Venture Capital

Marc Andreessen, one of Silicon Valley’s biggest venture capitalists, and Warren E. Buffett, of Berkshire Hathaway, have two things in common: They are both worth huge amounts of money, with billions of dollars at their investing disposal, and they both try to invest in companies that are undervalued.

But these two business titans disagree about the importance of investing in technology.

In an interview in New York Times Magazine, Mr. Andreessen argues that compared with blue-chip companies like General Electric, big technology companies, including Microsoft, Cisco, Google and Apple, are very undervalued. Citing this point, Mr. Andreessen says the talk of a bubble is nonsense.

“Not only is there no bubble — these prices are reflective of the fact that the market still hates tech,” Mr. Andreessen said in the interview, referring to the stock price of many large tech companies. “This bubble talk is about everybody being unbelievably psychologically scarred from 10 years ago.”

Mr. Buffett disagrees. In an interview with the DealBook blog, he said he did not plan to invest in social networks and was still weary of the price of some tech stocks.

Mr. Buffett said he was looking for tech stocks to invest in that were “not crazy.”

“Most companies I don’t know how to value, there’s a few that I think I know how to value, and every now and then one of those are a price number that falls within my valuation range,” Mr. Buffett said.

But who is right? Are tech stocks overvalued? Is investing in Facebook at a $100 billion valuation a good bet for investors, or is this the same mentality that brought on the bubble that burst 10 years ago?

SOME time after the dotcom boom turned into a spectacular bust in 2000, bumper stickers began appearing in Silicon Valley imploring: “Please God, just one more bubble.” That wish has now been granted. Compared with the rest of America, Silicon Valley feels like a boomtown. Corporate chefs are in demand again, office rents are soaring and the pay being offered to talented folk in fashionable fields like data science is reaching Hollywood levels. And no wonder, given the prices now being put on web companies.

Facebook and Twitter are not listed, but secondary-market trades value them at some $76 billion (more than Boeing or Ford) and $7.7 billion respectively. LinkedIn, a social network for professionals, said it hopes to be valued at up to $3.3 billion in an initial public offering (IPO). They were wrong, the market valued LinkedIn at $9 billion! Microsoft announced its purchase of Skype, an internet calling and video service, for a frothy-looking $8.5 billion—ten times its sales last year and 400 times its operating income. And those are all big-brand companies with customers around the world. Prices look even more excessive for fledgling firms in the private market (Color, a photo-sharing social network, was recently said to be worth $100m, even though it has an untested service) or for anything involving China. There has been a stampede for shares in Renren, hailed as “China’s Facebook”, and other Chinese web giants listed on American exchanges. 

Same again, Only different

So is history indeed about to repeat itself? Those who think not point out that the tech landscape has changed dramatically since the late 1990s. Back then few people were plugged into the internet; today there are 2 billion netizens, many of them in huge new wired markets such as China. A dozen years ago ultra-fast broadband connections were rare; today they are ubiquitous. And last time many start-ups (remember Webvan and Pets.com) had massive ambitions but puny revenues; today web stars such as Groupon, which offers its users online coupons, and Zynga, a social-gaming company, have phenomenal sales and already make respectable profits. 

The this-time-it’s-different brigade also points out that the 1990s bubble expanded only after numerous web firms were floated on stockmarkets and naive investors pumped up the price of their shares to insane levels. This time, there have been relatively few big internet IPOs (though that is likely to change). And there is no sign of the widespread mania in the high-tech world that occurred last time around: the NASDAQ stockmarket index, a bellwether for the tech industry, has been rising but is still far below its peak of March 2000. 

In one respect the optimists are right. This time is indeed different, though not because the boom-and-bust cycle has miraculously disappeared. It is different because the tech bubble-in-the-making is forming largely out of sight in private markets and has a global dimension that its predecessor lacked. 

The bubble is being pumped partly by wealthy “angel” investors, some of whom made their fortunes in the late-1990s IPO boom. Their financial firepower has increased and they are battling one another for stakes in web start-ups. In some cases angels are skimping on due diligence to win deals. When it comes to investing in more established companies like Facebook and the bigger web firms, traditional venture capitalists now face competition from private-equity companies and bank-led funds hunting for profits in a bleak investment environment. Gucci-shod leveraged-buy-out kings may appear to be more sophisticated than the waitresses buying dotcom shares a decade ago—but many of the newcomers are no more knowledgeable about technology. 

This boom also has wider horizons than the previous one. It was arguably started by Russian investors. Skype was born in Estonia. Finland’s Rovio, which makes the popular Angry Birds smartphone game, recently raised $42m. And then there’s China. Renren and Youku, “China’s YouTube”, supposedly offer investors a chance to profit both from the country’s extraordinary growth and from the broader impact of the internet on commerce and society. Chinese web start-ups often command $15m-20m valuations in early financing rounds, far more than their peers in America. 

