Is the Grass Really Greener on the Dark Side?

The spring semester of my Entrepreneurial Finance class starts tomorrow. During the next four months, we will examine over a dozen entrepreneurial ventures from a diverse mix of industries - technology, service, food & beverage, and fashion. We will also look at a variety of financing methods including venture capital, angel investing, licensing, franchising, roll-up, venture debt and my old favorite, bootstrapping. One thing that strikes me every time I teach the course and in my investing activities is how much easier it is to critique someone else's idea than build your own. In addition to the case study analysis, the students also have the opportunity to develop a business model and financial model for a new concept, which always proves a lot more challenging.

I think this same concept plays into what I've seen happening a lot more in the venture community: partners at VC firms jumping back into entrepreneurial ventures. There used to be a fairly standard career path in the venture capital industry. After a successful career in a technology leader (Intel, Microsoft, Cisco, etc.) or one or more exits as a start-up founder, you were enticed to become a partner on Sand Hill Road, or as some call it, jumping over to the dark side. With a limited number of these opportunities and 10-year fund cycles, there wasn't a lot of transition among partners in firms. In fact, most partners that left VC firms either cut back to a non general partner role and/or to personal investing and other activities.

However, over the past 5-10 years, we have seen a lot of changes in the make-up of firms, expansion and consolidation in number of firms and partners leaving to join other firms or more interestingly, to start companies or join other start-ups. I thought about the differences a lot when I spent several years as a venture partner. I had been considering moving towards a full time role as a VC, but decided I enjoyed the company side better and participating as an active member of the team rather than strictly an advisor, coach and board member.

Perhaps, this is partially driving some of the jumping across the table, but certainly the performance metrics of funds and individual partners has also played a key role. An argument can also be made that money remains the key driver and given the increasing competitiveness in the VC business in both raising funds and investing, that start-ups are now seen as the more lucrative route.

I'm going to continue to follow the paths of entrepreneurs turned VCs turned entrepreneurs again and see how it evolves. As an angel investor and start-up CFO, I should have a good vantage point.

Touched by an Angel

I think the title of this post is a TV show, but fitting as there has been much debate in the venture community as to the whether angel investors are good or bad for entrepreneurs and VCs. What would the VC corollary to Touched by an Angel, be. Well, you can certainly peruse The Funded for some descriptive terms for investors.

I was on a panel earlier this week with several other investors from Angel Groups in the Valley. The panel was a typical Silicon Valley shmoozefest hosted at a law firm with about 75+ attendees. A partner from the law firm (sponsor, covers the drinks and food) tosses out some softball questions to the panelists, the audience chimes in with Q&A and finally, culminates with the meet and greet where the panelists are flooded with business cards and pitches on the next great thing, which is often very similar to the last great thing. My facebook can beat up your facebook....

The theme of the event was angel investment trends for 2008. One of my comments was that we would likely see more institutionalization of angel groups and syndication of deals among groups. We have already seen the institutionalization of groups evidenced by the growth of the Angel Capital Association (ACA), which counts 265 angel groups and 10,000 individual members, up from probably a handful a decade ago. At Sand Hill Angels, we recently switched our IT infrastructure over to Angelsoft, which built a specialized application for angel groups. While currently free to angel groups, their business model revolves around aggregating the angel investment data.

Speaking of angel investment data, the Kauffman Foundation funded a paper on Returns to Angel Investors in Groups written by Robert Wiltbank at Willamette University and Warren Boeker at University of Washington. According to their research, overall returns on group-affiliated angel investments average to a 2.6X return on investment after 3.5 years. If my math is correct, this is approximately a 31% IRR, which has to beat individual angel investments on aggregate and venture capital returns over the period of the study (1990-2007). I found this data quite interesting and wonder how representative it actually is as most angel investments are not reported.

