Angel investors and venture capital funds have long been a part of the funding scene for software startups, both inside and outside of Silicon Valley. Angels and VCs specialize in investing seed capital to get startups through their prototype development and product validation phase, or to provide the early growth funding needed to accelerate an existing small company up the profit curve after an application or program has taken off.
Once upon a time, startup founders could rely on a clear and easily recognizable boundary between these two groups of investors. That changed during this past decade.
Seed funding and early capital
Angel investors were once typically individuals who had enjoyed one or more spectacular successes as startup founders. They then leveraged their subsequent fortunes to move from being business entrepreneurs to business investors. Angels normally worked the lower end of the investment spectrum, putting tens of thousands of dollars into new companies. Typically they came onboard during the seed round and supplied money in exchange small shares of equity while the startup was developing its proof-of-concept software. Along with their capital, angels normally brought experience, hands-on advice, and access to their network of contacts to a fledgling company before it had a working product with which to approach venture capital funds.
Venture capital funds, meanwhile, are member-owned investment funds where professional fund managers chose promising startups to invest the members’ combined capital in. In the recent past, software and technology VCs primarily operated on the high-end, with investments of a million dollars or more, and generally signed on during the Series A round of early growth funding after an operational prototypes had been developed.
The relationships between VCs and startups were and still are freighted with tension. In exchange for investing significant capital, a venture capital fund will want a degree of direct control over the company along with equity in it. This might be limited to one or two voting board positions being awarded to supervising fund members, or it could go so far as having a fund member or designated agent brought onboard as the startup’s CEO. Startup founders conversely want funding while retaining as much independence as possible.
While some of the larger Silicon Valley funds offer expert mentoring and well-developed industry contacts to startups they fund, it’s important to keep in mind that some VCs are run by bankers whose knowledge of software and the industry is sketchy at best.
So what changed, and what can these two types of investors do for you, the startup founder in the present day?
Angels, networked and super-sized
On the angel side of the funding house two things changed. The first of these developments was a wave of collectivization with several angel investors banding together to form angel investment networks or “angel groups” like the Angel List. This allowed these expert investors to pool their knowledge and boost the dollar amount of investment they made in startups from tens-of-thousands to hundreds-of-thousands of dollars. This took place just as new, leaner startup models emerged, with entrepreneurs using open source software and lean development methods to push combined seed and early funding requirements down from the range of seven figures to six.
At the same time, other lone angels investors leaped into that underserviced $100k gap by using their reputation and expertise to solicit, pool, and then invest other people’s money. These super-angels act like nimble one-man VCs, and have gone head-to-head with traditional venture capital funds in competing with the funds for both investor money and startups to back.
Another emerging trend on the now blurry boundary between angels and VCs is that of incubators. These “accelerators” as they are sometimes refer to themselves, are typically intensive three- or four-month courses in which an angel investor group conducts a rigorous round of interview and selects a group of startups for tutelage. In exchange for a small equity stake, the startup teams are run through a high-intensity instructive period in Silicon Valley or other industry hubs, during which they are introduced to major industry and industry media figures. Graham’s Y Combinator and competitor TechStars are two of the most famous startup incubators.
The VC funds have not taken all of this lying down. Some have begun looking to make smaller, higher volumes of investments in place of the handful of high-end investments that each partner previously signed off on each year. Additionally, the past few years have seen a drift towards VCs demanding less control over startups. Several founders have retained ownership of their companies, even after taking significant VC funding. Arash Ferdowsi and Drew Houston of Dropbox are famous examples of recent founders who remained in charge after the Series A funding round.
So, who will come out ahead in all of this? Will lighter, nimbler super angels and expert angel networks undermine the VCs? Or will the venture funds successfully make more fluid and focused use of their sheer investing power to expand their role in startup investments? At this point, no one knows, though many comentators and industry veterans have spilled much ink and pixels on the topic. Either way, for the time being this competition for startups to fund is good for you, the startup founder.
Approaching an angel or VC
Finding VC investors to pitch to is not as hard as many first time startup founders may think. These investment entities are on the lookout for new companies, and they often offer several venues to approach them through.
Most venture capital funds maintain web sites with both contact information as well as lists of conferences they have scheduled or will be participating in to meet startup founders and listen to their proposals. Fund managers and partners also frequent major industry events in order to stay current on events and meet with their peers. While taking the time to meet and network probably won’t land you an invitation to pitch to them then and there, developing face-to-face familiarity certainly can help when you do approach their fund to make a presentation with a well-prepared business plan and team of software development professionals to back you up.
On the other side of the investment field, angel investors are a diverse group, with different means of contact, and some require more research than others to reach. Super angel investors like Ron Conway who are faced daily with dozens of potential startups eager for their attention often require a referral from someone in the industry. Others like David Mcclure are prolific social media users (a blog and Twitter feed in this case) whose limited liability partnerships or LLCs also maintain websites with scheduled public events. Meanwhile, some angel networks such Angel List use online media to communicate lists of member angels who can refer startups to the group.
The famed business educational Kauffman Institute’s Angel Resource Institute offers a list of angel investor groups organized by regions as well as events involving angel investors. The ARI also sponsors publicly available research on topics such as the experiences of angel investors and the rates of Return on Investment they are looking for.
What are they looking for?
What an angel investor or VC fund manager look for in a pitch varies from individual to individual, and there is no replacement for doing your homework into what kind of startup projects and presentations have secured funding from them in the past. With that said, there are some general rules of thumb that apply.
For many angel investors looking to invest in a startup during its seed funding phase, negotiations can be somewhat informal. While some angel investors may want a copy of a developed business plan, others will be satisfied with a general outline along with a confident-sounding narrative of how the founders plan to develop their product and get it to the next round of funding and the marketplace. At this stage it’s difficult to assign a realistic valuation to a startup, and an angel investor may rely more heavily on his knowledge of the market and judgment of the competence and confidence of the founders rather than the technical details of their software.
Or to put it differently, an angel investor knows failings and shortcomings of the current lineup of available apps and programs on the market. That means he’s often on the lookout for scrappy founders willing to take on those shortcomings. Apparently many angel investors listen for a statement along the lines of “X and Y are doing Z, and they suck at it. Here’s why we can do it better.”
During the Series A funding round to attract additional angels or VC firms, it’s often necessary to have a more thorough business plan with detailed revenue projections, a break-even point, hoped for rates of return on investment, along with a couple of well-respected software developer resumes tacked on in an appendix.
The degree of niche analysis and product technical descriptions required for a pitch at this stage will depend on who you are approaching. Many angels and some VCs are technologically savvy, while others will be looking more at the perceived business acumen of the founders and how confident their product development narrative sounds. While the general lack of investor knowledge about even the basics of software development stuns many startup founders, it’s worth noting that business plans normally end up as casualties to unexpected market developments, unforeseen features opportunities, competitors’ unforeseen features, and consumer feedback information. A group of founders who are too committed to a step-by-step plan or detailed product description may well fold under pressure where a more flexible, gung-ho group will innovate their way to success, even if that triumph takes place a market niche outside of the one that they were initially gunning for.
Another important consideration for VCs and Angels who are looking at funding your early growth will be who you managed to bring onboard during your earlier round of seed funding. Earlier small business bank loans or even a Small Business Administration loan may act as a sign of your credit worthiness and commitment to this project.