These differences will have important consequences. The first is that the bubble forming in the private market could be pretty big by the time it floats into the public one. Facebook may turn out to be the next Google, and LinkedIn has a fairly solid revenue plan. But they will be followed by less robust outfits—the Facebook and LinkedIn wannabes—with prices that have been dangerously inflated by the angels’ antics. 

The froth in China’s web industry could also lead to unrealistic valuations elsewhere. And it may be China that causes the web bubble eventually to burst. Few of those rushing to buy Chinese shares have thought through the political risks these companies face because of the sensitivity of their content. A clampdown on a prominent web firm could startle investors and prompt a broader sell-off, as could a financial scandal. 

And after the angels have fallen?

With luck the latest web bubble will do less damage than its predecessor. In the 1990s internet euphoria caused a dramatic inflation in the price of telecoms firms, which were creating the infrastructure for the web. When internet firms’ share prices plummeted, telecoms investors suffered too. So far, there has been no sign of such a spillover effect this time around. But the globalization of the internet industry means that many more people could be tempted to dabble in web stocks in the current boom, adding to the pain of the bust. 

When will that be? This paper warned about both the last internet bubble and the American property bubble long before they burst. Irrational exuberance rarely gives way to rational scepticism quickly. So some bets on start-ups now will pay off. But investors should take a great deal of care when it comes to picking firms to back: they cannot just rely on somebody else paying even more later. And they might want to put another bumper sticker on their cars: “Thanks, God. Now give me the wisdom to sell before it’s too late.”

There really isn’t a one-size-fits-all formula that can be followed for optimizing the chances of attracting professional investment. Each company is different and faces challenges and issues that can be overcome only through creativity, perseverance and resolve.

There are, however, some elements that are so basic they cannot be ignored. Most institutional venture investors either expressly or intuitively address these requirements whenever they evaluate a business plan for a potential investment. Here are four to be especially aware of.

Is it a company or is it a product? - With the dramatic level of innovation that's taking place through startups in the social media/Web 2.0/online business arena, this question is increasingly important. Implicitly, investors want to know the product development – something that can go in a variety of directions. For example, can the product be developed to include additional features and functionality that will effectively redefine the offering in the eyes of the customer? Can the product be adapted to address the needs of more than a single vertical market? Is the product so compelling that the emphasis in the business plan shifts to the customer acquisition strategy?

The mobile application market is a good example of a product category that, in general, doesn’t offer a sufficient foundation to support a company. Individual app developers typically don’t require much capital or labor to be successful, and they don’t require professional investors. In contrast, there are online gaming companies—Zynga, Playdom, Social Gaming Network and others—whose product roadmaps concentrate entirely on the rapid development and production of new “hits”. Businesses like this require all the resources and disciplines of a full-fledged company to support their growth objectives.

How big does the market have to be to attract investment? - After the dot-com bust, the anecdotal answer to this question was $1 billion - or at least an annual growth rate that would get you close to $1 billion quickly.

In 2011, there is far more latitude, depending on the business plan of the company. With the advent of open source software, online development tools, cloud computing, and the ability to reach massive customer markets instantly through the Internet, startup companies have become much more efficient in product development and customer acquisition, and can more rapidly get to proof of concept and positive cash flow than ever before.

As a result, companies with online business models, for example, may not require nearly as much capital as they once did. Moreover, angel groups aren’t swinging for the fences the way the mainstream institutional VC firms do. Instead, (to continue the metaphor) they're frequently only looking to hit singles and doubles, and may be quite content to realize exits in the range of $10-$100 million.

Is prior management-level experience required? - Obviously, it doesn’t hurt. In particularly tough times, prior executive experience in managing a VC-backed startup may be a non-waivable requisite. Management experience of any kind is always a positive factor, since it directly relates to the credibility of the management team in the eyes of the investor.

Obviously, there are many amazing startup companies that have been built by founders with no previous experience, and lacking this experience should not deter an entrepreneur who believes he or she can build a great company. There are effective ways to work around the experience issue if it is an impediment to getting an invitation to present before a VC firm. Teaming up with a co-founder who does bring the necessary experience, finding a mentor who carries personal credibility, or organizing a board of advisors with relevant experience and expertise are all ways of addressing the issue.

Do you need to have customers or even first revenue? - There is a lot of dialogue around the need to “bootstrap” early stage companies to the point where a product has been developed and commercially released. This is particularly true of social media, gaming and other online business companies. In seeking to access professional capital, it comes down to supply and demand. Professional investors will look to tangible indicators of success and validation of the business model in evaluating a company's prospects.

