The Future of Venture Capital - Of Startups, Seed Funds, and Limited Partners

The annual PreMoney conference in June 2014 was themed ‘the future of venture capital’. One topic of discussion was the proliferation of angel investments and seed funds.

1. How to find the right match between startups and angel investors?
2. How do angel investors decide where to invest?
3. How should Limited Partners decide which seed funds to invest in?

Investors and startups should fall in love.  Elad Gil looked at the two sides of the angel investor - startup relationship. For a startup to fall in love with an angel investor, an angel can do several things to help the entrepreneur: making introductions to the network and providing access to privileged information, offering support like CEO dinners, and being available and discrete.

Investing requires to be principled. Elad suggest the most important criterion for angels to invest in a startup should be the market - as Andy Rachleff said, the market always wins, and the only way to make money is to be contrarian and right. Companies such as eBay and AirBnB were initially considered overvalued and are in fact perfect examples of those criteria. Jeff Clavier from Softtech VC added his key criteria for investing

• Do I like the founders? Are they a good fit for the category? Do the founders know what they don’t know?
• Am I passionate about the product? Do I love this deal? Every new piece of information in the course of due diligence should make you more excited.
• Is it fundable in 12-18 months?

He strongly suggested to invest if the founders are legit and the referrer is respectable. He also advocated building a strong investor syndicate to help fix the founders shortcomings, and to avoid the party rounds where no one is responsible.

Elad also offered suggestions how to avoid the trap of becoming a bad angel: re-inventing yourself, building networks and knowledge for your company, and focusing on things you can uniquely help with.

Network centrality and follow-ons distinguish seed funds. Limited Partners get inundated with pitches from 50+ new seed funds which have been created in the past years. The Limited Partner community cares about these MicroVCs, but needs help to understand which funds have deal flow and syndication. Jeff Clavier pointed out the importance of having a ‘shtick’ - a differentiated strategy by geography, sector, infrastructure, ecosystem, value add - to  distinguish from the hundreds of other MicroVCs. Anand Sanwal from CB Insights provided quantitative insight on the relative attractiveness of the funds and general partners

• Network centrality: Google PageRank for investors, and to high quality investors. Three of the top six leaders here are also members of Y Combinator: Alexis Ohanian, Max Levchin, Gary Tan, Marc Benioff, David Tisch, Paul Buchheit.
• Syndication and follow-on investments: Who invests afterwards provides more confidence. Follow on rates are highest for seasoned investors and entrepreneurs such Bobby Yardani, Larry Augustin, Matt Coffin, Gil Penchina. As an aside, CB insight found that VC involvement in seed rounds creates more follow-on funding.

None of the funds have a track record yet, and similarly, neither do many of the fund’s general partners. But the analysis promises to be an indicator of future success.

How To Become A Super Angel, Part Two: How To Spend It

In the first installment on how to become a super angel, we reviewed the seven steps to achieve liftoff and raise the first outside funds. This second installment takes a look at the subsequent evolution of the super angel cohort.

8. Put the outside money to work quickly. A $10 million fund will spend $4 million over the first two to three years, and keep $6 million in reserve for follow-on investments. The $1 - $2 million annual spending can still be used to pray and spray approach, but, more likely, the angel will write bigger checks to double down on initial investments. Given that the angel has made a significant number of investments over many years, deal flow should not be an issue. And if it is, there is always the option of creating one’s own accelerator, or leverage AngelList.
   
9. Increase the investment size.  At this stage, super angels typically still invest on their own time. Previous investments are taking up some of that time, and therefore super angels will very likely have to increase the size of their investments going forward. However, angels typically still do not lead investments and don’t take board seats at this stage. Their ability to provide timely advice may also be impacted.
   
10. Raise the next round. To take advantage of the momentum and the afterglow of the early successes, angels again need to raise as quickly as 18 months after the first round.

11. Hire some junior partners. Now that there is more money to spend, there are many more investments to be made. At this stage, the super angels run out of time and need to start leveraging their time.
    
12. Create a following among VCs. An analysis of micro venture capital firms by CB Insight shows that many investments of Chris Sacca’s LowerCase and Aydin Senkut’s Felicis Ventures are followed by blue chip venture capital firms. On their web site, Felicis notes that they have had 51 notable exits, evidence of an angel investor who he is highly networked with venture capital firms and with serial corporate acquirers such as Google and Facebook.
    
13. Adapt the business model. Quo vadis, super angel?  
    

• Become a micro/boutique VC. The bigger micro VCs like SoftTech VC and Felicis have raised in excess of $100 million and seem well on their way to becoming a traditional venture capital firm. Because they now lead rounds and are board members, they have hired and promoted additional partners.
  
• Build an accelerator. 500 Startups in particular has combined an accelerator with seed, early stage and later stage investments. Dave McClure has put in place a whole ecosystem of investments, events and global sourcing of entrepreneurs.
  
• Stay small. K9 Ventures seems to pursue this path where Manu Kumar remain a sole operator of a $40 million fund. According to Crunchbase, K9 has made 32 investments in 23 companies as of October 2014, two years after raising the second fund.
  
• Be opportunistic. Chris Sacca of LowerCase has been a master of doubling down on prior investments and leveraging his network. He first raised an $8.5 million fund from high net worth individuals he had built real relations with, and then raised additional funds just to buy Twitter shares as people were leaving.
  
• Start a syndicate on AngelList. Jason Calacanis and other angels have used their network and name recognition to launch nano funds. The committed amounts are still significantly below $10 million, but can eventually lead to larger investments from Limited Partners.
  

