Posts from Angel investor

As I read this post in the WSJ about the changing nature of VC funding of consumer web companies, I thought that we may be looking at the symptoms and not the disease. As the WSJ notes, VC funding of consumer web and mobile companies is down 42% in this first nine months of 2012 (vs the first nine months of 2011). And the big falloff is not in seed rounds, which are still getting done, but in follow-on rounds, which are not.

So what has changed in the past couple years? A lot, actually.

1) the consumer web has matured. we are almost 20 years into the consumer web and we have large platforms that are starting to suck up a lot of the oxygen. google, facebook/instagram, amazon, microsoft, apple, twitter, ebay, yahoo, AOL, craigslist, wordpress, linkedin together make up a huge amount of the time spent online, particularly in the english speaking world. there are still occasional new entrants into this list and departures too. tumblr and pinterest have risen a lot in the past couple years while myspace has declined. but consumer behaviors are starting to ossify on the web and it is harder than ever to build a large audience from a standing start.

2) the consumer is moving from desktop/web to mobile/app. we've talked about this transition ad nauseam on this blog. it is the single biggest megatrend in the consumer internet space right now. most new consumer internet startups need to build for iOS, Android, and web at the same time. it is making the startup more expensive and time consuming. distribution is much harder on mobile than web and we see a lot of mobile first startups getting stuck in the transition from successful product to large user base. strong product market fit is no longer enough to get to a large user base. you need to master the "download app, use app, keep using app, put it on your home screen" flow and that is a hard one to master.

3) the momentum/late stage investors have moved from consumer to enterprise. there is a large pool of money in the venture capital asset class that is opportunistic, momentum driven, and thesis agnostic. this pool is driven largely by the public markets. this pool of capital was "all in" on consumer web/social web in the 2009-2011 time frame. it drove a lot of activity throughout the venture capital markets because each layer of the VC stack (angel, seed, Srs A, Srs B, Srs C, etc) needs to be aware of what the next layer up wants to fund. when the momentum/late stage wanted web/social, the layers below gave them web/social. now that the momentum/late stage wants enterprise, we should expect the layers below to give them enterprise.

The combination of these three factors is making it harder for consumer internet companies (web and mobile) to get funding. But the first two factors are also making it harder for consumer internet companies (web and mobile) to breakout which is more and more a prerequisite for funding. As venture portfolios fill up with promising companies with solid products that are struggling to breakout, the VCs will naturally be drawn ever more to the companies that are in fact breaking out. It is a pernicious cycle and we see it playing out very clearly in the consumer internet space these days.

What does that mean for USV? Well not that much actually. We are thesis driven to the core. We believe in what we believe in, for good or bad. And that is large networks of engaged users that have the power to disrupt big markets. We are investing at the fastest rate right now in the history of our firm. We are doing a lot of Srs A and Srs B rounds right now because that is where we see the biggest vaccum in the market. We have not done a real seed or angel round in quite a while. But that doesn't mean we wouldn't and our next investment could well be a seed or angel round.

But we are a small firm. We put out maybe $40mm to $50mm per year across all of our core funds, across initial investments and follow-ons. That is a tiny fraction of the venture capital market. We are small on purpose. We don't want to be the market. We want to invest in a tiny slice of the early stage ecosystem where our thesis collides with great teams and unique and differentiated products.

All that said, these three trends are impacting our portfolio. We have fifty portfolio companies, with the vast majority in the consumer internet space. We encouraged our portfolio companies to raise a lot of capital in 2011 and many did. But even so, we are seeing fundraising challenges everywhere, even in our very best portfolio companies. We are also seeing many of the youngest companies in the portoflio, those started after the summer of 2010, struggling with the breakout challeneges I mentioned earlier in this post. We are patient investors and believe in our portfolio companies and the teams we have funded. We are seeing patience being rewarded, particularly in the mobile market. But it is a tougher time for early stage consumer internet companies than I have seen since the 2001-2004 time frame. And I think we are still in the early innings of this more challenging environment.

So things have changed. As they always do in tech. Those who adapt to the changing dynamics, who see the openings that were not there before and slice through them, will succeed. But the wind that has been at our back for 7-8 years in consumer internet is no longer there. It's tougher sledding and will likely continue so for some time to come.