These might include website traffic, conversion rates, your ability to launch a beta and more. Without anything but an idea to show, very few companies get funded to any meaningful degree.

For more traditional "brick and mortar" companies, the ability to get to “proof of concept” through bootstrapping methods is much more difficult. It is also likely that the amount of all-in professional capital necessary to support a company in this category to an acceptable exit—including the amount of so-called “seed stage” funding—is substantially higher than for a social media or gaming company, for example. As a result, there may be a lower expectation that founders will be able to bootstrap to get to professional funding, but the emphasis will be commensurately higher on the other investment basics, including size of the market, likely market impact of the technology, barriers to entry, credibility of the management team and the like. As a result, the bar to funding for companies in this category is fundamentally as high.

Now’s a good time for startups: VCs are investing more money now than they have since the recession hit. But do you have to be in Silicon Valley to get the contacts, staff, and VC attention you need to build a venture-backed company?

There’s no doubt, Silicon Valley is frequently the first choice for startups. And there’s a reason why: 39 percent of 2010 venture capital dollars were spent there, according to the National Venture Capital Association and PricewaterhouseCoopers. But the second largest region is along the I-95 corridor on the east coast, which attracted $6.8 billion, or 31 percent in 2010. And there are several great places for venture-backed startups there.

The best place to start your particular business ultimately depends on the field you’re in, but clearly, it’s best to stick to the coasts, because that’s where the money is.

Since much has been written about Silicon Valley, let’s look at the major startup ponds on the opposite side of the country that VCs are fishing right now.

1. New York

Over the last five years, New York’s share of east coast investments has increased from 18.3 percent in 2005 to 33 percent in 2010, almost doubling. What has fueled this? Digital media and e-commerce. And how have those industries performed? Over the same five years, net internal rates of return in these sectors have been 29 percent, according to the Mid-Atlantic Venture Association. New York is on a roll.

2. Boston

Biotech, material sciences, clean energy and mobile. These industries are vibrant and have eclipsed the region’s hardware and enterprise software businesses for venture capital funding. With an abundance of universities and lab space, this town has always attracted young people with creative ideas. Its educated workforce is unrivaled, and the region has reinvented itself over the last decade.

3. Washington D.C.

The Internet’s backbone started here. It is no coincidence Network Solutions, PSInet, MCI/Worldcom, AOL, Nextel, Sprint, Verizon and Mobile365 all operated in our Nation’s Capital they were dependent on changing telecommunications regulations. A decade later, we’re seeing a revival of the DC tech scene, built on the very Internet backbone that was created here.

This is the place to be if you’re in the business of cybersecurity: DC is a strategic hub, and that will only intensify as political uncertainty continues abroad. Ventures with affiliations to government agencies like DARPA, NSA or the CIA will do well here too.

Finally, look no further than the White House: the government is making efforts to be entrepreneur-friendly. Just weeks ago, the President joined forces with AOL co-founder Steve Case to spearhead Startup America, an initiative to spur investment in innovative American startups.

DC is emerging as a hotbed for startups and investment firms.

I'm starting to hear this for my numerous conversations with people.  Is this another internet bubble? The short answer is NO.  There is no bubble forming around Silicon Valley or tech startups because white-hot companies like Twitter and Facebook are able to show they have fundamental value and are capable of making money.

There is no bubble at current moment. There are very successful Internet businesses being created that are growing very rapidly and are making a lot of pretax profit.  The biggest red flag VCs need to worry about is when valuations seem out of whack with what investors understand about what the company actually does.  

We need to worry about a bubble when there are businesses being valued at sky high prices with no underlying fundamentals. Currently, any type of sky-high, bubble valuation dynamic is the exception and not the rule in the venture market.

Right now, VCs are most likely to be turning their attention to three main areas of growth as Silicon Valley continues to be an incubator for rapid fire innovation and increasing competition. Everything that can be 'socialized' will be. Social media is working its way into the enterprise and the mobile app experiences at a rapid pace. The consumer experience is being socially optimized now. The second biggest area is location-based services. All this data is going to be geographically located. Third is the mobile experience. The mobile world is growing leaps and bounds as the tablet market heats up and the iPhone/Android war continues.

Venture capitalists came raging back in 2010, putting $26.2 billion into 2,799 venture deals. That's up 11 percent from 2009 and a major sign that formerly wary VCs have begun to come off the sidelines, according to a study by Dow Jones VentureSource. The data also showed that 2,636 deals took in $23.6 billion, with the fourth quarter alone raising $7.6 billion through 735 deals a 6 percent increase in capital invested from the same quarter a year prior. 