There is no public information available about the performance of any of these super angels and their funds, many of which are still relatively young. There is some anecdotal evidence that the returns of some the funds are below the water mark, but similar to venture capital firms, success stories tend to be told and re-told, and losses swept under the rug called survivorship bias. For the time being, proxies like the CB Insights network centrality and investment follow-on analysis have to suffice to provide Limited Partners with insight about the potential returns of these newly minted super angels.

How To Become A Super Angel, Part One: Seven Steps To Lift Off

Historically, angel investors have been retired high net worth executives and entrepreneurs. But as of late, super angels and micro VCs have emerged as a new type of new angel investor.

The archetype of the super angel is Ron Conway who got his start in 1995. Since then, others such as Jeff Clavier, Aydin Senkut, and Chris Sacca have emerged, some of which have leveraged their early successes into building partnerships akin to the venture capital firms of the early days.

Even without a formal definition of a super angel, one can identify remarkable similarities by inspecting the early days of these investors. Without further ado, here then are seven steps to achieve super angel lift-off:

1. Have an immigrant mind set. This can encompass anyone from outside of Silicon Valley. Jeff Clavier grew up in France, Aydin Senkut hails from Turkey, Manu Kumar came to the U.S. at the age of 17. Chris Sacca grew up in Buffalo, New York, and carefully cultivates the image of a small town kid. What matters is the mind set.

2. Build your skills in adjacent roles. No one is born a super angel. The more prominent super angels had operating experience at a start-up. Launching your own company or being a member of a founding team is the best place to start; business development and product management roles can come pretty close. But realize that training wheels have to come off at some point.
   
   
3. Quit your day job. Spending more hours on due diligence and interacting with portfolio companies at least a couple of times per month correlates with greater returns. With a large size investment portfolio, there isn’t enough time to be a super angel while holding a day job.The price is high: You must be ready to spend years without receiving a paycheck. And the next step makes the financial picture even worse.
   
   
4. Spend your own money. Most super angels spent the first three years investing their own money in 10-20 startups. Chris Sacca’s story is the exception: He had just enough cash to invest in Photobucket, and had to immediately move on to steps #5 and #6.  

5. Hustle. Hustle. And then, hustle. Ron Conway is the consummate networker, and was able to invest in Google by getting both Sequoia and Kleiner Perkins to sign up for the Series A . Chris Sacca bootstrapped himself into Twitter by charging $25,000 to his credit card. Aydin Senkut got into Helsinki based Rovio - not exactly a drive-by Silicon Valley location. Reminder: This step is closely connected to step #1.
   
   
6. Get lucky. Jeff Clavier had a massive return after 18 months when AOL acquired Truveo, and had many other early exits in his first portfolio. Chris Sacca’s investment in Photobucket more than returned its money in less than a year. Three angels - Jeff Clavier, Aydin Senkut and Dave McClure  - have claimed Mint’s sale to Intuit as a significant early exit. Note: End customer related internet start-ups rule when it comes to quick exits.
   
   
7. Raise first outside money from High Net Worth acquaintances. Investment portfolios take time to generate returns even when there are some early successes, and eventually angel investors run out of money. The initial check sizes tend to be small, and hence this hobby is not likely to pay for the daily expenses. But early successful exits allow super angels to raise money from high worth individuals in their networks. In Chris Sacca’s words: He was able to raise money from people he had traveled with and who he had relationships with.

Stay tuned for Part Two: How To Spend It.

The Series A Crunch Has Officially Been Postponed. Here Is Why Professional Angel Investors Should Take Note:

Adeo Ressi predicted the so-called series A crunch in late 2011: A dearth of available Series A money caused by the concentration of venture funds in the top venture investment firms and the inability of many smaller venture firms to raise new funds from their limited partners. In fact, at the June 2013 PreMoney conference Naval Ravikant from Angellist confirmed that there is a gap in the market to write a $250 thousand to $1 million check, and to lead a round for a company that is not ready yet for Series A.

But not as many young start-ups have shut down as might have been expected. Instead, many have been able to raise follow-on rounds from their initial seed investors. These investors are willing to double down and provide additional funding hoping that significant traction can be achieved in another 9 to 12 months. 

As opposed to traditional Series A territory these rounds often are not priced. Y Combinator (YC) in particular has changed how entrepreneurs have raised funds: In 2010 Paul Graham infamously tweeted that ‘the convertible note has won’, and start-ups beyond YC have raised $1 million or more of initial seed funding using a capped convertible note structure.

The vast majority of the follow-on investors seem to be perfectly happy to further invest using these note structures. Rather than demanding debt conversion into equity or a loan repayment, they are willing to extend the duration of the initial loan terms, and caps may be raised further. Actual price setting and governance are pushed out into the future. Implicitly, these additional raises are expected to last long enough to meet all milestones assuming execution is flawless.

Fast forward by a few years: Entrepreneurs will ask VCs for equity investments where multiple millions of dollars have already been spent and the corresponding valuation expectations from founders will be high. In fact, Aydin Senkut of Felicis Ventures spoke of a 'shadow series A crunch based on convertible notes'.

Professional angel investors can afford to just sit and watch if they so choose to. But the Series A crunch may present an enormous opportunity for experienced angel investors to exercise leverage, provided they are willing to take the lead. Professional angel investment groups in particular are in a unique position to exert leverage by pooling resources and applying their institutional and operational know how. With relatively little capital, professional angel investing groups have the opportunity to top up a follow-on seed round, convert debt into into a priced round, and take a board seat.

Ron Weissman implored angel investors to look in the mirror when it comes to angel investing in the seed round. But the postponement of the Series A crunch raises an additional question: Angel investors now have to ask themselves whether they are ready to fill the void created by the convertible note shadow Series A crunch and lead start-ups to the next stage.