We perhaps do not give them enough credit. They are often the first ones to write a check and the ones who take the most risk. They often demand far less from our entrepreneurs than the pound of flesh VCs often seek. And they usually remain out of the spotlight, allowing others to take most of the credit when a company scratches and claws its way toward becoming a successful business.
Some call them angel investors, others call them seed investors, and still others just refer to them as “first money in.” And they are equally adored and dismissed, depending on whom you talk to. For entrepreneurs eager for capital beyond just friends and family, angels are a godsend. Angels rarely require a board seat, often simply write a check without negotiating terms and operate on that slim margin of hope that they too-as one $300,000 angel investor in Google will soon discover-may reap a return of 1000 X or more on their investment.
This column is an open letter to angel investors and the entrepreneurs they fund, an attempt to cross chasm of misalignment between what VCs really want and what angels often fail to provide. There is unexplored common ground where these two sets of investors can create a symbiotic relationship and help each other build greater shareholder value.
Armed with a new level of understanding of what our industry truly needs-highly disciplined, well managed, technology deals where a company’s capital structure is already appropriately aligned with the best interests of all past and future investors-perhaps angels can finally shift from being an underappreciated asset class to being the invaluable agent for growth they have every right to be.
For those in the private equity field who doubt that angels play any meaningful role in the company creation process, allow me to offer some data points. According to Mark Van Osnabrugge and Robert J. Robinson, authors of Angel Investing: Matching Start-Up funds with Start-Up Companies, angel investors fund 30 to 40 times more ventures than professional venture capitalists. Moreover, angels invest roughly $50 billion annually in early stage companies. And, in absolute dollars, angels invest three to five times more money than all venture capital firms combined, the authors say.
Noting the funding gap that exists at the earliest stages of company formation, Osnabrugge and Robinson point out that angel investors are essential in funding ventures that need $500,000 or less, since professional venture capitalists are seldom interested in making such small investments. “Venture capitalists get all the press, but the vast majority of entrepreneurial firms are actually funded by angels,” the authors say. What they fail to note, however, is the excessive heartburn created for VCs when angels create unrealistic expectations in the minds of entrepreneurs or fail to help young companies create capital structures and management teams that VCs can live with.
Shades of Gray
The importance of early stage funding is obvious, but the argument that angel funding alone is not enough when it comes to building sustainable companies is a far more subtle, yet perhaps far more essential, point. According to Thomson Venture Economics (publisher of Venture Capital Journal), the average age of a venture-backed company that went public in the second quarter was 6.9 years, compared to 3.5 years in Q2 1999. That kind of seasoning doesn’t happen by accident. It takes work, it takes guidance and it takes help.
Angels, perhaps more than any other investment group involved with early stage companies, have the opportunity to bake in such sustainable advantages at the earliest stages of the company building process. Writing a check is the first, and perhaps easiest, part. Yet angels-most of whom are themselves seasoned business executives, entrepreneurs, technologists and finance people-can do the venture community the greatest good by not just writing that check, but by stepping in and prepping the company for sustainable company growth.
“Is there a role at the seed round that complements the venture industry? I would say yes,” says John Dean, former head of Silicon Valley Bank and an active seed investor with his own Tupatele Venture Fund. “There are companies that are simply too early for venture money who could use a set of experienced advisors with more time to help them along from concept to product.” Dean notes that there is a whole category of companies that don’t really need a lot of money-maybe $500,000 to $1 million-to finish building a product and testing it with customers. These companies may not ever need institutional venture capital, just the help and guidance to create a viable business. From there, the growth of the company itself would determine whether further VC involvement is necessary.
These are the kinds of deals we love, ones where angels and entrepreneurs have already developed a set of standard operating procedures (SOPs) to get the company to cash flow positive. In Dean’s case, he has partnered with two or three individuals to help infuse these SOPs in every company in which they make an investment. Such procedures include (a) investing enough money to represent 50% to 75% of the initial investor class such that they’re not relying on a large set of individuals to get the company to cash flow positive; (b) having enough extra capital on hand to infuse into the company six to 12 months down the road so a company isn’t forced to try to find institutional venture capital; and (c) investing only in companies with a certain amount of sweat or home loan equity already built into the business, with technologies that have already been created and only need enough capital to prove that they will work.
