Angel Blog

The most important new data on angel investing comes from Robert Wiltbank of Willamette University and Warren Boeker of the University of Washington.

Robert Wiltbank is one of the world's pre-eminent researchers on angel and VC investment.

One of the fascinating aspects of this research is how VC investors affect the exits of angel-backed companies.

When I first saw this data, it leapt off the page at me.

This graph shows what the greybeard VCs and angels have known for a while. If your company has VC investors, they will reduce the probabilities of an exit that would produce a 1-5x return for the angels. That exit might have produced a 100x return for the entrepreneurs (because they paid much less than the angels for their shares).

Having VC investors does increase the probabilities of exits above a 5x return.

But there is no free lunch. The data shows that after a VC invests your chances of failing completely also increase significantly.

The other important factor, which unfortunately this data doesn't show, is that adding VC investors will also increase the time until a successful exit by about a decade.

This is an important message in my new book: "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs".

My previous post was about how it takes about a decade longer to exit in companies with venture capital investors.

That's much longer than most entrepreneurs and angel investors would guess.

Most VC funds are designed for ten year lifetimes. In actual practice, it takes significantly longer to actually exit the investments and shut down the typical IT VC fund.

The actual distribution of VC fund lifetimes is show in the graphic below.

The rest of this post explains why entrepreneurs often scare off angel investors by saying they are planning on a VC round.

My previous post showed how the math behind venture capital funds determined venture capital exit times. The post included a simple model to show what the median exit times really meant to entrepreneurs and angel investors.

That model illustrated how the decision to accept equity from venture capital investors statistically extends the time to exit for the angels by something around 12 years.

The graph below illustrates that happens to the time to exit, and probability of exiting, without and with venture capital investors. This graphic shows this from an angel investor's perspective. The times are even longer for the entrepreneurs and friends and family investors.

The rest of the post explains more. The full story will be available in my book: "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs".

My two previous posts described how venture capital investors will want to invest too much and exit only for very high returns.

Why are those bad things for entrepreneurs and angel investors?

They can be very bad because they make:

1. Venture capital exit times extremely long - much longer than you probably realize

2. The risk of actually achieving an exit increase dramatically

This post describes why these factors make venture capital exit times so long.

If the successful venture capital investments need to return 30x on average, or at the very least 10x, to generate a minimum VC return of 20% per year, how long will the VC fund have to hold the investment before an exit?

The graph below shows how many years it takes to generate a minimally acceptable VC fund return from the winning investments.

Some companies will create increases in share value faster than 30 or 40% per year, but these are extremely rare. Everyone who has run a company knows that generating consistent 30 to 40% annual increases in value requires a great deal of hard work and some luck.

This is especially true when you realize that these are not just the increases in the overall enterprise value, but instead the increase in the per share value of the company. The difference of course is the additional dilution from any future financings or employee equity plans.

The 8 to 10 years shown in the graph above seems almost impossibly long. Could it really take that long? The rest of this post shows actual data on venture capital exit times and describes what that really means for entreprenuers and angel investors.

Why the Size of Venture Capital Funds Matters to Angels and Entrepreneurs

My previous post was titled Venture Capital Firms Are Too Big. That post provides one important piece of data necessary to answer the really important question of why the size of venture capital funds matters to angel investors and entrepreneurs. This post describes the second key element.

Venture Capital Fund Math

Peter Rip of Leapfrog Ventures describes some of the math behind venture capital funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken – It's About Time.’ It provides some outstanding insight into how the math behind venture capital funds affects the way venture capital fund managers make investments and how they behave after they invest.

This post is a high level summary of how the math works for a typical venture capital fund.

In a Typical Fund the Returns are From 20% of the Investments

In a typical VC portfolio, most of the returns are from 20% of the investments. This is just a statistical fact - a law of nature. Statistically, if a VC makes ten investments, two will be winners and create most of the gains in the fund.

The Minimum Respectable Return on a VC Fund is 20% per year

A minimum 'respectable' return for a VC fund is 20% per year. This is set by the expectations of the investors in VC funds, the relative risk levels compared to other investment classes and the performance achieved by other venture capital fund managers.

What this Means for Angels and Entrepreneurs

This minimum acceptable return has profound implications for entrepreneurs and angel investors. It means that if company has venture capital fund investors, they will almost certainly block an opportunity to sell the company unless the price gives the VCs a 10 to 30x return.

The full post explains more of the math behind venture capital funds.

