Tag Archive for 'angels'

How to fundraise in the next six months

Is funding for startups now starting to tamper out? The answer is yes but not really.

Long term trends in the industry have fueled the creation of a seed bubble that is now starting to face the consequences of the tranche of new investors that increased activity in the market. The macro economic environment will create issues that impact the players that have driven the seed bubble which will create a sense of crisis in the industry, compounded with a permanent trend where it is simply now more competitive to raise money as a startup.

Ultimately, what is happening is a readjustment in the industry, rather than a cash crunch and a bubble bursting — and that there will still be money for smart founders and their teams. This is so long as they understand that one of the most important lessons to raising money is on the vision of the founder CEO and not just the traction of the product or calibre of the team.

I’ll be unpacking these statements below.

What made things bubbly
In mid 2010, we saw a dramatic turnaround in Silicon Valley: the boom was back. As some educated commentators noticed, a bubble formed in the early stage of the market. Seed stage startups were now raising money at inflated values. Rather than blaming this on any individual player, the long-term trends in the industry created this transformation in the industry,which in short are the lower costs to build an Internet business.

Consequently, the three major investor groups (incubators, angels and venture funds) boosted this trend to become a new boom. So how did it become bubbly?

Bubbles

With the incubators driven by the seed accelerators, it led to a dramatic increase in the volume of startups. The same money, but spread across more startups meant an increase in volume. This in itself is not what helped cause the early stage bubble, in the same way that a forest is not responsible for a bush fire. However, a less obvious explanation on the impact of this is that investors were now being over-whelmed by deal flow, that they now couldn’t spend the adequate amount of due diligence time required to make an investment. Quicker decisions made to not miss out, lead to fatigue due to the volume and consequently poor judgement, which may lead investors making deals that potentially may not have done if things were at a slower pace. When people are making investment decisions not grounded in fundamental valuations, that’s when we have a bubble.

And the angel investors have been no angels themselves. More startups were now getting funded, more often – shifting the perception of (perceived power) between investors and entrepreneurs that anyone could raise money now. Their biggest crime is in funding seed companies with small ideas hoping for quick returns (like talent acquisitions) or for status to build their personal brands, contributing to the amount of companies that survive post incubation by which will never make it past the gates of a VC.

The impact of venture capital in seed has also fueled the boom but on the valuation side. For a VC, putting money into a startup at a seed stage means less to them than an angel (ie, they are not as price sensitive). Several VC’s don’t set the terms of the money they put in, leaving the entrepreneur to, who price their round as high as they can (if someone was to give you a blank check, would you put a lower or higher number?!). So while some people claim it’s the VC’s that fueled the bubble, it’s more correct to say VC’s facilitated entrepreneurs to over-price themselves for short-term benefit — but long term at a disadvantage as they now have a higher bar to meet in follow on funding.

How the economy will impact the tech fundraising environment
You have $10m sitting around — what are you going to do with that cash? Well, invest it of course. You can have it sit in a term deposit, and make less than 1% interest; or you could put it into a startup and make a 900% return: that’s the allure of angel investing in the early stage. But what if you don’t want to do either? What’s going to generate a return in this economy that’s not idle cash in the bank but also relatively safe at generating a good return? The stock market.

When the stock market crashes due to a confidence issue after news is announced about the economy, so does the wealth of these wealthy individuals. For this reason, the correlation between the economy and the appetite of angels to invest will directly be proportional; whereas it will have practically no impact on newly raised venture funds (typically a 10 year fund, will be actively invested for its first three years).

This is especially true of funds that have been performing in the market as they will be able to continue raising money from limited partners desperate to get returns on their capital. (That said, the amount of successful VC’s is a separate issue — I’ve been told only 30 out of 600 firms in the last decade have shown positive returns.)

recession buster

In other words, don’t let the economic news affect your thinking on fundraising unless you’re trying to raise from an angel: VC’s actually love it in a downturn as they can now regain their inboxes.

The impact of the seed boom and the road from here
It’s now been 18 months since the seed “bubble” really started. It’s also now when we are seeing the results of these investments.

Startups eventually are going to need to tap into larger investment dollars available only by VC’s as angels bow out of the larger rounds. The impact for the entrepreneur is that it’s now a more competitive landscape to raise funding: a VC who previously picked 2 companies out of 20 to do a series A round, now has 100 to choose from…but can still only pick 2.

