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The New Funding Landscape



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October 2010After barely changing at all for decades, the startup funding
business is now in what could, at least by comparison, be called
turmoil.  At Y Combinator we've seen dramatic changes in the funding
environment for startups.  Fortunately one of them is much higher
valuations.The trends we've been seeing are probably not YC-specific.  I wish
I could say they were, but the main cause is probably just that we
see trends first—partly because the startups we fund are very
plugged into the Valley and are quick to take advantage of anything
new, and partly because we fund so many that we have enough data
points to see patterns clearly.What we're seeing now, everyone's probably going to be seeing in
the next couple years.  So I'm going to explain what we're seeing,
and what that will mean for you if you try to raise money.Super-AngelsLet me start by describing what the world of startup funding used
to look like.  There used to be two sharply differentiated types
of investors: angels and venture capitalists.  Angels are individual
rich people who invest small amounts of their own money, while VCs
are employees of funds that invest large amounts of other people's.For decades there were just those two types of investors, but now
a third type has appeared halfway between them: the so-called
super-angels. 
[1]
  And VCs have been provoked by their arrival
into making a lot of angel-style investments themselves.  So the
previously sharp line between angels and VCs has become hopelessly
blurred.There used to be a no man's land between angels and VCs.  Angels
would invest $20k to $50k apiece, and VCs usually a million or more.
So an angel round meant a collection of angel investments that
combined to maybe $200k, and a VC round meant a series A round in
which a single VC fund (or occasionally two) invested $1-5 million.The no man's land between angels and VCs was a very inconvenient
one for startups, because it coincided with the amount many wanted
to raise.  Most startups coming out of Demo Day wanted to raise
around $400k.  But it was a pain to stitch together that much out
of angel investments, and most VCs weren't interested in investments
so small.  That's the fundamental reason the super-angels have
appeared.  They're responding to the market.The arrival of a new type of investor is big news for startups,
because there used to be only two and they rarely competed with one
another.  Super-angels compete with both angels and VCs.  That's
going to change the rules about how to raise money.  I don't know
yet what the new rules will be, but it looks like most of the changes
will be for the better.A super-angel has some of the qualities of an angel, and some of
the qualities of a VC.  They're usually individuals, like angels.
In fact many of the current super-angels were initially angels of
the classic type.  But like VCs, they invest other people's money.
This allows them to invest larger amounts than angels:  a typical
super-angel investment is currently about $100k.  They make investment
decisions quickly, like angels.  And they make a lot more investments
per partner than VCs—up to 10 times as many.The fact that super-angels invest other people's money makes them
doubly alarming to VCs. They don't just compete for startups; they
also compete for investors.  What super-angels really are is a new
form of fast-moving, lightweight VC fund.   And those of us in the
technology world know what usually happens when something comes
along that can be described in terms like that.  Usually it's the
replacement.Will it be?  As of now, few of the startups that take money from
super-angels are ruling out taking VC money.  They're just postponing
it.  But that's still a problem for VCs.  Some of the startups that
postpone raising VC money may do so well on the angel money they
raise that they never bother to raise more.  And those who do raise
VC rounds will be able to get higher valuations when they do.  If
the best startups get 10x higher valuations when they raise series
A rounds, that would cut VCs' returns from winners at least tenfold.
[2]So I think VC funds are seriously threatened by the super-angels.
But one thing that may save them to some extent is the uneven
distribution of startup outcomes: practically all the returns are
concentrated in a few big successes.  The expected value of a startup
is the percentage chance it's Google.  So to the extent that winning
is a matter of absolute returns, the super-angels could win practically
all the battles for individual startups and yet lose the war, if
they merely failed to get those few big winners.  And there's a
chance that could happen, because the top VC funds have better
brands, and can also do more for their portfolio companies.  
