The traditional route to financing used to begin with bootstrapping. After bootstrapping got you so far (and assuming you were not able to fund future growth with revenue), you might turn to friends & family and/or angel investors. Then, the old story goes, you got venture capital (VC) money and you were on your way to IPO glory.
That story is not true for software startups today.
According to Darian Ibrahim, one of my favorite legal writers about startups asserts, there are at least three reasons, startups who are angel-backed might actually want to REJECT VC money.
The cost of innovation is less now than it used to be
Everyone knows that tech startups today enjoy far lower operating costs than they used to. Whereas founders might have had to actually buy Sun servers back in late ‘90s, today Amazon Web Services can pretty do much everything needed in the early stages (even Quora reportedly relies heavily on AWS). Whereas you may have needed millions in startup costs before, today you might need only $250k-500k to ramp up. Founders’ largest cost today are likely to be the cost of acquiring and keeping top engineering talent.
Professional angel groups can facilitate larger deal flow.
The traditional reason for getting venture capital funding is that VCs could inject much larger amounts of money into the startup. This is still true today. But, as discussed above, because the costs of running a tech startup, especially a web-based one, are so much lower today, professional angel groups (like Tech Coast Angels) can facilitate much larger deals and handle greater deal flow. The result could be that you could get most, or all, of the funding needed to ramp up.
Angel-backed companies may find strategic M&A easier than IPO
By comparison, the way VC funds are structured, the incentives are to go for the HUGE 1000x exit, which is most likely an IPO. However, the IPO market, especially for tech companies, is worst today than it ever was in the late ‘90s. In addition, regulatory changes, such as Sarbanes-Oxley, have made the IPO route more costly for startups. As a result, the IPO route for tech startups is a lot harder than it was back in the day. Sure, there will always be some startups that go public, but ask yourself this: if you were around in the late ‘90s, does the level of tech IPO today compare with that time?
Startups, on the other hand, might prefer a strategic sale to a larger company. Indeed, today, the big trend in exits for startups is M&A or the acqui-hire.
Some problems exist in the VC framework relative to current trends.
One problem with VC funds was alluded to above. Simply put, VCs need a HUGE exit to be profitable. Once you take VC money, you might be “locked in” to the company for a much longer time than you might want to be. Remember that VCs will take a few board seats of your company so they run the company
Investment in preferred stock rather than common stock
VC typically invest in preferred stock, as opposed to common stock like angel investors. I will get around to posting why preferred stock is so different from common stock and how it can cripple young startups. Suffice to say that the upshot of all this is that VC’s incentives are different than the founder’s. This is something to consider.
In a future post, I’ll talk about why it might actually be preferable to get only angel funding. [Note: future post updated here]