October 23, 2011
Smarter money is available for less innovative companies
Although game-changing innovation is expensive, laborious, time intensive and unplumbed, companies relying on existing technology find the market place (especially the ITC market) to be crowded, competitive, and cheap. Because starting a company is so much less expensive in 2011, many tech startups can succeed without taking outside funding at all. In the extremely rare event that VC money is available, the company and its founders must decide if VC investment is worth the attendant costs in equity and control, especially when there are cheaper sources of equally smart outside financing available. A company with promise may have access to angels and super angels; accelerators and incubators; and university funds, among others. A company can also raise capital that is not smart, like borrowing; debt financing; sales on secondary markets; leveraging various types of intellectual property; state and local funds; peer-to-peer financing; etc.
Angels and accelerators, two of the fastest growing types of smart money, are filling emerging companies’ capital needs. This post explains what founders know about the cost of angel and accelerator funding in 2011.
What new companies need to know about the cost of smart money in the new economy
Because the market for investing smaller amounts of money is being filled by angels, accelerators, and their variants, a promising company has choices of money that’s both smart and—at least comparatively—low cost. As a historical rule, dumb money—the money that doesn’t offer a rolodex, strategic advice, or other benefits beyond needed capital, is the most affordable and should be fully exploited before outside investments are taken.
Smart money costs companies equity and control
Unlike its dumb counterparts, smart money has two main types of costs: 1) economic costs and 2) control costs. Under the traditional big-money VC model, these costs were high. Equity dilution was borne by the company and founder control was usually halved. Founders who believed the costs hard to swallow and still accepted the terms correctly concluded that maintaining a minority position in a well-financed startup was preferable to maintaining firm control of a venture failing for want of money.
Many investors are founder friendly in 2011, so capital can’t afford to make too many demands
Investment-worthy companies have more traction in 2011 since there are a variety of investors willing to accept terms that are founder friendly. The investors hope that favorable terms will maximize their chance of securing an equity stake in a company that will yield a high multiple ROI. For an example of a founder friendly change, consider how founders were paid upon exit under the traditional model, and what the new options available are in 2011.
Under the traditional VC model, founders were the last paid in liquidity events. Now, investors are willing to make sure founder incentives are aligned with the performance of the company. One way to do this is by agreeing to management carve-outs that award the founder a portion of every dollar flowing from an exit event (regardless of the liquidation stack), with the percentage increasing along with the sell price. More specifically, an investor might not agree to pay the founder any percentage if the sale is for less than $10M (reasoning that such a low price means the founder didn’t work hard), but will award ten cents on the dollar if the company is sold for $11M; fifteen cents for a sale at $15M and up from there.
Voting provisions provide another example of founder friendly terms. Some very promising companies have negotiated for super-voting common stock (referred to as “F”—short for founder—stock) with heavy protective provisions.
In 2011, investors are willing to take something less to compete with their peers for the most promising investments. Lower equity and control costs are distinguishing factors when multiple smart money options are available. Two smart options, angels and accelerators, and their costs and benefits, are described below.
Smarter Smart Money Option One: Angels (and bands of angels)
Making generalizations about angel investors is quite difficult—the population is diverse, and data about angels is limited. Nevertheless, the term “angel” is usually shorthand for an individual investor whose motivations include something besides return on investment.
Factors informing angel capital costs: motivation; competition; and copycats
The “typical” angel usually makes an investment of tens of thousands of dollars, rather than millions, and is therefore an ideal source of capital for a company that has a great idea, but needs a little money. More specifically, the money needed exceeds the company’s ability to self-finance, but doesn’t rise to a level that would make the investment attractive to a VC fund.
Historic angel equity and control costs
Other motives aside, the angel wants a compounded annual return of at least 20 percent, liquidation in five to ten years, and a minority interest in the company. In the words of John May, an angel invests “after tax dollars . . . into a stranger’s company in a minority position of equity with no dividends, interest or cash flow, in a principle-to-principle relationship using time as well as money for a 3, 5, 7 or 9 year time period to earn long term capital gains and the only recourse is the rule of law.”
By comparison to VC, angel money has traditionally cost less in terms of company equity and control. On the other hand, angel money has also been considered less prestigious. For example, Y Combinator would traditionally advise a company with a choice of VC or angel money to choose VC (at least for an A round), since VC has a side effect of attracting more attention from other investors.
Angel activity is changing in 2011, and the costs of angel capital are changing too
Angel activity has expanded significantly to fill the need for small investments. More angel and angel-size investors competing to make small investments in the most promising companies have led to deals with founder-leaning terms. Yuri Milner, for example, makes investments that are passive. He buys an equity stake but doesn’t ask for control. Other angels are accepting convertible notes instead of equity. This is good for companies for three reasons.
