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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).

One of the supposed drawbacks of more seed stage funding in Silicon Valley is that it encourages more “quick flip” exits.  Max Levchin wrote an excellent post on this observation, and my friend and old colleague Bijan Sabet shared his thoughts on this as well. 

I largely share Max and Bijan’s affinity towards entrepreneurs that are trying built long-term, sustainable, and market transforming businesses.  Those companies tend to be the backbone of meaningful economic growth, and it’s just plain fun to be involved with these kinds of businesses. 

But I hope folks don’t get the message that all seed investors are driving towards quick flips.  Frankly, I think very few micro-VC’s (or Super Angels, or whatever) are driving towards quick flips.  And based on the folks I know, I think very few micro-VC’s invest in entrepreneurs who are explicitly going for a quick flip.  For what it’s worth, here are my more nuanced thoughts on this. 

Glimmers of Greatness. This is similar language that Mike Moritz used on stage at Techcrunch Disrupt. Really transformative companies usually begin with a glimmer of greatness.  And as Bijan said, very small amounts of capital can help an entrepreneur begin to pursue greatness. But a glimmer is just a glimmer.  It’s not a sure thing, and most audacious ideas start with something small, confusing, and maybe even seemingly insignificant. I would suggest that almost all micro-VC’s need to see this glimmer to make an investment, and hope that their seed capital gives birth to Thunder Lizards.. 

Prospective vs. Retrospective. Here’s what it gets interesting.  The difficulty in certain sectors of the internet is that often, it’s very very difficult to prospectively know whether a company is going to become great.  The glimmer may be there, but glimmers fade.  You might not get a thunder lizard… you may just get a Kimodo Dragon. There are so many examples of this it’s not worth listing.  The point is that most companies aren’t clearly “go big or go home” companies or “small but sure” companies.  Most companies fall somewhere in the middle, and the likely outcomes are very unce.rtain (and can change over time). 

Alignment and Slow Capital. Because of these challenges, large VC’s are in a difficult position.  They end up passing very often because an idea seemed “too small”, even if the entrepreneur was clearly going to build important value in the early years of the company.  What micro-VC’s are able to do is not worry too much about this.  They are better aligned with the entrepreneur early on because they can do well in both a smaller, capital efficient win, or a big, venture scale outcome.  They can allow the entrepreneur to make progress, build value, and make the decision of “go big or go home” with more information. It’s just a matter of incentives. At the end of the day, anyone managing a fund is just trying to produce meaningful returns.  As a rule of thumb, an exit that produces a “meaningful return” for a VC ~ their fund size, and that’s part of what drives alignment or misalignment. 

Making the Most of Time.  This element is usually overlooked I find.  It takes a lot of time to try to build a big company.  Also, if you’ve raised a lot of money, some investors will try really hard to keep a company alive to try to make their money back - and this also takes a lot of time. But an entrepreneur may get to year 2 or 3 of their company and say “there’s a 5% chance this can be huge but it will take another 7 years, or I could sell now for a good outcome and move on.”  What to do?  5% isn’t great odds, but some investors might really urge the entrepreneur to go big or go home.  I think the answer is: the entrepreneur should do whatever he/she wants.  Those 7 years are valuable, and who knows?  After a mid-sized win, this entrepreneur will just have more flexibility to go for a big home run. Which brings me to my last point:

It’s a Multi-Turn Game.  I think some investors are short sighted and think too hard about optimizing one deal or extracting as much money from one exit.  But it’s a multi-turn game.  Sure, it’s too bad if an entrepreneur decides to sell a bit earlier than an investor would like.   But they will be back, maybe several more times