Mind the Gap

One wrinkle that has really impacted the angel investment sector is the VC trend toward later-stage investing.  This has been documented in many places, but the VC industry has effectively stopped investing in seed stage ($500K and less) and startup-stage ($2M and less) opportunities. [Note: Predictions abound that 2010 may see a return to smaller funds that participate in earlier stages, which will be good for everyone.]

Drawing on another slide from the 2007 ACEF presentation already referenced, there is a resulting condition that has developed — large rounds left unfilled by either individual angels or venture firms:

This gap has been increasingly filled by organized syndicates of angel investors, either through managed groups, angel funds, formal and informal networks.  When it works, this syndication has been credited with a number of positive outcomes:

  • more professional deal screening and due diligence efforts;
  • less reliance on institutional (venture) investors for businesses that aren’t attractive to VCs;
  • better preparation of those businesses that do chose to pursue venture investment;
  • faster closing of rounds, with more consistent and reasonable terms;
  • better returns to angels (see the excellent study by Rob Wiltbank and Warren Boeker for the Kauffman Foundation, which I’ll be referencing later)

It’s this condition — inefficiency, desperation, and large amounts of money in flux — that has led to a lot of innovation in the angel investing sector, as well as a lot of questionable behaviour.  But as we’ll see in an upcoming installment, it’s a no-win situation.

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14 Responses to Mind the Gap

  1. [...] So what does this tell us?  Obviously, angel investment is a powerful component of the startup business funding ecosystem.  Does it tell us much about the interactions between angels and VCs?  Not really.  While conventional wisdom might say that a typical funding path for a high-tech start-up is: founders/family/friends, then angels, then VCs, in reality the investment profiles of the two groups keeps them separate much of the time.  I’ll explore the reasons why in a couple of posts: Profiles in Courage and Mind the Gap. [...]

  2. Brad Feld says:

    Steve – awesome to see you blogging about this stuff.

    I’d like to strongly disagree with your assertion that VCs aren’t making < $500k or < $2m investments. 6 of the 10 TechStars Boulder 2008 companies were VC-funded (all less than $1m financings) by a variety of firms (e.g. FB Founders, SoftTech VC, Alsop Louis, Highway 12, Foundry Group.) Also, three of our seven new investments in 2009 were seed investments (less than $1m). And USV, SoftTechVC, Maples, First Round Capital, and True Ventures have all done many seed investments in the past 12 months.

    As a % of software / Internet investments, I'd suggest that the number of new investments (vs. follow-ons) that are less than $2m are much higher than your assert when you say "the VC industry has effectively stopped investing in seed stage ($500K and less) and startup-stage ($2M and less) opportunities."

    My experience – this is a happy myth that has been used by angel groups to position against VC firms – especially given the shrinking over overall VC firm activity (which it has – and should).

    I believe the more important point is that VCs are a small percentage of the overall investment pool, and I think this a much more powerful argument for angels.

    • smurchie says:

      thanks, Brad – appreciate the insights. I hope you know I consider you one of the VCs that “gets it”, and the TechStars and Foundry Group strategies reflect a paradigm shift in the market. So let’s assume you (and the colleagues you mentioned) are at the head of the pack, not the middle of the herd. Here’s what the herd looks like (per PWC Moneytree):

      Q3 2009 VC investments

        Amount % of Total Deals

      Later Stage $1611M 33.49% 168
      Expansion $1610M 33.48% 185
      Early Stage $1081M 22.49% 198 <- avg = $5.5M
      Startup/Seed $507M 10.54% 86 <- avg = $5.9M WTF??!

      So, maybe we have a lot of bad data here, or maybe we're using different yardsticks, but even definitionally, 10% of overall investing placed in startup/seed is small.

      I do agree with you wholeheartedly that more seed/startup investments by VC firms is a necessary trend, and it will follow the retraction in the venture industry – but it is a retraction to older models that actually worked. Especially in the SW/IT sector, smaller investments can (and better) go a lot further than they used to.

      I hate to think that there is "positioning" going on between angel groups and VC. It would be a totally unnecessary competition when there is very little overlap in deals, investors, and even marketplaces. As you say, venture is just one part of the equation, and I think angels only need worry about not putting so much hair on a deal so it becomes unpalatable to VCs. The rest will sort itself out.

  3. bfeld says:

    PWC Moneytree data is an incomplete and inaccurate data set. For example, they list two investments made by Foundry Group in Q3 as Early Stage. Having been involved in both of these investments, one was a seed investment and one was early stage. Same for Union Square Ventures – at least one of their investments was mischaracterized. And I find it curious that one of the most active investors in Silicon Valley, Sequoia Capital, appears to be missing from the list.

    In addition, I think it’s generally important to look at the median number rather than the average. Also, the interesting % comparison would be the # investments vs. the $ of investments since seed / early stage will typically be much smaller than expansion / later stage.

