Frankly, the conclusion that angels who make follow-on investments can expect lower returns is distressing to me.  At a time when venture capital, on average, has moved to later stage investing, angels need to plan on making multiple investments to help startups survive to positive cash flow and eventually to exit.  Fifteen years ago, angels typically invested $250K to $500K in startup companies while the average venture capital investment was $2-3 million.  As we saw in Average Round Size in Angel Deals, the average angel investment is now about a bit over $300K but venture capital is now investing $7-8 million per deal.  While it may not have been true in the past, angels now need to provide startups with enough runway to get to positive cash flow, to venture financings or to an early exit through several rounds of angel capital.

How does a “one and done” investment strategy by angels provide higher returns?  I think there are several contributing factors, such as:

• There are a few angel funded deals that take off so quickly that the startup entrepreneur can easily raise $5 million or more in venture capital in the next round.  These deals are likely to provide early investors with very high returns.
• On the other hand, too many of us angels” throw good money after bad,” that is, we don’t pull the plug early enough.  We become convinced that our funded startup is just about to turn the corner…when they really aren’t.  So, we fund the company a second or perhaps even a third time before we acknowledge that the company simply cannot be successful.  These follow-on investments have a significant negative impact on portfolio returns for angels.  And, candidly, this is an important area of improvements for angel investors.
• Some angels invest in only one early round of funding, strategizing that the early rounds provide the highest returns.  Investing in later rounds only reduces the total return from any single portfolio company.
• Furthermore, some angels choose to invest in more companies rather than multiple rounds in the same company.  With a fixed amount of capital reserved for the angel asset class, these investors look for improved returns through a diversified portfolio.

Acknowledging the results of the Wiltbank study, the reality of angel investing today is that we can expect to provide multiple rounds of investment for new ventures.  Without multiple angel rounds, startup entrepreneurs simply cannot hit the milestones necessary for either an early exit and venture funding.  But, we angels need to be more diligent before providing second and third round funding to startups with little chance of success.  More objective due diligence on portfolio companies prior to second or third rounds of angel investment has become a best practice for higher angel returns.

Crowdfunding is an opportunity for new small businesses (lifestyle companies) to raise capital from many different sources using qualified websites to facilitate the deal.  For “mom and pop” businesses, this may make lots of sense.  Unfortunately from what I read, crowdfunders expect to invest in the next potential IPO in which IP may play a huge role in the success of the company.  Validating the IP may become a roadblock to crowdsources participating as equity investors in high-growth companies.

IP takes many forms, but let’s just consider patents for now.  The validation of a patent (perhaps not as yet issued) requires demonstrating that the innovation is unique by an exhaustive study of the prior art (early patents and publications).  Validation also requires consideration of “freedom to operate,” that is, clarity that the product can be made and distributed without violating the IP rights of others.  Verifying that a new company has a unique product or service that cannot legally be duplicated quickly by reverse engineering by competitors is a legitimate concern of investors.

So, how will crowdfunding sources validate the technology for investment in interesting startups?  There seem to be a few options:

• Crowdfunding sources will simply not require new companies to provide any validation of competitive advantage facilitated by IP.  OK…but that certainly seems to increase the risk of failure for investors in this very high risk asset class.
• The entrepreneur will ask hundreds, if not thousands of crowd investors to sign non-disclosure agreements to allow investors to validate the IP.  Gee….think about the nightmare if an inappropriate disclosure is made.  Tracking down the individual who made the unauthorized disclosure would seem to be a daunting task.  In fact, just maintaining the non-disclosure documentation for hundreds of investors would be a logistical headache.  Are 1000 non-disclosure agreements better than none?
• An independent facilitator will validate the technology and provide a non-confidential report to interested crowdsources.  Those with extensive experience in pursuing IP legal opinions understand that this is a time-consuming and expensive process ($10,000 to $50,000, or more).  Since crowdsources will be making small investments, the new company seeking funding will have to pay for these opinions.   Considering the legal liability, will these IP specialists complete these studies on a contingency (assuming their fees will come from the proceeds of the crowdfunding)?   I wonder.

