Angels & VCs
I was at the Capital Innovation event in Montreal yesterday where we heard from Jacques Bernier, head of Teralys Capital and his vision for a new risk capital sector in Canada as well as from Ian Sobieski, founder of Band of Angels, Silicon Valley’s oldest seed funding organization. It was interesting to hear Mr. Sobieski criticize the VC model to a room full of VCs and it got me thinking about the relationship between angels and VCs.
Sobieski talked about how when VCs come into angel deals the time to exit goes up and the probability of exit goes down. All things that kill returns for angels. His arguments echo and I believe in large part came from Basil Peters’ excellent book Early Exits.
Basil calls for a new model of angel investing and tech entrepreneurship arguing that “early” exits at $10M, $ 20M values are a good thing. The thinking being that this creates a virtuous circle of new angels and wealthier, proven entrepreneurs willing to bet bigger the next time around.
But here’s the rub: Band of Angels posts an impressive 53% annual rate of return (IRR). But, when you back out the nine IPOs in their portfolio their returns are negative 9%. What this tells me is that up till now, their success has been largely driven by VC-backed companies. You don’t get to NASDAQ-level run rates without serious capital that goes way beyond what even Band of Angels can provide.
Also, Band of Angels is quite transparent about their track record. For every 100 companies they have invested in, 27 have achieved an exit. This is no better than the overall VC assumption in terms of exit rate.
So, who’s right? Who’s more successful? Can angels live without VCs? Vice versa?
Angels have historically played a far bigger role than most people realize in funding startups. Sobieski shared some stats to back this up yesterday. With the VC industry contracting this trend will only continue. But, I think the relationship between angel and VC is a wary one and so as a startup you need to have a dual track growth plan.
The Plan
Angels are wary of VCs. So, if you present a funding plan that takes multiple rounds of capital and is absolutely dependent upon VC follow on, you will have a tough time. So, you need to break your funding strategy into two stages:
Angel only: A capital efficient plan that can be angel / seed funded that gets you to break even or enough traction, momentum and proof to generate an early exit, cash flow sustainability or follow on funding.
Venture: A plan that you turn on only if you and your investors decide to “go for it”, double down and go for venture-scale returns.
Angels are absolutely essential to early stage funding. Build your fundraising and growth strategy around their needs. If you decide to expand your vision and capital requirements later that’s all good. But don’t depend on more capital from day one.
This approach is also better for the venture community. They will get companies that, while small, have more validation and proof points. Companies will have more chance of raising venture because of these proof points.
Iterative Capital wins.
A very wise early stage investor who befriended me once told me that the world of early stage investing can be explained under two analogies. The commuter train & the express train. The express train takes on lot's of fuel and races to the end station with no stops.
The commuter train – must balance it's resources, stop often & ensure that all passengers reach their destination with the choice to get off.
In the last 15 years of venture investing we enjoyed the excesses of the express train model – where anyone could race to the trough of the public markets. Fuel was cheap, mistakes were easy to ignore & building real last shareholder value was placed secondary to reaching the IPO destination.
In the new commuter model of investing we face the opportunity to deploy iterative capital – ensuring that entrepreneurs, employees & shareholders (angels & vc's alike) have the opportunity to fund companies to get to the next stop.
As Mark, Ben & Chris point out – great companies require a track, intentional driving, plans & the right resources to get to the next station. In this model of company building if an entrepreneur wants to check out at the $XX million station then all investors can support them while sharing in the profits.
The only conflict is when too many resources are deployed and the only option is to get to the final station and past investors (angels) and new investors (vc's) want to exit at different stations.
Extreme conditions breed greatness & I share Chris's comments that Canada's anemic capital markets for innovation have bred some great companies with capital efficient venturenomics at their chore.
The next 5 yrs are going to be exciting
Thanks Austin. Great points. Exactly – too much capital reduces exit choices
I think that there is serious risk in the two-pronged approach. Very few ideas lend themselves to a dual-track, realistically. If you *plan* to be cash flow neutral, you are almost certainly going to end up with a non-venture company like a consulting company. If you *plan* to be a transformational company, you will almost always want some VC rocket fuel.
In my case, I pitched my angels on the VC route. Make no mistake, I am adherent of the lean startup community. But we are shooting for a big win, and our task is to discover a product/market fit that *many* VCs will believe. We will be focusing on customer interest, and customer profitability–not cash flow! If it works out, we will need to fund our growth.