Many bloggers have been saying recently that the VC Model is Broken. One of the most important reasons is that Venture Capital Firms are just too big.

In the 20th century, technology companies often required tens or hundreds of millions of dollars to build out and prove. Companies like Intel, Microsoft, Amazon and Google required hundreds of millions of dollars to scale up to the size where they were proven winners. This was one of the factors that led to venture capital firms becoming ever larger.

Being a VC fund manager was also a great job for the fund principles, once the fund was large enough. Most VC funds are structured so the fund managers charge a management fee of about 2.5% of the value of the fund each year. The management fee pays the salaries of the fund managers and their support staff. A small VC firm usually has four partners and some support staff. This means that the annual operating budget for even a small fund quickly grows to more than $2 million per year.

Most VC managers believe a fund under $100 million isn’t economical. The goal of most VC managers is to grow the fund to several hundred million, in part, because then they can start pull down some very attractive compensations. This is another reason that venture capital firms have continued to grow.

The graph below shows how these trends have led to the phenomenal growth in the size of venture capital firms over the past 30 years.

What This Means for Entrepreneurs and Angel Investors

For most startups it means that venture capital firms probably aren't the best source of funding - or that they aren't even a desirable source of funding. The full post, available here, begins the explanation of why this is. This is also an important part of my upcoming book: "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs".

For the purposes of this post, the term capital structure is simplified to include only shares. Later in a company's lifecycle, the capital structure may also involve various forms of debt.

Capital Structure and Share Register

All jurisdictions have a legal requirements for the share register to list all of the current shareholders of a company. This post provides an example of how to create a share register.

Capital Structure Projection is Necessary for a Meaningful Financial Projection

To build a meaningful financial projection for a company, and to predict the future value of the shares of the company, you need a projected capital structure (i.e. projected share register). The capital structure projection shows the effects of future financings on the number of shares outstanding, and the percentage ownership for the founders and investors. It is important for company founders and investors to agree on the projected capital structure as a confirmation that the entrepreneurs and investors are aligned and effectively communicating about future financings and the exit strategy for company. It is surprising how often the investors and founders have not in actual fact communicated clearly on these critical alignment questions.

A Projected Capital Structure is Psychologically Healthier

Another benefit of working with a capital structure projection is that is is psychologically healthier for founders to understand the realities of dilution and percentage of the company they will own after the third or fourth financing, rather than the percentage they own at startup. Most of the time, founders will fix the percentage of the company they owned at startup in their mind without factoring in the inevitable dilution from future rounds of financing. This often leads to a negative psychological reaction to issuing new shares to raise equity financing - regardless of whether it is accretive.

If you have not lived through the realities of dilution before, the easiest way to understand it is to spend some time working with a projected capital structure that incorporates a company's future financial requirements. The example share register available here includes several rounds of equity financing, typical of a successful angel backed company.

Investor Perception

The projected capital structure is one of the first impressions an investor receives when starting due diligence on a company. If the projected capital structure is complete, logically laid out and effectively formatted, prospective investors will feel like the company is organized, compliant and managed by entrepreneurs who understand how future rounds of financing will affect their company and their shareholdings.

Why do so few startups succeed?

One of the reasons is the "Gaps in Understanding" between the angel investors, VCs and entrepreneurs – individuals with wildly disparate natures, who have to work together for a company to be successful.

Startups Need Different Types of People

Most entrepreneurs need angel investors or VCs to succeed. Similarly, angel investors and VCs need entrepreneurs to succeed. Angel investors, VCs and entrepreneurs are all part of the same entrepreneurial ecosystem. Unfortunately, relationships between entrepreneurs, angel investors and VCs often become strained, substantially reducing the probability of success.

If you’ve seen, or taken part in, the disagreements between the warring factions of entrepreneurs and investors across the boardroom table, you might think age is the primary source of conflict. While age is sometimes a factor, disparity of experience is most often the culprit. Vastly different life experiences creates ”gaps in understanding” between angel investors, VCs and entrepreneurs - neither group fully understanding the motivations, economics or time horizons of the other. In the case of a fledgling company, not addressing these gaps in understanding can be fatal.

When I was an entrepreneur I could not understand our investors

When I was an entrepreneur, I just couldn't understand our angel and venture capital investors. Our angel investors were especially frustrating. My co-founder and I used to go for lunch together and complain bitterly about their meddling. We wished they would just leave us alone to run the business.

Click here for the full post.