Over the past several years, and especially since this summer when CommonAngels (where I serve as managing director) became the first angel group to join the National Venture Capital Association (NVCA), I’ve frequently been asked in varying tones of voice from the curious to the cynical, “Is CommonAngels an angel group or a venture capital firm?” The definite answer is “yes,” which is less a statement about CommonAngels than it is about the substantial changes in the capital market affecting entrepreneurs.
Here’s some history and context. The Tech Bubble of 1999-2000 and subsequent Tech Wreck of 2001-2004 did a lot more than just flood the market with money and leave it dry. This boom-bust was part of a classic economic supply shock that has led to a restructuring of the capital for new ventures and changes in investment strategy that determine how that capital is deployed.
In a supply shock, the dynamic between price and availability of a good—in this case cash—changes significantly. Often, there follows a restructuring of the market as more efficient or more successful suppliers gain market share, buyers shift to more reliable or specialized suppliers, and both sides seek to alter their strategies to accommodate the changed market.
Economic treatises have been written on the general effects of supply shocks. But in the case of venture investing, what happened during the Tech Wreck was that asset allocations—meaning the amount of money available to both angel investors and venture capital firms—fell sharply, invariably in proportion to the loss in market cap of their portfolios. Whereas total commitments from limited partners surged during the Bubble to $83B in 2000, they fell during the Tech Wreck to just below $10B in 2003—and have only recently resumed their pre-Bubble levels of around $20B per year, according to figures from the NVCA/PwC/Venture Economics MoneyTree Report and Dow Jones’s VentureOne service. However, with the comeback, the distribution of those funds has changed—and so have the investment strategies.
Changes to Angel Investing
Perhaps the most visible part of this evolution has been the increasing pooling of capital and expertise by individuals into angel groups. Whether it’s because individual investors see safety in numbers, a stronger negotiating position for future rounds, better diligence through shared efforts, or just a more enjoyable process by working in teams, the basic principle is a classic division of labor. Rather than have each investor repeat the whole diligence and investment process each time, work can be divvied up to those with the most skill for a particular task—allowing a lead angel or manager to coordinate the process for both individual investors and the entrepreneur.
In 1998, there were roughly 20 formal angel groups nationwide. Six years later, 46 groups became charter members of the Angel Capital Association—a trade organization founded to support professional development among angel groups. Today, there are over 125 ACA member groups and almost as many unaffiliated angel groups.
Many of these groups also have hired staff and some have funds under management, much like a venture capital firm but with some structural differences I won’t go into here. CommonAngels itself is now a hybrid organization. We have 70 active angels who cut their own checks on individual deals, two full-time managing directors, and two co-investment funds. We’re members of the Angel Capital Association, the New England Venture Capital Association, and the NVCA. Our large network helps source deals, evaluate opportunities, and help companies; our pooled funds and professional management provide additional capital, complement our operational expertise, and provide consistency for entrepreneurs and co-investors.
Changes to Venture Capital
Venture Capital firms also have changed, but because those changes have mostly been internal to existing organizations, it has been a bit harder to notice. Each quarter, the MoneyTree figures grab headlines over the total dollars invested in startup companies and the number of deals done by venture capital firms, institutionalized angel groups, and various corporate investors. VentureOne adds to the debate by offering its (usually) slightly different figures based on a different methodology from those tracked by the other group. By either of these measures, investment levels have returned to “normal,” pre-Bubble levels. Inside those figures, however, the dynamics have changed significantly.
Since the Bubble, the average size of a venture capital fund has doubled, according to VentureOne, from roughly $100M during the Bubble years of 1999-2003 to an average $200M in both 2005 and 2006. A decade ago, the average venture fund was closer to $80 million. More importantly, however, last year saw the creation of the fewest number of funds under $100 million since VentureOne started keeping data in 1992.
Additionally, as Scott Kirsner recently noted in the Boston Globe, there are many challenges facing VCs raising new funds. As a result of the disruption in the market, the large institutions that invest in venture funds (institutional LPs) are increasingly pursuing “flight to quality” strategies—putting more money into the most successful funds, thereby increasing their strength and leadership position. Many of these large venture firms have now launched or are developing multiple financial products such as sector-specific funds, regional funds, or funds tied to particular stages of company development.
The average round size, meaning the amount invested at various stages of a company’s development—seed, Series A, Series B, and so forth—also continues to increase. But with that increase come further changes in strategy—most notably fewer seed stage deals. In 1995, according to MoneyTree, 17 percent of all venture capital dollars went to seed investing. By 2002, that figure hit a low point of 1 percent, and at the end of last year had only recovered to 4 percent. More telling, in 2006 there were only 326 “seed” deals done throughout the country, versus between 500 and 800 per year pre-Bubble.
The larger fund size has also had an effect. Even when investing small amounts of money in early-stage companies, venture firms are looking for an implicit or explicit commitment from entrepreneurs to build an enormous success (usually with an exit value of greater than $250M) in order to “move the needle” on the fund. This often means building a portfolio company to 20-50 employees much faster than in the past, creating an “instant company” effect that can actually increase risk if the firm is under prepared for that growth or if the market is not yet ready to support it.
Co-opetition between Venture Capital and Angel Investing
As both venture capitalists and angel investors evolve their practices, they increasingly need those with complementary resources to work with them. In fact, they both compete for deals and cooperate, sharing skills to evaluate and help young companies, creating what Prof. Barry Nalebuff at Yale University calls “co-opetition.” Most often, this correlates to size: large venture firms get deal flow from smaller ones; smaller venture firms from angel groups; and angel groups from individuals. Investing style also affects collaboration. The “instant company” investors tend to prefer working together, as do those who take a more conventional “organic” approach to growth by going with, not ahead, of markets. Finally, the personalities of both individual partners and investors, and the relationships and trust among them, also play big roles in how firms collaborate.
For example, at CommonAngels, our closest relationships are with the other angel groups and with venture firms that operate relatively small funds of between $50M and $300M and take more organic approach to portfolio company growth. These partners have provided $10 for every $1 that we have invested this year—a new record. We also refer opportunities to each other and seek advice. Occasionally, we compete against each other, but we tend to prefer to collaborate, for instance, by pooling our investments together to create a Series A investment of $2M-3M. Competition also comes from bootstrapping (meaning the entrepreneur funds himself or herself) or by entrepreneurs choosing strategies that require more capital than we ever could provide, leading them to work with a totally different set of players.
Looking Ahead
These changes are neither intrinsically positive or negative, they are just evolutionary changes that the industry has gone through—but it is important to know what they are and adapt to them. In the next five years, don’t be surprised to see more angel groups joining NVCA. Five years from now, perhaps as many as half the angel groups around the country will have managed funds, and at least a few will likely have funds of between $50M-100M. Similarly, larger venture firms will have more specialized product offerings, and many smaller ones will take “boutique” strategies of being best in class for a specific sector, style, or geography.
As the capital markets change, entrepreneurs should do diligence on investors before starting to look for money. Particularly if you are new to fund-raising, or have not done it in a while, you will likely find the market more segmented than in the past. Look for investors whose strategy, expectations, and personalities are more in line with your own and your company’s. This will likely leave you with a much shorter target list than in the past. But it should also be a much better one.