The Gotham Gal and I have been fortunate to accumulate signficant capital over the past fifteen years. And the vast majority of it is invested in startups. We get distributions from a sale of one company and within months that capital (after taxes) is invested in more startups (including non profit startups). This has caused a few liquidity issues over the years. The Gotham Gal is always saying that we'll set aside a bunch of cash next time and then we go and do the same thing. I guess we can't help ourselves. Investing in startups is more appealing to us than leaving cash in the bank or putting capital into the bond market or the stock market.

When I think about the history of silicon valley and startup ecosystems in general, this is the pattern I see. Entrepreneurs, angel investors, and VCs take the profits from one deal and turn around an invest in more deals. They recycle capital back into the startup economy. If you look at silicon valley right now, particularly in the early stage/angel/angel list market, this is what is going on. Early employees of Google, Facebook, and a bunch of other succcessful tech companies have taken a considerable part of their paydays and become angels. And it makes sense. They work in the startup economy. They understand the technology, the market, and the gestalt of startup life. They are allocating capital to the startup ecosystem.

I bumped into a friend last week who sold his company a few years ago. He spent the required time with the buyer and then left. He's been spending his time since starting a family with his wife and investing in startups. He told me he's not sure he'll make a lot of money angel investing, but he's hoping to at least breakeven. So he's not doing it soley for the returns. He's doing it to stay connected to startups and support other entrepreneurs. I am certain he's not alone in his approach to angel investing.

I've been told that the US venture capital and startup system is the envy of the world. If so, then I think the rest of the world should pay as much attention to the way entrepreneurs recycle their capital as anything else. Yes, the institutional venture capital system is a big part of the success of our tech startup economy. But it starts with entrepreneurs and angels. Most VCs don't supply capital in the first year or so of a company's life. So startups need to get their initial capital elsewhere and that early money is where the real special sauce is. Think about Andy Bechtolsheim's $100k check to Google or Peter Theil, Mark Pincus, Reid Hoffman, and Sean Parker's early angel investment in Facebook. These entrepreneurs were recycling their capital back into the startup economy. Yes, those investments have paid off bigtime. But they also supplied capital when the company needed it the most.

The Gotham Gal and I allocate most of our capital to startups for many reasons. We do think we are going to generate good returns over the long run doing this. We have generated almost all of our capital over the years by investing in startups. But we also do it for the psychic benefits of investing in startups. When you back an entrepreneur early on, it is like making a large gift to a good cause. It feels really good. And when that entrepreneur uses your early support to create something important and valuable, it feels even better. You can't get that kind of feeling earning interest from a bank or trading stocks and bonds. And that's a good thing. Because capital formation for entrepreneurs and startups is the key to a healthy economy. And for all the problems we face in our country, we have a startup financing culture that is the envy of the world. And I'm really happy and fortunate to be part of it.

AVC regular Charlie Crystle asked me this question yesterday in the comments:

Fred, it might be helpful to some of your readers to explain when a startup should seek angel vs seed/early stage VC. 

If I need $250,000 to get to 100 customers, or $1 million to get to X, and I can raise both amounts from either Angels or VCs, where do we turn? 

And let's say both have significant interest, and the terms are the same, which is a better choice? (I no longer have an opinion on this, having gone both directions).

There are really two questions in here. The first is when you should SEEK angel vs VC and the second is if you have the option of taking money from both what you should do.

On the first, I believe entrepreneurs should seek angel money when their product is not yet complete, is not in the market and thus they cannot demonstrate real market traction to investors. There are multiple reasons for this and I'll try to articulate the most important of them.

A company without a product in the market is a very risky proposition. Some VC firms will invest at this stage but I am not sure its entirely appropriate for VCs to invest at this stage. Our firm will do it when we are backing a serial entrepreneur with a super strong track record that we are very familiar with. Otherwise, we stand on the sidelines and watch with interest but no capital at risk. A syndicate of angels, each with a small amount of capital at risk in the project, is a much more appropriate source of capital for a company at this stage because the risk has been well syndicated among the group.