    Finally, if you look at the underlying data, there are a number of biotech deals being listed as “seed stage” that are over $10m in investment. This is obviously having a huge impact on the averages. This is true in both New England (Epizyme – $32M, Avila Therapeutics – $30M, Agios Pharmaceuticals – $18M, Constellation Pharmaceuticals – $17M, Tetraphase Pharmaceuticals – $10M) and Silicon Valley (Soladigm – $21M, Ventana Health Services – $17M, SeaMicro – $15M, Blekko – $14M, Adesto Technologies Corporation – $14M, Shocking Technologies – $10M).

    I learned a long time ago that most of this data is crap and unless you do your own analysis, making assertions or reaching conclusions based on the average data is often very incorrect.

    • smurchie says:

      Thanks, Brad – your observations are dead on. I suspected bad data (gee, how can that happen when it’s reported by one of the world’s top auditor/accounting firms? :/ ). Just the same, the trend in average (not median) investment isn’t favorable no matter how you look at it, which mostly supports my thesis: the herd is moving upstream towards larger and more stabilized deals. Your characterization of the biotech “seed” deals is exactly what I would say: no one except an inbred institutional investor would even imagine these deals as being “seed” stage. I’d bet that most of the deals probably have $10M or more in grants already invested.

      The good news? The first couple quarters of 2009 seem to reflect more investment in earlier stages. And with more VCs like you, we’ll see more early-stage funding of startups.

  4. Rich Skrenta says:

    blekko is a search engine, not a biotech company.

    • bfeld says:

      Correct – I was just listing the top ones. I think most of the rest of bio although Shocking Technologies is a materials / semi company. Regardless, there is no way these should be classified as “seed” investments.

  5. Dale Tomrdle says:

    Steve, this is great stuff, keep it coming.

    Stating upfront that what I don’t know is a lot… My perspective isn’t based on data, but anecdotal and personal experience (even less reliable, I know). Working in the last year with a couple of companies outside software/internet (med devices: relatively high investment, long time frame; and consumer products and services: relatively low investment, short time frame; both with experienced founders who’ve already had successful exits), I heard a common message from VCs: “we aren’t interested in doing any deals unless the company already has customers and revenue…” Consistent geographically across the US. I would chock this up to the latest way of saying “No” to a lousy deal, except that overseas firms were and are interested. I assume part of what might be unsaid is current portfolio circumstances making it more difficult or impossible for VCs to make new investments. Regardless, what I find striking is the “perception is reality” impact this message seems to be having on parts of the start up ecosystem.

    I don’t see this as angels vs VCs, but as a shift in the system with implications for everyone in the game. Many potential funders believe the gap which in the past might have been funded by VC firms is now insurmountable. There doesn’t seem to be a lack of start up investors – VC or angel – with money, but rather an increased reluctance to invest in start up or early stage based on increased risk of failure to secure follow on investment from what was once viewed as a viable source. I certainly don’t know if this is normal ebb and flow amplified by recent financial chaos or something new, and don’t have an informed opinion if it is good or bad, but shared perceptions about VC investment criteria are shaping start up decisions and options.

    • smurchie says:

      thanks, Dale. I’ve seen a lot of the same behavior in angel circles. I think there has been a general “flight to safety” among investors in the past couple years, and with startups that often translates to bootstrapping longer and achieving more results on your own. Hopefully we can get back to more risk investing in the coming years.

  6. [...] his post Mind the Gap he made an assertion that “the VC industry has effectively stopped investing in seed stage ($500K [...]

  7. John Furrier says:

    Great post and great commentary from Brad. This is an important topic.

    My opinion is that Brad, Jon Callahan, Ycombo, and those other names are ahead of the pack for sure.

    In general my observation is that “Angel” investing in the classic sense has changed and that new “funds” are taking that role. These funds understand the risk side AND entrepreneurial side – this is their key to success.

    My vision is that these guys will formalize more research and incubation models on top of their early stage investing – this will allow for scale.

    My guess is that 2010 will be the year the herd starts to pick up on those leaders.

    • smurchie says:

      Thanks, John. Agree this is important, but I fear that it’s going to take a long time for the industry to shake out. If you consider the lifetime of a typical VC fund, their expressed covenants and goals on inception, and the enormous size that the big funds will seek to maintain, we’re looking at some major upheaval. I think it is the right direction for entrepreneurs in the US, though. Good time for the thought leaders, too.

  8. John Furrier says:

    Thanks for the replying. I’d love to followup with you on this topic for a series that I’m putting out on our community site

    my email is johnfurrier at gmail dot com

  9. [...] his post Mind the Gap he made an assertion that “the VC industry has effectively stopped investing in seed stage ($500K [...]

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