If you take funding from a venture capital firm or angel investor and want to build a large, enduring company, this isn’t the decade to do it. The collapse of the IPO market and dysfunctional math in the venture capital community has stacked the odds against you.

Here’s why.

The two decades from 1979 (when pension funds fueled the expansion of venture capital) to 2000 (when the dot-com bubble burst) were the Golden Age for entrepreneurs and venture capital firms. VC’s were making investments every other financially prudent institution wouldn’t touch – and they were printing money.

The system worked in predictable and profitable ways. VC’s invested their limited partners’ “risk capital” in a portfolio of startups in exchange for illiquid stock. Most of the startups they invested in either died by running out of money before they found a scalable business model or ended up in the “land of the living dead” by never growing (aka failing to Pivot.)

But a few startups succeeded and grew into profitable companies. Their venture investors made money by selling their share of these successful companies at a large multiple over what they originally paid for it. One of the most predictable ways for an investor to sell these shares was to take a company “public.” (Until 1995 startups going public typically had a track record of revenue and profits. Netscape’s 1995 IPO changed the rules. Suddenly there was a public market for companies with limited revenue and no profit. This was the beginning of the 5-year dot-com bubble.)

During the decade between 1991 and 2000, nearly 2000 venture-backed companies went public. Going public did two things for your company. You finally had money in the bank to expand your business, scaling it from the “build” stage into the “grow” stage. But more importantly, your VC’s could sell off their ownership stake. This changed their interest from managing your board for their liquidity to managing the board for all shareholders. Most VC’s would get off of boards of companies that went public.

The public markets for venture-backed technology stocks never really recovered after the collapse of the dot-com boom. Fast forward to today and take a look at the last ten years of IPO’s and M&A’s and you’ll see why life is different for entrepreneurs.

Depending on your industry, in this decade it’s 5 to 10x less likely that your company will have an IPO as an exit.Since there’s no public market for the shares your venture investor has bought in your startup, the most reasonable way for a venture firm to make money is to have you sell your company to another company. But unlike an IPO - where you sold stock to the public and got to run your company - in an acquisition, your company is gone. And odds are you will be too in a year or so.

None of this has gone unnoticed by the venture community. Some of the old-line venture firms have changed their strategy, but some are still locked into last decade’s model while the partners are living off of their management fees and go through cargo cult-like rituals. You can tell who they are by how often they remind you “this is the year the IPO market will come back.” (If the limited partners of these VC’s acted like real fiduciaries rather than waiting for the end of life of the fund, more than half of old-line venture firms would have shut themselves down today.)

New, agile and adroit venture firms with new business models have emerged to deal with the reality that Web 2.0 startups require significantly less capital to start, exits for venture firms are predominately acquisitions and a venture firm with a smaller fund <$150M matches these exits.

Floodgate, Greycroft, Union Square Ventures, True Ventures, etc. are example of this class of firm. (Raising a VC fund in this environment has it’s own perils.) And the explosion of private Angel firms continues to fuel this new ecosystem.

Other VC’s who invest in Information Technology have taken a different approach. They’ve created virtual IPO’s for founders and employees via late-stage private financing. It has put a per user dollar value on these sites and these few startups will be the next likely IPO candidates. In their short time as a fund, Andreessen Horowitz seems to be on top of this game with their investments in Facebook, Skype and Zynga.

But not all industries are as capital efficient as the Web or Information Technology. Biotech, medical devices, semiconductors, communications and CleanTech require significantly more capital to build and scale before they can generate profits. It’s in these industries that the lack of a public market has taken the heaviest toll on entrepreneurs and their startups. Great companies with innovative ideas have simply died not having the cash to scale. VC’s who would have normally kept writing checks were faced with no public exits and cut them off.

Some of these industries have turned to the U.S government for funding. Elon Musk has not only tapped the feds for his electric car startup Tesla, but also received hundreds of millions for his space launch company –SpaceX. Other Clean Tech companies have tried this approach as well. Yet while the U.S. government doles out funds to connected entrepreneurs, it lacks an integrated strategy to deal with the lack of public market financing for critical growth industries.

It may be that these entrepreneurial industries suffer the same fact as manufacturing in the U.S.- they die out of benign neglect and a lack of a coherent understanding of the role of risk capital in our national interest.

If you’re starting a software company, your exit is most likely a sale to a larger company. This decade has been a Darwinian filter – only the very best companies will survive as standalone companies.

If you’re starting a company in other, capital intensive industries, it’s no longer just about having great technology. You need a plan for partnership and long term funding from day one.

Why do angel investors exist?

Before answering this question, it’s useful to ask and answer a related question: why are there angels and why have they become more prominent in the last 10 years?  After all, doesn’t the definition of venture capital include all of the activities that angels perform? 

The answer lies in the history of technology companies and the differences between how they were built 30 years ago and how they are built now.  In the early days of technology venture capital, great firms like Arthur Rock and Kleiner Perkins funded companies like Digital Equipment Corporation (DEC) and Tandem.  In those days, building the initial product required a great deal more than a high quality software team. Companies like Tandem had to manufacture their own products.  As a result, getting into market with the first idea, meant, among other things, building a factory.  Beyond that, almost all technology products required a direct sales force, field engineers, and professional services.  A startup might easily employ 50-100 people prior to signing their first customer. 

