Monday, November 29, 2010

Where Angels fear to tread

I don’t want to add fuel to the fire already ignited by the behavior of a group of super-angels here in Silicon Valley, or to further endorse Ron Conway’s excellent reprimand of that behavior – but, I do want to say that this behavior is rare in the valley – and in fact rather common where I come from. For some reason in other countries Angels, and VCs and PE investors are seen as competitors rather than key pieces of the value chain for startups and their growth. I was at an event in Australia recently, where it was proudly proclaimed that the angel network is so strong that "we don’t need the VCs anymore." As I dug further into this I discovered there is a deeply ingrained belief that Angels are in direct competition with VCs, and this was a big surprise ...

Furthermore, in places like Australia, or the mid-west US, where the VC ecosystem is fragile it's critical for groups to work together even if it is in the form of "coopetition."

At present this entire class of investments is being called into question and if there is to be growth in risk capital to support entrepreneurship all the parts need to work together. Where things get really screwed up, and this is typical of Australian deals, is when a private investor buys a large piece of the company for little cash and then will not allow the company to raise further rounds unless they are at major step ups in valuation. This forces the company to go to more naïve money, and get less and less help from their investors.

These companies become literally uninvestable in any traditional sense and while they often survive in purgatory for a long time, they don’t often give the founders what they had started a company for in the first place. It is not unusual to see a company where the investors own 80-90%, but have only carried the company halfway through the investment cycle. The solution should be simple, to raise more money, but this class of investor won’t stand for dilution and blames the management for their plight.

I have talked before about the numbers that enable venture investments to work--good Angels know these numbers well and make their investment synergistic with them in anticipation of a VC firm paying up for the deal, and taking the Angel along for the ride with the founders.

Typically Angel investments are simple convertible notes, no equity, until the A round gets priced and led by a VC. The Angel gets a substantial discount for taking the early stage risk, and more often than not gets asked to stay on or come onto the BoD because they usually have great domain knowledge that can really help the company. This is the other area where sugar cane farmers and mining millionaires can mess up tech companies because they often insist on BoD seats based on ego, despite bringing no value to the company. This is not to say that such people aren’t great at negotiating deals and selling companies or that they don’t have great business acumen, but the art of growing a tech startup is highly specialized and needs people who have done it before to help entrepreneurs who perhaps haven’t.

In the Internet deal, it's possible to get to success metrics with very little money--one side of this means an Angel or super Angel can fund the company entirely. But I don’t believe this is the right model or even a true model. What can and does happen well with Internet deals is a little bit of cash can quickly tell you if you have a successful idea or not. You can fail fast and cheap.

The failure I think of the Angel approach is not to bring in substantial capital to take advantage of the beachhead and own it before competition gets wind of your success. Some Internet deals can be entirely bootstrapped, yet regardless of the type of business web or traditional they always need money to support growth and strategic initiatives (see Atlassian) – this money comes from VCs or PE or IPO or credit cards ;-)