Angels are also more hands off and I believe hands off investors are better for a company where defining, building, and tuning product is the primary exercise. VCs have a responsibility to their partners, both the partners in their firm and the partners who fund their firm, to be highly engaged in the business. So like it or not, they are going to be engaged in the business. I think it is best when that engagement is applied to a product that is in the market and gaining traction, and building the business is the primary exercise.

Finally, selling a VC on a concept on a whiteboard is a very hard sale. It is extremely time consuming with very little chance of success. Selling an angel on a concept is much easier. So simply in terms of where you should spend your time raising capital, angels are a better target in the "concept to product" stage.

The second question, what to do if you have the option of taking money from both sources on the same terms, is more interesting in many ways.

My answer is do both, if you can. When we participate in seed rounds, we most often do it by ourselves with a syndicate of high quality angels. We have done this at least a dozen times now and it works extremely well. We behave as if we are one of the angels and try to be relatively hands off. And we hope that the angels will add value just as they do in their other syndicates where there is not a VC firm involved.

But when the company needs another round of financing, we are there to provide more financing. Sometimes the angels follow in the successive rounds. But mostly they do not. It really doesn't matter, because we can fund the company on our own as long as the capital requirements are modest.

This is our preferred model and we have used it with great success. I think it benefits entrepreneurs the most as well. There are a number of VC firms that use this model. I first saw it practiced by Brad Feld about a decade ago in the seed deals he was doing in the Boulder area when he was at Mobius and I admired it immediately.

If for some reason, you must choose between VCs and angels, then I would choose a VC firm, as long as you have a very good relationship with the firm and the specific individual who will be leading the investment from the firm. In almost every situation, you are going to need more than one round and VCs can and will do multiple rounds and angels often cannot.

I will end this with a comment on the emerging seed and super seed fund models. They exist somewhere between angels and VCs and some are growing and turning into full blown VCs as I have mentioned recently in another blog post on this topic. Seed and super seed funds are "institutional angels" and as such I would mostly categorize them as angels. But many of them do have more capital at their disposal and can, at times, provide additional rounds of funding. So in some ways they are a hybrid. A syndicate of a seed fund or super seed fund and angels is a great way to go if you can put that together. A syndicate of a VC, a seed fund, and some angels might even be better.

To finish this post, I think entrepreneurs should target angels and seed funds when they are pre-launch but if they have the opportunity to pair a VC firm with angels and seed funds into a single syndicate they should do that because it will provide most stable funding platform for the business going forward.

I exchanged some blog comments with Tereza yesterday. She's starting a web company and is raising angel money. She said she did some phone pitches against her better judgement and they didn't work out. I advised her not to do them anymore.

Here's my thing about phone pitches. They aren't very effective. I hate taking them and almost never do. I don't think they allow the entrepreneur to show themselves very well which is the most important thing of all.

And it is so easy to say no over the phone. There's no real human connection. It's easy to pay half attention or less on the phone. It's easy to fake that you are listening when you are not.

I admit that I am really bad on the phone. I always have been. It's not a medium that I like very much. So I am probably worse than the average investor. But even so, I think doing phone pitches is a mistake and you should avoid doing them.

I do think a short phone call introducing the opportunity at a very high level and making the case for an in person pitch is an important thing to do. You can accomplish that in a few minutes or less. It's basically an elevator pitch. But don't agree to do the whole pitch on the phone. Ask the investor make time for you in person to do that. That will determine if they have sufficient interest for you to invest your time with them.

And what about a video chat on skype or another similar service? I do think a video chat is sufficiently better than a phone call to make it a semi-viable alternative. If a plane ride is required to see an investor, then a skype/video chat is a decent first step. But again, you should do it with the objective of getting an in person meeting. 

But if you can visit the investor in person without getting on a plane, I think you should always opt for that over a conversation over the phone or skype. There really is nothing like the in person, face to face meeting when it comes to fundraising or any kind of high level sales effort.

Fundraising is such a hard thing to do, particularly for first time entrepreneurs without a track record and an investor following. Don't make it harder by putting a wire between you and the investor.

There is a big banking reform bill working its way through the Senate right now. It is sponsored by Chris Dodd, Chairman of the Senate Banking Committee. It has a long name I can't remember, so I'll call it the Dodd Banking Bill.