It is the opinion of this writer that IP validation is simply one more strike against crowdfunding as a source of capital for high-potential, high-growth startup companies.

But, as Mark Suster points out, the valuation of startup ventures also varies with demand.  When asked if we are now in another demand bubble, Mark responds “Duh…of course….!”  So, not only does valuation increase as companies mature, the valuation of new enterprises vary with a demand cycle.  Demand was extremely high during the Internet bubble (ending in 2001) and very low in 2007-09.  And, in 2012, prices have risen dramatically again.  Will this bubble end soon?  Suster suggests we will see the valuation bubble burst within the next 24 months.

So, valuation varies with demand and with the maturity of the company. 

But entrepreneurs must also realize that there is very little valuation consistency across the geographic and business vertical spectrum of this country.  Some geographic markets are hot (high demand for startup deals in NYC) while others are not (pricing in Montana is much lower).  Some business sectors are hot (Internet) while others are cooling (medical devices).   Entrepreneurs must research startup valuations in both the local market and their business vertical before negotiating for funding.  Also look at several valuation methodologies prior to seeking capital.

What is the message regarding startup valuation?  Entrepreneurs:  Know your marketplace.  Do not expect the same valuation for a gaming startup in Atlanta as for a biotech startup in Boston.    

Here are some important points for entrepreneurs to remember when raising seed/startup capital:

• Raise money far in advance of need.  It always takes longer to raise money than one expects.
• Don’t try to predict the fundraising cycle.  You will probably be wrong anyway.
• Hit as many milestones as possible before raising money, to maintain as much ownership in your company as possible.
• On the other hand, if investors come knocking at a reasonable valuation and you will eventually need to raise funds – take the money!  A bird in the hand…you know the rest.
• And, if you are oversubscribed (investors offering more money than you had intended to raise) – take the money!  You never know when a hiccup will result in your new enterprise needing more money than expected.

Since the IPO market has been in the doldrums for most of the past decade, high-profile private companies have chosen (or been forced) to stay private while raising huge sums of money from VCs and other private equity sources.  But, this SEC limit has created some problems for these high-tech phenoms, both in raising additional capital and in private sales through secondary markets in which early investors resell shares to a large number of smaller US buyers.  This shareholder limitation has made it difficult for companies like Facebook to stay private, even if the shareholders and management team were not inclined to go public.

Most recently, the number of shareholders issue has arisen as Congress considers legalizing crowdfunding which may allow hundreds or even thousands of smaller investors to make equity investments in startups.  Raising $1000 each from 1000 investors would surely seem to violate current SEC regulations.

We have heard that SEC chairman Mary Schapiro “recently instructed the staff to review the impact of our regulations on capital formation” (according to CNN Money).  It would appear that Congress and the SEC are both considering raising the limit to at least 1000 shareholders.

But, the SEC limit on the number of shareholders is not the only issue entrepreneurs should consider.  If large amounts of capital are required for startup companies to dominate a market, then the preferences of larger investors, such as angels and venture capitalists should be paramount in importance to entrepreneurs.  Let’s be frank:  neither angels nor VCs choose to invest alongside large numbers of less-than-sophisticated investors.  Why?  Because shareholder votes are required for numerous corporate actions and marshaling the approval of large numbers of shareholders is difficult, sometimes impossible without shareholder lawsuits.  Consider the following two examples (and assuming new SEC limits are not exceeded):

Company A raises $500,000 from 1200 investors using a crowdsourcing website (average investment: $417).  The company proves to be in a really hot space and, to grow rapidly and stay ahead of the competition, must raise $6 million. 

Company B raise $40,000 from five friends and family members and then $460,000 from twelve angels who are members of a single angel group.  The angel group has one member of the board of directors. The company proves to be in a really hot space and, to grow rapidly and stay ahead of the competition, must raise $6 million.

If a venture capitalist was evaluating these two opportunities and both were essentially equally exciting, which do you think the VCs would fund?  Clearly, the company with fewer shareholders would be the first choice of sophisticated investors.  Angels and VCs  generally choose not to invest alongside larger numbers of investors with little or no experience investing in startup companies.  This is not a new rule-of-thumb.  This has been the case for decades.

