Olson’s Observations

Technology. Innovation. Science. VC. Media. :: by Eric Olson

Angelitis

with 3 comments

I read a great post today by Matt McCall of Portage Ventures. The post was titled “The Angelitis Blues” and focused on how seed round deal structures can really affect future professional VC funding rounds. Apparently this is becoming a bigger issue in the new “low cost” start-up market. Matt mentions that he and his partners at Portage had to walk away from three deals recently because of the deal pricing discrepancy issue. Essentially what had happened was the entrepreneurs had priced their previous angel rounds too high and did not want to go through a down round.

This is something that I had not thought of when going through my previous “Fixing the VC Model” posts. I had focused a lot on how cheap it was to build companies, the disconnect between the mega VC funds and entrepreneurs needs and how more angel funded companies could be a good thing for entrepreneurs. In reading Matt’s post the hole in my thoughts (one of them at least) was brought to light. I had failed to discuss how angel funded rounds, if not structured properly, could potentially impede a company’s ability to raise money from a professional VC.

I will quote Matt’s example so you can get an idea of the problem:

The company raises the first $500k at a $5M post-$. They grow and need more capital to ramp sales/marketing, so they raise the next $500k at a $10-15M post-$. At this point, the company is probably doing $1-3M in annual sales and growing linearly. The entrepreneur decides it is time to raise a venture round now, and goes to market with a $5M raise at $20M pre-$ valuation ($25M post-$). This is where the disconnect hits.

A company that is growing linearly (say $1-2m going to $3-5m this/next year in revenue) is going to be valued at a $3-7m pre-$ valuation. (I will write about different pricing approaches coming up.) The revenue often does not ramp as quickly as the entrepreneur expects (plans from two years ago had probably shown revenue of $10M vs. the actual $2M). Angels, being less price sensitive, had been willing to invest at the higher valuations. However, when the company needs more capital to scale (and is tired of living off of $500k rounds), it is forced to go to the professional venture community.

Matt provides one possible answer to this dilemma saying that entrepreneurs should use a convertible debt structure for their angel rounds. This will allow the money to convert to the professional VC round when it is raised. The angels may push back on this for various reasons but if they go for it it will ensure the entrepreneur is not stuck in the future. Entrepreneurs should heed this advice and really think past the dollars when considering their initial funding rounds (and all financings for that matter). Thanks for bringing this up Matt. I look forward to some more posts on Angelitis soon!

Written by Eric Olson

March 14th, 2006 at 10:53 pm

Posted in Fixing the VC Model, VC

3 Responses to 'Angelitis'

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  1. finally, eligible for valleyway…

    i keep getting asked, why are you guys never in valleywag? my stock answer is always “well, we aren’t in the valley.” as of today, i can’t use that one anymore. with the addition of Don Loeb to the team……

    line of site

    15 Mar 06 at 1:30 am

  2. Eric,

    I love reading through your Fixing the VC model. Fund sizes are creeping back up (more $600m and even a handful of $1B funds coming back out…hard to kick the management fee crack). In looking at your previous postings about niching the business and going for more modest returns, there is one challenge. The VC business is based on multiples (e.g. need 10x) since tube shots are nice round -1x results. A good VC fund will have 40% tube shots, 20% 1-2x, 20% 2-5x and the rest have to be 8-10x to make up for the losses. Even in a niche, darwin has his way with early stage companies. If you can eliminate the goose eggs, you have to have the long balls or you fight just to return capital. That is the issue with the venture business if it gets too crowded…people convince themselves they can lower returns on deals, but the laws of physics are still in place. Keep up the great writing…good stuff.

    Matt McCall

    17 Mar 06 at 1:01 am

  3. Great point Matt. VCs still need big winners to obtain overall returns that justify the amount of risk investors are taking. It’s all about risk/reward!

    eric

    17 Mar 06 at 10:39 am

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