What does a bill attempting to regulate the banking industry have to do with startups? Well unfortunately, it contains two provisions that are quite problematic and hurtful to entrepreneurs and startups. They are:

1) Changing the definition of a "qualified investor" in angel and venture deals. Not just anyone can invest in a startup company. You have to be a qualified investor. A qualified investor is currently defined as anyone with a net worth of over $1mm or net income of over $250k. Dodd's bill would increase that to $2.3mm and $450k respectively. And then index those numbers to inflation.

2) Eliminate the existing federal pre-emption over state regulation of "accredited offerings." Angel and venture financings could be regulated state by state creating a fairly burdensome set of rules  and regulations that each financing would need to be subject to. Currently there is a federal pre-emption that makes getting these kinds of deals done fairly easy.

I have no idea why either of these provisions ended up in a bill designed to regulate the banking industry. Entrepreneurs and startups don't use banks to finance them. They get their initial capital from angel investors and then VCs as they grow. This system works well, did not blow up in 2008, and is not in need of reform of the type Dodd wants to throw at us.

In fact, what we need is to eliminate all accredited investor requirements for small investments of up to $25k. Why does someone have to be a millionaire to invest in a friend's startup? I understand that we don't want someone mortgaging their home, or betting their entire life's savings on a startup. But for a small amount, like $25k, we should not be regulating angel investing.

My dad sent me an email the other day pointing out a news story about an incubator in Texas that was cranking out startups and creating jobs. He told me that he believes that the work entrepreneurs and the people who work with them (ie me) are doing is incredibly important to the health of our economy. He's right and we need to explain that to Chris Dodd and his friends in the Senate. If they are going to reform accredited investor regulations, they should liberalize them, not constrain them further.

I'll get on the phone and call my Senators and Representatives. Hopefully you'll do the same. This is nonsense.

UPDATE: Irene left these details in the comments which will be helpful when you contact your representatives:

The section numbers in question are Sec. 412 for accredited investors and Sec. 926 for federal pre-emption or Reg D.

Link to pdf of bill: http://bit.ly/duxjSr

Link to TechFlash article with more info on possible influences: http://bit.ly/96uuEx

UPDATE #2: Dan Primack of PE Hub has just posted that congress is listening to all the uproar over this. Maybe we'll get to keep things the way they are. But I am still going to make the case that we need an exclusion for small investments made by non-qualified investors.

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I did a "Room For Debate" on the New York Times yesterday with Ken Auletta and John Markoff. Here's the first part and here's the second part. The topic was Google; are they too powerful and if so, what the government should do about it.

I said this about anti-trust efforts in technology:

I am not big fan of governmental intervention in technology markets.
Technology moves very rapidly and one decade’s dominant monopoly is the
next decade’s fading giant.

I would prefer our government focus on creating the right
environment for innovation and new technology development so that the
next Google can come along and change the game again. Things like
immigration reform (the start-up visa movement), patent reform
(elimination of software patents), net neutrality and open spectrum are
all much more important than filing an antitrust case against Google.

No sooner than when I wrote those words I found out about another public policy issue that impacts the technology startup world.

William Carleton pointed out to me yesterday on this blog, in the comments, that Senator Dodd's financial system reform bill contains two provisions that will be very harmful to startups. If passed as currently drafted, the bill calls for:

(1) increasing the threshold for accredited investors

(2) ending the federal preemption of "all accredited" offerings, so
that states would be permitted to regulate such offerings, even if they
meet federal requirements under Rule 506 of Reg D.

I'm not a security lawyer and I hope we get some discussion of these two points from security lawyers in the comments, but both of these seem wrong headed to me.

The angel funding mechanism is potentially the single most important funding mechanism in startup land. Most entrepreneurs get their first real investments from angels, not VCs. If you lower the amount of angel capital in startup land, you'll end up lowering the number of entrepreneurs who can get their projects off the ground.

So now there's one more thing we all have to start calling Washington about. I'm going to call my representatives about this. You might want to do the same. And while you have them on the phone, tell them we also want their support on the startup visa movement, elimination of software patents, net neutrality, and open spectrum. That seems like a lot to ask, but this stuff is important and getting more so.