The Evolution of Angels into VC’s

evolution of man

We’ve been witnessing an institutionalizing of angel investing in recent years.  For the most part, it’s good. There continues to be a gap in the market for stage appropriate seed investors, especially in the East Coast.  But it’s interesting to watch some of these funds pursue a predictable path of evolution. 

It’s goes something like this.  An angel investor writes a lot of checks and has some level of success.  It’s amazing how right out of the gate, and individual angel can get into many good deals with a bit of hustle and a willingness to deploy capital in small chunks.  They find themselves coinvestig with many great funds and getting a bunch of write-ups and some small wins.  ”Man, this is easy!”, they think. Those big funds are dinosaurs. I’m in way more interesting deals than many of them.  And I bet I could do even better with more money.

Some LPs agree, and the angel becomes a small VC (aka a super angel).  Maybe managing $7M-$25M. They continue to pursue their strategy of writing many small checks. But they quickly realize that this doesn’t work well. That $50K they have in the next hot company may yield a 20x, but it doesn’t move the needle on the fund. The logical strategy evolution is: “Ok, I must invest more per deal, and I must focus only on companies that have the potential to move the needle in my fund.”

Then, they realize something. Hey, it’s tougher to get into great deals now!  It used to be easy for investors to let me in for $50-$100K.  But now that I’m writing a bigger check, there isn’t enough room because I’m actually eating into another investor’s target ownership.  I need to work harder to encounter companies earlier, and I need to spend more time on each company to develop a reputation of being an excellent, value-added investor. 

To make matters worse, the Super Angel is not in a great position to lead many deals. They quickly realize there is a big difference in tagging along on another investor’s deals and leading one.  There is usually only room for one or two leads, and you usually need to write a meaningfully sized check to do it. 

The super angel also realizes that they need a follow on strategy.  "Guess what, investing heavily into your winners makes a lot of sense" they say. "I knew company X was going to be a winner, I should have put way more capital behind it!" . The funny thing is that this conclusion is made with incomplete data.  The angel only responds to the regret of the good companies that they wish they had invested more in.  They look back and say “it was obvious that this was the winner!”.  But it’s more difficult to know this prospectively than one would think, and the super angel does not have the scar tissue of throwing good money after bad that many VCs have seen happen themselves.

At this point, the portfolio is starting to get pretty hefty.  So the super angel starts thinking of scaling their team. More people means more mouths to feed.

So, here are all the motivators that have arised to raise a bigger fund:

1. Wanting to put more into each deal to make them meaningful

2. Wanting to be able to lead deals and get ball control

3. Wanting to reserve more to invest big in the winners

4. Having more mouths to feed and needing more fees.

So, what happens next? Viola! The next fund is a traditional VC fund with $50M/partner or more. Meanwhile, the VC is annoyed by the new crop of seed investors that somehow keep on getting into good deals with their small checks.

Parting Thoughts:

1. This isn’t immediately obvious, but as an individual angel, there is actually an advantage in terms of deal flow. You can invest at a scale where most investors will let you in, especially if you see an investment early and have a reputation for helping.

2. Institutionalizing is harder than it looks.  There are some terrific firms that have had the opportunity to raise much larger funds but have resisted in order to stick to their strategy.  But this is hard to do and many end up raising larger and larger funds or pursuing new strategies like growth or international expansion. 

3. Super Angels are VC’s. They are governed by the same incentives or anyone else managing money.  And have a tendency to look and behave more like VCs over time, unless they start out with a completely different strategy from the beginning and are very disciplined about sticking with that strategy (ie: Ron Conway, Paul Graham).

Two days ago, I gave a talk at Angel Bootcamp titled “Unicorns and Tom Brady - Picking Winning Founders”.  The purpose of the talk was to illuminate some data around founders, and what characterizes successful ones.

It was meant to be directional, and help folks who don’t have the benefit of being a professional investor and getting a “gut” for great founders through pattern recognition.  A couple points and takeaways:

1. I took a chunk of data from Silicon Alley Insider’s Digital Media Top 100.  It was as good a dataset as any for promising companies.  But obviously isn’t exhaustive and definitely skews towards my areas of focus, which are digital media and internet enabled businesses. 

2. My partner Lee has blogged at length about our love for Tom Brady entrepreneurs. Read more about it on his blog.

3. My partner Dave has blogged about authentic entrepreneurs, which is very important to us. As I said in my talk - a 40-year old enterprise sales executive would never conceive of AirBnB and make it work. 

