Parsing the Venture landscape

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I have been searching for a practical breakdown of the various sources for venture capital, in a way that can be easily digested by typical entrepreneurs as they navigate through each of the major breakpoints in the life cycle of their ventures.  This post by Manu Kumar from K9 Ventures, probably does the best job I’ve seen of making this arcane world a little more transparent for first-timers.  By the way, I highly recommend following @ManuKumar and K9 Ventures —  a voice of experience that is inherently pragmatic and always thought provoking.

So here it is, at http://k9ventures.com/blog/2011/05/14/investor-nomenclature-and-the-venture-spiral/.  It’s absolutely worth the read.

Friends and Family: Or sometimes referred to as the 3Fs for Friends, Family and Fools. This is probably the very first group that an entrepreneur who is starting out may approach for some funding for his or her idea. These are “investors” who are investing in you, i.e. not on the basis of your idea or the merits of your investment, but on the basis of a personal relationship with you. Sometimes this money comes with strings attached – strings in the form of expectations, which if not met can often hurt the relationship. The 3Fs invest their own hard-earned money, usually under $50K. They may or may not be accredited investors, and they don’t invest regularly or often.

Incubators and Accelerators: Incubators and accelerators have to a large extent replaced the funding from friends and family. The incubators and accelerators are investing $15-$50K in a large number of early stage teams(the current YC class has 60+ teams!). They provide additional value add in the form of coaching and mentorship, and most of all access to a network of other entrepreneurs and smart people – that to me is really the real value of being involved with an incubator / accelerator. The incubators also help get their teams get visibility amongst potential investors. The funding for the incubator of accelerator may come from the principals running the incubator (as I believe is the case for AngelPadi/o ventures etc.) or may come from VC firms (as is now the case with YC being funded by Sequoia).

The incubators invest usually for an equity stake and buy equity at a extremely low valuation (for example, 7% for $15,000, which implies a pre-money valuation of less than $200,000). The companies go through a 3-6 month long startup bootcamp and then typically try to raise angel/seed funding.

Angels: Angels are individual investors, who are investing their own capital and doing so on a part-time basis. Most angels will usually invest under $50K per investment. They are generally high net worth (accredited) individuals who have done well in their career, either as entrepreneurs or as executives and early employees at some of the companies that have done well (in the Valley that usually means Paypal, Google, Facebook etc).  Most angels invest for a couple of reasons – some do it because they genuinely love the startup space and this is their way of continuing to be involved in a startup, sometimes vicariously. Others do it because they are somewhat naïve about the returns from angel investing and think that this is a way to make a lot of money (in most cases the returns from angel investing will not be anything to write home about). Some do it for their own ego, to be able to say “I’m an investor in X, Y or Z” at cocktail parties. However, for whatever reason an angel takes his or her money and invests it in a startup, they’re an invaluable part of the startup ecosystem as it exists today.

There are too many angels and an even higher number of wannabe-angels. In fact, I would go as far as saying that there are too many unsophisticated angels. This is what has led to the current frothiness at the seed stage, because these angels pay up for access to deals. They know that they will only be able to get into the deal by accepting whatever terms are proposed to them – because the supply of money at the seed stage far exceeds the number of good quality companies at the seed stage. They are also insensitive to valuation because they’re investing a small amount of money and they’re hoping for a big hit – they’re buying expensive lottery tickets.

This in theory is very similar to the behavior of institutional investors, however, there is one big difference. Institutional investors make sizable investments in a company, so that when they do get a big hit that can make the whole fund. IMHO, the big hit approach doesn’t really work at the angel investing stage, given the small amount of capital being contributed by any individual angel (in short: less leverage).

Super Angels:  This is where my definition of a Super Angel differs from the press’ definition of a super angel. I define a super angel as an individual investor, who is investing his or her own capital, but doing so on a full-time basis, i.e. this individual has decided to be a professional investor. He or she doesn’t have a “day-job” but spends all of his or her time in evaluating new investment opportunities or working with portfolio companies. They invest prolifically and also write slightly larger checks (~$100K) than the individual angels might and have a somewhat more sophisticated view of investing. They typically have a thesis that they’re trying to test and prove. More often than not, the “Super Angel” is a transient phase – you could very well define a Super Angel as a person who has decided to be a professional investor and is in the process of building his or her track record to be able to raise a fund — to become a micro-VC.

Micro-VCs: This is the category that the press has really been calling “Super Angels”. However, in my view, the big difference here is that the micro-VCs are not investing just their own capital. They are still individual investors, they invest on a full-time basis as professionals, but they have funds with Limited Partners. The limited partners may themselves run the gamut from individuals, family offices, venture capital funds to institutional LPs.

