The New Funding Landscape

[The New Funding Landscape]

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| Want to start a startup? Get funded by
Y Combinator. |

October 2010

After barely changing at all for decades, the startup funding
business is now in what could, at least by comparison, be called
turmoil. At Y Combinator we've seen dramatic changes in the funding
environment for startups. Fortunately one of them is much higher
valuations.

The trends we've been seeing are probably not YC-specific. I wish
I could say they were, but the main cause is probably just that we
see trends first—partly because the startups we fund are very
plugged into the Valley and are quick to take advantage of anything
new, and partly because we fund so many that we have enough data
points to see patterns clearly.

What we're seeing now, everyone's probably going to be seeing in
the next couple years. So I'm going to explain what we're seeing,
and what that will mean for you if you try to raise money.

Super-Angels

Let me start by describing what the world of startup funding used
to look like. There used to be two sharply differentiated types
of investors: angels and venture capitalists. Angels are individual
rich people who invest small amounts of their own money, while VCs
are employees of funds that invest large amounts of other people's.

For decades there were just those two types of investors, but now
a third type has appeared halfway between them: the so-called
super-angels.
[1]
And VCs have been provoked by their arrival
into making a lot of angel-style investments themselves. So the
previously sharp line between angels and VCs has become hopelessly
blurred.

There used to be a no man's land between angels and VCs. Angels
would invest $20k to $50k apiece, and VCs usually a million or more.
So an angel round meant a collection of angel investments that
combined to maybe $200k, and a VC round meant a series A round in
which a single VC fund (or occasionally two) invested $1-5 million.

The no man's land between angels and VCs was a very inconvenient
one for startups, because it coincided with the amount many wanted
to raise. Most startups coming out of Demo Day wanted to raise
around $400k. But it was a pain to stitch together that much out
of angel investments, and most VCs weren't interested in investments
so small. That's the fundamental reason the super-angels have
appeared. They're responding to the market.

The arrival of a new type of investor is big news for startups,
because there used to be only two and they rarely competed with one
another. Super-angels compete with both angels and VCs. That's
going to change the rules about how to raise money. I don't know
yet what the new rules will be, but it looks like most of the changes
will be for the better.

A super-angel has some of the qualities of an angel, and some of
the qualities of a VC. They're usually individuals, like angels.
In fact many of the current super-angels were initially angels of
the classic type. But like VCs, they invest other people's money.
This allows them to invest larger amounts than angels: a typical
super-angel investment is currently about $100k. They make investment
decisions quickly, like angels. And they make a lot more investments
per partner than VCs—up to 10 times as many.

The fact that super-angels invest other people's money makes them
doubly alarming to VCs. They don't just compete for startups; they
also compete for investors. What super-angels really are is a new
form of fast-moving, lightweight VC fund. And those of us in the
technology world know what usually happens when something comes
along that can be described in terms like that. Usually it's the
replacement.

Will it be? As of now, few of the startups that take money from
super-angels are ruling out taking VC money. They're just postponing
it. But that's still a problem for VCs. Some of the startups that
postpone raising VC money may do so well on the angel money they
raise that they never bother to raise more. And those who do raise
VC rounds will be able to get higher valuations when they do. If
the best startups get 10x higher valuations when they raise series
A rounds, that would cut VCs' returns from winners at least tenfold.
[2]

So I think VC funds are seriously threatened by the super-angels.
But one thing that may save them to some extent is the uneven
distribution of startup outcomes: practically all the returns are
concentrated in a few big successes. The expected value of a startup
is the percentage chance it's Google. So to the extent that winning
is a matter of absolute returns, the super-angels could win practically
all the battles for individual startups and yet lose the war, if
they merely failed to get those few big winners. And there's a
chance that could happen, because the top VC funds have better
brands, and can also do more for their portfolio companies.
[3]

Because super-angels make more investments per partner, they have
less partner per investment. They can't pay as much attention to
you as a VC on your board could. How much is that extra attention
worth? It will vary enormously from one partner to another. There's
no consensus yet in the general case. So for now this is something
startups are deciding individually.

Till now, VCs' claims about how much value they added were sort of
like the government's. Maybe they made you feel better, but you
had no choice in the matter, if you needed money on the scale only
VCs could supply. Now that VCs have competitors, that's going to
put a market price on the help they offer. The interesting thing
is, no one knows yet what it will be.

Do startups that want to get really big need the sort of advice and
connections only the top VCs can supply? Or would super-angel money
do just as well? The VCs will say you need them, and the super-angels
will say you don't. But the truth is, no one knows yet, not even
the VCs and super-angels themselves. All the super-angels know
is that their new model seems promising enough to be worth trying,
and all the VCs know is that it seems promising enough to worry
about.

Rounds

Whatever the outcome, the conflict between VCs and super-angels is
good news for founders. And not just for the obvious reason that
more competition for deals means better terms. The whole shape of
deals is changing.

One of the biggest differences between angels and VCs is the amount
of your company they want. VCs want a lot. In a series A round
they want a third of your company, if they can get it. They don't
care much how much they pay for it, but they want a lot because the
number of series A investments they can do is so small. In a
traditional series A investment, at least one partner from the VC
fund takes a seat on your board.
[4]
Since board seats last about
5 years and each partner can't handle more than about 10 at once,
that means a VC fund can only do about 2 series A deals per partner
per year. And that means they need to get as much of the company
as they can in each one. You'd have to be a very promising startup
indeed to get a VC to use up one of his 10 board seats for only a
few percent of you.

Since angels generally don't take board seats, they don't have this
constraint. They're happy to buy only a few percent of you. And
although the super-angels are in most respects mini VC funds, they've
retained this critical property of angels. They don't take board
seats, so they don't need a big percentage of your company.

[...]

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