest too much in the Series A stage.”

When there’s a lot of competition for deals, the number that moves isn’t the amount of equity that VCs take, but the amount that they invest and thus the valuation of the company, Graham said. In the case of the most promising startups, Series A investors force companies to take more money than they want to raise.

“Some VCs lie and say that the company needs that much,” he said. “Others are more candid and admit that their business models require them to own a certain percentage of the company, but we all know that the amounts being invested are not determined by the amount that the companies need.”

It used to be that startups needed to give up that much of their company to raise money, but those days are over. With that in mind, Graham thinks that the first VC who breaks ranks and starts doing Series A investments for the amount of equity that the founder is willing to sell stands to reap huge benefits.

“If there were a reputable top tier firm that was willing to do a Series A round for as much stock as the founders wanted to sell, they would instantly get almost all the best startups,” Graham said. “And the best startups are where the money is.”

I talked to him about that theory and about how Y Combinator has scaled in the video above. (Skip ahead to about 5:30 to hear his thoughts on changing equity structures.)