In previous blogs, I discussed the investment models for the asset classes of venture capital and private equity. Of the roughly $3.2t put into private investment in 2017 (Federal Reserve Bank Q1, 2018), most of this is internal investment (companies investing from profit) and debt-based investment. Approximately $524b was invested in/by private equity and $84b by venture capital firms (according to crunchbase), but many of these investments would not be possible without the deal flow enabled by the much smaller amount of investment ($25b in 2017) from angel and seed investors. These investors fill a critical niche to enable the ecosystem of entrepreneurial maturation as they provide investment at the earliest stages before most venture investors would consider investing. In this blog, I will discuss how angel and seed investors vary from venture capital, which I discussed here.
There are a very wide variety of seed and angel investors and models and there is a distinct difference between the two ideas, but both are leveraging the generalized model for venture capital corporate development and investment for similar reasons; this is shown below in figure 1. Seed capital is the funding for a company when it is just an idea and the company is performing customer development. Seed capital always includes founder investments, even if just in time and personal resources, but when raising seed capital is discussed, it means raising a small amount to bridge the company to product / market defined. Angel investment can enter at this stage, or a series-A, depending on corporate development progress.
Figure 1: Early Stage to Exit Startup Funding Model
In early stage investing, it’s worth discussing the importance of not raising too much money and operating in a lean mode. Seed and angel financing are generally small numbers; under $250k for seed and under $1.5m for angel (even with recent round inflation). These financing amounts are going into companies whose corporate valuation might be as low as $500k. As a founder, if an investor puts $250k into your startup which is valued at $500k, you just gave up 1/3 of the equity in the company for $250k. Equity is precious and giving up that much early on is likely a large mistake that can leave the company encumbered in future raises and accelerate founder’s loss of control of the company. Taking in smaller amounts and developing the underlying valuation of the company through meaningful, objective corporate development milestones will yield a higher likelihood of success.
Seed capital can come in a wide variety of forms including founder investments in the company, friends and family investments, grant, and incubator awards can all fit into this model. The amounts vary, but typical total seed funding is less than $250k. Founders should expect to invest their own time and money, and leverage their own intellectual property (whether developed at this stage or previously – and clearly owned by the founders). Some founders will utilize debt at this stage, but should recognize that this will always come with personal accountability and collateral. Even if a business loan at this stage, expect a personal guarantee rider to the business loan; meaning founder’s assets are at risk as collateral. Grants are a viable means of very early stage fundraising, especially for development of technologies or economic development; the motivation for grants is wide and an extensive search can yield some surprising opportunities. The two great cautions to grants as a fundraising method are that the timing / competition for the grant can leave the company without funds when they are needed, and some grants may encumber the intellectual property of the company or include future obligations that may not be desirable. All of these terms are available in advance before a grant pursuit is initiated. Finally, incubator awards can also be an important source of funding. Many venture capitalists, angel capitalists, universities, and economic development groups are backing an increasing proliferation of incubators because of their ability to stimulate downstream deal flow, innovation, and jobs. These incubators usually combine formal programs, advisory and connection support, training, and informal connection opportunities in low (or no) cost models that can also include the opportunity to receive early funding for equity or outright cash awards / grants. These funds are institutional in nature, but often tied to a different investment return objective than typical venture or private equity that includes indirect benefits in future deal flow, innovation, jobs, and economic development. The amounts are generally small commensurate with this stage’s valuation levels.
Angel investors invest their own money; many are motivated by a combination of a desire to earn an investment return as well as to give back to the community. Many angels are successful entrepreneurs or previous corporate executives, some family funds carve out a portion of their portfolio for angel investing (some do this in venture and private equity as well). Angel investors are often looking to invest at the product / market defined milestone. The company has a defined market, a defined product sold to at least one customer and preferably more, an operating model with some preliminary understanding of gross margin and how it can moved, and a marketing and sales model with some preliminary understanding of how it can be moved. Many angel investors will say they are far more interested in the team and the market than the product and the corporate development processes. This is based on the theory that early stage successes are likely followed by further pivots and setbacks and it is the right team that is the determinant of success under those conditions more so than the presence of single product / market success data point. Angel investors typically invest in syndicates; these are ad hoc groups of angels that form to invest in a company usually with one or two lead investors, who may invest 50% or more of the syndicate investment, and many followers investing much smaller amounts. This structure is highly desirable for the founders; negotiating an investment round with twenty individuals can be time-consuming and frustrating; the syndicate enables that negotiation to occur with just one or two principals on the other side of the table. Angel investors will often get involved with the company, providing advisory and connections help as well as instilling early governance guidance. Given the expertise level of these individuals, this help may often be as valuable as the cash infusion. Lastly, most angel investors don’t invest further as the company scales; dilution is part of their model, so expect attention to capital efficiency balanced with value creation pace for IRR.
Interestingly, according to a 2017 joint study by Josh Lerner, head of the entrepreneurial management unit at the Harvard Business School, and Antoinette Schoar, professor of entrepreneurship and finance at MIT Sloan School of Management, angel investors outperform venture capital. Angel backed companies are 14%-23% more likely to survive the 1.5 to 3 year period following funding, increased employment by 40%, and had a 10%-17% higher likelihood of successful exit. Angel investors achieved nearly 2x the IRR of venture funds (9.98%) over the last 15 years.
In the last 3 blogs, I have presented an overview of the investment, financial, and corporate development models most commonly used by private companies from concept to maturity and renewal. Successful corporate strategy, fulfilling a company’s purpose, requires a company to operate in a manner that delivers the products and services that fulfill its mission and create corporate value. Corporate strategies that don’t build and leverage a common corporate development model with all their stakeholders, generally fail to reach their goals. To be clear, this is an important discussion to have with each investor as they are brought on to the company to ensure all of the key stakeholders are operating to a common vision of how to build the company. For this reason, companies using these institutional investment tools, must develop and execute their corporate strategies in concert with these models. Companies that don't bring on institutional investment must rely on organic and debt financing; while the process of developing the right corporate development model in these cases involves fewer and different stakeholders, the importance of capital efficiency can be even greater. In future blogs I will look at the strategic planning and execution using the tools noted in this post, and many other topics relevant to this model. If you would like to discuss how your company is evolving, need help with any of the tools noted above, or just have a question please contact us.