[3]Because super-angels make more investments per partner, they have
less partner per investment.  They can't pay as much attention to
you as a VC on your board could.  How much is that extra attention
worth?  It will vary enormously from one partner to another.  There's
no consensus yet in the general case.  So for now this is something
startups are deciding individually.Till now, VCs' claims about how much value they added were sort of
like the government's.  Maybe they made you feel better, but you
had no choice in the matter, if you needed money on the scale only
VCs could supply.  Now that VCs have competitors, that's going to
put a market price on the help they offer.  The interesting thing
is, no one knows yet what it will be.Do startups that want to get really big need the sort of advice and
connections only the top VCs can supply?  Or would super-angel money
do just as well?  The VCs will say you need them, and the super-angels
will say you don't.  But the truth is, no one knows yet, not even
the VCs and super-angels themselves.   All the super-angels know
is that their new model seems promising enough to be worth trying,
and all the VCs know is that it seems promising enough to worry
about.RoundsWhatever the outcome, the conflict between VCs and super-angels is
good news for founders.  And not just for the obvious reason that
more competition for deals means better terms.  The whole shape of
deals is changing.One of the biggest differences between angels and VCs is the amount
of your company they want.  VCs want a lot.  In a series A round
they want a third of your company, if they can get it.  They don't
care much how much they pay for it, but they want a lot because the
number of series A investments they can do is so small.  In a
traditional series A investment, at least one partner from the VC
fund takes a seat on your board.  
[4]
 Since board seats last about
5 years and each partner can't handle more than about 10 at once,
that means a VC fund can only do about 2 series A deals per partner
per year. And that means they need to get as much of the company
as they can in each one.  You'd have to be a very promising startup
indeed to get a VC to use up one of his 10 board seats for only a
few percent of you.Since angels generally don't take board seats, they don't have this
constraint.  They're happy to buy only a few percent of you.  And
although the super-angels are in most respects mini VC funds, they've
retained this critical property of angels.  They don't take board
seats, so they don't need a big percentage of your company.Though that means you'll get correspondingly less attention from
them, it's good news in other respects.  Founders never really liked
giving up as much equity as VCs wanted.  It was a lot of the company
to give up in one shot.  Most founders doing series A deals would
prefer to take half as much money for half as much stock, and then
see what valuation they could get for the second half of the stock
after using the first half of the money to increase its value.  But
VCs never offered that option.Now startups have another alternative.  Now it's easy to raise angel
rounds about half the size of series A rounds.  Many of the startups
we fund are taking this route, and I predict that will be true of
startups in general.A typical big angel round might be $600k on a convertible note with
a valuation cap of $4 million premoney.  Meaning that when the note
converts into stock (in a later round, or upon acquisition), the
investors in that round will get .6 / 4.6, or 13% of the company.
That's a lot less than the 30 to 40% of the company you usually
give up in a series A round if you do it so early.  
[5]But the advantage of these medium-sized rounds is not just that
they cause less dilution.  You also lose less control.  After an
angel round, the founders almost always still have control of the
company, whereas after a series A round they often don't.  The
traditional board structure after a series A round is two founders,
two VCs, and a (supposedly) neutral fifth person.  Plus series A
terms usually give the investors a veto over various kinds of
important decisions, including selling the company.  Founders usually
have a lot of de facto control after a series A, as long as things
are going well.  But that's not the same as just being able to do
what you want, like you could before.A third and quite significant advantage of angel rounds is that
they're less stressful to raise.  Raising a traditional series A
round has in the past taken weeks, if not months.  When a VC firm
can only do 2 deals per partner per year, they're careful about
which they do.  To get a traditional series A round you have to go
through a series of meetings, culminating in a full partner meeting
where the firm as a whole says yes or no.  That's the really scary
part for founders: not just that series A rounds take so long, but
at the end of this long process the VCs might still say no.  The
chance of getting rejected after the full partner meeting averages
about 25%.  At some firms it's over 50%.Fortunately for founders, VCs have been getting a lot faster.
Nowadays Valley VCs are more likely to take 2 weeks than 2 months.
