Insider's Guide to Silicon Valley's Investors
In Silicon Valley, people say that the investor-entrepreneur relationship is like a marriage, only more important. Like most jokes, there's a fair amount of truth behind it: Matchmaking mistakes between investors and entrepreneurs can have long-lasting and far-reaching consequences.
The initial pitch meeting feels a little like a first date: Each side looks for a "click" of personality. Next, in the courtship stage, everyone is on their best behavior, and little real assessment of fit takes place. The problem is that though liking each other is important, it is not enough to assure a good outcome in an investment relationship. Entrepreneurs are too often seduced by the friendliest individual investor or the biggest "name," and don't consider the long-term strategic alignment of their goals.
All savvy investors seek to put their money and other resources behind great teams to build high-growth businesses that deliver outsize returns, but different types of investors take very different approaches to achieve this objective. Variations in strategy exist between super angels, large venture firms, and micro VCs, with some firms applying hybrid models. It can be confusing for entrepreneurs to sort out, because each of these types of investors frequently look at and invest in similar types of investment opportunities, even though they manage their portfolios very differently.
I've been a venture capitalist for nearly 10 years, and prior to that I spent a dozen years as a serial high-tech entrepreneur, with one IPO and two M&A exits behind me. In each role, I learned about the importance of aligning the interests between entrepreneurs and investors--sometimes the hard way. Here's what I think every entrepreneur should know about some of the different strategies employed in early-stage tech investing.
Super Angels: "Club" Deals
Super angels have been accelerators of innovation in investing strategy. They move quickly, are great collaborators--syndicating investments with people they know and trust--and have broad networks with high-quality contacts. Super angels usually invest their own money and make small investments in a large number of new companies, sometimes as many as 20 to 40 a year. Because of the smaller amounts of capital each investor commits, there are typically many co-investors in the investment round--leading such deals to be nicknamed "club" deals.
Super angels are known to move very quickly, are usually hands off in terms of allowing entrepreneurs to make their own decisions, and often bring together syndicates of like-minded investors, saving time and energy for entrepreneurs to focus on their business.
As with any investor, there are tradeoffs. Super angels invest across a wide spectrum of sectors, so they may not have prior industry experience in every area they invest in. Additionally, with so many concurrent investments, they can't take board seats, be active in supporting all of them, or reserve follow-on capital for every company in their portfolio. Their overall strategy is to pick the winners and place bigger bets behind a few.
Super angels go into deals expecting many to fail but that a few will become home runs, making up for the losses: One well-known super angel says he expects at least 80% of his investments to fail. With so many investments, a super angel's time is scarce, and helping the companies that have the most immediate success will take up most of their time, connections, follow-on capital, and mentorship opportunities.
The best way to manage downside risk if you are seeking capital from super angels may be to round out your financing round with a syndicate of investors that includes people you know and trust, that know your industry/sector well, and that are putting enough skin in the game for your success to be meaningful to them.
Large Venture Capital Firms: "Option" Deals
It is now more common for large VC firms that focus on growth-stage investments to also invest in a few seed-stage companies. These early-stage deals are small "bets" and don't represent enough capital to have a meaningful impact on large funds; firms do them primarily to gain the opportunity to lead the next larger round of financing with promising young companies. As a result, these deals are nicknamed "option" deals.
Many of the large firms have built prestigious brands, making it compelling for entrepreneurs to choose them as an investor. Large, well-established VCs bring credibility to a company that may be useful in recruiting, gaining customers, and getting news coverage, among other things.
Again, there are tradeoffs to consider. Large VCs have broad networks that can be leveraged, but they may not spend significant time on their "option" investments until they are certain that the company is on a path to justify a next round of financing. Typically, they don't take board seats or become very proactively involved until they invest at that higher level. If your company is fortunate to be one of the hits, having the prior relationship with a prestigious firm with deep pockets can be very advantageous.
Taking "option" money from a large VC firm can also create unanticipated risk for your company, potentially making it more difficult to raise your next round of financing. Investor Chris Dixon, co-founder of Hunch, has said that he personally knows of 15 start-ups that had trouble raising their next financing round after taking large VC money.
The problem is that if a large VC firm chooses not to participate in your next financing round, it is a red flag to the market, signaling to other investors that it's not a good investment. A large VC firm might decline to put more money in for many reasons: a pivot in strategy into an area that competes with an existing portfolio company (like Andreessen Horowitz experienced with Instagram); your champion/partner leaves the firm or is too busy to take on new investments at the time you are fundraising; or most likely, your company is simply taking off more slowly than originally planned and is no longer seen by the VC as having home-run potential.
If you choose a large VC as an early investor, there are several things you can do to mitigate your risk: Avoid publicly announcing these investors, and create a level playing field for future investors by not accepting a right-of-first-refusal requirement on your next financing, because this can limit competition--potentially lowering your valuation and diluting your ownership.
Micro Venture Capital Firms: The "Lean Start-up" Play
OK, I am biased here: My venture capital firm, Illuminate Ventures, is a micro VC, and we have experienced success with this model.
Micro VCs represent a relatively new style of firm--one that has emerged in parallel with the ability to leverage public cloud-computing technologies to launch companies at a much lower capital cost than ever before. It is a strategy, dubbed "lean start-up," that recognizes that it is not smart for entrepreneurs to take too much outside capital before they know that they have a company that can grow exponentially.
Since M&A is currently the most common outcome, and the average M&A deal is under $30 million, limiting the early amount of capital put into a company can help ensure a good outcome for both the entrepreneur and the investor, even if the company only gets "on base." This strategy has meant success for us as a firm and for the entrepreneurs we have backed--companies such as Wild Pockets, Red Aril, and Clair Mail, among others. Of 14 investments made over eight years, four have exited profitably, only one has failed to return capital, and several are continuing toward home-run status.
Investors that rely on home runs to produce returns may pressure a founder to take too much capital and swing for the fence too soon, causing an unnecessary strike out. This happens all too frequently. For more on this, see The Startup Genome Project's research showing that the vast majority of start-ups that fail do so due to premature scaling.
Micro VC firms do a relatively small number of early-stage investments each year and usually at a dollar level that can significantly impact fund performance. As a result, they are highly motivated to assist each portfolio company: They take board seats and work closely with the founders to accelerate progress to meet the milestones needed to secure the next round of financing. Micro VCs are often former entrepreneurs themselves with large networks (Illuminate Ventures has an active 40-plus-member business advisory council), and because they typically invest in specific niches in which they have domain experience, they can provide access to a unique set of highly relevant contacts.
And yes, even in the category that I love, there are tradeoffs for entrepreneurs. Micro VCs reserve capital for follow-on rounds of funding; however, with their smaller fund size overall they must balance follow-on capital with portfolio diversity. Fortunately, this is well recognized, so if a micro VC doesn't participate in the follow-on investment, it is less of a black mark. Also, not every micro VC is able to attract great follow-on lead investors for their portfolio: Be sure to look at this aspect of a firm's track record. And because these firms invest not just their own but also third-party capital, they typically conduct very thorough due diligence and may take longer to make investment commitments than angel investors. One way to leverage this diligence effort is to ask your investor to have access to it. You may be surprised by what you learn from their well-researched insights regarding competition and target market segments.
With a growing number of options to choose from, selecting the best type of investor is an increasingly complex and strategic decision for entrepreneurs. An uninformed choice can have unexpected outcomes. Unlike most flirtations, it would be wise to consider the long-term strategic fit early in the courtship. The type of investor you "marry" will likely affect your exit strategies and outcome, and should be chosen wisely.