Cheers! Mike
I agree that is both difficult and rare to hit break even on one angel round. To do so implies flatlining and not investing for growth.
I spend most of my time in the web / SaaS World where you can and should go very lean out of the gate till you have market validation and ideally early proof points on per user economics. These two milestones to me are the key for raising VC should you choose to. So, in my World, the 2 pronged approach works well.
In Canada we are starting to see more and more Home Run potentials: Beyond The Rack, Netshelter, Tynt, Woozworld, Stream the World, Status.net, iBwave Vantrix, Tungle …. the winners are the startups that first focused on validation, proving their model, gathering traction, building the pipeline… before closing large amount of VC funding (except one above listed company that raised substantial funding early on)… These companies are making their way to becoming industry segment leaders. Putting Canada on the map and help build our ecosystem. Many of the entrepreneurs leading the above companies first made their teeth on smaller successful and less successful exits. Some deals require less ambition to be successful, to generate return. Others, have the potential of being huge home run's… if they first prove out their model before raising big cash. And hopefully, in both cases, we will see more and more angels working with VC's!
Got to jump on a flight now. Hope to read more comments tonight.
Chris, great comments. Thank you. They deserve to be in their own blog post. Glad to hear you show openness to the return and ecosystem potential of "smaller" wins. Exits, regardless of size, get everyone focused and motivated. We need lots of them. Big, small, in between. Build that entrepreneurial culture.
I think that for a tech startup today, its more about doing more with less cash: prove your model, get VALIDATION, confirm virality, have real growth trends and sustainability… then raise big cash (that's exactly what Twitter, Google, Paypal and Foursquare did).
We need to be reasonnable on the potential of a deal. Any type of deal (VC or Angel funded). When a company only needs 2M and sales for 30M… the return is pretty good for all involved. And for the entrepreneur… it make him/her want an even bigger success next time around. It's important that we work on building a strong ecosystem, and that requires recurring successful entrepreneurs at the forefront, a network that goes beyond our borders, understanding of what it takes to generate strong returns for vc funded companies, but also requires all kind of success stories, big and small. Its about changing our entrepreneurial culture one deal at a time. Dreaming and thinking BIG is an absolute need. Yes! But, that requires making sure we have the tools within our ecosystem to allow us to dream of changing the world! If we don't know how to build the next Facebook, Google or Twitter how will we make our dreams come true? That's when having many more small to mid size successes will help build such ecosystem. But when well prepared, it doesn't mean we shouldn't aim for the fence and knock it out of the park either! __
Would love to see this debate expanded and put to the forefront even more! Too bad I missed the Capital Innovation event in Montreal yesterday. I also just read Les Affaires article by @mckenTeralys et sa bande: …http://bit.ly/dhZv58 OUCH! This didn't sound good!
I think the most interesting thing that Ian Sobeski said yesterday was with respect to being honest about exit opportunities when seeking financing (from angels or VCs). He pointed out that he'd rather have an entrepreneur say to him, "This is a small, $10-$20MM exit" than give him the "party line" of, "This is a $100MM company, look at the hockey stick."
I thought that was refreshing, because I know that many entrepreneurs are targeting smaller exits but feel it's necessary to build "$100MM in 5 year models."
Having said that (arguing to some degree that small exits are good), the math doesn't add up as you pointed out for the Band of Angels at least without the IPOs.
Clearly there has to be a lot more alignment of interests from entrepreneur to angel to VC. And for the entrepreneur a much clearer understanding of how much money they need to achieve appropriate milestones. For example, let's say you need $250,000-$750,000 to get to a stage where you could exit at $5-$15MM. Well that's perfect for angels. And when you're nearing that stage, when inquiries for acquisition are coming in around that mark, that's when you should be making decisions on whether to scale to the next level with VC or exit early. That's maybe a "perfect scenario" but it at least provides clearer alignment.
Its important to remember the audience for your projections. As you said the sub $ 750K to get to exit is great for angels and you can be open with them if that's your goal. But you need to sing a different tune if you're pitching VCs, even seed VCs at the same time.
Thanks Scott. And welcome back from DEMO
One thing I do with startups right after they close funding is figure out our operating plan for what we will achieve in runway from a bottom up perspective so that we either don't need more $ or have enough momentum and traction to raise more. Doing that planning *before* the raise would allow you to be specific about use of proceeds. In the pitches I work on we capture this both in the pitch and in the financial model