The way startups raise money is changing, fast. Angels, super angels and VCs have to figure out the new rules, but that's good -- really good -- for founders themselves.
By JS Cournoyer, contributor
Paul Graham, YCombinator. Image via CrunchBase
I have been reading about the changing landscape of how technology companies get their initial outside funding after friends and family have chipped in. Seed or early stage investing, as it is referred to by entrepreneurs, angels, VCs and their investors (limited partners) is a critical part of the technology innovation and funding ecosystem because it has historically been the only consistent source of returns for the industry. This is where angels and VCs make their money and why so much has been written about the subject over the past 6 months.Paul Kedrosky started the discussion with "The Coming Super-Seed Crash" in which he argued that a crash was inevitable as a result of too many companies getting funded by too many angels and third string VCs at skyrocketing valuations.
Entrepreneur, angel investor and blogger Chris Dixon picked it up and wrote an interesting post about how the changes were caused mostly by entrepreneurs getting smarter about raising money, which I believe is part the reason. Successful venture capitalists and bloggers Fred Wilson, Mark Susterand Brad Feld felt compelled to chime in and describe their approach to seed investing and their thoughts on the evolving funding landscape. Dave McClure, the most outspoken of the angels wrote this now infamous post "Moneyball for Startups" in which he called traditional VCs dinosaurs and on the way to extinction and talked about how investors had to innovate to remain relevant. Angels and VCs even publicly discussed the evolution of deal terms and the pros and cons of straight equity versus convertible debentures at the seed level. As you can read my post "Equity vs Convertible Debt: What's best for Entrepreneurs", I believe equity is the way to go for investors and entrepreneurs alike because it aligns the interest on both sides.
Then Michael Arrington dropped into the conversation in dramatic fashion by accusing a group of "Super Angels" of collusion and price fixing at the seed level in his post "A Blogger Walks Into A Barâ?¦". These events are now referred to as Angelgate. Finally, Paul Graham, the founder of Y combinator which is at the center of this storm wrote this great essay "The New Funding Landscape" which claims that the changes Y combinator companies are currently experiencing (convertible debt, faster and bigger rolling seed rounds, higher valuations, etc.) and that the competition between Super Angels and VCs are here to stay. Although he makes a lot of good points, his essay mostly reflects the realities of Y combinator, which graduates less than 50 companies per year.
I agree with Paul Graham that the world of entrepreneurship and early stage investing in web, Internet, mobile, software, digital media, casual gaming and advertising, especially in San Francisco â?? Silicon Valley and New York, is going through a major change and that entrepreneurs are the main beneficiaries. For the time being, the balance of power has definitely shifted away from the VCs, the traditional power brokers, into the hands of a new group. We won't know for years whether VCs, angels, Super Angels or an evolution thereof will win the funding war, but whoever wins will have to bend and kiss the ring of the new king who has already been crowned. Our world will never be the same.
As you all know by now, the costs associated with launching a new startup, building a product, achieving product/market fit and validating your business model is trending to zero on the back of major trends like open source software and frameworks, cloud computing and distribution platforms (social, search, mobile, and business app exchanges). Engineer entrepreneurs who can live with no salary for 3-6 months don't need to raise seed funding. Y Combinator and Techstars have proven this model. As you can read in "Should Entrepreneurs Raise a Seed Round" entrepreneurs have a choice and I argue should only raise money to reduce their personal risk or accelerate their path to market validation in the form of new hires, networks, know how, etc. As an entrepreneur, once your business has achieved market validation, you hold all the cards and investors will fight for your business, especially in efficient markets like San Francisco-Silicon Valley and New York, although i believe that within the next ten years, most markets in North America should be there.
So what happens in a world where capital is no longer enough for investors to win the day?
Entrepreneurs have a choice. They can choose to bring an investor into their company, or not. Pros and cons in both scenarios, but it's still a choice.
VCs, angels and Super Angels now have to fight for this business, and the competition will only increase over time. Over are the days of investors treating entrepreneurs badly because they can. These guys are dead. Over are the days of investors claiming to add value to startups when the reality is quite different. These guys will disappear as well.
There are three ways for investors to compete. Build a personal relationship with the entrepreneurs prior to a funding event, provide cheaper capital or provide value capital.
Building personal relationships with entrepreneurs is hard work. You can't fake it. It starts with being a decent guy and treating people with respect. Having been successful also helps. You have to know and be known by a lot of people. Availability and experience are key. It's better if you blog and go to startup events, big and small, and hang out with the attendees. Try to touch as many entrepreneurs and aspiring entrepreneurs as you can. The best investors either have been around for a long time and/or were part of successful companies and draw on these networks.
Cheaper capital can mean higher valuations, common shares, convertible debts with no caps, less vetos and restrictions, no board seat, etc. VCs with large funds can do this at the seed level if they're buying an option for the next round, but I argue in this post and thispost that entrepreneurs have to be careful about the alignment of interest when taking this capital. Regular angels can do this as well, but Super Angels have less flexibility as it would drastically affect their return profile.
