Post Category → Seed Rounds

Angel Investors v. “Angel” Investors

TL;DR: The term “angel” investor has connotations that in reality don’t apply to a significant portion of early-stage seed investors outside of Silicon Valley. Historically, angel investors were very wealthy individuals who’d take big, almost irrational (from a risk-adjusted perspective) bets on entrepreneurs for reasons that go well-beyond a profit motive. Many “angels” that you’ll encounter as an entrepreneur, however, think and act in a much more self-interested, conservative manner; much like venture capitalists, but with smaller checkbooks. Both types are crucial to startup ecosystems, but knowing the difference is still important.

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One of the core reasons behind this blog’s existence is that the majority of legal/fundraising advice available to startup entrepreneurs comes from places (like Silicon Valley or NYC) that are dramatically different (in terms of access to capital and key resources) from the environments in which most tech entrepreneurs find themselves. That doesn’t mean at all that SV or NYC advice is bad or wrong. On the contrary, much of it is very very good and founders who look only to local advice will screw themselves – see: The Problem with Localism. But founders also need to understand the mismatches between the advice/culture they’re exposed to on the most popular podcasts, blogs, etc., and how things tend to work for normals.

One important area where I see the disconnect arise is in founders’ expectations in interacting with “angel” investors. The typical “angel” investor that you encounter in Austin, Houston, Atlanta, Dallas, or Miami does not look, think, or act like what Silicon Valley people have historically referred to as “Angels.” 

Classic Angels

While the full origin of the term “angel” investor goes beyond this post, in general very early stage investors were very wealthy individuals who, in addition to other activities, wanted to “give back” to the business community by making bets on promising entrepreneurs that no one else (rational) would be willing to make. Hence, their investments were “angelic.” While this doesn’t mean at all that Angels didn’t scrutinize their investments, or that that they acted completely out of charity (hardly), the term absolutely has (correct) connotations of motives that are much broader than just making a great return.

These classic “Angels” were wealthy enough that writing a $100K or $200K+ check barely moves their needle, and so they could take the risk of investing in a company with little more than a very promising team and an idea, and perhaps the very early beginnings of a product. If it fails, NBD. They’re doing it for the relationships, the excitement, and the chance at supporting something new.  I often see founders take very early money from investors that fit the classic “Angel” profile, but those relationships take a long time to build. They don’t spark over a pitch contest or business plan competition.

Anyone who says there isn’t enough money in Texas/the South is painting with way too broad of a brush. There’s tons of money floating around here and elsewhere. The core difference is that in Silicon Valley, the true capital-A “Angel’ money was created in tech, and therefore much more easily flows back into early-stage tech (because the Angels trust their judgment on tech teams/companies). Outside of that environment, much of the ‘Angel’ money comes from other industries (like Energy, Healthcare, etc.), and so much more relationship-building, selling, and (cultural) translation is needed to convince it to go into a tech startup.  Great t-shirts and a pitch deck won’t get you there.

Most “Angels”

In most other tech ecosystems (outside of SV), when people speak of “angel” investors they are often talking about successful individuals who, while willing to take on the risk of early-stage seed investment (which is great), are not so wealthy and altruistic that they’ll barely feel losing $100K-$200K.  That means that most “angels” seen in non-SV ecosystems are much more conservative in how they pick their investments (and will therefore have higher expectations), because to many of them angel investing really is about making a great financial return.

Classic Angel investors were/are generally very wealthy senior executives and business people with net worths well into 8 figures and above, who will bet on team, vision, and minimal traction (if any); so very early stage. The majority of “angels” that entrepreneurs encounter in their own ecosystems, however, come from broader backgrounds (lawyers, doctors, real estate, business owners, etc.) and are affluent/comfortable, but not quite the 0.1% (their angel investments are material to them), and they”ll often want to see clear customer traction, revenue, and a more mature product; and a lower valuation. 

Of course, there are far more “angels” than Angels, so I’m not suggesting at all that the more conservative, self-interested nature of typical “angel’ investors is bad or a problem. They are crucial to startup ecosystems. I’m not running around writing $100K checks on team+vision either. But the distinction between the two categories often gets lost on first-time entrepreneurs, with negative consequences.

You likely need a Pre-Angel Plan

So the net result of the above is that tech entrepreneurs outside of the most dense ecosystems like SV and NYC encounter much higher expectations from “angels,” and therefore (and I’ve written this in prior posts) pre-angel money, what is typically called “friends and family” money, is often essential to building something attractive to “angels.” If I encounter a founder team planning to start a company without a viable path to $50K-$200K in initial funds, either from their own savings, friends and family, or a classic Angel, that is very often a red flag. Not game over, but it is a concern. 