4. See my interview with Matt Lauzon to hear some crazy stories about a young, first time entrepreneur who is creative and hustles. 

5. Here’s a link to the academic paper and the book around evaluating human capital that I referenced.  They are excellent reads. 

6. If you are in Boston and want to get more involved in the startup community - check out my Hitchiker’s Guide to the Boston Tech Community. 

Thanks! 

aaronwhite:

thegongshow:

I *love* all the data exhaust coming out of Stack Exchange.  
Here’s a simple chart demonstrating the correlation between the quality of a developer and age.  Older hackers rule.

This is pretty cool stuff. Although, I’m sure there’s a real bias here towards older devs who are still involved w/ community are better hackers, because clearly the pool of them on stack exchange is much smaller, it makes it harder to trust the average rep as being indicative of older hackers as a whole.

aaronwhite:

thegongshow:

I *love* all the data exhaust coming out of Stack Exchange.  

Here’s a simple chart demonstrating the correlation between the quality of a developer and age.  Older hackers rule.

This is pretty cool stuff. Although, I’m sure there’s a real bias here towards older devs who are still involved w/ community are better hackers, because clearly the pool of them on stack exchange is much smaller, it makes it harder to trust the average rep as being indicative of older hackers as a whole.

5 Under-hyped Companies I’d Invest In at a Wild Valuation

Tons of chatter recently about the remarkable growth of companies like AirBnB and Square.  I’m big fans of both, and love how ambitious those companies are trying to be (and progressing nicely).  Even if some folks perceive the market as frothy, I think it’s a great thing that there is so much attention around entrepreneurs taking big swings at problems that really matter.

This got me thinking about some of the other companies that I love that might not get as much fanfare.  Either because they were founded a little while before the media rediscovered the internet, or because they aren’t perceived as “sexy” products, or both.  This thinking led me to remark on twitter:

Not much talk about Yelp these days. But I think it has a decent shot to be worth more than Groupon and Foursquare long term”

Based on my @replies, there were pretty mixed responses.  So I thought I’d expand and share my top 5 under-hyped companies I’d love to invest in, even at a crazy valuation. Disclaimer, I am not an investor in any of these companies, and tried to remove any companies I have a major affiliation with from consideration. Also, I am a seed stage investor, and all of these companies are private and mostly later stage, so I have little real information to go on aside from my observations and gut :)

1. Yelp Not as hyped as Groupon, or FourSquare, but I think realistically far more useful for me as an end user and greater sustainability long-term.  The content that the site has amassed (and continues to build) is a very strong sustainable competitive advantage and one that is very difficult to overcome, IMHO.  Groupon monetizes better at the moment, but I worry about the barriers to entry and what will likely be declining open rates and gross margin in that category of businesses. FourSquare is cool, but just doesn’t have enough coverage of local businesses to be consistently useful enough for me.  To me, Yelp is the LinkedIN of the local space.  It’s slowly and steadily going to emerge as a fundamentally sound and very durable business. 

2. Tripadvisor: Ok, very similar themes to Yelp, so I guess this speaks to my own personal biases.  The company is being spun out as an independent public company later this year, and I think it has been significantly undervalued within Expedia.  The company scores very well on Bill Gurley’s “revenue scorecard" and has been wildly profitable for years.  The biggest knack on the company is that the product experience isn’t great and the reviews are too generic.  I see this as an opportunity for the company, which is remarkably successful despite these drawbacks.  As un-sexy as people think the product may be, I do not book a hotel room without first checking Tripadvisor (and I usually do this very close to the end of the research funnel).  Furthermore, I love that the founder Steve Kaufer has stayed at the helm of the company even after having his “exit” many years prior - you have to bet on the dogged persistence and vision of a motivated founder. 

3. DropBox: Ok, I’d say that Dropbox probably does have a reasonable amount of hype.  Then again, that may just be because everyone I know uses it.  It’s an amazing service, with high switching costs, very predictable revenue, and a very lean operation.  As I’ve said before, I’d probably invest in DropBox at any valuation the market would bear. 

4. Behance: My last two choices are more under the radar.  Behance is a New York based company that is emerging as the dominant platform and community for creative professionals.  It’s not really in the public spotlight, but everyone I know in the design/creative industry is well aware of the company and a participant in the network.  I also love Scott Belsky's vision for how the creative process should evolve (and by extension, how creative professionals can capture more of the value they create in the industries that rely on them).  