The numbers backed up a report from Thomson Reuters last week that showed VCs spent the most money in 2010 since 2007. VentureSource said that while healthcare and IT initially lead the charge, they are not currently driving growth, because investment in business technologies, consumer solutions and energy companies "gained the most traction" in 2010. IT companies raised $7.2 billion from 889 deals in 2010, a jump from the $6.7 billion put into 858 deals in 2009. Software, too, did well, becoming the only IT sector to see an increase in both deal activity and capital invested, with 608 deals raising $3.8 billion. 

However, VCs weren't necessarily spending the kind of cash they did before the credit crisis, a drop that has recently been part of a major debate about how ready the venture capital community is to jump wholeheartedly back into large deal sizes generally. The median deal size for 2010 was only $4.4 million, a drop from the $5 million median in 2009. Still, interest in Web companies did help growth overall, said VentureSource, as "sizable cash infusions" for maturing Web companies boosted deals in other sectors. 

The study said this is most likely because VCs are now pursuing strategies more akin to growth equity investing than traditional venture capital with some of their maturing Web companies. Companies like Groupon, Zynga and Facebook are generating hundreds of millions of dollars in revenue so VCs don't need to exit quickly," said Scott Austin, editor of Dow Jones VentureWire. "Instead, they are growing these companies through acquisitions of technology and talent as well as business development, which can require sizable cash infusions. 

VCs are also still waiting longer to invest, with later-stage deals accounting for 40 percent of the year’s deals and 61 percent of total capital raised in 2010. It was a minor bump up from 2009, when later-stage deals made up 38 percent of deals and 55 percent of capital raised overall. 

Seed- and first-round investing remained largely unchanged, comprising 36 percent of deals and 18 percent of capital invested during 2010, a barely noticeable difference of the 35 percent of deal activity and 19 percent of capital raised year-over-year.

Venture titan John Doerr: Cleantech’s “Netscape moment” coming next year.

Cleantech investing may have fallen by 30 percent in the past few months, but legendary venture capitalist John Doerr said that he’s still optimistic about backing startups in this field.

Doerr, whose investments include Internet giants like Google and Amazon, said that looking at the amount of money invested doesn't indicate the quality of companies after all, during the periods of peak venture investment, many "inconsequential" Web startups got funded. On cleantech in particularly, Doerr said the industry is waiting for its “Netscape moment”. In other words, the industry needs a big, successful initial public offering that will “capture the imaginations of investors and consumers alike.”

“I think we’re very likely to see that next year,” Doerr said. (Some cleantech companies, namely Tesla and A123Systems, have already had successful IPOs, but their stock price subsequently dropped.)

Doerr was speaking at VentureBeat’s GreenBeat conference on the Stanford campus. In the past few years, Kleiner Perkins Caufield Byers (where Doerr is a partner) was largely seen as refocusing on cleantech, but it made headlines in the past few months around its mobile and social investments. Still, Kleiner is definitely “open for business” in cleantech, Doerr said, and it invested in six clean energy companies during the past year.

This is a tad random but in the late 90's through 2000, it was a cake walk for an entrepreneur in Silicon Valley to get VC funding. They just needed to know how to spell Java, have a few fancy Powerpoint slides, and impressive statistics put together by an Analyst that's never done anything in their respective field working purely with subjective data in a world that will never exist. That was our version of resourcefulness.

Fast forward... 2005-2010 have been very tough times for entrepreneurs. There are plenty of powerful ideas, real products, and markets with potential, yet pockets remain tight. There are many reasons for this, for one there's no longer the IPO pot of gold at the end of the rainbow. But I think the other reason is that many of us from the dot com days and this generation never learned to be truly resourceful.

Kimmie Weeks from Liberia, founder of Youth Action International, which focuses on raising global philanthropy in youths, kicked off the Kellogg Innovation Network Global Summit with a wonderful talk. She discussed a program they launched giving women in Sierra Leone looms to make clothes and drive self-sufficiency. One interesting quote was "when you have people who get by on a dollar a day, imagine what they can do with small amounts of money you give them? They are resourceful and not to be only pitied." It reinforces how one needs to see the positives tied to all negatives

You see this resourcefulness in the entrepreneurial world with both bootstrapped companies and some of the small grants given by accelerators. This Spartan DNA is the number one predictor of success in portfolio companies. It shows both their respect/understanding of dilution and their innovativeness and resourcefulness.

Okay, that was all over the place. Here's the point, because we live in a world full of wealth, we take a lot for granted, and more times than not, entrepreneurs are not resourceful to the extent that they need to be. Take some simple lessons from the less fortunate and you may find the path to success is staring you right in the face.

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.