Post Category → Venture Capital

How Angels & Seed Funds compete with VCs

TL;DR: The emerging “seed ecosystem” of angel groups, seed funds, and accelerators now provides local startups a viable path to seed funding, and eventually “going national,” w/o having to prematurely commit to a Series A lead.  That has dramatically reduced the leverage that local institutional funds once had over their local ecosystems.

Background Reading:

Once upon a time, startup ecosystems (if they could even really be called that) outside of Silicon Valley had only a handful of local VC funds writing checks. Without AngelList, LinkedIn, Twitter, Accelerators, good videoconferencing, and the many other recent developments that have reduced geographic friction in startup capital flows, those funds effectively “owned” their cities, including most of the startup lawyers in those cities; which often resulted in harsh terms and aggressive behavior. For more on this, see: Local v. Out-of-State VCs.

Raising “angel” money in that era often meant needing close connections (family, friends, professional) to very high net worth individuals willing to make big bets on you until you were ready for one of the few local funds to take you under their wing. If you were one of those lucky few chosen, those local VC funds would then, once they were out of their own capital, show you off to one of their trusted out-of-state growth capital funds.

The pipeline was narrowly defined, and choice was minimal: local angels (or friends and family), then local VC, then out-of-state growth capital.

Times have changed.

Today, angel groups are much bigger, organized, and collaborative across city and state lines. Seed funds – which weren’t really even much of a concept a few years ago – will write checks of a few hundred thousand to a few million dollars for rounds that may have been called Series A 3-5 years ago, but are now “seed” rounds. Prominent accelerators have themselves joined the mix, writing their own 6-figure checks and serving as valuable filters / signaling mechanisms to reduce the search costs of investors.

This “seed ecosystem” of organized angels, flexible seed funds, and accelerators has not only increased the amount of “pre-VC” capital available to startups, but very importantly, it has significantly reduced the leverage that local VC funds have over their local startup ecosystems. 

As I wrote in Optionality: Always have a Plan B, sunk money has very different incentives from future money. A seed fund/angel that has mostly maxed out the amount of capital it can fund you with has every incentive to help you find a great Series A lead at a great valuation; they are quite aligned with the common stock. They want a higher valuation and better terms for the existing cap table, just like you do, because they are being diluted too.

However, a VC fund that wrote you a small seed check but wants to lead your Series A has very different incentives. The “seed ecosystem” wants to maximize your Series A options, while a VC fund wants to minimize them, until it gets the deal it wants.

Foreign capital will usually require some heightened level of de-risking or credible signaling before it will cross state lines. It’s much less risky to rely on my local referral sources, and “monitor” my portfolio where I can drop in by the office whenever I need to. If I’m going to write a check a thousand miles away, I need a little more reason to do so. In that regard, it’s well-known that there is a “flipping” point beyond which the pool of capital available to a startup moves from being mostly local to much more national: that point is somewhere between $500k-$2MM ARR (it used to be higher, and can be even lower if you have a strong network). 

Historically, reaching that flipping point was almost impossible without local VC, and this effectively kept startup ecosystems captive to their local funds. The new seed ecosystem, with its ability to often fund 7-figure rounds all on its own, has changed that. Now, if a desirable startup wants to, it can often raise $1-2MM in seed capital without taking a single traditional VC check, then use that to hit the “flipping” point, after which the number of VCs it can talk to goes up considerably. 

Of course, this dynamic is not always so clean cut.  More progressive VCs have wisely developed symbiotic relationships with this seed ecosystem for the obvious reason that it can serve as a pipeline when startups are ready for bigger checks. That is a smart move. What we’ve also seen is that large VCs are playing much “nicer” in seed rounds than they used to, as an acknowledgement of their reduced control over the market. Years ago you much more often saw VCs condition a $250K or $500K check on a side letter giving them the right to lead your Series A. That is increasingly becoming an anachronism, and for good reason.

At the same time that AngelList, accelerators, LinkedIn networks, and other signaling / communication mechanisms for startups are giving foreign capital more “visibility” into other ecosystems, allowing it to invest earlier and more geographically dispersed, the emergent seed ecosystem is also increasingly allowing local startups to “go national” without having to commit themselves to a particular VC fund. The obvious winners in this new world are entrepreneurs and investors willing to be open and flexible with how they fund companies. The losers are the traditional investors – particularly those who used their old leverage to squeeze founders – who haven’t understood that the old game is gone, and it’s not coming back.

Optionality: Always have a Plan B

TL;DR: Always build some optionality into your startup’s financing strategy. Failing to do so will overly expose you to being squeezed by sophisticated players who can see how dependent you are on them.

Background reading:

The below is a fact pattern that we have seen happen with several of our clients. It will provide some context for why the point of this post is so important.