Value capital, or smart money, is by definition more expansive for entrepreneurs but comes with additional benefits. These benefits can include strategic advice, access to networks, hiring support, business and corporate development support and access to capital, in good and bad times. A lot of investors claim to be smart money, but very few work hard enough and provide the kind of value that would warrant tougher terms. The social web makes it very easy for entrepreneurs to diligence investors and hold them to their proclaimed higher standard. Investors should be willing to provide value to entrepreneurs before an investment is made.
The early stage investors that will survive and thrive in this new age will treat entrepreneurs and their companies as customers. They have to become more like late stage VCs and buyout firms who invest in growing, profitable companies that don't need financing. Most of these firms like TCV and Insight Venture Partners all have internal teams with deep functional expertise dedicated to the success of their portfolio companies including hiring, corporate and business development, sales, finance, operations, etc. They also have a team of analyst that reaches out to companies early in their lives and on a regular basis over time, building relationships that will often last years before an investment is made. Late stage VCs also offer entrepreneurs a valuable benefit: partial liquidity through a secondary sale of their shares. I've seen transactions where founders take as much as $100M of the table as part of a late stage round.
Most early stage VCs with funds greater than $150M have enough budget (2.5% times $150M = $4.25M) to do some of this. The bigger the funds, the bigger the budget. I predict that over the next few years, successful firms will spend an increasingly higher percentage of their budget on functional teams or advisory boards to better support their portfolio companies. Smaller VC funds like Real Ventures and First Round Capital and Super Angel funds are a disadvantage here because of their lack of budget. That being said, there are other ways to do this. Dave McClure for one has built a team of over 70 mentors and advisors to support his portfolio companies. Not sure how he compensates them but I'm convinced it's not with cash. First Round has a fairly large team for a small fund, so I suspect that the partners are getting paid below market. We're doing the same at Real Ventures, large team, mentors and advisors, and below market compensation. As for founder liquidity, I predict that we'll see more of that as well earlier in the life of companies, but definitely not at the seed stage.
The Age of the Venture Capitalists began in the late 1960s, withGreylock Partners, ARDC, James Guzy, Sutter Hill Ventures, Venrock Associates and then Kleiner Perkins, Caufield and Byers and Sequoia Capital in the early 70s. The industry grew in power, influence and returns up until 2001 (except for most of the 80s), when the bubble delivered a fatal blow. From 2002 through 2006, the VCs that still had dried powder aggressively pursued more mature startups that were having a hard time raising money due to the pullback of many funds with major portfolio issues. During that period, VCs became financial engineers, with the rise of the double, triple and quadruple participating preferred, guaranteed returns, forgetting their roots and bleeding the entrepreneurs that had made them so successful over the years. They also pulled back from their bread and butter, seed and early stage investing, which except for the bubble years, had generated the overwhelming majority of the returns of the industry since the 60s. This bad behavior created an opportunity for a new class of investors to fill the void: Super Angels. Ron Conway, Jeff Clavier, Keith Rabois, Mike Maples, Peter Thiel, Reid Hoffman and First Round Capital were some of the pioneers of this new model. We can call the period from 2004 through 2010 the Age of the Super Angels.
With the cost of starting a company and getting market validation trending to zero, the balance of power has shifted again for good. It is not about the VCs, angels or Super Angels anymore. The rules have changed and we have a new king in town.
We have now entered the Age of the Entrepreneur.
-- JS Cournoyer is a co-founder and partner of Montreal Startup and Real Ventures, seed funds investing in web, mobile, software, digital media and gaming. This item was reposted with permission.
Screen name (Select one with 3-12 characters; Numbers and letters only)
Enter your e-mail address below and we will send you an e-mail with a link and code to reset your password.
Already have the reset code?
Reset code
New password
Password
Forgot password?
Not a member yet?
Screen name
Password
Type what you see in the grey box
CNNMoney will use the information you submit in a manner consistent with our Privacy Policy. By clicking on "sign up" you agree with CNNMoney's Terms of Service and Privacy Policy and consent to the collection, storage and use of this information in the U.S. subject to U.S. laws and regulations. (learn more)
This service is temporarily unavailable. Please try again soon.
Thanks!
Please check your e-mail and click the link to confirm your membership. Then, you'll be ready to participate in all activities and conversations on our site.
Go to your Profile page
Be the first to know when there is breaking financial news with timely alerts delivered straight to your inbox.
Fortune's Philip Elmer-DeWitt brings you Mac news from outside the reality distortion field.
Fortune columnist Anne Fisher answers your career-related questions.
Money Magazine's Walter Updegrave answers readers' toughest financial questions.
Fortune managing editor Andy Serwer keeps tabs on Wall Street
CNN's Gerri Willis gives tips and tools for saving more and spending wisely.
A complete roundup of each day's trading activity.
Fortune editor at large Pattie Sellers shares fascinating, fun and valuable insights into people who sit at the pinnacle of power.
Read Full Article »