Are we close to the peak?
Should tech angels stop investing in startups?
There is lots of chatter about whether this or that event indicates the beginning of the last steep ascent to the summit of tech investment for the moment. Those of us who have lived through the cycles know that the virtuous circle of abundance of capital, turns very quickly to a vicious one (and back again).
The so-called Series A crunch is, however, a permanent, structural feature of our system and is one that needs to be top of mind when investing in tech startups.
Sometimes called the ‘valley of death’ for a startup business, the period between raising the initial friends and family or seed round and the first institutional money is a very difficult one and requires very careful navigation.
a piece of research from CB Insights dating back to December 2012 clearly stated: “1000+ STARTUPS WILL BE ORPHANED; $1 BILLION LOST”
For me , the question is what should startup companies do to mitigate and how can angel investors minimise the ‘death rate’ of their investments?
At TAG we know a thing or two about the valley of death and the Series A crunch having invested in more than 100 tech startups.
Understandably, startups are obsessed with getting their seed round closed so that they can get on and make their first hires and building their products and markets. A bit more work and thought needs to go into where to get their seed funding and just how much cash is necessary.
A lot has been written about the so-called ‘signalling effect’ of taking seed funding from a top tier VC. The phenomenon and the concern is easy to understand. An investment from a top VC at Seed who then does not follow-on (for any number of reasons) provokes suspicions in prospective Series A investors.
The research by CB Insights proves the fallacy of this widely held theory.
“On average, 39.4% of seeded companies go onto raise follow-on financing. Interestingly and contrary to what the punditry have often said, seed deals in which VCs participate have a historically higher rate of getting follow-on financing as compared to seed deals in which VCs are not participating.”
This result makes perfect sense to me. VCs are better at predicting what VCs are likely to want to invest in at Series A.
This truism has been at the cornerstone of the LocalGlobe Seed philosophy from the very start and is largely the reasons why more than 70% of our seed investments have gone on to raise Series A.
Raising a Series A is, of course, no guarantee of building a decent business. Many companies need further rounds of capital to get to the point where they are generating cash. Getting a VC to back your series A is just the beginning. Sustaining and building on the relationship by delivering results is what will cement the partnership and building a really big business does require the full hearted support of top class VCs.
Raising funds for startups is generally much more difficult in Europe than it is in the US — particularly in the valley. As a result, the companies that do get funded tend to be more conservatively managed and focus on getting to breakeven quicker and on revenue and profitability at the expense of growth in users/customers.
During tough fund raising cycles — which may occur at some time in future - this approach has its advantages — but also leads to better habits and company culture — in my experience.
In addition to the usual criteria for investing in great entrepreneurs addressing large markets etc, angel investors really need to look at the opportunities with “VC eyes”.
A good understanding of the workings of Series A investors is a decided advantage. My time at Atlas Ventures in London — a day a week as Venture Partner — and for the last 5 years with Index has given me insight as to what to look for in a solid venture backed opportunity.
How will the founders play to an investment committee of a top tier VC firm?
Can you envisage the business being large enough to ‘move the needle’ for the fund which is likely to be a candidate for series A?
Will we have sufficient runway to hit the milestones necessary to make it clear that product/ market fit has been achieved? With a bit of contingency;)
Will we have the time and the resources necessary to ensure that the “go to market” strategy has been tested and validated?
So, Angels should definitely NOT stop investing in tech startups but do need to define their entry criteria really well.
It should seldom be about valuation but always revolve around the person or people being backed, their vision and how they are thinking of going about building something big. The initial valuation should take into account what has been achieved with scant resources but more importantly must reflect what the ultimate value of the company is likely to be.
Angels need to cultivate strong relationships with a few VCs and take time to understand them and their needs.
In turn, most VCs are on the lookout for active angels — often their best source of quality dealflow.
A big dose of mutual respect goes a long way.
Returns available for angel investors who take the time to study the markets and apply the appropriate disciplines are really very strong indeed and the opportunities available today exceed anything I have seen in 15 years of active investing.
Note: The bulk of this article first appeared as a post on the TAG Blog in February 2013. It has been updated to reflect the ‘current conversation’