Company X has raised a decent-sized seed round, which includes several angels as well as a “lead” VC; though that VC is not on the Board. The Company knows that it will run out of funds in 3 months if it does not raise more money, and it has been in regular communication with the VC about that. The VC reassures the founders that they will “support” them with a new bridge round. A month passes, and the founders ask about the bridge. “Don’t worry, we’ll cover you” is the response. Then another month passes, with more reassurances, but no money. Then 2 weeks before their fume date (the date they’ll miss payroll), the VC drops a term sheet with very onerous terms, including a low valuation, and mandated changes to the executive team. The VC makes it clear that they won’t fund unless those terms are accepted. The founders panic. 

Before we dive in, there are a few important points worth making about this situation. First, it was clear every time that it has come up that the bait-and-switch dynamic was planned by the lead investor. They paid very close attention to the exact date that the Company would run out of funds, and timed the “switch” to deliver maximal pressure. Second, the regular “reassurances” provided to the founder team were calculated to discourage them from using their time to find other funding sources. Third, the best way to avoid investors who engage in this kind of “below the belt” behavior is to do your diligence before accepting their check; see: Ask the Users. 

Always have a Plan B.

A startup’s ability to avoid being burned by the above behavior depends on its level of strategic optionality.  Optionality means strategically avoiding a situation in which you have no choice but to depend on one investor/investor group for funding. This is very different from not committing to certain lead investors as your main funding sources. “Party rounds” are what you call financings where literally every investor is a small check. The end-result of a party round is that no one has enough skin in the game to really support the company when it hits a snag. You really are just an option to them. 

I strongly support having true lead investors writing larger checks in your rounds, because they will usually provide far more support than just money. And if you’ve done your homework and have a little luck, they’ll never even think about engaging in the kind of behavior described above. But in all cases the best way to maximize the likelihood of good behavior is to ensure a right of exit if someone decides to cross a line. I always try to work with “good people.” But no good strategist builds their life or company around the full expectation that everyone will be good. 

Lead fundraising yourself.

CEOs sometimes believe that they are doing themselves a favor by letting a lead investor do their fundraising for them – coordinating intros, negotiating terms with outsiders, etc. – so they can “focus on the business.” It often backfires. Angels and seed funds whose money has been sunk into the company, and who aren’t planning on writing larger checks in the future, are usually quite aligned with the founders/common stock in helping raise a Series A or future round. They’re being diluted just like you are.

But a VC fund with plenty of dry powder and a desire for better future terms is significantly mis-aligned with everyone else. Watch incentives closely.  Founders/the lead common holders should maintain visibility and control in fundraising discussions, with trusted independent advisors close by. 

Start early, and don’t tolerate unnecessary obfuscation and delays. 

Do not wait until a few weeks from your fume date to start communicating with investors for new funds. If someone says they will support you, great: when, and what are the terms? You want to know them now, not later. “We will support you” means very little without knowing what the price will be.

Expecting things to happen in a few days is unrealistic, but a month or more of delays is usually a sign that someone is playing games, and it’s time to pull the plug. No serious fund worth working with is that busy.

Build “diversity” into your investor base.

The power dynamics in a company are very different when all the major investors have strong relationships/dependencies with each other, and communicate regularly, relative to when various players come from different “circles.” Geographic diversity – meaning taking money from various cities/states – is a good strategy to avoid unhealthy concentration of power among your investor base. Also, diversity of investor types – angels, seed funds, institutionals, strategics – will ensure that your investor base includes people with differing incentives/viewpoints, which reduces the likelihood of collusion. 

In the scenario where a bad actor has tried a “bait and switch” on a founder team, a group of angels willing to write quick checks for an emergency bridge, or a lender offering a credit line, can be enormously valuable to relieve pressure and build time to correct course.

Contracts matter. A lot. 

Every commitment you make to investors requiring their approval, or guaranteeing their participation, in future rounds can have material strategic implications for how much optionality you have. Protective provisions matter. Super pro rata rights and side letters matter.  When you see dozens of financings a year, you regularly see how commitments made at seed/pre-seed stage play out over years and seriously affect the course of fundraising.

Good lawyers well-versed in the ins and outs of startup financing will go much further than just plugging some numbers into a template, which software can do.  They’ll dig deep on how the specific terms you’re looking at will impact the company, in its specific context, and how much room there is to stay within “market” norms while still keeping flexible paths open for the future. That’s, of course, assuming they aren’t actually working for your investors.

Make money, and own your payroll.

The ultimate optionality is being able to run on revenue if you need to; being “default alive” in Paul Graham’s words. Yes, you may grow slower than you’d like, but growing more slowly is always lightyears better than being forced into a bad deal.

Every salaried employee on your payroll raises the revenue threshold needed for your company to be default alive. Ensure that every member of your roster is essential, and that there aren’t redundancies that could be addressed by asking someone to be more of a generalist. And don’t let an institutional investor pressure you into hiring a high-salaried professional executive unless you have a clear strategy for how you are going to afford them, because, yes, that is another way that they can add fundraising pressure.