5. Pinterest: Pinterest is a very new company that is seed financed. We did not participate in the seed round, because I only recently heard about the company. I’ve said before that I think experiential shopping is a big opportunity, and the process of buying stuff like art, furniture, fashion, etc should be very very different than what we typically see from e-commerce today.  The day before I heard about Pinterest, I was literally thinking about how to create a product that merges the best of SVPPLY and Polyvore for the market for home-goods.  I’ve been using Pinterest for this purpose ever since.  The product is beautiful (if a little slow), the content I’m finding from other users is inspiring, and I’m noticing mainstream friends of mine signing up for the service way more than some much more hyped companies like Instagram. It’s super early, but I think the company is on a great path. 

Special mention: CSN Stores.  I’m conflicted in saying this for a bunch of reasons, so I’ll just quickly state my opinion that CSN is also wildly underhyped, for what I think is likely to be one of very few ecommerce companies to break out to Zappos-like scale or better. 

Just posted a video interview I did with David Hauser. See the summary and additional details on Xconomy

What Is The Ideal Seed Round Composition?

I’ve been having this conversation quite a few times over the last several weeks, so I thought it would be important to do a post on this.The question that I often get asked is “how should I think about the composition of my seed round?”  

This is related to my prior post on how to think about VC’s in seed rounds, but I’ll try to be more specific.  By way of background, of our 12 investments at NextView, 4 were with only angels, 3 were only with seed funds, and 5 were with some combination of VCs, angels, and seed funds.

It seems like a high-class problem for an entrepreneur to be able to influence round composition, and it is.  But I find that once a company has investor interest, many other folks tend to want to pile on.  How should an entrepreneur think about the different options on the table?  Here are a few of the typical configurations and the pros and cons of each.

The One VC Led Seed

  • Definition: This is the case when a large (ie: greater than $200M fund size) VC takes a significant portion of a seed round, and maybe leaves 50% or less of the round available for angels or seed funds.  In this case, the VC will typically take a board seat, be very active in the company, and the entrepreneur has basically gone through the standard investment process of the firm. 
  • Pros: High degree of VC commitment, easier to attract good value-added folks to fill out the round. More dry powder in case there is a need for an extension and the VC feels supportive of the company. 
  • Cons: Locked in to the incentives of the VC around outcome size, portfolio strategy, etc.
  • Series A Dynamics: This is a middle-of-the-road outcome in terms of optimizing your next round of financing.  If the company is doing really well, the VC will have an incentive to try to do more of the next round at perhaps not the highest possible valuation.  Their aggressiveness sends a signal to the market.  But, it’s very typical for a VC to say “we are committed to half the series A, go find an outside lead” and be helpful in making that happen.  That’s probably what would happen if the company is doing well and is a fine outcome IMHO. This is what happened with Gemvara (FKA Paragon Lake).  We saw the series A at my prior firm, Highland was committed for half the series A, which we took as a positive signal of support.  But if the VC is not participating in the follow-on round for any reason, you’ll be in a pretty difficult spot. 

The Two VC Led Seed

  • Definition: This is a the case where two large VC’s partner to take a significant portion of the round together, often leaving only a small piece for value added angels or seed investors. In this case, the VC’s really consider this a true investment of both time and reputation. This tends to be more common on the East Coast where there is more of a history of firms buddying up with the intention of doing the next couple rounds of financing together. Often, the VC partners have worked together before and both have deep domain experience that is very relevant to the company. This is distinguished from a round with multiple VC’s that are not leading.  
  • Pros: Lots of help from the VC’s. Potential for very quick and easy series A and even series B if things go well. Lots of credibility at even a very early stage. 
  • Cons: Not much space for new investors in future rounds.  Locked in to the incentives of the VCs. Limited options for series A. 
  • Series A Dynamics: When a seed round like this happens, you are banking on the VC’s to lead your series A round together.  It’s harder to go outside and create competition for the round unless you are absolutely knocking the cover off the ball.  But, if you were able to get the right investors to participate together in the seed, it can work out well.  We did this quite a bit at Spark with Tumblr (Spark & USV) and Admeld (Spark & Foundry). 