Some of the more well known uVCs (which the press insists on calling Super Angels) are Mike Maples atFloodgateAydin Senkut at Felicis VenturesJeff Clavier at SoftTech VCDave McClure at 500 Startups (although Dave has LPs, he also has a very unique model which spans incubator/accelerator and the uVC category). From what I know the credit for pioneering the uVC space really goes to Josh Kopelman from First Round Capital. First Round was the first uVC fund. (Although some might argue that First Round has now scaled and graduated to the ranks of a true early stage instititutional fund since they have a fund that is over $100M) Note: Since K9 also has LPs (individuals and family offices), I would also classify K9 as a uVC.

The fact that these micro-VCs have LPs is not to be understated, since it changes how they are investing. They now have a fiduciary responsibility to their LPs. This also changes the types of deal terms that micro-VCs will undertake. As fiduciaries, the general partners of the uVC funds have to begin to focus on the dreaded VC I-word :IRR. This now means that they will slowly start behaving less like Angels, and more like institutional venture capital funds.

At first blush, uVCs acting more like institutional venture capital funds may be considered a bad thing. However, there is a difference. The founders of these uVC funds are entrepreneurs in their own right – either as people who have founded successful startups before, or as the founders of their own venture funds – which are also startups.  In my view this means that these uVCs relate better to founders, creating for a more founder-friendly early stage investor.

The uVCs acting more like the institutional funds can have positive effects as well. They will probably become more active in taking board seats, and take a more active role in helping the companies – the way the institutional funds used to do at the early stages about 10-20 years ago.

Institutional Venture Funds: aka your friendly neighborhood traditional VC fund. The institutional funds typically manage a relatively large pot of capital (~$300M or higher per fund, with multiple funds running). They have 4-10 partners who are investing on their behalf. They typical check size for the institutional venture funds has edged upwards to be $3M – $5M for an initial investment. Since the funds are managing a bigger pot of money, they need to be able to deploy $10-$20M per investment in order to the math to work out for them and consequently they look for much bigger $0.5B – $1B type of exits.

Here is a handy cheat sheet for investor nomenclature:

Investor Category Friends & Family Incubator / Accelerator Angel Super Angel Micro-VC Institutional Corporate
#Deals/Year Very few,
usually 1
Lots, 20-100 5-10 10-20 5-20 1-2 per partner Varies
Individual / Partnership Individual Partnership Individual Individual Either Partnership Partnership
Initial Investment <$50K in aggregate $10K – $100K $50K $100K $100K – $1M $3M – $5M $2M +
Full-time /
Part-Time
Part-time Full-time Part-time Full-time Full-time Full-time Full-time
Accredited? Yes/No (generally no) Yes Yes/No (generally yes) Yes Yes Yes Yes
Source of Funds Personal Money Pooled resources or Limited Partners Personal Money Personal Money Personal Money AND Limited Partners Limited Partners, very little Personal Money Corporate Money
Investment Structure Debt or Convertible Note Common Stock Convertible Note or Preferred Stock Convertible Note or Preferred Stock Preferred Stock Preferred Stock Preferred Stock / Warrants
Board Seats No No No No Yes Yes Varies

 

Given the craziness in the market at the seed stage and the lack of good Series A / Series B investment opportunities for a couple of years between 2007-2009, several of the institutional venture funds have tried to move ”downstream” to do more seed and angel stage deals. In my view, this is a temporary and unsustainable phenomenon.

It is temporary, because when I look at the seed deals that were done in 2010 – 2011, there are several high quality companies that are in the pipeline for a Series A and Series B. So the institutional investors will have enough deal flow in the near future to keep them busy (in fact, we’ve already been seeing some of this in Q2 of 2011). The institutional VCs playing the in the seed stage is also unsustainable since the economics of doing so simply don’t work for them. If the seed stage deal doesn’t mature into a Series A or Series B that they can pre-empt, then it’s not really worth their time for the amount of money they are able to deploy, since even a great return will not move the needle on their fund.

The Series A is now the third round of financing for a company, but the nomenclature hasn’t been changed. The first round is the 3Fs or incubator round, then the Seed/Angel round, where the Angels, Super Angels and the uVCs play, and then the Series A, which is where the institutional venture funds step in.

In the venture industry, the only way for a venture fund to grow, is to move upstream and start managing a bigger pot of money. It is the natural evolution of the venture business and funds. This is what has happened with a lot of the institutional funds over the past decade. This gradual upstream movement in the venture industry, is what I refer to as the Venture Spiral.

The angels of today, will become the super angels of tomorrow. The super angels of today will be the uVCs of tomorrow, and the uVCs of today, will become the early stage venture capitalists. The institutional venture funds will morph into what we used to call growth funds (Anyone else notice how Kleiner Perkins has been moving upstream into later stage deals: GroupOnTwitterLegalZoom). The cycle will continue, as it inevitably does.

The one change that seems here to stay is the initial financing of companies will come from the angels, super angels and uVCs, who have become an intricate part of the venture capital eco-system.

 

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