This post is part of a series of posts called “Pitching a VC” that explains how to get access to VC’s, what to say when you get there and what will happen afterward. The series outline is here and the first post “what goes in a VC presentation” is here. But you can read this stand alone.
A friend of mine who lives in Silicon Valley called me last week to talk about his new company. He’s been a very prominent member of the technology community for 15+ years and is deeply respected by both junior and senior members who have worked closely with him. This is the exact kind of guy who as a VC you would love to invest in provided he can deliver on a well rounded team (getting there) and a great idea (done).
We had a lengthy conversation about whether he should take angel money, which has been offered to him. The investment money he’s been offered has been “priced” (meaning the value of his company at which the angels would buy stock has been set at the recommendation of the angel investors) and he was wondering whether he should take the money.
His alternative is to hold out for “convertible debt” that would not immediately be priced. The purchase price for investors in this type of investment is set in the future when he would raise his first round of venture capital money. (Quick side note for explanation: when you raise money as convertible debt it means that the money you raise is in the form of a loan and not given as equity. It is called convertible because it usually automatically converts to equity when you raise your professional round of venture capital. It typically gets a discount to the price that the VC pays. The discount can be any % number but in my experience is usually between 15-30%).
The conversation about angel money is one I have all the time with entrepreneurs so I thought it would make for a good post on understanding angel investing – how they think, how you should think and how the first round venture capital firm will think by the time the deal gets to them.
How Angels Think – OK, let me start by saying that I rarely do angel investing since I mostly think it’s a sucker’s bet unless you have very deep pockets or unless you’re in a tech bull market (’97-00, ’05-’08) where exits can happen without a lot of follow-on rounds of funding. If you want to know more about why I feel this way feel free to ask in the comments section and I’ll elaborate. I have had the discussion about whether angels should pricing their investments or offer convertible dent with many professional angel investors in the past and 2 in particular that I’ll use in this discussion.
One side of the argument – angels should price: 18 months ago I sat on a panel with Ron Conway, the legendary angel investor from Silicon Valley who invested in Google, Twitter, Digg and many other early-stage Silicon Valley success stories. The topic of angel pricing came up. Ron said he never likes to do convertible debt deals and always insists on pricing his investments. His rationale was clear, “If I invest in a company I open my Rolodex for them. I help them with business development introductions. I introduce employees. I give them credibility in the fund raising process. Let’s say the company was worth $1 million when I met them and I’ve helped them with both my Rolodex and my cash and they can now raise a round of venture capital at a valuation of $6 million. I would be hurting my own interests. A $500,000 investment at a 30% discount to a $6 million round is still priced and more than $4 million and is certainly worth much less than my investing at a $1 million pre-money where I could own 33% of the company.”
This is how I believe angel investors should think. You’re money helps the entrepreneur get through a very difficult period and your money has a lot more risk since you don’t know whether VCs will really want to back this idea or team. Your biggest risk is what we call in the industry, “funding risk” and it is especially prevalent in tough economic times like now where VC money is harder to come by. Now more than ever I think angels should be pricing rounds.
The other side of the argument – angels should not price if the deal is “hot”: I had breakfast in Palo Alto recently with a friend of mine who is a very well known angel investor. He actually invests angel sized rounds on behalf of a larger VC fund. He told me the following in private (versus Ron’s comments on a public panel) so I’d prefer not to reveal his name since I didn’t ask for authorization.
His argument was simple, “The best deals in Silicon Valley are very competitive and I only want to invest in the best deals. If I have to spend weeks debating valuation with entrepreneurs then my probability of getting into the best deals is decreased. I’d much rather be in the deal at a 30% discount to the VC round then to out of the deal altogether and miss investing in the best deals. If the market conditions worsen then I’ll ask for a larger discount. Maybe 40%? Maybe 50%?”
He has a point. This individual really does have access to the best deals in Silicon Valley at formation stage based on his solid reputation for working with entrepreneurs in a hands-on way to help them with their business strategy before raising money. People like working with him and feel he gives credibility. His view is that if he gives the entrepreneurs more time to get around to meet all the angel stars in Silicon Valley (Ron Conway, Mike Maples, Jeff Clavier or any of the other host of angel investors who have sterling reputations and once under their spell it may be harder for my friend to close the deal.
In my estimation he has done good investments in the past 2 years but obviously we’ll need to judge that later when we see whether these investments make money. My bet is they will. Two observations here: 1) he has very unique access to the some of the most proprietary deals in the world and 2) he has only been a VC for 2 years and therefore might see a side benefit of increasing reputation by being in “hot” deals.
For everybody else I believe angels should price. So why do many angels agree to fund with convertible debt? Maybe there are more sophisticated reasons than I am aware of so feel free to weigh in with comments if you think I’m missing something.
I believe most convertible debt deals by angels are done by people who are not professionally investors. There are many groups of angels who like to pool their money together to invest in technology. Sometimes they are ex Tech execs who have made a bit of cash and sometimes they are groups of wealthy doctors, lawyers, real estate professionals – whatever. But I believe they don’t
price either because they don’t know better or they want proprietary access to deals they think they otherwise wouldn’t have been able to invest in without agreeing this structure.
