Don’t Cross the Streams!

Fascinating pair of events in Atlanta this week… the DLA Piper “Venture Pipeline” and the Angel Capital Association annual summit. I’ve learned a bit, and have definitely gotten a few ideas to think about.

No surprise to anyone who’s active in the startup community… investment in early stage companies is down but not out. Deals are still getting done. And the most savvy investors realize that prices of early-stage equities are as cheap now as they will be for a long long time… it’s a good time to buy.

(That’s not the greatest news for the entrepreneurs, but don’t let it stop you. Waiting for valuations to go up just means you’re letting your competitors run unopposed.)

The most interesting discussion so far was led by Basil Peters. He’s crunched a lot of numbers in writing his book “Early Exits” and come up with some non-intuitive conclusions.


First, check his premises:

  1. Venture economics dictate that VC funds must have a certain number of home runs to make up for the number of deals that simply go broke.
  2. The average size of a venture fund has grown from $100M to $350M in ten years. That means the home runs have to be bigger… as a rule of thumb, you probably need to exit at $200M to “move the needle.”
  3. The angel market has matured so that syndicates of angels can now invest $3-5 million over the life of a deal.
  4. The rise of cloud computing, SaaS, Asterisk, BPO, and other outsourcing services means that many companies now require an order of magnitude less capital than they did a decade ago. (Not true for biotech, but certainly true for software startups!)
  5. The IPO market for venture-backed companies is dead. Thank you, Sarbanes-Oxley.
  6. 92% of U.S. M&A exits are for less than $20 million.
  7. Related: The number of potential acquirors is much larger for a $20M purchase than a $200M purchase. As Basil relayed, a Fortune 500 friend of his said “I can get a $20M deal approved at the divisional level. A $200M deal requires the board of directors, and that’s not going to happen right now.”

Any issues on that list? Any one of them is probably worth a blog post, but it’s hard to argue with any of them as representative of the current situation in 2009.

And one item that Basil didn’t point out, but it’s probably in his book:

  • The death of the IPO market means that participating-preferred shareholders (meaning VCs with liquidation preferences) will get a disproportionate amount of cash out of an M&A transaction.

Alright, toss all that in a pot and simmer. What do you come up with?

The interests of angel investors and venture capital investors are inexorably diverging.

That’s a big deal. It has the potential to change the dynamics of the entire early-stage investment market.

I’m typing this sitting in an ACA session on the current angel market. The angel and VC markets have always been synergistic, and somewhat intertwined. Getting a VC to invest in your early-stage firm has always been a “seal of approval” for your angel investment, and 62% of angel deals last year attracted VC funding. Some angel groups won’t invest in a company if they can’t convince themselves that the deal will attract VC money. A lot of senior or emeritus VCs are active individual angels. Now, VCs are even inviting top-end angel groups to join their Series A syndicates.

And Basil claims that it’s all headed for divorce.

Venture Fund Economics

The economics of a venture fund are pushing them towards deals where they can put at least $5M to work. Do the math: a 10X exit means the VC equity has to be worth $50M; if they own a quarter of the company, that means a $200M acquisition. And deals are taking longer… the DLA Piper presentation emphasized that average holding period from Series A to liquidity has grown from barely two years during the Bubble to over eight years today.

Ten-year funds aren’t ten-year funds anymore. The average ten-year fund doesn’t wind up until Year 14, and a non-trivial fraction last until Year 18 or even longer.

Time is the enemy of VC firms. The longer you hold the equity, the higher multiple you need to hit your IRR target (and venture firms live and die by IRR). Waiting until Year Seven for a 10X exit that you expected in Year Five means your portfolio IRR can drop from 35% to 20%. That may be the difference between raising a new fund and being invited to explore other career opportunities.

So all the forces are pushing VC firms to do bigger deals, that consume more capital, that deliver the potential for ever-higher multiples. 10X may not be enough… maybe your target now needs to be 20X, or 30X. You’re swinging for the fences every time.

If you’re an angel investor, this may not be a good idea.

If you can put $2M into an angel investment over two rounds and sell your stake in Year 3 for $6M… that’s only a 3X multiple, but a a 54% rate of return! If you own a third of the company, that means an $18M acquisition… as mentioned above, that can be done as the divisional level at many, many large companies.

No substantial VC is going to be interested in a deal that sells for $18 million. “Doesn’t move their needle.” “Failure to launch.” If they have one of these in their portfolio, its counted as a failure.

But if you’re an angel investor, investing your personal capital, that’s a darned good deal! It’s not going to let you retire to Cayman Brac, but it’s certainly going to pay for some nice trips and toys.

