Series A Crunch...just Darwin at work

As December and 2012 draws to a close, I've decided to weigh in with my thoughts on the impending (or not depending on which blogs you read) Series A Crunch.  It seems that The Series A Crunch has been discussed almost as much as the Mayan calendar this month and I've mostly sat on the sidelines figuring that if the world were really going to end, I had better things to do than write a blog post.  Alas, we survived 12/21 and looks like we will have to get back to work in 2013.

For those readers not already familiar with this concept, it refers to the bottleneck for Series A financing created by the increasing number of seed financings and constant number of Series A financings.  While this has been discussed ad nauseum on twitter and the blogosphere, I have relevant perspective given my three different roles in the new venture ecosystem - investing in seed deals as an angel, raising seed investment as a start-up CFO and teaching entrepreneurial finance as a Professor. 

I'll summarize some of the varied opinions and data before weighing in with my own thoughts. A good place to start for data is CBInsights' Seed Investing Report- Startup Orphans and the Series A Crunch.  According to their research, 2,283 companies received seed funding over a 5-quarter period beginning Q3 2011.  Out of these companies, 102 have received follow-on funding and 212 have been acquired (or more likely acqui-hired).  Out of the remaining 2,200, they estimate that 1,200 will not be able to raise follow-on financing (see visual explanation below) and $1 billion in angel investment will likely evaporate.

Is this a high success rate?  Is this a low success rate?  Is this Armageddon?  Depends on who you read.  Sarah Lacy started this round of debate a few weeks ago with The Series A Crunch is hitting now.  Jason Calacanis responded and argues in There is No Series A Crunch that this is a non-issue and up to the seed financed start-ups to prove they are worthy.  If there are more companies that have met Series A milestones and metrics, VCs will increase the number of Series A financings.  If you are entrepreneur that isn't in a position for Series A, find other financing sources and/or figure out how to bootstrap to cash flow breakeven or in Jason's words "put on your big boy undies". Sarah, of course, responded with Jason is Wrong. Have we reached the "Jane, you ignorant slut" point?

For those who haven't already left this post to catch the latest YouTube cat video, let me see if I can bring these divergent opinions together.  I did finally chime in on the twitter discussion yesterday:

I first blogged about this topic almost two years ago when I called out the large number of convertible debt seed financings that weren't going to have any conversion event.  It turns out the financing instrument probably isn't as material as I had thought, although it doesn make the mechanics different.  From an investor standpoint, I've discovered there actually can be greater leverage with convertible debt if the appropriate protections have been included.  I've had a couple of deals where investors were paid out a multiple on exit and in a better position than if holding preferred stock, where the payout would have been subject to escrow and over multiple years.

Is it a good thing that so many entrepreneurs are able to get $250K - $1.5M in seed financing? HELL YES!!! Investors know (or damn well should) the risk they are taking in making seed investments.  The accelerators clearly know the game and the ground rules.  If as CBInsights posits, $1B is going to be lost by angels in seed financings, one Instagram makes most of that back and presumably there will be positive returns on a material percentage of the remaining companies.

Giving more entrepreneurs the ability to step up to the plate is a good thing.  I love the accelerators and am a regular on Demo Days for 500 Startups, YC, AngelPad and others.  However, many of the graduates of the accelerators aren't even companies, let alone businesses.  They are projects and experiments.  These are part of the entrepreneurs' education.  Learn how to build a product, pitch investors, raise a small amount of angel funding, hire the early team, acquire users, sell, iterate.  If it works, great.  If not, move on and join another team or come up with another idea with the same or different co-founders.  With my academic hat on, this is wonderful.  I specialize in experiential education and there is no better way to learn entrepreneurship than doing it.

My recommendation used to be that it was best to do this learning on someone else's dime and would advise students to spend a few years working in a start-up or potentially large tech company before doing own start-up.  However, they now can still do this on someone else's dime, but it is the angel investor and not an employer.  As an angel, do I take this kind of gamble?  Sometimes, if I feel the opportunity is big and the team is fully committed.  But generally, I'm also looking for those proof points that go beyond what most entrepreneurs coming out of an accelerator have.  Domain expertise is critical and many of these entrepreneurs don't have enough.