Why does this matter? If less startups are being funded, it means they will fizzle out. Investors lose their money. And the truth sets in that angel investing is a risky game. This won’t lead to a significant decrease in angel investing, but it does mean a sobering reality for those investors who just lost some of their wealth.

For existing startups that have already raised a seed round (from angels or VC’s), we’re going to see the impact of the seed bubble in three ways:

(a) You need to sell more than a dream now. For startups trying to raise follow on funding, they now have more data points of their traction and so venture investors are more acute of their cost of capital needs being met.  Seed rounds are considered the new Series A, meaning the funding is significant enough that a startup can exist for 18 months — a lot can happen during that time period, so when they go to raise their Series A, the VC’s are no longer investing in an idea and team (a “dream”), but an idea, team, and quantified traction of how realistic the business will be (still a dream, but instead that dream is being explained the next day when people are awake…).

(b) You may be great but overpriced. For startups with existing high valuations from the seed round, we’re going to see higher priced Series A rounds. The consequence is that the smart money will simply step away from this. Others may participate. But what was previously thought a good thing — entrepreneurs being able to over-price their seed round just because they could — is now going to impact them as they now will be raising (or expected to) at a much higher valuation without the necessary traction to justify it.

(c) The bar is now higher. VC’s are being flooded with deal flow now, thanks to the broader trend of lower costs to start a company and looser capital at the early stage (and no, that’s not a good thing as it’s leading to burnout in VC’s trying to keep up which will lead to poorly-researched deals being done, making a real bubble). As a consequence and to the point I raised earlier, there is now just more competition for the same finite spots of investment opportunity by a venture fund. You may have a great product, a great team, and some great traction — but you’re now being compared to many more startups who also have great products, great teams, and great traction.

Never forget in fundraising the cost of capital investors need to meet
At the TechCrunch Disrupt conference in San Francisco last year, I noticed an interesting thing: what the angels and micro-VC’s were saying about what you need to raise capital, was very different from what the experienced VC’s were saying. The VC’s talked about vision, the angels talked about customers, revenues and traction.

If you’re fundraising, don’t underestimate vision and quantifying your market opportunity. Cost of capital is the reason.

golf lesson

In finance, the cost of capital is a term to describe a return needed on equity — think of it like the interest rate on debt. Venture funds who raised money from limited partners, have a cost of capital which is to be able to return the fund and then some. I feel like people see professional investors as rich guys that can give money simply if they like you — not quite. VC’s need to make money, and they are going to do that by investing in startups that they think have a chance of generating a return.

So how do that do that? Well, they look at the team and the product because after all that’s the execution part of the equation. But just as important and if not more important, is the market opportunity. If a VC has a $200m fund, that means they need to have a 20% stake in a billion dollar startup for them to return their fund. If they invest in anything that’s worth less than a billion dollars, then it’s not worth the investment. Of course, VC’s have differing strategies in their investment thesis and may invest in something for other reasons, but for the most part, the reason why VC’s are so interested in the vision is because the CEO founder is painting the picture of a best case scenario of what the opportunity is.

The fundraising equation a professional investor needs satisfied in their head could be explained as the market opportunity (potential valuation) multiplied by the probability of achieving that opportunity (the risk factors in execution reducing the probability) multiplied by the percentage stake in the business. If you’re a billion dollar idea which a good chance at success, why wouldn’t a VC want to invest in you? Founders overlook the importance of the vision because they ignore the fact VC’s are professional investors in the business of generating returns, and instead focus on the product, relationship, and confusing a good product from a product that has the potential to meet an investors cost of capital.

As an aside, this is also why long term we will be seeing more and more micr0-VC funds existing, funding smaller ideas. Why? Because if you think of the equation above, the return needed by Micro VC’s (with say a $50m fund) is much smaller now — an acquisition signed off by a Google/Microsoft/Yahoo VP for $50m rather than a billion dollar IPO is all they need.

The moral to this story?
The industry is in an adjustment phase but we’re not going to see the ugly side of the seed boom as the bubble will be absorbed and far away from the public markets.

the road gets better from here

You need traction to raise money as that proves your execution and reduces the risk for an investor, but traction without vision is just as bad as a vision without traction. In the next few months, people are going to start panicking, but don’t — the best entrepreneurs will still be able to raise money. You just need to be aware of the cost of capital for the investors you pitch.

Just remember to nail that vision bit.

Scouting Angel List

I’ve become an Angel List scout.