It’s certainly been done before, especially when the founder team is very self-contained and willing to work for nothing until there is real traction, but most companies will never make it to the “angel” investment stage (product, traction, revenue) without either bootstrap/F&F funds, or a classic Angel investor willing to make a big bet. Accelerators have helped with this issue by (often) being the first non-F&F money in and serving as a valuable signal to “angels”, and they deserve credit for that, but even getting to a point where you’re attractive to a top accelerator often takes some real cash.

In short: most angel investors are much more conservative, and have higher expectations, than the term “angel” suggests, because they’re in a different category from the classic wealthy “Angel” investors that give the term its meaning. Be mindful of that fact, and prepare for it in your early-stage fundraising strategy.

Did you get a “good” valuation?

TL;DR: What a “good” valuation is depends highly on context: geography, industry, timing, size, team experience, value-add of money, control terms, and a dozen other variables. Be careful using very fuzzy guidelines/statistics, or anecdotes, for assessing whether you got a good deal. The best valuation for your company is ultimately the one that closes.

VC lawyers get asked all the time by their clients to judge whether their financing terms are good, fair, etc; especially valuation. And that’s for good reason. There are very few players in ecosystems who see enough volume and breadth of deals to provide a truly informed assessment of a financing’s terms. Executives have usually only seen their own companies. Accelerators see only their cohort’s. Most advisors/mentors have even more limited visibility.

But VC lawyers/firms with well-established practices see deals that cross geographic, industry, stage, etc. boundaries.  In addition to a firm’s internal deal flow, there are third-party resources that can be subscribed to with data on VC valuations across the country and the world. Those resources tend to be expensive (5-figure annual subscriptions), and only firms with deep VC practices will pay for them. Given how much you’ll be relying on your lawyers for advice on your financing terms (for the above-mentioned reasons), ensuring that they are objective (and not biased in favor of your investors) is crucial. 

The above all being said, founders should understand that determining valuation at the early stages of a company (seed, Series A, B) is far far more an art than a science. It is for the investor making the investment, and it is for the people judging whether the terms are “good.” That’s why relying on broad metrics like “median Series A valuation is X” is problematic; there are simply too many variables for each company that could justify deviating from the median, in either direction (lower or higher).

What some people call a seed round, others might call a Series A. Some companies raise a Series A very early on in their company’s history because the nature of their product requires serious capital expense to even get to early milestones. Other companies bootstrap for a decade and only use a Series A as true growth capital (the way others would use a Series C or D). I saw a $150MM ‘Series A’ once. I’ve also seen $500K ‘Series A’s. And everything in between as well. So whenever someone asks me “what’s a good Seed or Series A valuation?” the answer has to start out with: “it depends.” 

Below is a break-down of the mental analysis that I might use in assessing a company’s valuation. Remember, it is an art, not a science. There are widely varying opinions here, and this is just one of them. Consider it a set of suggested guidelines, not rules.

1. What was the last valuation a professional investor was willing to pay, and what progress has been made since then?

The easiest answer to “what is X worth?” is “whatever price someone was willing to pay.” While not entirely helpful in the VC context, it certainly is relevant. If you’re doing a Series A and you have institutionals who invested in a convertible note at a $5MM cap a year ago, the obvious question then is “how much progress has been made since then?” This, btw, is why it’s dangerous for companies to set their own valuations without a true market check from professional investors. Your earlier valuations will influence your later ones.

2. What city are you in?

Location. Location. Location. One of the strongest determinants of valuations is the density of startup capital in the city your company operates in; because density means competition. Silicon Valley valuations are not 2-3x those of the rest of the country because the VCs there are just nice guys who are willing to pay more. It’s a function of market competition. SV has the highest valuations. NYC follows. And then there’s the rest of the country, with variations by city. Austin valuations are generally higher than Atlanta’s, which are generally higher than Houston’s or Miami’s. General deal terms are also more company-friendly where there is more investment density.

While the entire concept of “founder friendly” investors does have an important moral/human dynamic to it, people who play in the space enough know that at some foundational level it is a form of self-interested brand differentiation. The ‘friendliest’ investors are the ones in the most competitive, transparent (reputationally) markets. Why take our money over theirs? Because we’re ‘founder friendly’… which can mean a whole lot of things; some of which are relevant, and others which are nonsense.

Yes, online networks are breaking down geographic barriers and you are seeing more capital flow between cities/states, but the data is still crystal clear that if a Silicon Valley VC is investing in an Atlanta or Austin company, they are going to want to pay something closer to Atlanta or Austin (not SV) prices. Much like all the Ex-Californians buying up Austin homes, they likely will pay slightly above the local market (and in both cases, it pisses off local buyers), but not much. 

