Startup Funding Environment
We're not in the midst of a startup-bubble...but valuations of businesses are frothy. Angel investors ought to think about the following...
- Portfolio dynamics & diversification
- It's a winner take all market - the majority of your returns will come from 1 or 2 big outcomes
The current series A crunch equates to an exploding number of companies, while the the number of VCs has stayed the same. [For more info on check out this Inc.com article on "Why the Series A Crunch May Be a Good Thing". Image from Inc.com]
In today's startup market, the cost of starting a company has decreased. What used to cost $5 million in the 1999 bubble dropped down to $500,000....and now $50,000 is enough.
What Venture Capital does now is really Growth Capital:
- Series A is done by the accelerators and the Hackathons
- Series B is done by the angels, superangels, and seed funds
- Series C and up is where the VCs start
Financing a Startup
There's currently a fundamental misunderstanding about how to build a company. Many people think that the right way is raising $1 million from angels, then prove that you have something - only then go to VCs for a Series A. This is the classic startup financing model (and it fails).
| There's a better way to raise:|
It just doesn't take as much money to build a profitable, successful company anymore.
The JOBS Act is the only major bipartisan bill to pass Congress and get signed into law in the past 4 years - how can you vote against something called the JOBS Act!? There are many elements of the JOBS Act that specifically benefit startups:
- Streamlined IPO process
- 500 shareholder max raised to 2000
- General solicitation ban is lifted (can publicly fundraise)
- True (equity) crowdfunding
Consumer vs. Enterprise
The bar has moved, particularly for consumer startups. No "Series A VC" wants to talk to you unless you've reached escape velocity or unless you're an extremely branded entrepreneur. Otherwise you must show a lot of traction or that you're doing something really unique or difficult. Pre-money Series A valuations are also evolving:
- 2007 - 2009 valuations were around $2-$4 million
- 2009 - 2012 valuations got a little crazy - as high as $6-$10 million
- 2013 valuations are coming down to the $3-$5 million range
Accelerators are a very complicated topic, as there is a range of quality between accelerators coupled with the pros and cons of giving away 6% of your company. We are witnessing the unbundling of: Advice, Control, and Money. No one wants to give away control and that's where the angels come in (they require less ownership percentage).
Accelerators have branded advice and have institutionalized it. Venture capital is a lot about branding yourself, so you are able to get into to the hot deals.
Accelerators are like the new graduate schools, except:
- Instead of paying to go you get paid to go
- Instead of going out and getting a job you go out and create jobs
- Instead of doing derivative work you do original work
- Accelerators are a better graduate school, and they are shorter / faster
| You should go through an accelerator if:|
Conversely, you should make careful consideration before giving away any equity to an accelerator. Going through an accelerator could be an expensive deal if:
- You already have a product built
- You have some traction in your space/industry
- You can get to escape velocity on your own
- If you know how to build a company
- Already have a solid network in place
Successful Outcome (Probability)
Naval speculates on the successful outcome of startups...and his projections may surprise/scare you:
Consumer company the success rate is less than 10% (from an angel investors point of view under 1/10).
Enterprise company the success rate used to be 1/3 or 1/5, but now the enterprise space is getting crowded so the ratio has diminished to 1/10.
That said, most companies will fail. Naval himself started 7 companies and launched 40 or 50 projects in his career. AngelList is the first one Naval would truly say has "product-market-entrepreneur fit" so that's it might succeed.
|A few considerations for entrepreneurs and startups:|
AngelList is Unbundling VC
AngelList is improving access to deal flow by bringing in transparency, so everyone is able to see what each investor's value add is (it's not enough to say that they just bring value). In doing so, they're also bringing in a lot of people who might have a lot of value to offer (specialized domain expertise) and who have good access, but don't necessarily have the capital (syndicates solves that).
The idea that some people can only invest in Seed and some only invest in Growth is a false dichotomy. If everyone can see everything (transparency) you can cross boundaries:
- There are angels that should be able to do a Series C or Series D.
- There are VCs that might want to set up an accelerator in the cloud, offer $100k-$150k for 6% instead of the standard $25k, and be able to offer their own structured network and resources as a value add.
- The moment you take all the companies and all the investors and throw them together, people can start "cross-pollinating".
What Makes A Great Company?
The factors that make a great company are different from what makes a great syndicate: One is a reality while the other is a perception of reality.
Reality of what makes a great company:
This is why the Syndicate Lead is so important because someone has to go out and do the due diligence, spend time with the founders, etc (it's a judgment call).
What Makes a Great Syndicate?
Essentially what makes a great syndicate is Signaling - being able to convey to people that you do in fact possess the factors that make a great company.
- Are the founders accomplished?
- Have the founders done something in the past that would indicate that they are able to do things in the future?
- Is the Syndicate Lead a good judge?
- Does the Syndicate Lead have a good track record?
- Does the company have early traction?
- Is there an indication that "the dogs are eating the dog food" (company uses it's own product to demonstrate the quality and capabilities of the product)
- Is the product visually appealing?
- Is the space not too crowded?
- Is the product novel, is it new?
Novelty matters. On AngelList people see everything, so by the time the 3rd or 4th company gets in there, most people have already made up their mind about the space or if there is a conflict from an existing investment.
Syndicate backers actually turn out to be very high quality angels. Naval thinks that those people shouldn't really be backers in syndicates (as opposed to leading their own syndicate). The intended backers are going to be:
- Limited Partners (LPs)
- People who are out of the market (geographically)
- Wealthy individuals who aren't professional investors
For the real Backers (listed above) to invest in a syndicate, they need to see not only a strong signal from the deal, but also difficulty of getting access. This difficulty in getting into the round is important. This is why they need the Syndicate Lead for, otherwise they could have simply invested directly in the round themselves (and not had to pay the carried interest to the Syndicate Lead and AngelList, if any). This can be thought of as "High signal, low access."
The Lead Syndicate really needs to convey to the backers and make sure they understand:
- What deals the Lead Syndicate is showing them (so that they know there is no adverse selection - not keeping the best deals for themselves).
- Clearly understand that angel investing is extremely high risk, and that they should spread their bets over a long period of time, be very careful, and go slowly.
Angel Investing vs. Gambling
The distribution curve of outcomes looks a lot like gambling:
- Negative expected value when gambling, and the house is actively working against you.
- Positive expected value when investing in startups, and it's also good for society.
People have to understand and be comfortable with the risk, and the fact that there is no liquidity.
Optimal Number of Deals in an Angel Portfolio
Angel investors need to invest in at least 25 to 30 companies (maybe more) in order to have a decent angel portfolio. There are practitioners (VCs) who do less deals (around 10) but they do lots of due diligence / spend a lot of time with each company.
This is the classic early-stage VC approach. Unless you are willing to put in a significant amount of time and diligence into the company you cannot narrow your portfolio to only 10 companies.
Diversification can be seen as a hedge against a lack of knowledge. For early-stage deals: no matter how much work you put in, you will not get more than 30% knowledge. The other 70% is up to the market, up in the air, and anything can go wrong.
The Rolling Close & Convertible Notes
Convertible notes have their advantages because you can keep fundraising all the time. The idea that you fundraise once, it's closed off for 18 months and suddenly reopens (only to close again) is an artificial old model driven by the realities of how VC and fundraising used to work.
The reality today is that fundraising is now more of a blend:
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What do you guys about Naval's point on accelerators being a new kind of business school. If you see yourself going into banking or as an executive at a large company than business school is still the optimal path; but MBA grads are increasingly choosing the entrepreneurial route and starting companies... Thoughts?