Our experience was unusual; vesting is the norm for amounts that size. Y Combinator doesn't require vesting, because (a) we invest such small amounts, and (b) we think it's unnecessary, and that the hope of getting rich is enough motivation to keep founders at work. But maybe if we were investing millions we would think differently.

I should add that vesting is also a way for founders to protect themselves against one another. It solves the problem of what to do if one of the founders quits. So some founders impose it on themselves when they start the company.

The angel deal takes two weeks to close, so we are now three months into the life of the company.

The point after you get the first big chunk of angel money will usually be the happiest phase in a startup's life. It's a lot like being a postdoc: you have no immediate financial worries, and few responsibilities. You get to work on juicy kinds of work, like designing software. You don't have to spend time on bureaucratic stuff, because you haven't hired any bureaucrats yet. Enjoy it while it lasts, and get as much done as you can, because you will never again be so productive.

With an apparently inexhaustible sum of money sitting safely in the bank, the founders happily set to work turning their prototype into something they can release. They hire one of their friends-- at first just as a consultant, so they can try him out-- and then a month later as employee #1. They pay him the smallest salary he can live on, plus 3% of the company in restricted stock, vesting over four years. (So after this the option pool is down to 13.7%). [7] They also spend a little money on a freelance graphic designer.

How much stock do you give early employees? That varies so much that there's no conventional number. If you get someone really good, really early, it might be wise to give him as much stock as the founders. The one universal rule is that the amount of stock an employee gets decreases polynomially with the age of the company. In other words, you get rich as a power of how early you were. So if some friends want you to come work for their startup, don't wait several months before deciding.

A month later, at the end of month four, our group of founders have something they can launch. Gradually through word of mouth they start to get users. Seeing the system in use by real users-- people they don't know-- gives them lots of new ideas. Also they find they now worry obsessively about the status of their server. (How relaxing founders' lives must have been when startups wrote VisiCalc.)

By the end of month six, the system is starting to have a solid core of features, and a small but devoted following. People start to write about it, and the founders are starting to feel like experts in their field.

We'll assume that their startup is one that could put millions more to use. Perhaps they need to spend a lot on marketing, or build some kind of expensive infrastructure, or hire highly paid salesmen. So they decide to start talking to VCs. They get introductions to VCs from various sources: their angel investor connects them with a couple; they meet a few at conferences; a couple VCs call them after reading about them.

Armed with their now somewhat fleshed-out business plan and able to demo a real, working system, the founders visit the VCs they have introductions to. They find the VCs intimidating and inscrutable. They all ask the same question: who else have you pitched to? (VCs are like high school girls: they're acutely aware of their position in the VC pecking order, and their interest in a company is a function of the interest other VCs show in it.)

One of the VC firms says they want to invest and offers the founders a term sheet. A term sheet is a summary of what the deal terms will be when and if they do a deal; lawyers will fill in the details later. By accepting the term sheet, the startup agrees to turn away other VCs for some set amount of time while this firm does the "due diligence" required for the deal. Due diligence is the corporate equivalent of a background check: the purpose is to uncover any hidden bombs that might sink the company later, like serious design flaws in the product, pending lawsuits against the company, intellectual property issues, and so on. VCs' legal and financial due diligence is pretty thorough, but the technical due diligence is generally a joke. [8]

The due diligence discloses no ticking bombs, and six weeks later they go ahead with the deal. Here are the terms: a $2 million investment at a pre-money valuation of $4 million, meaning that after the deal closes the VCs will own a third of the company (2 / (4 + 2)). The VCs also insist that prior to the deal the option pool be enlarged by an additional hundred shares. So the total number of new shares issued is 750, and the cap table becomes:

shareholder shares percent ------------------------------- VCs 650 33.3 angel 200 10.3 uncle 50 2.6 each founder 250 12.8 employee 36* 1.8 *unvested option pool 264 13.5 ---- ----- total 1950 100

This picture is unrealistic in several respects. For example, while the percentages might end up looking like this, it's unlikely that the VCs would keep the existing numbers of shares. In fact, every bit of the startup's paperwork would probably be replaced, as if the company were being founded anew. Also, the money might come in several tranches, the later ones subject to various conditions-- though this is apparently more common in deals with lower-tier VCs (whose lot in life is to fund more dubious startups) than with the top firms.

And of course any VCs reading this are probably rolling on the floor laughing at how my hypothetical VCs let the angel keep his 10.3 of the company. I admit, this is the Bambi version; in simplifying the picture, I've also made everyone nicer. In the real world, VCs regard angels the way a jealous husband feels about his wife's previous boyfriends. To them the company didn't exist before they invested in it. [9]

I don't want to give the impression you have to do an angel round before going to VCs. In this example I stretched things out to show multiple sources of funding in action. Some startups could go directly from seed funding to a VC round; one of the companies in the 2005 SFP did.

The founders are required to vest their shares over four years, and the board is now reconstituted to consist of two VCs, two founders, and a fifth person acceptable to both. The angel investor cheerfully surrenders his board seat.

At this point there is nothing new our startup can teach us about funding-- or at least, nothing good. [10] The startup will almost certainly hire more people at this point; those millions must be put to work, after all. The company may do additional funding rounds, presumably at higher valuations. They may if they are extraordinarily fortunate do an IPO, which we should remember is also in principle a round of funding, regardless of its de facto purpose. But that, if not beyond the bounds of possibility, is beyond the scope of this article.

Anyone who's been through a startup will find the preceding portrait to be missing something: disasters. If there's one thing all startups have in common, it's that something is always going wrong. And nowhere more than in matters of funding.

For example, our hypothetical startup never spent more than half of one round before securing the next. That's more ideal than typical. Many startups-- even successful ones-- come close to running out of money at some point. Terrible things happen to startups when they run out of money, because they're designed for growth, not adversity.

But the most unrealistic thing about the series of deals I've described is that they all closed. In the startup world, closing is not what deals do. What deals do is fall through. If you're starting a startup you would do well to remember that. Birds fly; fish swim; deals fall through.