To Dean’s list I would add, early money should invest in (1) companies with decent business plans that can prove customer interest once the technology passes beta; (2) a management team that’s humble enough to retain a realistic equity stake in their business while realizing there has to be enough left to go around to share with investors and employees; and (3) companies that have had the forethought to establish proper accounting procedures, legal protections and realistic growth projections.
For Dean, two companies have already proven his model that seed investors can truly add value to companies beyond just being the first money in. EazyRez, a Hawaii-based software company offering Web-enabled software tools for the back end of the travel industry, needed less than $1 million when it was seeking capital. It had proven technology, a client or two and the revenue needed to build out its product to get to cash flow positive. With Dean’s financial expertise and contacts, and one of his partner’s penchant for reading software code, EazyRez’s growth now exceeds its initial projections, representing a deal any VC would be willing to take a look at.
A second Dean company is BioImagene, a software company with technology developed in India that addresses the needs of the medical life sciences space specifically in the field of gene pathology. In this case, the company’s initial valuation was a bit higher than a typical seed deal, but the CEO, Mohan Uttawar, was a serial entrepreneur and the technology was already largely established within an as yet unaddressed market opportunity. In a second specific piece of advice for angels, Dean says that even seed-stage companies should have valuations set upon taking first money. “You’ve got to keep it at a price that looks reasonable to VCs down the road, while still leaving room for the original seed investors to do another round before a venture round,” Dean says. Though some entrepreneurs prefer convertible notes with warrants for first money in, this can get quite expensive when it comes to VCs looking to set a future valuation, as they may have to set it at a higher price than deemed appropriate to make room for all angels and their convertible stock.
What Dean understands is what venture capitalists hope more angels might be willing to learn: that we all need to start speaking the same language. There’s too large of a variance between angel investing and the output they should be producing. They can’t be 90% investors and 10% board members and then wonder why their early stage companies are neither bankable, nor worthy of valuations that should have justified the early risk taken. Angels must understand that, even for them, company involvement and strategic planning must be shared equally with the checks they write-and that the money they invest should only be half of what they intend to put in. That if they want to be allotted the same terms and covenants as VCs, they should plan on setting aside enough money to participate in any series A raised.
As Michael Schwab, managing partner and founder of San Francisco-based Big Sky Partners notes, “Angels in general are people who have money but often little to no experience in the specific technology they are looking at, so I felt that in order to be successful as a seed investor, I had to be a self-taught technologist. As a result, when I go sit down with a company, if I can bring four to five things to the table from other companies I invest in, and vice-versa, then it’s something I would clearly consider being a part of.”
Schwab, like Dean, offers an example of an angels putting together deals that, though different in terms of technology content, yield companies with the similar parameters of success that most VCs look for and most often lead to success. One of Big Sky’s most successful portfolio companies, ProcessClaims, a Manhattan Beach, Calif.-based Web-enabled insurance claims software company, was equally one of his earliest and most active investments. With a significant chunk of angel money and active board participation at the earliest stages, ProcessClaims is now a profitable business with more than 70 employees and revenue growing at greater than 40 percent.
“The problem up until now, especially during the boom,” says Schwab, “is that you had all of these angel groups with all of this money who thought they were VCs but they really weren’t. Me, I have no interest in being a VC. … Of the first six companies where I was the first one to write a check, I just liked the plan, I liked the technology and, most importantly, I liked the people. And then I did everything I could to help the company succeed.” It’s a strategy that should be shared by more and more like-minded seed-stage investors-for the betterment of our entire industry and the companies we hope to create.
Ravi Chiruvolu, a general partner of Charter Venture Capital, is a regular technology columnist for VCJ. Send him feedback or ideas to