Angel Round Led By A Micro VC or Seed Fund

  • Definition: This is a the case where there are no large VC’s investing in a round but a dedicated seed fund or Micro VC is acting as the lead.  Often, a member of the seed fund’s team will take a board seat and be actively involved.  Sometimes, there will be multiple seed funds participating, or there will just be one and a number of angels. 
  • Pros: Good incentive alignment. Round can come together quickly. Lots of optionality and less signaling in future rounds. Strong credibility in the market if the round is led by a respected seed fund. 
  • Cons: Will need to attract outside capital for subsequent rounds. Varying degrees of willingness to do an inside round or bridge. 
  • Series A Dynamics: Your seed investors are well aligned to help you raise your series A from the best parter at the highest price that makes sense for the company.  The potential for competition is high.  The downside is that some funds are very reluctant to do inside rounds or extensions, so it is up to the entrepreneur to gain external validation from the market. 

Individual Angels Only 

  • Definition: This is a round comprised only of individual angels.  In the best case, a very sophisticated angel acts as the lead for the round that others can participate in.  In the worst case, there is no angel that emerges as a true lead. 
  • Pros: Good incentive alignment. Can get some support/help from multiple angels
  • Cons: If there is no lead, it’s much harder to actually pull the round together. Also hard to raise a larger amount of capital (ie: >$500K) since most angels are writing modest sized checks. There may be a lack of credibility from the perspective of partners, customers, or potential series A investors unless the angels are very well known and respected. 
  • Series A Dynamics: This really depends on who the angels are.  In theory, most angels should be well aligned to help you raise your series A.  If you have well known angels, they can be a strong asset.  The downside is that angels usually have limited capacity and interest in following on. 

The Large VC Chip-In

  • Definition: This is an angel round of many different potential compositions, but includes at least one or more large VC chipping in a small % of the round. 
  • Pros: Good to get another very smart person around the table who can help the company.
  • Cons: Usually won’t get that VC’s full time or attention.  The investment is explicitly an option to keep tabs on the company and potentially participate in the series A if things are looking good. 
  • Series A Dynamics: Others have talked quite a bit about this. I’ve heard the argument that investor signaling is reduced if there are more VC’s in the round, but I’m not sure if that is necessarily true.  I do think that entrepreneurs have become savvier at navigating these situations and maximizing their outcomes if things are going well (such as our investment in RentJuice that had Highland as a small investor prior them leading their first true VC round).  Of all the scenarios, this is the trickiest and most idiosyncratic.  It’s possible that the VC’s participation can exert a lot of negative influence in the future round, and it’s also possible that that VC’s gets very aggressive and catalyzes a pre-emptive series A.  In any case, it’s important for entrepreneurs to have their eyes wide open if they enter into a round with this composition. 

When Seeking Inspiration - Operate in Short Sprints

I met with a few entrepreneurs recently who left interesting companies to pursue their own ideas.  In both cases, they wanted to experiment with a number of different concepts and had plenty of runway to figure out where they ultimately wanted to devote 110% of their efforts.

This is an exciting and liberating time for an entrepreneur.  The world is suddenly your oyster, and it’s a time to start exploring brand new industries and problems.

The problem is that these expeditions often end fruitlessly.  It’s also very hard to “force” inspiration to strike when it could happen anywhere at any time.  Now that an entrepreneur is a free agent, how does one come up with an idea or decide what kind of company to start?

I was able to chat about this a bit with a friend of mine who is a 4x serial entrepreneur.  He is in the midst of one of these searches now, but gave some pretty interesting guidelines that I thought were worth sharing.  I originally had a few points I thought were interesting, but ultimately realized there was just one major lesson:

Don’t “brainstorm and filter”.  Operate in short sprints. 

It’s very natural for people to try to collect a bunch of ideas up front, filter them based on some research and/or personal conviction, and then choose a few to try to pursue simultaneously.  It’s a decent way to start, but the pool of ideas dries out quickly.  I find that few good companies originate out of a brainstorm-and-filter approach.  Couple issues: 1) too theoretical.  2) too easy to kill an idea when it’s an idea.

Instead, operate in short sprints.  You do do some idea generation of course, but the goal isn’t to decide what you are going to work on for the next few months.  The goal is to figure out what you want to devote 1-full day on.  It’s amazing how much you can accomplish in a day – talking to customers, reviewing competitors, trying substitutes, etc.  Also, the bar is low.  A lot of cool ideas are worth one day of exploration and real diligence.