Stay in control of your fundraising. Start discussions early, and don’t tolerate delays. Build diversity of geography and incentives into your investor base. Let your lawyers do their actual job. And finally, watch your payroll closely. Following those guidelines will minimize anyone’s ability to squeeze you, and your investors will then act accordingly.

ICOs and Crowdfunding

TL;DR: Crowdfunding failed at fulfilling its goal of unlocking a massive new source of unprofessional capital for startups. Regulated, fully legally compliant token offerings (not the mostly unlawful ones done historically) may succeed where crowdfunding failed.

I am not going to spend any time in this post explaining or defining ICOs or Crypto. I know most SHL readers are familiar with them and, if not, a quick google search will do the job.

There was a time, I would say between 2016 and some of 2017, during which ICOs/Token Offerings were certainly on our firm’s radar as potential fundraising mechanisms for startups, but we were highly skeptical of their legal compliance; for reasons that the SEC and other regulatory agencies have now made clear. It is safe to assume that the vast majority of crypto tokens today are securities under U.S. law and that, just like a convertible note or SAFE, U.S. companies issuing them need to find some way of staying within the applicable legal boundaries. Forming some offshore entity to try to get around the securities law issues (tax issues are a separate matter) is playing with fire, and don’t expect us to play with you.

On top of the obvious legal issues, our skepticism of ICOs was supported by the fact that most of the teams we saw pursuing ICOs were, shall we say, not the “caliber” we like to work with. It was clear that in the early days the ICO space had an adverse selection problem: putting aside the small number of stellar teams building unicorns with legitimate reasons for being in crypto, the significant majority of the projects pursuing ICOs were simply the rejects of the conventional angel/seed fundraising world.

In other words, my skepticism of ICOs paralleled to a large extent my skepticism of “crowdfunding.” While the pre-sale kind of crowdfunding (Kickstarter, Indiegogo) has clearly been impactful, securities crowdfunding was pitched to the world as opening the floodgates of this vast world of middle class capital just dying to get into hot startups. It didn’t work out that way.

First, the middle class in America is trying hard to afford college, housing, and healthcare, and have some kind of retirement in place. It never was dying to invest in startups; beyond the occasional “man I wish I’d gotten into Facebook” hindsight remark. Second, average investors aren’t stupid, and are well aware that most crowdfunding sites are not full of A-level teams, but are often packed with the teams rejected by professional angel and seed investors. Startup investing in general is extremely high-risk even for professionals. Given the adverse selection issues, it’s orders of magnitude riskier for every-day investors seeing only the bottom 20%. Given all of this, the supply of capital simply isn’t there.

As of today, the impact of non-accredited investor crowdfunding on the general startup ecosystem has been marginal, at best, and I don’t see that changing much in the near future.

But… over the past year or so I’ve come to believe in the possibility that legally compliant (regulated) ICOs/token offerings may have a legitimate shot at realizing crowdfunding’s unfulfilled dreams. Here’s why: 

A. Unlike the average middle class American, the newly created “crypto rich” have (i) significant disposable income and, (ii) from the simple fact that they got into crypto early, tend to be much more tech literate and interested in early-stage projects than the average investor. They trust their ability to judge early-stage technology, and are therefore willing to invest in risky projects.

B. Regulatory agencies, instead of pounding the industry into non-existence by banning everything, have instead taken a more measured approach by going after the most egregious bad actors, but also extending an olive branch to those interested in finding fundraising mechanisms compatible with a valid legal framework.

C. Crowdfunding platforms, eyeing an opportunity to tap a market that actually exists, are pivoting toward supporting ICOs/token offerings that work within the legal framework created by the crowdfunding movement. That framework certainly adds some friction around how the classic wild-west “easy money” ICOs have historically been conducted, but it is significantly more greased (and could be greased further) than conventional startup investing; including “mini IPO” regulations that were previously passed that could allow tokens to be traded openly in a way that doesn’t bust securities laws.

D. The average caliber of teams we see approaching us with an interest in a token offering has gone up significantly. We have a few clients actively working on token offerings fully compliant with securities laws right now.

E. While most token offerings until now have involved utility tokens that actually serve a function in the operation of the company’s technology (which limits the types of companies that can offer them), the infrastructure is being built for “security tokens” that allow almost any asset – including shares in a corporation – to be sold and traded much like utility tokens.

I was quite skeptical of non-accredited “crowdfunding” generally. I was also deeply skeptical of the easy-money ICO boom that made headlines over the past few years. But I’m becoming cautiously optimistic that the infrastructure and demand is coming for a legally compliant ICO/Token Offering wave that could win where crowdfunding lost. The next 2 years will be interesting to watch.