The Future of Startup Funding

[The Future of Startup Funding]

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August 2010

Two years ago I
wrote about what I called "a huge, unexploited
opportunity in startup funding:" the growing disconnect between
VCs, whose current business model requires them to invest large
amounts, and a large class of startups that need less than they
used to. Increasingly, startups want a couple hundred thousand
dollars, not a couple million.
[1]

The opportunity is a lot less unexploited now. Investors have
poured into this territory from both directions. VCs are much more
likely to make angel-sized investments than they were a year ago.
And meanwhile the past year has seen a dramatic increase in a new
type of investor: the super-angel, who operates like an angel, but
using other people's money, like a VC.

Though a lot of investors are entering this territory, there is
still room for more. The distribution of investors should mirror
the distribution of startups, which has the usual power law dropoff.
So there should be a lot more people investing tens or hundreds of
thousands than millions.
[2]

In fact, it may be good for angels that there are more people doing
angel-sized deals, because if angel rounds become more legitimate,
then startups may start to opt for angel rounds even when they
could, if they wanted, raise series A rounds from VCs. One reason
startups prefer series A rounds is that they're more prestigious.
But if angel investors become more active and better known, they'll
increasingly be able to compete with VCs in brand.

Of course, prestige isn't the main reason to prefer a series A
round. A startup will probably get more attention from investors
in a series A round than an angel round. So if a startup is choosing
between an angel round and an A round from a good VC fund, I usually
advise them to take the A round.
[3]

But while series A rounds aren't going away, I think VCs should be
more worried about super-angels than vice versa. Despite their
name, the super-angels are really mini VC funds, and they clearly
have existing VCs in their sights.

They would seem to have history on their side.
The pattern here seems the same
one we see when startups and established companies enter a new
market. Online video becomes possible, and YouTube plunges right
in, while existing media companies embrace it only half-willingly,
driven more by fear than hope, and aiming more to protect their
turf than to do great things for users. Ditto for PayPal. This
pattern is repeated over and over, and it's usually the invaders
who win. In this case the super-angels are the invaders. Angel
rounds are their whole business, as online video was for YouTube.
Whereas VCs who make angel investments mostly do it as a way to
generate deal flow for series A rounds.
[4]

On the other hand, startup investing is a very strange business.
Nearly all the returns are concentrated in a few big winners. If
the super-angels merely fail to invest in (and to some extent
produce) the big winners, they'll be out of business, even if they
invest in all the others.

VCs

Why don't VCs start doing smaller series A rounds? The sticking
point is board seats. In a traditional series A round, the partner
whose deal it is takes a seat on the startup's board. If we assume
the average startup runs for 6 years and a partner can bear to be
on 12 boards at once, then a VC fund can do 2 series A deals per
partner per year.

It has always seemed to me the solution is to take fewer board
seats. You don't have to be on the board to help a startup. Maybe
VCs feel they need the power that comes with board membership to
ensure their money isn't wasted. But have they tested that theory?
Unless they've tried not taking board seats and found their returns
are lower, they're not bracketing the problem.

I'm not saying VCs don't help startups. The good ones help them a
lot. What I'm saying is that the kind of help that matters, you
may not have to be a board member to give.
[5]

How will this all play out? Some VCs will probably adapt, by doing
more, smaller deals. I wouldn't be surprised if by streamlining
their selection process and taking fewer board seats, VC funds could
do 2 to 3 times as many series A rounds with no loss of quality.

But other VCs will make no more than superficial changes. VCs are
conservative, and the threat to them isn't mortal. The VC funds
that don't adapt won't be violently displaced. They'll edge gradually
into a different business without realizing it. They'll still do
what they will call series A rounds, but these will increasingly
be de facto series B rounds.
[6]

In such rounds they won't get the 25 to 40% of the company they do
now. You don't give up as much of the company in later rounds
unless something is seriously wrong. Since the VCs who don't adapt
will be investing later, their returns from winners may be smaller.
But investing later should also mean they have fewer losers. So
their ratio of risk to return may be the same or even better.
They'll just have become a different, more conservative, type of
investment.

Angels

In the big angel rounds that increasingly compete with series A
rounds, the investors won't take as much equity as VCs do now. And
VCs who try to compete with angels by doing more, smaller deals
will probably find they have to take less equity to do it. Which
is good news for founders: they'll get to keep more of the company.

The deal terms of angel rounds will become less restrictive
too—not just less restrictive than series A terms, but less
restrictive than angel terms have traditionally been.

In the future, angel rounds will less often be for specific amounts
or have a lead investor. In the old days, the standard m.o. for
startups was to find one angel to act as the lead investor. You'd
negotiate a round size and valuation with the lead, who'd supply
some but not all of the money. Then the startup and the lead would
cooperate to find the rest.

The future of angel rounds looks more like this: instead of a fixed
round size, startups will do a rolling close, where they take money
from investors one at a time till they feel they have enough.
[7]
And though there's going to be one investor who gives them the first
check, and his or her help in recruiting other investors will
certainly be welcome, this initial investor will no longer be the
lead in the old sense of managing the round. The startup will now
do that themselves.

There will continue to be lead investors in the sense of investors
who take the lead in advising a startup. They may also make
the biggest investment. But they won't always have to be the one
terms are negotiated with, or be the first money in, as they have
in the past. Standardized paperwork will do away with the need to
negotiate anything except the valuation, and that will get easier
too.

If multiple investors have to share a valuation, it will be whatever
the startup can get from the first one to write a check, limited
by their guess at whether this will make later investors balk. But
there may not have to be just one valuation. Startups are increasingly
raising money on convertible notes, and convertible notes have not
valuations but at most valuation caps: caps on what the
effective valuation will be when the debt converts to equity (in a
later round, or upon acquisition if that happens first). That's
an important difference because it means a startup could do multiple
notes at once with different caps. This is now starting to happen,
and I predict it will become more common.

Sheep

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