Venture capital firms are in the business of funding promising entrepreneurs. The conventional wisdom, which some say has fallen by the wayside as older firms have matured, is that returns are better when VC firms are entrepreneurial — nimble, forward-looking, well connected and armed with an appetite for risk.
A new crop of investors — dubbed “super angels” — are trying to bring that model back into vogue, making deals that now giant firms like Kleiner Perkins Caufield & Byers and Sequoia Capital might have done in their younger days.
Filling a funding gap between so-called “angel” investors and VC firms, super angels combine the traits of both, while also putting a timely, web-savvy stamp on the process of starting and building companies. Super angels are often former entrepreneurs themselves; several came out of companies like Google and Paypal. They are exceedingly well connected among techies, conventional angels, larger VCs and most of all, each other.
While almost none post office phone numbers on their websites, they all actively use Twitter and blog, and regularly refer to, and comment on, one another’s postings. They say that maintaining active social networking profiles generates buzz for themselves and their investments; it also fosters the impression that they are at the nexus of a smart, cool, sought-after community of founders and funders.
Whereas regular angels only invest their own money, super angels manage small funds that put their own money alongside that of friends, family and offices that administer the finances of wealthy extended families. Some super angel firms have attracted institutional money from universities and elsewhere, and at least a few more say they are likely to seek out more of that type of funding as they build track records.
Super angel funds are typically $10 million or less, though they are starting to break through that ceiling. Individual investments by super angel firms are usually less than $500,000. They can be tens of thousands in some cases, but rarely top $1 million. By contrast, individual investments by traditional VC firms are often in the multimillion dollar range. When a seed-stage company needs $500,000 to $2 million, super angel firms are more likely to expand their syndicate of co-investors than to write bigger checks.
Like angel investors, super angels are committed to seed stage companies, often investing in ideas that at the time amount to little more than “a Power Point presentation” in terms of tangible results, according to Josh Kopelman of First Round Capital, a Philadelphia-based super angel firm. For the time being, most seem determined to stay in that space, though some are starting to leave room in their funds for follow-on investments to help their start-ups further grow and evolve. This allows the firms to “lean heavily into the most promising companies,” suggests New York-based super angel Roger Ehrenberg. Also, additional investments can be necessary to avoid having their ownership significantly diluted if a start-up goes on to take money from big VCs, notes Bo Brustkern, a former VC who now runs a valuation consulting firm.
Whereas angels and VCs collectively invest across a broad range of sectors, super angels favor a select few, experts say, where start-up costs are minimal, burn rates are nominal and it is clear in six months to a year if an idea is viable. You will see super angels investing in mobile and web-based software; social networking tools and platforms, and web-based advertising and media ventures — some business-oriented, many consumer-oriented. An extreme example of how this type of investment can work: Chris Sacca, the founder of super angel firm Lowercase Capital in Truckee, Calif., notes, “I have a company in my portfolio that has a $3,500 a month burn rate. The cost is not technology; its people and food and rent.”
You won’t see super angels in cash-intensive sectors like hardware, semiconductors, retail, biotech and life sciences or clean tech, states Manu Kumar, who runs the one-man super angel shop K9 Ventures in Palo Alto, Calif. The choice is a smart one, Wharton management professor David Hsu says, because “the back-end technology is commoditized. So the question is can you [instead] find a good idea and people who can execute on that?” Once super angels do that, it often doesn’t matter if a start-up’s initial idea fails. With such a slow burn rate, “[super angels can allow the fledgling company to] iterate and evolve and adjust course,” until they hit on a business plan that’s profitable, Kopelman points out.
Quick Turnaround, Smaller Returns
That type of strategy is why super angels so far seem to have a lower rate of out-and-out failures than big VCs, observers say. Ehrenberg, the super angel in New York, has invested in 40 companies in the last five-and-a-half years. He’s exited from five, but only three have flat-out failed. The rest have either gone on to bigger investments or are still finding their way while whittling away at their funding.