So, what are the key takeaways for entrepreneurs besides pulling up their big boy (or girl) undies:

1. Keep your options open.  Don't raise seed financing with only one path to raise Series A.  I'm not a fan of "Go Big or Go Home".  That works great for big venture funds with a broad portfolio, but not so good for an entrepreneur committed to a market opportunity.  Have a plan for Series A, but also have a plan for slower growth, intermediate funding, and a route to cash flow breakeven.
2. Seek appropriate financing.  Most businesses don't fit the venture model and if that is your only path, the most likely outcome is hitting the wall.  I always hate when folks disparage an entrepreneur who is building a "lifestyle business".  If you can build a business that provides a good income, doing something you love, living where you want, and pursuing passions outside of the business, more power to you.  I'm guessing that's how Richard Branson started and he seems to have a nice lifestyle.
3. Nothing wrong with a cash flow business.  Follow around a middle market private equity investor for a few months and you will likely discover some businesses that have great cash flow potential. Unless yoru only end game is being acquired (and if so read point 1 above again), the experiments need to yield a business model that can create a sustainable business that isn't dependent on continued funding to remain off life support.

That advice should work in good times, bad times and all those in between.  

Democratization of Angel Investing

I had a conversation recently with Alex Mittal, Co-founder and CEO of FundersClub (FC) and decided to revisit my blog post from last fall that was skeptical of crowdfunding for angel investments.  FC is the latest Kickstarter type site to launch to give entrepreneurs the opportunity to raise financing from a large number of individuals.  Some of the current services act on the investment bank model and either facilitate transactions between investors and companies (i.e. Micro Ventures) or provide a secondary marketing between investors (i.e. Second Market). 

FC's approach is much more akin to the deal flow and social proof model of AngelList, with the ability to make small investments in a number of companies.  Since the provisions of the JOBS Act relating to angel investments by non-accredited investors haven't been finalized yet, these platforms are currently only available to accredited investors, who already have the ability to make angel investments.  However, there are many pieces of the FC model that are intriguing.

First, a little background on the company.  FC is a YCombinator (YC) company in the current Summer '12 class that will be pitching at next Tuesday's Demo Day. The site has recently launched and all of the 6 companies on FC are part of the same YC cohort.  Only one transaction has closed to date.  Surprise! Surprise! It is FundersClub, so good to see they are eating their own dog food, in VC parlance.

In many respects, the service is similar to the way Angel Groups operate, or at least the way Sand Hill Angels, where I was a long time member does.  Individuals pool their cash in to a single purpose entity to make the investment in the company.  Individuals can make smaller investments in a number of companies, gaining portfolio diversification benefits.  And the company has only one investor on the cap table but can (if they wish) take advantage of a larger group network. On FC, you can see who else is investing, invest with a few clicks, and see how the round is coming together by viewing a real time thermometer. Very cool!  I had always thought AngelList would go in this direction and this indeed may be on their roadmap.  You can connect to FC through Facebook and LinkedIn, but not AngelList...Investors pay a one-time 12% administration fee on top of the investment amount.  This may seem steep, but is certainly cheaper than the annual 2% management fee and 20% carry of a typical venture fund.  Of course, this is comparing apples to oranges.

One of FC's goals is to expand the pool of investors.  While I will be attending the YC Demo Day next week along with many other Silicon Valley Angels, this is not a public event and difficult to attend for those out of the area.  Anyone can now have access to many of the highly competitive investment opportunities.  In addition, the angel investment process can be time consuming and daunting to those not familiar with venture deal terms.  Now, if you wish, you can make investments as small as $1,000 in several companies in a matter of minutes.

I'm curious as to how the SEC will view FC.  The site was designed with the very simple registration process we are all demanding, including checking a couple of boxes to prove you are an accredited investor.  It is no more difficult to move through this than all of the under 13-year olds who have facebook profiles by checking that they are 13 or up.  I'm guessing (if FC proves successful) that there will be unsophisticated unaccredited investors making investments and that the SEC may see this as a public offering of securities. On SecondMarket, there is a much more rigorous interview process and an electronic signature is required.

I still don't see FC as a place I'll make many investments and the administrative fee seems like it will have a material impact on returns, but could prove a great way to have your own angel investment portfolio with aggregate investment amount of $50K instead of $500K-$1M.  Jury is still out, but I'm excited to track their progress and am optimistic that there will be a successful angel investment crowdfunding platform. 

I wouldn't bet against FundersClub.  Unfortunately, I can't bet on them.  I was on vacation last week and missed out on investing in FundersClub through FundersClub before the opportunity closed.  Perhaps, there will still be an opportunity to invest the old fashioned way, but signing a bunch of docs and writing a check. 

Angel Groups Panning for Gold

ProfessorVC just returned from an Alaskan vacation and was mortified to realize it was almost six months since the last blog post. One of our stops was in Skagway, which became the biggest city in Alaska during the Klondike Gold Rush.  Most of the prospectors came up empty and of those who did strike gold, most lost their new found wealth through bad investments or dealings with swindlers. This got me thinking about the "suckers bet" of angel investing and how most don't strike gold for a variety of reasons.  Interesting enough, it was an entrepreneur (John Nordstrom) who was able to get out of town with his gold and opened a little shoe store in Seattle.
 