3. How much is being raised?

Valuations can (and often do) vary widely between markets, while the actual dilution that founders absorb doesn’t vary as much. How is that? Because founders in markets with higher valuations raise larger amounts of money, and founders in markets with lower valuations raise smaller amounts of money; in each case getting the VCs/investors to their desired %. A $1MM raise at a $4MM valuation produces the same dilution as a $5MM raise at a $20MM valuation.

You should never close any round without modeling (lawyers often help here) the actual dilution you are going to absorb from the round, including any changes required to your option pool. Many investors focus first on their desired % and then back into the right valuation and round size. Smart founders should focus on %s as well. It’s not intuitive; especially if you have multiple rounds involved.

4. Who are the investors?

Value-add, known-brand institutional VCs and professional angels that will be deeply engaged in building your company after the check hits are (obviously) worth a lot more than investors who just bring money. And they will often price themselves accordingly (lower valuations). Some money is greener.

Diligencing the valuations your specific investors were willing to pay for their past investments is a smart move. Again, it still requires discussions about the differences between companies, but it can help address any statements like “we never pay more than $X MM for Series A.”

5. What are the other terms?

A $4MM valuation with a 1x non-participating liquidation preference looks very very different in an exit from a $6MM valuation with a 2x participating liquidation preference. So does a $3.5MM valuation with investors getting 1 out of 3 Board seats v. a $5MM valuation with them getting 2/3. The non-valuation terms matter. A lot. Juicing up valuations by accepting terrible ‘other’ terms gets a lot of companies in trouble. 

6. Other Business-Focused Variables

  • What are valuations within this specific industry looking like over the past 12 months?
  • What are the obvious acquirers paying for companies they buy?
  • Where is the company in terms of revenue? Revenue-multiples generally don’t have a place in early-stage, but a $25K MRR v. $300K MRR absolutely influences valuation.
  • Any serial entrepreneurs on the team? Good schools? Other de-risking signals?
  • What’s growth look like?
  • Size of market?
  • etc. etc. etc.

Obviously, multiple term sheets are a great way to have a very clear idea of where your valuation should be, but in most non-SV markets that is a privilege bestowed on a small fraction of companies.

Take-homes:

A. If your friend’s startup got X valuation for their Series A round, that can be totally irrelevant to what valuation you should get,

B. Other terms of the financing matter a lot too, as well as who is delivering them, and

C. If you have in your hand a deal that isn’t exactly at the valuation you wanted, remember that there are thousands of founders out there who got a valuation of $0.

Over-optimizing for valuation can mean under-optimizing on a host of things that matter far more for building your business. Get the best deal that you can actually get, given your business, location, and investors, and then move forward. And ignore the broad market data, particularly the Silicon Valley data, that isn’t relevant to your own company.

The Best Seed Round Structure Is the One that Closes

Nutshell: People with strong opinions can argue endlessly about whether founders should be structuring their seed rounds as convertible notes/SAFEs or equity. The problem is that the optimal structure for any type of financing is highly contextual, so anyone offering absolutes on the subject should just “Put that Coffee Down” in the Glengarry sense, before they hurt someone.  The X round that closes is better than the Y round that doesn’t.

Complete standardization of startup financing structures has been a pipe dream for over a decade. Every once in a while someone will produce a new type of security, or flavor of an existing security, and proclaim its superiority. The problem, of course, is very much like the problem faced by any product whose founders hopelessly believe that it will achieve market dominance on technical superiority alone: distribution channels, inertia, and human idiosyncrasies.  In the end, a financing is the act of convincing someone, somewhere, to give you money in exchange for certain rights that they value enough to close the deal.  Values are pesky, subjective things that don’t do well with uniformity.

Outside of Silicon Valley and a very small number of other markets, the people writing the early checks are usually not all rich techies in jeans and t-shirts debating the latest startup/angel investing trends on twitter. Even in Austin they aren’t. They’re successful individuals with their own backgrounds, culture, and values, and very often won’t give a rat’s ass about a blog post saying they should suddenly stop using X security and use Y instead.

So let’s start with the core principle of this post: The Best Seed Round Structure Is the One that Closes. That means priority #1, 2, and 3 for a group of founders is to get the money in the bank. Only from there can you work backward into what seed structure is optimal.

SAFEs are better than Notes? Many non-SV investors don’t care.