What’s Angel List? It’s a service that my good friend Naval Ravikant launched in February 2010 with the Venture Hacks crew, which is dramatically improving the process that is the tech fundraising model. Need high quality investors for a startup? All you need to do now is pitch it via a form.

What’s an Angel List scout? Someone that the Angels on Angel List can trust, who will help filter and provide social proof on startups.

Why am I an Angel List scout? I get a lot of people wanting to meet with me to discuss their startup and help them get introductions to people I know. This is partly due to my profile in building the Australian tech community, my involvement in the DataPortability Project, and my most recent initiative the StartupBus which I launched in 2010 as an entrepreneur development program and with its success I now hope to turn into a qualified community of entrepreneurs (more on that another time).

By being made a scout, I’m now going to be able to direct people to Angel List and formally provide social proof to the investors who want to know more about the startups applying. I won’t be investing in the startups that apply, but I can provide recommendations to people who will.

I don’t get paid for this. Actually, I don’t get any benefit from doing it, other than the satisfaction of helping people like future entrepreneurs and my friends at Angel List. But hopefully, I can now make my interactions with people more valuable as I have a direct connection with what I believe could transform Silicon Valley and consequently the world one day.

So if you have a pitch, go ahead and fill out the form – add my name in the referred field and they will circle back with me for my opinion (currently free-form text, but it will soon be a drop down). Also, if you want to be visible to me when applying, you have to choose me from the “angel picker” when me apply. I’ll try my best to make coffee time for as many entrepreneurs as possible who stop by San Francisco, as I have been in the last year and a half since moving to America.

Update January 2 2011: I just got told that “as a scout, you can see, vote, and comment on startups that have chosen to be visible to you. So you do have some real powers in influencing the investors on the site and crowdvoting up the good startups”. So once again I can’t *do* anything that will get you funded, but I can help :)

How the super angels are saving Silicon Valley

Michael Arrington has written about the current bubble in Silicon Valley: the angel investor. He suggests a war is occurring with this new class of investor, and that entrepreneurs need to pick their faction. I don’t doubt the politics is real, and I’m sure it exists between the angels themselves – let’s hope they realise that united they stand, but divided they will all fall.

But I think this “conflict” is really about a change in times. Much like how the traditional gatekeepers of information – the newspaper industry – are battling the process-journalism innovators that we call ‘bloggers’. (Like, ahem, TechCrunch.) No one appointed the Venture Capital industry as the gatekeeper for technology innovation, which is similar to the arrogance of the newspapers that think they ‘own’ the news and deserve special protection because of it. Maybe these over-sized funds should take a lesson from the newspapers and realise the times have changed and their model needs to change as well.

But where I differ with Arrington’s perspective is his prognosis that this is bad for innovation. Conflating this with ‘bigger ideas not getting funded’ is wrong. The point is, is that more innovation can get funded, more veterans are being developed, and more value is being created in the long run. This should be analysed not by the growth of a single tree, but the overall development of the entire forest.

We need more seed-accelerators, more super-angels, and more incubators – because inevitably, it will lead to more startups. And whilst not all will hit a home run, the odds of ‘the next big idea’ happening will improve dramatically.

Why I like angel list

Feedback is now coming out about Angel list, a new service from the blog Venturehacks. It’s a simple concept: get a group of angel investors and promise you will send quality deal flow to them that’s been vetted; likewise say to entrepreneurs that all they need to do is fill out a form and they will get access to some of the smartest investors in Silicon Valley. It’s so simple that is hurts, and yet only people like Naval Ravikant and Babak “Nivi” Nivi would be able to pull it off as it takes serious credibility to get both groups involved. Venturehacks in my opinion is the number two blog on venture and investment in technology, after Fred Wilson’s blog.

Angel list is a special thing that I believe will transform Silicon Valley. Much like how Michael Arrington exploited the market dynamic to make TechCrunch the success it was, Ravikant and Nivi is doing the same thing by connecting entrepreneurs with investors. And not just any investors: the early stage investors that startups really need. Simply put, it’s reducing the costs of innovation in Silicon Valley – the ‘thing’ that has changed the world.

I really hope the industry rallies around this and collaboration opportunities with other high profile angels continue. Jason Calacanis for example is doing something equally impressive with the Open Angel forum, and I sense they both have equal motivations due to their annoyance at how other investor groups have abused their position in the industry. Even though I see them adding different value to the startup scene (they’re similar but different – and should stay different for maximum value creation), all I can say is “awesome – I want more”.