Based on these challenges, startups developed specific requirements for venture capital partners:

• Access to large amounts of money to fund the many complex activities
• Access to very senior executives such as an experienced head of manufacturing
• Access to early adopter customers
• Intense, hands-on expert help from the very beginning of the company to avoid serious mistakes

In order to both meet these requirements and build profitable businesses themselves, venture capitalists developed an operating model which is still broadly used today:

• Raise a large amount of capital from institutional investors
• Assemble a set of experienced partners who can provide hands-on expertise in building the product and then the company
• Evaluate each deal very carefully with extensive due diligence and broad partner consensus
• Employ strong governance to protect the large amount of capital deployed in each deal.
• This includes requisite board seats and complex deal terms including the ability to control subsequent financings
• Manage own resources effectively by calculating the amount of capital/number of partners/maximum number of board seats per partner to derive the minimum amount of capital that must be invested in each deal 

It turns out that building a company has changed quite a bit since the early days of venture-backed technology companies.  Building a company like Twitter or Facebook is quite different from building Tandem.  Specifically, the risk and cost of building the initial product is dramatically lower.  I emphasize product to distinguish it from building the company.  Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks and has raised hundreds of millions of dollars to build their business.  But building the initial Facebook product cost well under $1M and did not entail hiring a head of manufacturing or building a factory. 

As a result, for a modern startup, funding the initial product can be incompatible with the traditional venture capital model in the following ways:

• Lengthy diligence process. Venture capitalists take too long to decide whether or not they want to invest because they are set up to take large risks and have complex processes to evaluate those risks. 
• Too much capital. Venture capitalists need to put too much capital to work – often a VC will want to invest a minimum of $3M. If you only need 4 people to build the product and get it into market, this likely won’t make sense for your business.
• Board seat. Venture capitalists often require a board seat and, for that matter, a board of directors be formed. If 100% of the company is building the product and the team knows how to do that, then a board of directors may be overkill. In addition, it may be too early to decide who you want to be on the board. 

As a result of the above, a venture capitalist usually requires a serious commitment from the entrepreneur to pursue an idea that is highly experimental. If the product doesn’t stick, it might make sense for the entrepreneur to pursue a totally different idea or drop the business altogether.  This is much easier to do if you’ve raised $300,000 than if you’ve raised $3,000,000. 

As entrepreneurs needed someone to bridge the gap between building the initial product and building the company, angel investors stepped up. 

Angel investors are typically well-connected, wealthy individuals. They generally use their own money and come with none of the above VC constraints describe above: they don’t go on boards, they don’t need to put in lots of capital (in fact, they usually don’t want to), they prefer dead simple terms (as they often don’t have legal support), they understand the experimental nature of the idea, and they can sometimes decide in a single meeting whether or not to invest. 

On the other hand, angels do not manage huge pools of capital, so entrepreneurs need to find someone else to fund the building of the company (as opposed to the product) and most angels do not plan to spend a great deal of time helping entrepreneurs build the company. 

When should you raise an angel round and when should you raise a VC round?

This question really comes down to the company’s development. If you are a small team building a product with the hope of “seeing if it takes” (with the implication being that you’ll try something else if it doesn’t), then you don’t need a board or a lot of money and an angel round is likely the best option. On the other hand, if you’ve developed a strong belief in your product or your product idea and you are in a race against time to take the market, then a venture round is more appropriate. You will benefit from both the extra capital and extra support that comes with a serious and large commitment from your investors. 

So who is qualified to invest in each?

Obviously angels can invest in angel rounds, but what about VCs? Is it safe to have them participate? The answer turns out to be “if and only if they behave like angels.” What does it mean for a VC to behave like an angel? Well, they must:

• Be able to make an investment decision quickly, e.g. in one or two meetings
• Be able to invest without taking a board seat
• Not require control of subsequent funding rounds
• Not impose complex terms

If the VC wants to be in the angel round, but refuses to behave like an angel, then entrepreneur beware.  Having a VC who behaves like a VC in the angel round can jeopardize subsequent financings.  Angels can be great participants in venture rounds, but it’s generally better to have a VC lead those deals as they have more financial and other resources required to build the company. 

Where does the money come from that private equity (venture capital, growth equity and buyout) firms invest?  It might indirectly come from you.  Key constituents include the likes of government employees, employees of large corporations, trade organizations (e.g. teachers) and wealthy families.

Wealthy Families / Foundations

The original investors in venture capital firms were wealthy families.  The Phipps family was behind Bessemer.  The Rockefeller family was behind Venrock.  These wealthy families often invest out of vehicles like family offices or foundations.  From those roots, many wealthy families have played impactful roles in backing some of the best names in private equity.  As the asset class has became more known and attractive, the sources of capital grew to include more institutional sources.  But, behind every institution are regular people.

Endowments

One of the most aggressive investors in venture capital has historically been school endowments.  When you make that annual class gift to your college, if you designate it for the endowment, some of your gift just might be put into various venture capital and buyout firms.  Typically, universities are charged to protect your endowment gift, so they invest it, and use the returns generated from the investment to fund various school initiatives.  Major universities like Harvard, Yale, Stanford, MIT, etc. have been big proponents of investing some of that endowment principal into private equity firms.

Pension Funds

Another prominent investor in venture capital has been corporate and public pension plans.  Pension plans (of the defined contribution variety) are just another type of retirement plan used by state governments, labor/trade unions, and large corporations.  As you work at a company or state government and thereby accrue pension benefits, the company or organization funds a pension account based on actuarial models tied to its potential pension payout obligations.  A portion of these funds are often allocated to the private equity asset class.  Major states investing in this asset class include New York, New Jersey, California, Oregon, etc.  Major corporations like AT&T, General Motors, etc. have also been active investors.

Fund of Funds

Many foundations, endowments, and pension funds lack the capacity or resources to evaluate and monitor different private equity firms.  Hence, the fund of funds industry has sprung up to pool capital from these sources into funds and then invest on their behalf.  Unlike the other sources of capital, fund of funds have to raise their capital from third party sources, just like the firms that they invest in.

So, if you follow the money through, your child’s college financial aid package or your pension plan – might be tied to a couple engineers working on some project in Silicon Valley or tied to the big buyout you read about in the Wall Street Journal.