If that goes well, decide whether to invest a week on the concept.  Again, it’s amazing what you can do in 1 week – do a quick customer acquisition test, take users through hand-drawn mockups, talk to more customers, etc. 

If that goes well, decide whether to invest a month.  And so it goes.  Many ideas won’t make it this far, but the idea is to engross yourself into something and know you are only investing a day or a week.

There are many benefits to this approach but the most important is that it maximizes learning-by-doing.  That’s not only the best way to begin building a company, but it’s also the best way to encounter new problems that may not be obvious at first blush.  I really really believe that inspiration for companies come from authentic needs that one faces or experiences in their personal or professional life.  Doing these sprints allow you to get deep enough into a project to uncover other needs or problems that aren’t as obvious to someone who is “brainstorming and filtering”. 

An entrepreneur may even want to go as far as doing some advising or work 1-day a week with a company in a completely new or unrelated sector.  It not only helps with some of the loneliness of the process, but it also allows you to be exposed to a brand new set of problems that you probably never knew existed.  Especially for an experienced entrepreneur, a lot of companies would be excited to have a little bit of their time in exchange to the opportunity to encounter new authentic problems.  

Kissing Frogs

A common phrase in the venture business is that you have to “kiss a lot of frogs to find a prince”, meaning that you have to look at a lot of companies to find the real gems.

I think folks outside of the venture industry think that it’s very obvious when a great company comes along for investment.  But the truth is, it is not.

It is generally pretty easy to filter through 90% of investment opportunities and figure out quickly that it is not a fit.  But the remaining 10% is very difficult to evaluate.  There is usually a lot to like about these companies, but even the best are not sure things.

If you see a company at the early stage, you wonder about the viability of the product, whether end users will like it, how well it will monetize, etc.

If you see a company a little further along, you wonder about the scalability of the team, the threat of larger and smaller competitors, the durability of the early economics, and so forth.

Very early companies have tons of uncertainty.  But even companies that are showing great traction are not that easy to invest in.  Usually, the market is sufficiently efficient such that competition drives the valuations of investments to the point of uncertainty and discomfort.  I remember when I was at Spark looking at the series B for Twitter.  In retrospect, it was a brilliant move for the firm to invest, but at the time, there was a lot of head scratching - wondering if it made sense to pay what seemed like an insane price for a very speculative service that had major stability issues. 

On the opposite side, the reasons why investors pass on the 10% of deals that seem like a potential fit is quite varied and somewhat random.  It may simply be that the investor is preoccupied with other things at the moment (a struggling portfolio company, another deal that is closing, a major transaction, personal things at home, etc).  It could also simply mean that for whatever reason, an investor just doesn’t have much intuition about a space to have great conviction to make an investment, or spend the time necessary to develop that conviction. 

It also doesn’t mean that a company that has an easier time fundraising is necessarily worse than one that struggled.  If both were in that top 10% of opportunities, whether they could get over the finish line may have just as much to do with luck and timing as anything else.  I’ve seen some companies that I thought were not that strong raise seed or series A rounds very quickly, while others slug it out for a long time before having the round come together.  If that sounds fickle, it’s because to some degree, it is.  It’s just not as objective as folks on the outside would think. 

A couple practical points for entrepreneurs:

1. Try to figure out quickly if you are in that top 10%.  Not all “no’s” are created equal.  If an investor has you meet other members of their team, clearly does some diligence in between meetings, and ultimately passes, it at least means that you cleared the “I think there is something there” bar.  It doesn’t take too many meetings to figure out if you are consistently clearing that bar, and if so, I’d say don’t be discouraged by “no’s”.  Take the feedback, adjust, but keep pushing forward.  

But if you are not getting that kind of traction, that’s probably a signal.  Although investors differ quite a bit at how they evaluate the top 10% of opportunities, I’ve found they are pretty consistent about figuring out if a company is in the top 10%. 

2. You are kissing frogs too.  I’ve never really liked the “kissing frogs” metaphor (does that mean that entrepreneurs are frogs and VC’s are princesses?).  Entrepreneurs are evaluating investors too - you want ones who see the world the way you do, or can engage with you in a productive way about the challenges you face. I think that if you can find yourself in the position where you are in the top 10%, you should have confidence that you will get the funding you need.  So the exercise is more finding the right investor at the right time, vs. just getting people to say “yes”.

Rob Go Thanks for visiting my blog! Learn more about me or ask me a question.