Startups are fragile plants—seedlings, in fact. These seedlings are worth protecting, because they grow into the trees of the economy. Much of the economy's growth is their growth. I think most politicians realize that. But they don't realize just how fragile startups are, and how easily they can become collateral damage of laws meant to fix some other problem.

Still more dangerously, when you destroy startups, they make very little noise. If you step on the toes of the coal industry, you'll hear about it. But if you inadvertantly squash the startup industry, all that happens is that the founders of the next Google stay in grad school instead of starting a company.

My second suggestion will seem shocking to VCs: let founders cash out partially in the Series A round. At the moment, when VCs invest in a startup, all the stock they get is newly issued and all the money goes to the company. They could buy some stock directly from the founders as well.

Most VCs have an almost religious rule against doing this. They don't want founders to get a penny till the company is sold or goes public. VCs are obsessed with control, and they worry that they'll have less leverage over the founders if the founders have any money.

This is a dumb plan. In fact, letting the founders sell a little stock early would generally be better for the company, because it would cause the founders' attitudes toward risk to be aligned with the VCs'. As things currently work, their attitudes toward risk tend to be diametrically opposed: the founders, who have nothing, would prefer a 100% chance of $1 million to a 20% chance of $10 million, while the VCs can afford to be "rational" and prefer the latter.

Whatever they say, the reason founders are selling their companies early instead of doing Series A rounds is that they get paid up front. That first million is just worth so much more than the subsequent ones. If founders could sell a little stock early, they'd be happy to take VC money and bet the rest on a bigger outcome.

So why not let the founders have that first million, or at least half million? The VCs would get same number of shares for the money. So what if some of the money would go to the founders instead of the company?

Some VCs will say this is unthinkable—that they want all their money to be put to work growing the company. But the fact is, the huge size of current VC investments is dictated by the structure of VC funds, not the needs of startups. Often as not these large investments go to work destroying the company rather than growing it.

The angel investors who funded our startup let the founders sell some stock directly to them, and it was a good deal for everyone. The angels made a huge return on that investment, so they're happy. And for us founders it blunted the terrifying all-or-nothingness of a startup, which in its raw form is more a distraction than a motivator.

If VCs are frightened at the idea of letting founders partially cash out, let me tell them something still more frightening: you are now competing directly with Google.

Thanks to Trevor Blackwell, Sarah Harlin, Jessica Livingston, and Robert Morris for reading drafts of this.

(This article is meant to be a complete summary of funding options for startup founders. In effect we're open-sourcing the kernel of what we tell founders about funding at Y Combinator.)

Venture funding works like gears. A typical startup goes through several rounds of funding, and at each round you want to take just enough money to reach the speed where you can shift into the next gear.

Few startups get it quite right. Many are underfunded. A few are overfunded, which is like trying to start driving in third gear.

I think it would help founders to understand funding better-- not just the mechanics of it, but what investors are thinking. I was surprised recently when I realized that all the worst problems we faced in our startup were due not to competitors, but investors. Dealing with competitors was easy by comparison.

I don't mean to suggest that our investors were nothing but a drag on us. They were helpful in negotiating deals, for example. I mean more that conflicts with investors are particularly nasty. Competitors punch you in the jaw, but investors have you by the balls.

Apparently our situation was not unusual. And if trouble with investors is one of the biggest threats to a startup, managing them is one of the most important skills founders need to learn.

Let's start by talking about the five sources of startup funding. Then we'll trace the life of a hypothetical (very fortunate) startup as it shifts gears through successive rounds.

A lot of startups get their first funding from friends and family. Excite did, for example: after the founders graduated from college, they borrowed $15,000 from their parents to start a company. With the help of some part-time jobs they made it last 18 months.

If your friends or family happen to be rich, the line blurs between them and angel investors. At Viaweb we got our first $10,000 of seed money from our friend Julian, but he was sufficiently rich that it's hard to say whether he should be classified as a friend or angel. He was also a lawyer, which was great, because it meant we didn't have to pay legal bills out of that initial small sum.

The advantage of raising money from friends and family is that they're easy to find. You already know them. There are three main disadvantages: you mix together your business and personal life; they will probably not be as well connected as angels or venture firms; and they may not be accredited investors, which could complicate your life later.

The SEC defines an "accredited investor" as someone with over a million dollars in liquid assets or an income of over $200,000 a year. The regulatory burden is much lower if a company's shareholders are all accredited investors. Once you take money from the general public you're more restricted in what you can do. [1]

A startup's life will be more complicated, legally, if any of the investors aren't accredited. In an IPO, it might not merely add expense, but change the outcome. A lawyer I asked about it said:

When the company goes public, the SEC will carefully study all prior issuances of stock by the company and demand that it take immediate action to cure any past violations of securities laws. Those remedial actions can delay, stall or even kill the IPO.

Of course the odds of any given startup doing an IPO are small. But not as small as they might seem. A lot of startups that end up going public didn't seem likely to at first. (Who could have guessed that the company Wozniak and Jobs started in their spare time selling plans for microcomputers would yield one of the biggest IPOs of the decade?) Much of the value of a startup consists of that tiny probability multiplied by the huge outcome.

It wasn't because they weren't accredited investors that I didn't ask my parents for seed money, though. When we were starting Viaweb, I didn't know about the concept of an accredited investor, and didn't stop to think about the value of investors' connections. The reason I didn't take money from my parents was that I didn't want them to lose it.

Another way to fund a startup is to get a job. The best sort of job is a consulting project in which you can build whatever software you wanted to sell as a startup. Then you can gradually transform yourself from a consulting company into a product company, and have your clients pay your development expenses.

This is a good plan for someone with kids, because it takes most of the risk out of starting a startup. There never has to be a time when you have no revenues. Risk and reward are usually proportionate, however: you should expect a plan that cuts the risk of starting a startup also to cut the average return. In this case, you trade decreased financial risk for increased risk that your company won't succeed as a startup.