Back to the panel. There were a couple of comments by other panelists that I found interesting. One group charges entrepreneurs "an administrative fee" to present to the group. Mind you, this is not a $20 fee to cover printing nametags and making copying an executive summary into a book. It is several thousand dollars, which is a lot of cash for a struggling entrepreneur in search of seed funding. Just seems that the guys with the money shouldn't be charging the guys who don't have any....One of the other panelists mentioned that they don't charge the entrepreneurs, but do require them to spring for lunch at a follow-up meeting. I found this amusing as well, but presume the entrepreneurs get to choose and can bring PB&J sandwiches. At Sand Hill Angels, we won't charge you to pitch and will even spring for the food!

Another comment which probably deserves more discussion is around valuation. One of the panelists mentioned that they have gotten very valuation sensitive (nothing wrong with that) and like to purchase preferred stock rather than invest in convertible notes. Again, I see nothing wrong with this, although entrepreneurs often prefer convertible debt as it defers the valuation discussion and leaves the Series A price for the venture firm to set. He also said they typically only invest at a $1 million pre-money valuation or less. He then went on to say that this type of financing was good for the entrepreneur (vs taking VC money) because they got to keep more of the company.

This got me scratching my head and ready to open up a debate. However, there was not any interest on the other side in debating me in front of the group of entrepreneurs, so I'll have to do it here. Valuation at this stage is clearly much more art than science, but I subscribe to the splitting up the pie school of thought. There needs to be enough equity to go around for founders, early investors, later investors, and employees. We typically invest at pre-money valuations between $1 - $5 million, with the sweet spot somewhere in the middle.

At a $1 million, pre-money, with an investment of $500K, that would leave 67% of the company for the founders and initial option pool. Let's say the company hits it out of the park with that $500K and can now raise $10 million at a $15 million pre-money valuation. Keeping this simple with no employee option pool and just founders and investors, investors would hold 60% at this point (20% for angels and 40% for VCs) and founders would have 40%. Under an alternative scenario, entrepreneurs go for VC funding to start and raise $4M at a $4M pre-money. For the next round, assume pre-money stays at $15M and amount raised is $6.5M for a total of $10.5M of funding in both scenarios. Now the investors have 65% (35% for first round and 30% for second round), while founders have 35%. I guess you can make the argument that the founders keep more of the company under the take angel money at a $1M pre-money valuation, but the stars need to be aligned and it is much more likely that initial VC funding in the angel scenario would be at a lower valuation with significantly more dilution. I'm sure I lost all of you, but I feel better now having completed the analysis.

I guess the moral is, make sure you know where the angel is touching you.....ProfessorVCs office hours are now closed. See you next time.

Who does this ProfessorVC think he is?

Ok, so I think I'm the last guy in Silicon Valley to start a blog. I've thought about it for the past 5 or 6 years and finally decided to do it this afternoon. I'm so late hopping on the train that we are probably pulling into the station. I put up my Bodega Partners web site in 1995 and it served its purpose for a number of years, but I just didn't spend the energy to keep it current and finally just took it down last month.

I thought I'd just go with a simple blog name like Steve Bennet, but wasn't available on Blogger so I had to come up with something else. The first thing that popped in my head was Start-up CFO Guy, but that didn't quite roll off the tongue. ProfessorVC was the second name and being impatient I just typed it into the blog creation tool and before I could think twice, it existed in cyberspace. I mentioned the name to my wife and you she thought it made me sound arrogant. I next tried it on my 14 year old daughter and she said it was completely lame. Of course, she thinks most things I do are lame.....

I thought about the name some more and I do spend much of my time teaching entrepreneurship and coaching entrepreneurs. I have also been a VC and am currently actively angel investing as a member of Sand Hill Angels. For now, I'll keep it, but will certainly solicit comments and suggestions for a better name.

In the blog, I plan on sharing my opinions (I generally have no shortage of these) on venture capital, angel investing, teaching entrepreneurship, and anything else that strikes my fancy. First post will be about a panel I was on earlier this week with several other angel investors.