Raising capital from large numbers of investors, through crowdsourcing or elsewhere, may work well for companies that can achieve all their milestones without raising large amounts of additional capital from angels or VCs.  However, SEC limits on the number of shareholders in privately-held companies may not the primary issue for entrepreneurs.  If entrepreneurs need to raise significant subsequent funding from sophisticated investors, crowdfunding is not the most favorable source for early stage capital.

The two major differences in the exit environment in the past decade are (1) the disappearance of the IPO market and (2) the rapidly increasing size of the average VC fund.

The NASDAQ IPO marketplace was changed radically by the Sarbanes Oxley (SOX) legislation, which was Congress’ unsuccessful attempt a decade ago to preclude future ENRON financial disasters.  SOX and radically higher NASDAQ fees have limited those new ventures going public to much more mature and highly visible companies.  And, before you ask, startup companies can go public on active foreign exchanges, such as the Toronto’s TSXV and the London AIM market.  But, startup companies go public for two reasons: to raise capital and to provide liquidity for investors.  Both the TSXV and the AIM markets are thinly traded and can provide only limited liquidity for investors.  Consequently, the fraction of venture funded companies that have used the IPO to define the exit for investors has been reduced from 90% twenty years ago to less than 10% today.

Without explaining how and why the average venture capital firm is managing larger funds today compared to a decade ago, let me describe how this change has impacted the startup funding landscape.   With more money to invest per principal, venture capital has chosen to invest more money per round of investment.  The average VC round has moved up from $2-3 million twenty years ago to $7-8 million today.  But, angel investors are funding round sizes between $150,000 and $1 million, just as they did twenty years ago.  So, a gap has emerged between angels with little funding available between $1.5 million and $4 million.  I described this Funding Gap in an earlier post.

Larger VC rounds and the lack of early IPOs for exits have also resulted in substantially longer times to exits for venture capitalists.  Companies that might have provided VCs with exits in 2-3 years a decade ago, may now require eight or even ten years to exit.  Angels and entrepreneurs who invest ahead of VCs are required to have much more patience than in the past.

These changes suggest three messages for entrepreneurs:

1. Don’t try to raise $3 million (in the gap between angels and VCs).  There are simply very few investors doing gap funding.  Design your milestones around the capital sources available.

2. Raising venture capital may lead to a huge exit.  But, it will take much longer than in the past.  And, extending the time to exit also increases the risk of failure – perhaps by being blind-sided by technology or a large competitor.

3. Consider an “angel only” deal, raising only a million or two in multiple rounds from angels.  Plan to prove your business model and get to positive cash flow with angel money and without VC investment.  Then, plan an early M&A exit to a much larger player who is deliberating a “make versus buy” decision on your business proposition.

The scarcity of IPOs and the increase in VC fund size has led to several changes in capital markets.  VCs are investing more per company and waiting longer to divest via a M&A transaction.  And, angel s are beginning to choose to do more angel-only deals, then looking for an early exit to an interested large player.

Recognition of the peerless setting in the Valley leads me to observations for several groups in the entrepreneurial landscape:

To entrepreneurs:  If you need to raise tons of money and/or create critical strategic partnerships with high tech companies, move to Silicon Valley (or perhaps NYC, Boston, Seattle or Southern California).  You are much more flexible than are VCs or strategic partners – they prefer not to travel and have lots of local opportunities to invest.  Your chances of raising venture capital from a Valley VC for a startup in the Bay Area are much higher than being located anywhere else.  But, know in advance that the competition in the Valley is fierce.  If you don’t need to raise $10s of millions, stay where you are and grow your business in the friendly confines of your community.  Most of the tools are there…they are just harder to find.

To investors:  Stay where you are.  Entrepreneurs in your area need funding and the environment close to home is likely much less competitive than in the Valley.  (This is not to say that there is no competition for deals in Seattle, Boston, New York and elsewhere.)  While deal flow may not be as high as where you are now located, attempting to break into the Valley will be daunting.

