Reasons why angel-backed startups should reject VC money

by admin

angel investing venture capitalThe 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.

Lock in

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]

{ 5 comments… read them below or add one }

MichaelSinsheimer

Totally agree with this perspective – in today’s environment, one should only take VC money to scale an enterprise that doesn’t reach an exit and can’t really scale without a substantial infusion.  If this is the route to be taken, the entity should do the best it can to validate the business so that the valuation is maximized and dilution is minimized.  Beyond the points here, crowd funding is also starting to be a finance avenue.  We are building our social commerce business at Flash Purchase to grow as organically as it can without venture money.

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melayan

 @MichaelSinsheimer Thanks, Michael. Dilution is a big concern and more founders should position themselves to have as much leverage as they can as they seek financing. Best of luck with Flash Purchase!

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MichaelSinsheimer

 @melayan  @MichaelSinsheimer Thank you.  Dilution is actually a positive if one believe the contribution (monetary or sweat equity) adds value at least equal to the contribution if not greater.  I actually look forward to dilution under those circumstances, but entrepreneurs should know that equity is the most precious thing they have as they can’t get it back once given away unless there’s some forfeiture clauses negotiated.

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MichaelSinsheimer

 @melayan  @MichaelSinsheimer Thank you.  Dilution is actually a positive if one believe the contribution (monetary or sweat equity) adds value at least equal to the contribution if not greater.  I actually look forward to dilution under those circumstances, but entrepreneurs should know that equity is the most precious thing they have as they can’t get it back once given away unless there’s some forfeiture clauses negotiated.

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Ian @ projects2crowdfund

Certainly! I think this post highlight the advantages of crowdfunding over using VC money. Great post!
http://www.projects2crowdfund.com/crowdfunding-market/

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