As Ive blogged before, the market conditions are driving early-stage investment capital back to basics. VCs have always fostered great entrepreneurs with great ideas. But the model has changed profoundly and permanently (see my earlier blog: Why the VC Investment Model is Broken).
So how do great entrepreneurs build their business in 2009? Professional Angels.
Most professional angels are members of angel groups. (See http://www.angelcapitalassociation.org/ for the largest trade association.) In these groups, members generally act as individuals for their own investment, but team on the key aspects of deal sourcing, deal screening, due diligence, investment pooling to ensure that there is sufficient capital overall for the company, and then monitoring the deal afterwards (including board representation). In this regard they act like an early-stage VC fund, but the decision making is on an individual basis. In the Seattle Alliance of Angels (www.allianceofangels.com) these groups have grown from an average size of about 2-3 investors to 6-12 investors in the last 4 years. Such organization makes life easier for the entrepreneur, since they only need to negotiate with one person (the lead investor) and they get more money. From the angel investor point of view, there is more leverage on the deal, more shared due diligence, and the knowledge and wisdom that comes from the entire group.
Professional angels in groups also behave differently than the individuals. Most, if not all, now reserve for follow-on rounds (even though the entrepreneurs business plan might call for this being the only round of financing required), just as a VC would do. For example, the Alliance of Angels did 44 transactions in 2007, with 15 being new companies; 29 were therefore follow-on rounds. In 2008, this pattern continued with the AoA doing 36 investments, where 19 were new, so 17 were follow-on. This behavior allows an angel group to carry a company through from inception to cash flow positive in many cases. No VC or institutional funding is required for this sort of deal. This is a new phenomenon that will help shape the market going forward.
The implications of this are the following:
1) Angel groups and funds can and do provide the capital needed for a capital-efficient company to make it to cash flow positive.
2) Entrepreneurs and investors are positioned for more rapid exits, since the valuation needed for a successful exit is often much less. If a startup takes in VC money, it will often require an exit over $150M for a successful exit (http://blog.drosenassoc.com/?p=7). These exits are rare and the company often either fails or is sold for the liquidation preference, so the entrepreneur does not have a successful outcome. On the other hand, if the total capital is low, even an exit of $20-40M can be hugely positive for both investors and entrepreneurs.
3) Companies can now be built in a more capital efficient way. With better tools, open source, Amazon Web Services, stimulus money, SBIR grants, etc. small amounts of capital can now go a long way.
Professional angels are filling the void created by VC funds getting larger and startups being more capital efficient.