Understanding The Early Stage Investment Process
Every entrepreneur will face this question at some point in the cycle of their business: Does it make sense to pursue outside capital to accelerate the growth of my business or do I go at it alone? With few exceptions, especially in deep technology businesses, startups are able to generate enough early-stage revenue and cash flow to be self-sustaining and rely on a well-defined investment hierarchy and funding process.
The investment cycle for early-stage companies consists of four well-defined stages:
- Founders invest the first round of capital to develop an early business plan and proof of concept.
- The next stage consists of family, friends and as a great investor once mentioned to me - fools.
- After this stage, the company raises enough capital to bring the business to a point where early market validation begins and a more robust prototype of the business takes place.
- Once the company completes this stage, angel investors are the next source of available capital.
Typically, angels provide the bulk of early-stage funding for startup companies. There are thousands of angels and hundreds of angel networks across every region in the US, Europe and Asia.
These angel networks provide a great nexus for startups to access a vast number of investors as well as provide a platform for angels to source deals, support on due diligence, mentor early-stage companies and provide capital. On average, individual angels allocate around $25-$50k per deal and the networks invest around $250k per deal.
Numbers in other regions may vary, but historically, if a company is looking for $1 million in funding the founder will spend quite a bit of time researching the right investors and will have to syndicate the deal which is quite hard, as most of the Angel networks are independent. In my experience, it’s often easier for a startup to secure $5 million raising a Series A round than to raise the first $500k-$1M for a venture. In most cases, angels are not full-time investors and have other objectives beyond simply investing in startups, such as networking.
There is now a new class of angel investors: super angels or micro venture capitalists. These investors tend to dedicate a significant amount of their time towards investing in startups, write bigger checks and have a robust network of relationships that help cover the $1 million threshold of a seed round. They also tend to have thorough investment processes and due diligence. In some cases, the lead super angel or micro venture capitalist continues to support the company as it hits milestones and needs further capital. Alternatively, the company may decide to pursue institutional investors, such as venture capital.
There are many positive stories of venture capitalists supporting successful technology companies. Just look at the biggest names in tech today and you will find strong investors supporting it.
There are issues, however, in the venture capital industry that have undergone major transformation throughout the last five years. Fund sizes have grown exponentially, meaning that most VCs are now focused in later stage businesses.
According to the latest Venture Monitor, 2017 experienced $84.2 billion in deal value (the most since the DotCom bubble), which was allocated to 8,076 deals (a 23% drop since the 2014 peak).
Additionally, there was roughly $19.2 billion allocated to 73 Unicorn deals last year, which is a 10% increase. All of this data supports that less than 1% of the deals in 2017 took 23% of VC investments and more than 50% of the deal value attributed to deals of $50 million or more.
Companies are now taking longer to go public, and many VCs have temporarily taken the space of public markets and continue to extend financing to large private companies—such as Uber, Lyft, SpaceX.
At the end of the day, entrepreneurs should evaluate if adding VCs to the cap table increases the odds of success for the business. Data on this topic is scarce, but the Kaufman Foundation evaluated more than 539 accredited angel investors and 1,137 exits and concluded that the impact of deals where angles were involved and there was further allocation of VCs in follow-up rounds.
As you can see from the data below, the companies with VC involvement had more extreme outcomes or “fat tail” distributions. These deals had a larger failure rate and more occurrences of large exits. The deals with no VC involvement had a lower failure rate and a significant cluster in the 1-5X exit threshold.
This return distribution makes sense as venture capitalists have greater incentive to take risks. Angels are investing their own money, while VCs are investing Other People’s Money or “OPM” via funds, and are compensated via management and performance fees. Typically, VCs have to overcome some type of hurdle rate, so having more fat tails in a return profile makes sense with the riskier profile taken by VCs.
Personally, I was surprised by the larger failure rate of VC backed companies -- I found it counterintuitive. One explanation is that VCs tend to follow investment trends and once the trend plateaus, they cut their losses, stop funding the companies that won’t make it and move on to look for the next “big thing”. For example, in 2017, according to Venture Monitor, over $4.2 billion was raised via ICOs. Regardless of your opinion on ICOs, many can agree not all will succeed and follow the traditional boom-bust model.
However, the data clearly shows that simply following VCs on a particular investment gives no assurance of success. Many investors are now taking a "Spray and Pray" approach hoping for a small % to become big winners, and those tend to have a weaker upfront due diligence, which explains the sweeping failure rate.
On the upside, VCs outperformed on the 5X to 30X plus exits, but the fat tails that outperformed on exits over 10X wasn’t by much. This puzzled many, as venture capitalists are professional investors and should in theory achieve greater outperformance.
More studies and data are needed to prove the added value of VCs to startup companies. For example, looking solely at the return distribution doesn’t give startups a clear-cut answer on whether or not VCs determine long-term success.
What is clear is that founders should carefully consider the funding path they would like to take when building out their business. It’s important to remember that capital should be only one of many factors for an investor to qualify being added to the cap table. Experience in the sector, high level of involvement in the business and willingness to mentor and advise should all be foundational criteria that every founder looks for in an investor.
This insight was also featured on VC-List.com.