And for those of us concerned about economic development and technology-investment ecosystems… the funds from that exit are available for reinvestment in the next deal much more quickly! Once the angel is back from a three-week golf trip or dive trip or whatever, he or she has substantial liquidity available, and is likely to want to do another deal, and another… and probably in the same local market. By contrast, the VC fund exit, whenever that occurs, gets distributed back to their institutional LPs. With all the chaos on Wall Street, who knows when, or if, that money will ever make it back to the local market?


The conflict arises if you are the angel investor looking at a potential $18M acquisition, but you’ve taken VC money. As seen above, the VC is pre-programmed to need a $200M exit. The VC syndicate is going to control the board, and they’re likely to “double down”… rather than taking the early exit, they’ll plow in more money (most VCs have plenty of money), maybe try to roll up a competitor, and build that $200M exit. If they miss, the deal goes into their list of writeoffs. And it’s probably too late to go back and make that $18M sale that was available four or five years earlier. That potential acquiror has moved on.

Basil quoted a study by Robert Wiltbank of Willamette University (funded by our indispensable friends at the Kauffman Foundation). He looked at a large historical database, and compared results for companies that only received angel investment versus companies that received a mix of angel and VC dollars.

When angel investments attracted VC dollars, the overall number of exits in the 5X to 10X range increased by about 8%. That’s good.

But the number of exits in the 1X to 5X range fell by nearly 20%. That’s bad.

And the number of complete failures increased by about 12%. That’s terrible. How many of those companies would have had solid “base hits” exits if the venture investors had not been swinging for the fences?

Impact on Entrepreneurs

So if you’re an entrepreneur… what does all this mean for you?

It depends. (The answer to almost any reasonably complex question is usually “It depends.”)

If you’re discovering pharmaceuticals or building medical devices, nothing changes. Structural issues in your market, such as FDA approval, will continue to drive you towards raising large amounts of venture capital from VC firms.

If you’re developing a new Web 2.0 service… you might want to think about an angel-only strategy. Your likelihood of a profitable exit goes up, even though the likelihood of being on the cover of Wired goes down. Make enough money to fund the next company yourself… and that one might get you on the cover!

And if you’re in another sector… well, it depends. Cleantech deals are looking more and more like biotech (heroic amounts of capital, long holding periods). Some software deals may begin look like SaaS deals, where you can run them on a relative shoestring. It’s certainly worth understanding these dynamics before you start mixing streams of angel capital with venture capital.

Venkman said “Don’t cross the streams!” It’s still good advice.



  1. Paul Freet says

    Angels want in on deals that VCs will be interested in. I guess be careful what you ask for.

  2. Stephen,
    Excellent article!

  3. David Sung says

    I think the answer is clear and Sevin Rosen had it right years ago. The venture model is broken and they will force unnatural behavior on companies even though the exits don’t justify.

    For 99% of Venturelab and ATDC deals, VC fund ability should not be a requirement. VC’s are not stupid. For new investments, the requirement must be a major home run. That’s why they’re stymied on what to do and are not making investments. The equation does not work.

    Every play has to be capital efficient. Another words, requiring little equity. This doesn’t necessarily mean you can’t get a 10X or beyond. The multiples can be great, the cash on cash won’t be impressive because of the size of the funds in VC.

  4. Knox Massey says

    We’ve played in the Angel to VC space for years–with interesting results. Our biggest positive exit to date (12x-15x depending on final payout) had nothing to do with VC’s–and was our shortest timeframe(11 month investment). We have had other positive exits with VC’s involved–but the exits have been somewhat uncommon so far—secondary transactions by later VC investors wanting in once the company was cash flow positive, etc. I have no doubt that some of our (earlier) 1999-2002 investments will soon do well (Atlanta Technology Angels has been investing since 1999), but may not exit until 2010-2012 timeline. 8-13 years is a long time to wait for an angel! If angels don’t exit in a reasonable timeframe–that money cannot be re-circulated into the community to fund other entrepreneurs and early/seed stage stage companies. When that happens, you have to constantly find new angels to keep the funds flowing to companies. It’s really that simple–no exits, no continuing capital. So, you are hearing many, many angels discussing how to build greater resources within their respective groups to exit earlier (as I mentioned on Twitter Tuesday). Angels are taking greater roles in the exit strategy long term–and not just content to “hand it over” to the VC funds. Don’t get me wrong, we like VC participation, but the days of patience for the financial engineering of terms is over. And, we’re way over the “we like it if the VC likes it” phase. For angels, it’s no longer “just about the money”. It’s about the resources within the group(s) to help make ALL angels successful (which is what the Angel Capital Association is about).

  5. I have long thought that many Internet apps can and should be built, launched, and scaled without the need for traditional venture capital. Something more like super angel funding in the $1.5 range. If an entrepreneur approaches their startup with this strategy the data seems to back up that it is more likely to be successful. And if it is successful you can also go after venture capital funding at a later date.

