Sunday, August 1, 2010

Thank God For Angels!

During the past year or so, it has been incredibly difficult for seed and start up stage companies to raise money from professional venture investors. Yes, there have been a few notable exceptions that have been heralded by the financial press, but for the most part, traditional capital sources have yielded to angel funding; in my view this is not necessarily a bad thing.

First let's examine what has happened to venture capital. In the previous decade limited partners dedicated enormous sums to the venture capital asset class and inevitably, this money was deployed by both older firms and relatively new ones across the entire company life-cycle spectrum including stages such as seed, start up, early emerging, growth, buy outs and the like. Historically, venture firms have been able to generate decent returns in each segment. Of course, parameters and behavior vary by stage so that, for example, it is axiomatic that failure rates and exit horizons are higher/longer with early-stage investments than they are for more mature ones. Nevertheless, with proper discipline and mathematically-oriented investment criteria, it certainly was (is) possible to assemble very attractive portfolios at every stage, including the early ones.

So why has seed/start up money dried up? One reason is that according to Cambridge Associates, an organization that likes to keeps tabs on venture capital performance, investment returns during the past 3, 5 and 10 years have been worse than anemic. This is typified by a) too much money chasing deals, b) too few firms willing to cut and run and c) even for reasonably successful companies, a very hostile exit environment (ie. almost no IPOs, very stingy M & A, etc.) So what transpired is that venture capital partnerships are now loaded with inventory from prior investments and accordingly, they don't have the bandwidth to cope with new, early stage investments which on balance, take more effort than their later stage brethren. The following WSJ article about board seats neatly illustrates these points:

Compounding this is that the fund raising atmosphere for existing venture capital firms and especially for new ones is murky at best. This has engendered a hypersensitivity biased towards shorter investment horizons and quicker, although not necessarily larger (as a multiple of capital invested) exits. My friend, former colleague and fellow blogger Larry Cheng has written an interesting article about why his practice now favors growth-stage investing:

Moreover, unfortunately the entire venture capital industry is shrinking. Even though this is caused by poor investment returns delivered in the past decade as well as the egregious behavior exhibited by venture investors in aggregate, one thing that the United States has been particularly good at through the years has been nurturing, growing and commercializing innovation. If early stage investing significantly evaporates, I believe that our nation will lose a critical strategic/financial resource and a key economic driver. Another WSJ piece summarizes the situation:

So why am I optimistic about early-stage investing? While angel investors have fundamentally always been an important funding source, it seems that they have recently been filling the seed/start up investment vacuum very aggressively. Even some well-established venture funds have committed capital to so-called "Super Angel" groups so that they can maintain their relationships with early opportunities that are initially shepherded by designated angels. Universities are also establishing direct funds, incubators and the like so as to care for and feed those concepts that are developed in academia. The following two articles highlight these efforts:

There are few inherent flaws associated with seed and start up investment activities so long as those who are involved pay attention to several precepts:

1. Concepts and technology should address very large markets, defined as at least $1B+ at the outset. Technical and execution risk is high enough with early stage companies so that if a company manages to pull off a successful commercial launch, there should be a very broad audience for whatever the thing is.

2. The early investor's initial ownership must be very significant. This not only helps mitigate future dilution but also provides a foundation for investment rewards when a company eventually navigates to a liquidity event. My rule of thumb is that early stage investors should receive 40% of the equity, entrepreneurs get 40% and 20% is reserved for future contributors. This formula operates somewhat independently from the amount being invested since it relates purely to seed and start up opportunities.

3. Investment discipline is paramount. If, for example, the founders have laid out a plan that shows that the idea will be demonstrable as a prototype for say, $500,000 then by the time $250,000 is spent, they better be way beyond 50% complete. Or if a company starts to modify the original investment thesis, then at that instant, the entire enterprise needs to be reevaluated with at least the same diligence effort applied when the investment originated.

4. It's imperative to cut losses short. If as in the above example, $250,000 has been spent and the thing isn't working, then it might well be better to just pack it in at that point, unless there is a highly compelling reason to continue.

5. Recruit new investors before exhausting the initial investment. If the early investor can't find fresh money at a reasonable valuation step-up (protecting against severe dilution) after the company has achieved important milestones, then this may be a reason to terminate further early-stage investment.

6. Seek customers and partners immediately after the company proves that the concept is viable. There are usually a plethora of early adopters for great, demonstrable ideas. If the company has trouble soliciting interest in the prototype, this can be a very bad signal. Of course, the usual and customary intellectual property protections need recognition here.

7. While inventors seldom have the skills requisite to propel a company beyond its early years, it is often a mistake to recruit executive "talent" too rapidly. The early stage investor should be qualified and prepared to fill the overseer role until such time as the company is actually ready to enter markets. This will not only conserve financial resources and reduce potential friction, but also, will allow the company to recruit higher quality personnel at the appropriate time.

Given the venture capital industry's woes, and assuming that there is a reasonable behavior pattern involved, I believe that the future for early stage angel investing, university funding, incubators and the like is quite bright. Angel investing and related activities operate on a scale much smaller than institutional investors such as venture funds. With a $10 million capital pool (minuscule by venture capital standards) and assuming that 6/10 $500,000 investments fail outright, 3 return capital and 1 achieves a $100M exit (also modest by venture capital measures), that pool will produce at least a 3X return. If it does so in 5 years then the annual return rate is nearly 25%, dropping to about 12% if it takes 10 years.

Returns such as this will not "move the needle" for large venture capital partnerships since this analysis doesn't assume finding the next Google so to speak. But early stage investing by angels and their counterparts can provide meaningful investment returns for smaller players, and just as importantly, it will continue to fuel the innovation that America so badly needs.

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