But they're still not as fast as angels and super-angels, the most
decisive of whom sometimes decide in hours.Raising an angel round is not only quicker, but you get feedback
as it progresses.  An angel round is not an all or nothing thing
like a series A.  It's composed of multiple investors with varying
degrees of seriousness, ranging from the upstanding ones who commit
unequivocally to the jerks who give you lines like "come back to
me to fill out the round." You usually start collecting money from
the most committed investors and work your way out toward the
ambivalent ones, whose interest increases as the round fills up.But at each point you know how you're doing.  If investors turn
cold you may have to raise less, but when investors in an angel
round turn cold the process at least degrades gracefully, instead
of blowing up in your face and leaving you with nothing, as happens
if you get rejected by a VC fund after a full partner meeting.
Whereas if investors seem hot, you can not only close the round
faster, but now that convertible notes are becoming the norm,
actually raise the price to reflect demand.ValuationHowever, the VCs have a weapon they can use against the super-angels,
and they have started to use it.   VCs have started making angel-sized
investments too.  The term "angel round" doesn't mean that all the
investors in it are angels; it just describes the structure of the
round.  Increasingly the participants include VCs making investments
of a hundred thousand or two.  And when VCs invest in angel rounds
they can do things that super-angels don't like.  VCs are quite
valuation-insensitive in angel rounds—partly because they are
in general, and partly because they don't care that much about the
returns on angel rounds, which they still view mostly as a way to
recruit startups for series A rounds later.  So VCs who invest in
angel rounds can blow up the valuations for angels and super-angels
who invest in them. 
[6]Some super-angels seem to care about valuations.  Several turned
down YC-funded startups after Demo Day because their valuations
were too high.  This was not a problem for the startups; by definition
a high valuation means enough investors were willing to accept it.
But it was mysterious to me that the super-angels would quibble
about valuations.  Did they not understand that the big returns
come from a few big successes, and that it therefore mattered far
more which startups you picked than how much you paid for them?After thinking about it for a while and observing certain other
signs, I have a theory that explains why the super-angels may be
smarter than they seem.  It would make sense for super-angels to
want low valuations if they're hoping to invest in startups that
get bought early.  If you're hoping to hit the next Google, you
shouldn't care if the valuation is 20 million.  But if you're looking
for companies that are going to get bought for 30 million, you care.
If you invest at 20 and the company gets bought for 30, you only
get 1.5x.  You might as well buy Apple.So if some of the super-angels were looking for companies that could
get acquired quickly, that would explain why they'd care about
valuations.  But why would they be looking for those?   Because
depending on the meaning of "quickly," it could actually be very
profitable.  A company that gets acquired for 30 million is a failure
to a VC, but it could be a 10x return for an angel, and moreover,
a quick 10x return.  Rate of return is what matters in
investing—not the multiple you get, but the multiple per year.
If a super-angel gets 10x in one year, that's a higher rate of
return than a VC could ever hope to get from a company that took 6
years to go public.  To get the same rate of return, the VC would
have to get a multiple of 10^6—one million x.  Even Google
didn't come close to that.So I think at least some super-angels are looking for companies
that will get bought.  That's the only rational explanation for
focusing on getting the right valuations, instead of the right
companies.  And if so they'll be different to deal with than VCs.
They'll be tougher on valuations, but more accommodating if you want
to sell early.PrognosisWho will win, the super-angels or the VCs?  I think the answer to
that is, some of each.  They'll each become more like one another.
The super-angels will start to invest larger amounts, and the VCs
will gradually figure out ways to make more, smaller investments
faster.  A decade from now the players will be hard to tell apart,
and there will probably be survivors from each group.What does that mean for founders?  One thing it means is that the
high valuations startups are presently getting may not last forever.