This was the same reasoning in a prior post of mine: Should Texas Founders Use SAFEs? To summarize my answer: unless a TX founder is absolutely certain that every investor they want in the round will be comfortable with a SAFE, it’s usually not worth the hassle, and they can get 99% of the same deal by just tweaking a convertible note. Yes, a SAFE is technically better for the Company than a convertible note, and YC has done a great thing by pushing their use. But the differences are (frankly) immaterial if they pose any risk of slowing down or disrupting your seed raise. Here’s what a conversation will often sound like between a founder (not in SV or NYC) and their angel investor:

Angel: Why do we need to use this SAFE thing instead of a familiar convertible note? I read the main parts and seems pretty similar.

Founder: Well, it doesn’t have a maturity date, in case we don’t hit our QF threshold.

Angel: So you’re that worried about failing to hit your milestones and hitting maturity?

:: long pause::

Put. That Coffee. Down.

Debt v. Equity? Do you really have a choice?

There are so many blog posts outlining the pluses and minuses of convertible notes/SAFEs v. equity that I’m going to stay extremely high-level here. The core fact to drive home on the subject is that the two structures are optimized for very different things, and that’s why people debate them so much. Your opinion depends on which thing you value, and that will depend on context.

Convertible Notes/SAFEs are built for maximal speed and flexibility/control up-front. Cost: Dilution, Uncertainty. You defer virtually all real negotiations to the future, save for 2-3 numbers, and note holders often have minimal rights. You can also change your valuation quickly over time, at minimal upfront cost, as milestones are hit. The price for that speed is you’ll usually end up with more dilution (because notes have a kind of anti-dilution built into them) and possibly more liquidation preference. See: The Problem in Everyone’s Capped Convertible Notes.  You’ll also pay a harsher penalty if your valuation goes south before a set of Notes/SAFEs convert than if you’d done equity from the start.

Equity rounds are built for providing certainty on rights and dilution. Cost: Legal Fees, Control, Complexity. An equity round is more inflexible, and slower than debt/SAFEs, but the key benefit is that at closing, you know exactly what rights/ownership everyone got for the money.  Those rights are generally much more extensive than what note/SAFEholders get. If the business goes south, or the fundraising environment worsens significantly, you’ll pay a lower penalty than if you’d done a note/SAFE. But for that certainty, you’ll pay 10x+ the legal fees of a note round (if you do a full VC-style equity round), and have 10x the documentation. That’s why you rarely see a full equity round smaller than $1MM.

Raising only $250K at X valuation and planning to raise another $500-750K at a higher valuation soon, before your A round, because you’re super optimistic about the next 6-12 months? Note/SAFE probably. Raising a full $1.5MM round all at once that will last you 12-18 months, with a true lead? Probably equity.

Seed Equity is a nice middle ground, but if your investors won’t do it, it’s just theoretical. Series Seed, Series AA, Plain Preferred, etc. Seed Equity docs are highly simplified versions of the full VC-style equity docs used in a Series A. They are still about 2-3x the cost of a convertible note round to close in terms of legal fees, but dramatically faster and cheaper than a full equity set. They are a valuable middle ground for greater certainty, but minimal complexity and cost.

But after pondering the nice theoretical benefits of seed equity, we’re back to reality: will your seed investors actually close a seed equity deal? I can’t tell you the answer without asking them, but I can tell you that I know a lot of seed investors in TX and other parts of the country, including professional institutionals, who would never sign seed equity docs.

There is an obvious tradeoff in the convertible note/SAFE structure that has become culturally acceptable for both sides of the deal. Founders get more control and speed up-front, and investors get more downside protection and reassurance that in the future they will get strong investor rights negotiated by a strong lead.

With seed equity, investors are (like with Notes) being asked to put in their money quickly with minimal fuss, but without the downside protection of a note/SAFE, and with significantly simpler investor rights. Many seed investors see that as an imbalanced tradeoff. Whether or not they are right isn’t a question that lends itself to a single answer. It’s subjective, which means the Golden Rule: whoever has the gold makes the rules.  Can they beef up those protections in the next large round? Sure, but many don’t see it that way, and good luck ‘enlightening’ them when every delay brings more reasons for why the round may never close.

I think seed equity is great, and am happy to see founders use it as an alternative to Notes or SAFEs for their seed raise. But that doesn’t change the fact that for every 10-15 seed deals I see, maybe 1 is true, simplified seed equity. And those usually look far more like Friends and Family rounds – where the investors are so friendly that they don’t care about the structure – instead of a true seed with professional seed money.

When it comes down to getting non-SV seed money in the bank, most founders only really have 2 choices for their seed structure: convertible notes or a full equity round. If you’re lucky enough to get a SAFE or seed equity, fantastic. Go for it. But don’t let the advice of people outside of your market, with minimal knowledge of your own investor base, cloud your judgment with theories. When a team debates what type of product to build, the starting point isn’t which one is technically superior, but which one their specific users will actually pay for. Seed round structuring (like coffee) is for closers.