In Silicon Valley, you can make verbal agreements representing tens of thousands, hundreds of thousands or even millions of dollars. Before you sign a document or transfer money, you can have an extremely high level of confidence that the investor will follow through with the investment. These are called 'commitments.'
There are a few reasons why commitments work well here:
- Reputation is important. Usually the best companies can choose their investors, so founders tend to pick those with the best reputation. [1] For those who invest often, there's an incentive to protect your reputation and follow through.
- Standardized terms. Terms have become fairly standard in startup investing in the Valley. Especially for seed rounds, which narrow down the area of agreement to the amount invested, the price of the round and the potential discount. [2]
A founder and investor could disagree over whether they actually committed. This is the main risk of handshake agreements. Paul Graham recently wrote a post suggesting how the handshake agreement process should work, which minimizes that risk. [3] You can see the email above that we started using for commitments. It worked great.
With that said, being highly confident that someone will invest isn't the same as the actual investment; it's not your money until it's in the bank. As one example, Modista had $600k in commitments; they were hit with a patent lawsuit and none of their investors followed through with the investment. [4] During the financial crisis in 2008, many investors withdrew their commitments. That was just 5 years ago. Commitments work, but they are never the same as an actual investment.
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[1] When Dropbox raised their $250m round, they were able to pick the investors they wanted the most. This would also apply to other companies that are high in demand. It helps for an investor to have a great reputation to be able to participate in these deals. Someone without a good reputation wouldn't be invited to invest: http://dealbook.nytimes.com/2011/10/18/dropbox-confirms-250-million-investment/?_r=0
[2] For seed rounds, convertible notes are relatively standard. There are also standardized series A docs, which are still more complex than a convertible note. In that scenario, you sign a term sheet with general terms and then refine the details afterward.
[3] Paul Graham has a helpful post about the commitment process: http://ycombinator.com/hdp.html
[4] Modista was sued by Like.com before they collected their commitments: http://www.k9ventures.com/blog/2011/04/27/modista/