To the extent that valuations are being driven up by price-insensitive
VCs, they'll fall again if VCs become more like super-angels and
start to become more miserly about valuations.  Fortunately if this
does happen it will take years.The short term forecast is more competition between investors, which
is good news for you.  The super-angels will try to undermine the
VCs by acting faster, and the VCs will try to undermine the
super-angels by driving up valuations.  Which for founders will
result in the perfect combination: funding rounds that close fast,
with high valuations.But remember that to get that combination, your startup will have
to appeal to both super-angels and VCs.  If you don't seem like you
have the potential to go public, you won't be able to use VCs to
drive up the valuation of an angel round.There is a danger of having VCs in an angel round: the so-called
signalling risk.  If VCs are only doing it in the hope of investing
more later, what happens if they don't?  That's a signal to everyone
else that they think you're lame.How much should you worry about that?  The seriousness of signalling
risk depends on how far along you are.  If by the next time you
need to raise money, you have graphs showing rising revenue or
traffic month after month, you don't have to worry about any signals
your existing investors are sending.  Your results will speak for
themselves.  
[7]Whereas if the next time you need to raise money you won't yet have
concrete results, you may need to think more about the message your
investors might send if they don't invest more.  I'm not sure yet
how much you have to worry, because this whole phenomenon of VCs
doing angel investments is so new. But my instincts tell me you
don't have to worry much.  Signalling risk smells like one of those
things founders worry about that's not a real problem.  As a rule,
the only thing that can kill a good startup is the startup itself.
Startups hurt themselves way more often than competitors hurt them,
for example.  I suspect signalling risk is in this category too.One thing YC-funded startups have been doing to mitigate the risk
of taking money from VCs in angel rounds is not to take too much
from any one VC.  Maybe that will help, if you have the luxury of
turning down money.Fortunately, more and more startups will.  After decades of competition
that could best be described as intramural, the startup funding
business is finally getting some real competition.  That should
last several years at least, and maybe a lot longer. Unless there's
some huge market crash, the next couple years are going to be a
good time for startups to raise money.  And that's exciting because
it means lots more startups will happen.
Notes[1]
I've also heard them called "Mini-VCs" and "Micro-VCs." I
don't know which name will stick.There were a couple predecessors.  <NAME> had angel funds
starting in the 1990s, and in some ways First Round Capital is closer to a
super-angel than a VC fund.[2]
It wouldn't cut their overall returns tenfold, because investing
later would probably (a) cause them to lose less on investments
that failed, and (b) not allow them to get as large a percentage
of startups as they do now.  So it's hard to predict precisely what
would happen to their returns.[3]
The brand of an investor derives mostly from the success of
their portfolio companies.  The top VCs thus have a big brand
advantage over the super-angels.  They could make it self-perpetuating
if they used it to get all the best new startups.  But I don't think
they'll be able to.  To get all the best startups, you have to do
more than make them want you.  You also have to want them; you have
to recognize them when you see them, and that's much harder.
Super-angels will snap up stars that VCs miss.  And that will cause
the brand gap between the top VCs and the super-angels gradually
to erode.[4]
Though in a traditional series A round VCs put two partners
on your board, there are signs now that VCs may begin to conserve
board seats by switching to what used to be considered an angel-round
board, consisting of two founders and one VC.  Which is also to the
founders' advantage if it means they still control the company.[5]
In a series A round, you usually have to give up more than
the actual amount of stock the VCs buy, because they insist you
dilute yourselves to set aside an "option pool" as well.  I predict
this practice will gradually disappear though.[6]
The best thing for founders, if they can get it, is a convertible
note with no valuation cap at all.  In that case the money invested
in the angel round just converts into stock at the valuation of the
next round, no matter how large.  Angels and super-angels tend not
to like uncapped notes. They have no idea how much of the company
they're buying.  If the company does well and the valuation of the
next round is high, they may end up with only a sliver of it.  So
by agreeing to uncapped notes, VCs who don't care about valuations
in angel rounds can make offers that super-angels hate to match.[7]
Obviously signalling risk is also not a problem if you'll
never need to raise more money.  But startups are often mistaken
about that.Thanks to <NAME>, <NAME>, <NAME>, <NAME>, <NAME>, <NAME> and <NAME>
for reading drafts
of this.