While angels count on passing the companies they invest in up the food chain to conventional VCs, super angels routinely bypass the big firms. Instead, they will let their entrepreneurs sell to a large company like Google, Facebook, eBay or Microsoft after the start-up has proven their concept works but before they have developed a clear market (which often requires bigger cash infusions). Those tactics lead to faster exits from investments than either VCs or angels typically see, and smaller monetary returns than VCs like to settle for.
Currently, traditional venture firms typically hold on to companies for five to nine years, according to Dow Jones VentureSource. And angel investors usually can’t get out of a company until after their VC counterparts have, notes Brustkern. In sharp contrast, super angels routinely exit companies in four years or less. For example, super angel firm Felicis Ventures has had 15 liquidity events since founder Aydin Senkut began investing in early 2006. He writes on his website that he made each exit within three and a half years after his initial investment in the respective company.
The acquisition deals super-angel-backed companies take often fall somewhere between $10 and $50 million. The buyers are often a handful of tech companies that have a lot of cash on hand. “Big companies like Google, Facebook, News Corp, Motorola, Amazon, Yahoo! and Microsoft will all buy start-ups, whether it’s a talent acquisition at $2 million to $3 million per engineer or a $20 million strategic acquisition of a young company that’s beginning to inflect,” Sacca notes.
Those sums are peanuts by VC standards but Hsu points out that, “given the low costs [of the initial investments], you only need a modest hit rate to have a sufficient return for the holding period and the level of risk involved.” Kumar concurs. “If I’m investing hundreds of thousands in a company that exits at $50 million, that’s a good return. [Super] angels depend on lots of good returns.” For example, one of the sector’s success stories is an advertising technology company called Invite Media, which was founded at the start of 2007 and received seed funding from First Round Capital at the end of that year. Two years later, the start-up got another round of money from First Round, and an investment from a corporate VC, but the total funding overall “was less than $5 million,” according to Kopelman. This past June, Invite Media’s founders sold it to Google for a reported $80 million.
Some observers in the venture industry, however, have lately been complaining that super angels are cutting short the lives of companies that could be “the next Google” by selling them to Google before they’ve even developed a market. But others think that could be frustration talking: By allowing some of the brightest and most promising founders to cash out early on, super angels are cutting into VCs’ deal flow — and the firms need good deal flow to survive. According to David Wessels, an adjunct professor of finance at Wharton, the super angels are simply playing to their strengths, just as the VCs do. “The companies could grow and go through their paces, but then these investors wouldn’t have their cash back to reinvest as quickly as they do. Their core skill set is to get them off the ground, not to get them through those next stages.”
That said, Wessels adds, “If a super angel did find the next Google they would hold onto it. So the idea that you can’t get a Google out of a super angel is silly.” Indeed, super angels were among the first investors in Twitter, Facebook and the online personal finance service Mint.com. They are still along for the ride with the first two. First Round broke its seed-stage-only rule to participate in several rounds of Mint.com’s funding before Intuit acquired it in 2009 for a reported $170 million.
“We don’t just count on the quick exits,” Kopelman notes. “We had a company we sold to Google for $100 million, and other companies [where we were] offered more than that [but chose to say] no and keep going.” Super angels “don’t aim for the $25 million or $50 million exit,” he says, but because his firm’s total investment is relatively small, “that exit can yield a positive outcome for us.”
While K9, First Round and Ehrenberg’s IA Venture Partners invest at a typical rate of a handful of companies per partner per year, several of their peers invest at an astonishingly rapid rate. Senkut has backed 60 companies in four and a half years. Well-known dealmaker Ron Conway, who raised a $10 million fund earlier this year and was at one point an early stage investor in Google, Ask Jeeves and PayPal, averages about four investments a month, according to TechCrunch. This puts him roughly apace with a firm the size of Kleiner Perkins, which has more than 30 partners and a full support staff.