How entrepreneurs should think – So now that you know how angels think about pricing early-stage deals, how should this affect your decisions in the fund raising process?
As an entrepreneur you should raise money from the most experienced people possible – period. If you have the opportunity to raise a small amount of money from a group of experienced investors who have a track record of helping companies get from that tricky idea stage to being a well-formed company with a good product and solid market-entry strategy I would take the money – even if it were priced. Worrying about giving up an extra 10% of your company at this stage can be meaningless if the ultimate outcome is either success or failure. Even VC’s think this way, which is why Fred Wilson when describing his decision to syndicate a portion of his invesment in GeoCities to another investor says, “I learned that good partners are worth every penny of returns you give up to get them.” (whole article here if you’re interested)
Don’t worry about getting “screwed” by sage angel investors. If they really are well regarded and serial investors they won’t likely screw you. Why? Because if they try to take 50% of your company for $500,000 then they know it will be very hard to raise VC because we’ll know that too much of the value has been taken away from the founders before our investment.
People like John Greathouse and Klaus Schauser in Santa Barbara have a great track record both in building companies themselves and also in helping the companies that they angel fund pull together great management teams, launch great technology products and importantly raise VC from top-notch VC’s.
If you’re the kind of person that Ron Conway, Klaus Schauser or John Greathouse would be willing to fund then you’re probably the kind of person who could string together a group of wealthy real estate professionals to give you a convertible debt financing and avoid taking as much dilution at this early stage of your company. Should you take the “cheap” and easy money?
I’ve obviously laid out my case in the argument. Most companies have binary outcomes: you’re either really successful as a company or you’re not. Unfortunately the overwhelming majority of companies end up in the latter category. You know the old saying, “a larger percentage of zero is still zero.” So my advice is to stack the odds as much in your favor as possible by taking the experienced money from people who have a reputation for really helping entrepreneurs.
If you’re struggling to raise money at all then you should obviously take the money from wherever you can get it and many times that is reality. If you believe you have a great idea and are passionate about trying to build a company around it then the only thing worse than raising money from inexperienced people is raising no money at all. Go for it.
If you can raise money from prominent angel investors AND get the investment done as convertible debt – knock your socks off! Take the money. (note: this advice does not include taking convertible debt from VC investors, which I generally advise against. (Again, if you want me to elaborate I’m happy to do so in the comments section).
How do VC’s think about your angel money structure? – First, let me state that many VC’s have done many earlier-stage, angel-like deals in the past few years. It takes less money to start companies than it did 10 years ago and these VC’s had seen the best deals get done by über-wealthy angels. As a result many VC’s were getting into the game of writing $500,000 – $1 million checks.
Will this continue? I don’t know for sure. On the one hand I believe many VC’s have realized that this early-stage investing is riskier than they had perceived and they’ll just end up doing the $3 million rounds down the line when the business has more proof points. So I think many VC’s may pull back to their traditional roles of letting angel investors take the early stage risk.
On the other hand, it is true that it takes significantly less capital to get companies off the ground these days and given Cloud Computing I believe this trend will continue (see my experiences and views here). It is also true that many VC fund sizes going forward will likely be smaller as LP’s come to realize that smaller fund sizes for VC funds (as opposed to growth equity funds) better aligns the interests of the VC and the LP. So I suspect some VC’s will continue doing deals that are on the border between what an angel would do and what a VC would do. I am personally in this camp. And Andreessen Horowitz certainly is as well, announcing their willingness to deals as low as even $50,000.
But to the question of how a VC thinks about your angel money if you do raise it, here are my thoughts:
- Your chances of raising money from a VC are significantly greater if you have raised money from prominent people.
- In most cases we probably don’t care whether the deal was priced or convertible debt. We would, however, look to make sure that you didn’t take too much dilution, which would be a negative.
- If you did convertible debt at a large discount (say 30%) and it was done only 2 months before you’re talking to a VC they will probably grumble about the discount that the previous investor is getting. But ultimately I believe most VCs will get over this because the dilution taken from the discounted convertible debt will likely come from the founders and not the VC
- If you have many angels (say a group of 10-15 people) and if these people are not sophisticated serial angel investors it could cause problems. VC’s will be a bit wary of having small investors who try to hold the company hostage during future financing rounds. Anyone who has been around the industry long enough would have seen this happen at least once. If you do round up money from a load of small unsophisticated investors please make sure to get a great corporate lawyer with experience in doing VC deals to structure the deal to minimize the amount of signatures you need to get for approvals and to ensure that every angel has signed an accredited investor statement.
If you ever see me in person ask me to tell you the story about the pig farmer who seed-funded my first company. I have all the scars from F’ing up the formation of my first company to write blog posts like this.
Next VC post – how do you value private companies?
(Cross-posted @ Both Sides of the Table)