First, convertible debt is customizable, and allows different terms for different angels. This means a company can reward an angel willing to make an early, risky investment that hasn’t been “endorsed” by other angels. As Paul Graham writes in his essay, High Resolution Fundraising, “it’s much safer to invest in a startup Ron Conway has already invested in; someone who comes after him should pay a higher price.”
Second, the use of individual convertible notes means that the company doesn’t have to decide how much money it needs before fundraising (as it would, for example, with an equity issue). Instead, it can take the money on an as-needed basis.
The third reason is informed by the first and second—convertible notes help founders avoid holdout problems. Holdouts are one potential downside of fixed-price equity issuance, which might come together at snail-pace, since potential investors who are marginally interested hold out and wait to see who else “endorses” the deal by investing money.
Although some angel activity is VC-distinct, some mimics the VC model
Interestingly, many angels are investing in ways that look a lot like the VC model. For example, angel investments in early-stage companies declined by four percent in 2010 —the difference was made up by angel investments in later-stage companies, an area formerly covered by VC money. Beyond that, there are now “super angels” who invest for others, or for groups, and angel consortiums of various types, which allow angels to spread risk among a portfolio of companies (usually using VC-like processes and term sheets) reducing the risk attendant to making one or only a few investments.
Angels are reducing the costs of the VC money
In order to avoid lost opportunities and gain good will for generating series A opportunities later, VC funds are making angel-sized investments that do not command the same terms attendant to infusions of several million dollars.
According to Paul Graham, the VCs behavior change may not be enough to compete. He says “the fact that super-angels invest other people’s money makes them doubly alarming to VCs. They don’t just compete for startups; they also compete for investors. What super-angels really are is a new form of fast-moving, lightweight VC fund. And those of us in the technology world know what usually happens when something comes along that can be described in terms like that. Usually it’s the replacement.”
But the truth of the matter is, angel, super angel and VC money are not mutually exclusive, they can be, and frequently are, cobbled together. This is good for the company, but doesn’t fit within the VC model at all. More specifically, from the founder’s perspective, cobbling reduces the cost of VC money. A company that scales fast on angel money may not ever need VC money, but if it does, the earlier angel investment means that the company will be VC-funded at a higher valuation. The VC incurs a cost because the VC wins less from the investment even if it is wildly successful. Said another way, if the company had foregone angel investment, then the VC would have been able to buy in at a lower valuation. The company had accomplished less when it first needed money, and VC buy-in at that time would have been at a lower valuation. This means that assuming the VC money works just as well (as the angel first round plus VC second round) to secure a top sell price, the VC’s larger investment reduces the ROI significantly.
Smarter Smart Money Option 2: Accelerators and incubators
The colloquialism, “two heads are better than one,” is especially true for quantitative heads. Psychology scholars Patrick Laughlin, Erin Hatch, Jonathan Silver, and Lee Boh proved that for intellectual problems, “groups of size three, four and five performed better than the best of an equivalent number of individuals.” This is one of the ideas contributing to the increasing popularity of emerging company accelerators. When a new company participates in an accelerator or incubator, they spend a small period of time—days to months depending on the program—hyper-focused on improving their ideas and companies through collaboration, mentorship from proven industry veterans, and a very small amount of money. Unlike VC money (which is heavily concentrated in Boston, D.C., and California), and angel money (which is usually distributed within a 300 mile radius of the angel’s home), accelerators exist in many states. In fact, the accelerator ranked best through collaborative evaluation by Kauffman, the Kellogg School, and Tech Cocktail is in Boulder, Colorado. Others top accelerators are in Chicago, IL; Durham, NC; Dallas, TX; and Seattle, WA. The number of accelerators, like the number of angel-investments, is large and growing to accommodate players “hoping to capitalize on a Web investment boom and cheap-to-build technology that can quickly make fast, nimble startups attractive acquisition targets.”
The costs of accelerators and incubators (are pretty low)
The funding-to-equity ratios of accelerators vary, but the bottom line is that the equity cost is low and board control is not a cost of the transaction. To bring home the point, consider that Y Combinator takes an equity stake between two and ten percent of very young companies—some that are little more than an idea—in exchange for a cash infusion of $11K plus an additional $3K for each founder. Although this is a very small amount of money, particularly considering that participants are required to move to the San Francisco Bay area for the three-month program, the infusion often steers participants to what YC calls “ramen profitability.” If the company is able to exit quickly without taking on more money—as accelerator alums sometimes do—the ROI can be huge.
The attention created by the accelerators is part of the plan—former entrepreneurs, who often set up the accelerators, have a reputational value that can rub off on the participant companies. Beyond that, one benefit of the accelerator is rapid-fire networking among a community of peers. An established company that notices the buzz can be tempted to acquire a participant before his competitors have a chance, and moving fast means that the acquirer won’t have to suffer a prolonged and expensive bidding war to acquire the company later. Beyond that, if the buzz is wrong, failing at a low valuation is much better than failing at a costly one.
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