New Temptations and Challenges
Super-active super angels are literally seeding a field of start-ups and seeing what takes root. But critics argue that this strategy might be covering up a reluctance, or inability, to distinguish promising companies from duds, which could hurt these investors when market conditions don’t favor them the way they do now. Wessels suggests, however, that the strategy makes a certain amount of sense. “A large fund puts so much due diligence in because it’s investing at a later stage where you can pick winners and losers. With really small companies you’re better off putting feelers out, giving a little capital and a little guidance and seeing what happens, seeing who should get more money or more mentoring from you.”
Of course, the super angel strategy of making a lot of small bets, hanging on to a few of the most promising and quickly selling the rest for a modest sum to a defined group of cash-rich acquirers, seems very “of-the-moment” in an industry where everything from the hot sectors to the best exits are cyclical. Thus, some observers wonder where these super angels will be in five years.
M&A, like everything else, grows and contracts in cycles. In the first half of 2010, there were 197 IT-related M&A deals in just the San Francisco Bay area, according to the 451 Group. The firm reports that Google alone has acquired 43 companies over the past three-and-a-half years. Yahoo! EBay and Adobe have bought 18, 10 and seven, respectively. Eventually, however, experts expect that the activity will slow down.
Kopelman points out that, given the slow burn rate of most super angels’ portfolio companies, the firms could “easily ride out a 12-to-18 month blip in the M&A market.” For the time being, he is probably right, experts note. But the Web 2.0 sector will eventually mature, like the e-commerce, search engine and other sectors before it. At that point, super angels will have to either find a new cash-efficient niche or change their exit strategy to accommodate higher-cost companies. If this happens as the M&A market slows, the firms could really be squeezed.
Additionally, if the IPO market loosens up, VCs could start hitting more home runs again. Limited partners, especially institutional ones, could become less satisfied with super angels and their string of base hits, no matter how steady. Doug Collom, vice dean and lecturer at Wharton and a partner in Wilson Sonsini Goodrich & Rosati in San Francisco, observes this change happening already. “If you have VCs looking for deals and the IPO window is shut, you have to focus on companies that appeal to the big acquirers,” he suggests. Although super angels have the edge because they have more pricing flexibility than VCs, “the equity markets have begun to open for tech IPOs, which is a hugely positive development. Now the VCs can look at companies that cater to huge markets without regard to whether they feed the big acquirers.”
In the meantime, on the fundraising end, success brings new temptations and challenges for super angels. Sacca points out that institutional investors came knocking on his and other super angels’ doors, but a $10 million fund is too small for most of them to squeeze into. “That’s the amount they want to put into one fund,” he says. Some super angel firms have gotten bigger to accommodate those new clients. Many firms seem to be trying to grow in a way that allows them to stick to their niche, capping themselves at $15 million or $20 million per each principal in the firm, half or less than what the partners in a bigger VC firm might handle. But it still results cumulatively in more capital chasing tiny seed deals, experts note.
Moreover, answering to institutional clients is different from answering to yourself as an angel or to a circle of family and friends. “My most successful investments are still independent. They’re growing and I want them to be bigger and successful so they can get a larger M&A offer or even an IPO,” Ehrenberg states. “As an angel, I didn’t care; I could be patient. But with an LP the timing of exit is material; there’s the desire for liquidity. So that raises all these issues I didn’t have to deal with before.” Due to all of the changes in the sector, K9’s Kumar predicts inevitable evolution. “We’ll all move up that spiral. If I take institutional money [and he hopes to with his next fund] I will get bigger. And if that’s how you grow, it will inevitably change the types of investments you are making.”
At the same time, observers say that as the Web 2.0 sector and its exit strategy mature and picking winners gets harder, super angels who count on broadly seeding the field instead of cherry-picking stand outs could stumble and fall by the wayside. But others will no doubt settle into the seed-stage niche, adapt as it changes and be happy with the relatively small amount of wealth it generates for them. “Super angels have a different chemistry than VCs do,” Wessels says. “They’re not finance professionals; they’re former entrepreneurs. If you are a true entrepreneur [that way of doing business] is in your blood.”