To economic developers:  Don’t think or say “we are going to create the next Silicon Valley here”!  Instead, compare you environment to other entrepreneur-friendly communities and then beef-up the startup weaknesses in your community.  But, don’t set up false expectation:  You will fail to create the next Silicon Valley – like so many others have before you.

To the press:  I know this is difficult…but please recognize that “There Is Only ONE Silicon Valley”!  If you want to report on entrepreneurial activity in the US, get off your butt and travel a bit.  You will find that entrepreneurs and investors do things differently in Boise, Tucson, Little Rock, Cincinnati and Atlanta that they do in the Valley.  Valuations are generally higher in Silicon Valley, term sheets are different, capital sources are different, building a management team and Board of Directors requires a different strategy; just to scratch the surface on the dissimilarities.  Please stop pontificating from the Valley about “how entrepreneurship or startup funding works.”  Your message, in many cases, simply does not apply outside the Bay Area.

To research universities:   You may compete for research grants with the best and the brightest, but if you are not located in the Valley (or a few other places), tech transfer to a whole new generation of startups is unlikely to happen.  Don’t attempt to emulate Stanford and MIT when you can’t match their entrepreneurial landscape.  Figure out what will work for you by looking at similar communities that seem to be doing better at tech transfer than you are.  And, unfortunately, there are not many good examples.  Tech transfer from first class research universities in the US to startup companies is embarrassingly low.  Do something about it!  How?  How about eliminating royalties on licenses to alumni!  By any measure I’ve seen, successful alumni-entrepreneurs give more money back to universities than the entire tech transfer royalty stream.  Why make it so difficult to move technology from universities to startups?

The Valley is a magical place where all pieces of the entrepreneurial landscape come together.  It will not be duplicated in my lifetime.  My advice is that players understand the Valley landscape and then carefully adopt and adapt those characteristics that are important to your future.

As you can see, nearly 2/3rds seed stage VC deals were funded in these five regions.  In 2010, MoneyTree© reports that only 138 seed stage VC deals were done outside of California, New England, NYC Metro and the Pacific Northwest.

I note a couple of trends:  (1) Seed stage venture capital financing have been pretty stable over the past five years and (2) while the number of deals funded was a bit lower in 2009 and 2010 for most regions, the NYC Metro area had a significant increase in the number of seed stage deals funded. 

Then, I took a look at the average seed stage deal size in 2010 ($$$$ ÷ # of deals, in millions), as follows:

Wow…four of the five most active seed VC regions reported deal size above the All Seed-VC average, while the average deals size in NYC Metro was less than half the size of the average in each of other regions reported.  VCs in NYC invested, on average, only $2.4 million in seed stage deals in 2010.  And, according to MoneyTree© for the first three quarters of 2011, the average invested in NYC Metro seed stage VC deals was even less.  You will also note that NYC Metro was the only region reporting that the number of seed stage deals increased significantly in 2010 over previous years.  Will that trend hold in 2011?  Who know!

Then, I looked at angel investment in the US over the past five years, as reported by the Center for Venture Research, in billions of dollars.

This data on angel investing is clearly not as granular as the MoneyTree© data for VC investing.  We do not yet have data by state or even by stage of development for angels, but we do know that about 1/3 of angel deals reported are seed stage deals – approximate 20,000 seed stage companies funded with $300,000 or so, per round.

Observations

In 2010, angels funded about 50 times as many seed stage deals in the US as did VCs.  But, the average VC seed stage round of investment was about 15 times larger ($4.5 million versus $300,000) than for seed rounds from angels.  (Considering the difference in the size of the average seed round between angels and VCs, I wonder if the two groups are using similar definitions for seed investments.)

Since US angels are funding so many more seed stage deals than are VCs and investing so much less per seed stage deal, it does not appear there is much competition between angels and VCs.  In fact, my sense is that in most regions, angels and VCs are cooperating and sometimes co-funding startups.

However, in New York City, the funding environment seems a bit more spirited.  Typical VC round size is dropping and the competition (as measured by valuation and reported at 2011 Valuation Survey of North American Angel Groups) for seed stage deals in NYC Metro appears to be increasing.