    An entrepreneur needs to ask if they want to be rich or famous. I concur with your suggestion of rich first, famous later.

  6. Eric Winter says

    With the disparate motivations, it’s hard not to agree with the conclusion. I especially liked your correlating VC funding and its impact on base hit exits and outright failures.

  7. Commenting on my own post…

    Sitting in Friday morning panel at ACA. James Geshwiler of CommonAngels just related an anecdote that fits with this. He led a deal, then brought in Benchmark who eventually invested $8M… and wanted to do more. Hoping for a billion-dollar home run.

    Turned out the target market couldn’t support a big company, and they wound up selling the company for $28M. With $22M of liquidation preferences.


    Geshwiler went on to say that, had they syndicated with other angels, they could have spent less than $8M, gotten the same $28M exit, had no liquidation preferences, and everyone would have made a lot of money…

    Single datapoint, but insightful.

  8. Knox Massey says

    Great to see you at the ACA event. Regarding your above comment–much, much more of that discussion was happening in the hallways and outside at the tables–as well as in the more formal sessions. Angel Group syndication is alive and happening. I had conversations with groups in SC, FL, NC, TN, VA, etc about Atlanta companies (not just Internet app companies) during the week. The money is there–believe me–it’s there. Atlanta needs to be better about working together on local deals to bring in the outside capital….

  9. I agree entirely with the merits of angel-only funding for web startups. My current startup got the beta to market on $250K in angel funding (and a lot of sweat equity), and will launch 1.0 on less than $400K. We’ll need another $1M to drive growth and get to breakeven. Our goal is to be able to make everyone happy with a $20M exit (though we hope for more).

    The challenge I see is that a $1M angel round is at the high end of what’s reasonable, and is likely to require lots of investors. So I’m also looking at small VC funds that are also happy to put in $500K.

    Another advantage of this approach is that it forces you to stay lean and mean. That’s a lot harder to do when you have $8 million in the bank. The pressures to “get big fast” lead to a lot of bad decisions and attempts to make markets grow faster than their natural rates.

  10. I am a scientist, not a financial type, and left big pharma for private technical consulting to start-ups about 8 years ago. I have no direct VC or angel experience, but am directly affected by these financial forces and see them operating at reasonably close range. My experience from the past 5 or perhaps 6 years (strictly in biotech/pharma/cleantech start-ups) is that the VC funds are trapped in an unsustainable business model no different than the business model that has trapped the big pharma companies – the spiraling need to produce bigger and bigger winners, requiring ever-larger investments, thus requiring even greater returns, and so on.

    I am also struck by the apparent paradox; I hear repeatedly that there is plenty of money to waiting to invest, I see a simultaneous need for investment in small companies, but investments cannot be made because they cannot by big enough to provide the required returns – so nothing happens.

    My experience also suggests a direct parallel between the increasing disconnect noted in the article (between smaller and larger investing entities) and the increasing gap between the point where a given piece of technology can be developed with minimal funding, and the point at which anyone will make an investment.

    As an outsider with no financial education, my admittedly naive conclusion is that VC funds are simply too big. A question: if things worked better when funds were only $100M, why not go back to funds of $100M, or even smaller ? I suspect the answer is found at the end of the posting by Michael Slater – the “pressure to get big fast…[and]… make markets grow faster than their natural rates.”

    And that suggests a further parallel to what I see happening in big pharma (which has become too big) and the investment community generally; the early discover & development is handed over to small companies that are built – and expect – to work only in that early environment, with late development, full-scale production and marketing taken on by corporate entities which are designed to work only in that very different environment.

    Thus the division between angel and VC investors would seem a natural event that should be encouraged. Finding benchmarks to set expectations around such a division of risk & return would seem the next step; Knox Massey’s post seems a good start here.

  11. I completely agree and I think it’s ironic that the thing VCs have been preaching for so long (capital efficiency) is the very thing that threatens their business model. Ultimately, VCs will just have to focus on deals where the company needs $10MM+ like biotech, cleantech and the like and angels, instead of being a feeder for VCs will become an alternate.

  12. Stephen – outstanding post! Thanks very much for your coverage of my talk at the ACA event. One small clarification to your summary – the *majority* of private company acquisitions are under $20 million. About 92% of exits don’t work for VCs, but that percentage was based on a minimum exit size of around $100 million. I’m working on a post at AngelBlog to clarify that point.

    Knox’ and James’ comments are excellent.

    It was a pleasure to meet you in Atlanta. Thanks for all the valuable information in your blog.

  13. I don’t listen to podcasts (not time-efficient), but this one is probably pretty good:

    Look for the one titled “Basil Peters on Early Exits”… if there’s an obvious way to link to a particular episode, I haven’t found it.

  14. Looks like Business Week is joining the chorus:


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