Earlier this year, I left Sand Hill Angels, the angel group I was actively involved with since 2005.  I've been meaning to share my thoughts about angel groups and will do so in an upcoming post.  In the meantime, I ran across the recent Halo Report on angel group investing prepared by Silicon Valley Bank.

 Some of the nuggets from the report are summarized in the infographic below.

A few of my takeaways:

• Interesting that 81% of deals completed outside of California.  This compares with less than 50% of venture deals being outside of California.  I would guess that overall angel investments are greater than 50% in California, which means that angel groups are active in areas where VCs and individual angels are not.  With deal velocity so great in Silicon Valley along with the large numbers of experienced entrepreneurs and investors, there is little need to associate with an angel group.

• Median pre-money valuation of $2.5 million also indicates a majority of deals being done outside of California, where I would guess the median is closer to $3.5M.  There are a number of reasons for the premium, not the least is the cost of engineering talent.

• Internet dominates total deals while Healthcare received the largest share of funding.  If you add mobile, ratio is greater than 2:1 on deal basis and a little higher on funding.  With the low cost of creating these companies, they are a good fit for angel groups that can move quickly, make a number of bets and have the ability to follow-on.  Healthcare (primarily medical device companies) are very well suited for angel investments.  At Sand Hill Angels, we invested in a number of these medical device companies that had serial entrepreneurs, patents filed, low valuations, and clear paths to exit.  The investment thesis made sense from both sides as funding could get to (or though FDA) and requirement for further funding was low.

Rebuild our Inner Cities one Venture at a time?

As an active participant in the Silicon Valley new venture ecosystem and entrepreneurship educator, I'm intrigued by the recently announced program Venture for America (VFA). VFA is sending high achieving recent college grads into small businesses and start-ups in inner cities.

Conceptually, this is very intriguing and goes against the current popularity of accelerators in start-up hubs (Silicon Valley, New York, Boston, Seattle, Boulder) that are filled with recent grads and drop outs looking to build the next web sensation. I am a big fan of the accelerator programs and while most of the companies coming out won't be successful, many will, and all of the graduates will receive a tremendous education. Many will likely be successful in subsequent ventures and you can't start your second company until after you've done your first.

VFA is taking a different approach to fostering entrepreneurship. It is modeled after Teach for America (TFA), a program that sends high achieving college grads into inner cities as teachers. These have become very high sought after jobs as TFA has been successfully recruiting students that would otherwise be going to McKinsey or Goldman Sachs. Rather than spending 80-100 hours per week on Wall Street, these students spend 80-100 hours per week creating lesson plans and learning how to teach disadvantaged children. While certainly a laudable mission, I question how many of these teachers actually remain in the career vs. using TFA as the golden ticket to Stanford Business School, Harvard Law or other select grad school.

VFA's tagline is "Mobilizing graduates as entrepreneurs" and is "A program for young, talented grads to spend 2 years in the trenches of a start-up with the goal that these graduates will become socialized and mobilized as entrepreneurs moving forward." In an Inc magazine article on VFA, one student is quoted:

I've applied to a ton of companies," she says. "I have this entrepreneurial mindset that I have to work at a start-up and do marketing, but every company I have applied to, whether it was a start-up or not, said they found someone more qualified or I didn't have enough experience."

Nothing against Ashley from UVA, but that is not how you go about finding a job in a start-up. You network! You attend start-up events! You go hang out at the engineering school! You find companies you are passionate about and where you can offer solutions to problems! You don't send in a bunch of applications. Is this the kind of individual that is going to create jobs in inner cities? I don't know, but I'll bet against her.

Couldn't you accomplish the same thing within the university environment? That is what I am doing with the ELAB program at San Jose State University. (Entrepreneurship Lab Provides Students Work Experience in Start-up World) We have had 50 students through the first four offerings of the program and almost 50% have received job offers at the end of the semester for either full time jobs or paid internships. All have received tremendous experience not available in a typical academic setting.

Back to Venture for America. I hope they are successful in creating companies and jobs in inner cities. Clearly, we live in a bubble in Silicon Valley and our economy is rarely in sync with the nation as a whole. If the rest of the country were experiencing the new company growth, hiring challenges, decreasing office vacancies and rising rents that we are in the Bay Area, the economy wouldn't be the top issue in the presidential campaign. In fact, nobody outside of the far right would care about the Republican primaries as Obama's reelection would be a fait accompli. Politics aside, as the Beach Boys sang, "Wouldn't it be nice"...