So you are raising money for your startup. You have a product and a little traction — now you need to grow. Who do you talk to? How do you get the round closed as quickly as possible without screwing your long term prospects?
You don’t know what you don’t know. Let this article be your intro guide to fundraising. The right partners make all the difference.
“Diamonds are forever”
This is one of the most successful marketing campaigns of all time. De Beers (the evil diamond company from Blood Diamond) convinced women and the world that without a diamond, the marriage wouldn’t last — the man wasn’t serious.
You have to put your money where your mouth is, so to speak.
And startups are a bit like marriage. You are “stuck” together for life. And it can be awesome or awful — it depends on the partner. And since the average US marriage before divorce is 8 years, it equates very nicely to the startup-investor relationship.
I am not cynical enough to say you should spend as much time dating investors as seeing a significant other before getting hitched, but keep this in mind.
Remember, business partnerships are like marriage, without the sex… they aren’t always fun.
Sources of funding
Other than bootstrapping your business, friends and family money and loans or grants, there are 4 main sources of fuel for your startup: angels, VCs, angel groups and syndicates.
Hopefully are familiar with these four groups. If not, you really need this article.
The 4 Sources of Startup Capital
1. Venture Capitalists
Let’s start with the obvious one: venture capital. Venture capitalists manage large pools of money (think several million to several billion dollars in assets under management (AUM). VCs operate what are called funds, typically with ~10 year lifespans (plus options for an additional 2 years). They fundraise, just like startups, but from bigger, wealthier players. Traditional LPs (limited partners — the people investing in VC firms) include pension funds, university endowments, family offices and ultra-high net worth individuals (UHNWIs). In some regions like the Nordics, Middle East and China, local governments invest in venture as well to both drive ROI and boost the country’s economy.
2. Angel Investors
Angels, unlike many VCs, start not as investors but operators in industry. Whether as entrepreneurs or employees, angels are individuals that accrue significant wealth (minimum $1M net worth [excluding primary residence] or greater than $200k per year in income [for at least 2 years]) and reinvest their capital in upstarts. Some angels shoot for returns, others just look to give back.
A wealth of angel investors is the mark of a healthy startup ecosystem. The more successful founders exiting and reinvesting into the next wave, the greater the density of talent, innovation and successful outcomes.
3. Angel Groups
As the name suggests, angels often form groups. There is power in numbers. Groups of angels can cut larger checks, get better terms, spread out due diligence and leverage larger networks to help startups succeed.
Typically angel groups charge anywhere from $100–1000/yr in dues. These dues help run the network and manage events.
Ever since the Jobs act in 2012, the world of investing has been very different. This bill created the ability to form special purpose vehicles (SPVs) to invest in companies. Syndicates use this structure to allow groups of investors (up to 99) to invest in startups via a single SPV — meaning only one addition to the cap table.
This is helps startups keep cap tables clean (a big must for later financing) and reduce legal work. The Syndicate cuts a single large check (rather than lots of little ones from angels/angel group) and still provides a sizable investor base of folks with networks and skillsets that are often willing to get their hands dirty.
Carry and management fees
One last concept to understand before diving deeper into the pros and cons is the incentivization structure. Knowing investors incentives helps startups level the playing field.
You are probably thinking, “The only thing that matters is massive outcomes, right?”
Because VCs manage money for you, they typically earn the most. Generally VCs employ a 2 and 20 model, meaning they get 2% management fees and 20% of carry.
Management fees are based on AUM (assets under management). For small firm with a $10M fund, that equates to $200k/yr in fees — to run the fund, source companies and support investments. Seems reasonable.
It gets more interesting the larger the fund gets. On a $100M fund, it is $2M/yr. $1B fund — $20M per year.
That is the reason VCs are almost always looking to raise larger funds. The bigger the fund, the better the management fees and the bigger their paycheck.
But we can’t forget carry. Carry is the defined as the difference between money in and money out.
Examples work better here. Let’s say a venture firm invests $1M at a $10M pre money valuation. That means that buy 1/11th of the company (investment divided by pre money valuation plus cash infusion).
Now fast forward 10 years. The company is crushing it and is now valued at $1B. And let’s say Facebook buys them because Zuckerberg wants to kill the competition.
Well that is 100x return. If we assume the company never raised more money (just to simplify dilution — note: they probably raised more money), then 100 times $1M is $100M.
The difference between initial investment and result is $99M. The carry, typically 20% is paid off of this.
So the VC firm earns an additional $19.8M in carry. That is the concept of carry.
Of our four groups, only VCs and syndicates usually charge investors carry — both generally at 20%.
And only VCs have management fees. Now that you know the basics, we are ready to look at this from a startup perspective.
The pros and cons of each investor class
For an detailed understanding, we should breakdown the important criteria startups have when fundraising. Then we can evaluate VCs, angels, syndicates and angel networks to see how each stack up in terms of founder friendliness.
The 11 criteria to consider:
- Decision speed
- Investment size
- Control requirements
- Outside help
- Industry experience
- Ability to follow on
- Liquidation preferences
- Common problems
- Help with future fundraising
Note: All scores will be generalized across the investment sector. Individual groups, firms, syndicates and angels are all different. We will work off the average.
1. Decision speed
As a startup, you NEED money now. Although planning your raise in advance and to have 6 months to prepare and close is ideal, you probably procrastinated. You probably need money and you need it now.
Your burn rate is tough. There isn’t a ton of cash in the bank and even the Ramen is running out. Who do you turn to?
- Angels — The fastest investor is almost always the angel. Angels can cut checks after just coffee, it is their money. They can do with it what they want.
- Syndicates — After angels, syndicates come in 2nd. Syndicate leads can quickly decide on deals and share them their investors. Typically syndicates will run 2–4 weeks but hot deals close fast. But as a founder, as long you know the allocation will be met, an extra 2 weeks isn’t a huge deal.
- VCs — Venture firms are often slow and bureaucratic but can move quickly when motivated to do so. For hot startups and fast moving deals, VCs can push investments through and, pending due diligence, be done nearly as fast as syndicates. Typically however they are a bit slower due to processes in place.
- Angel Groups — Angel networks are definitely the worst here. While there are some fast moving ones, many groups only have pitch events every few months or quarter, meaning entrepreneurs often need to wait. And even if angel groups are a go, convincing enough members to cut checks can slow the process further.
2. Investment size
While speed is great, you need runway even more. A $25–50k check might buy you a few months, $500–1M and suddenly you are set until your Series A. And the check size impacts how many investors you need onboard, crowding on the cap table and the number of meetings you need to schedule to complete your close.
- VCs — Venture firms usually cut the biggest checks. They typically have ownership % targets they need to make their economics of their fund work. Most VCs want every investment to be able to return the fund. So if that is 50 investments per fund, they need companies that can go 50x. All VCs will vary on check size but most early stage firms cut at least $250k checks, with many going north of a few million.
- Syndicates & Angel Groups — This one is a toss up. It depends on the size of syndicate and angel group. Some syndicates on AngelList like Gil Penchina’s Flight Ventures have close to $10M in backing. They “can” cut big checks. It doesn’t always work that way though. The same is true for angel groups. Here minimum investment size plays a huge role. Many syndicates (ours included) let investors invest just $1k to get in on a deal. This empowers investors to participate but due to the 99 investors clause, this can prevent massive check sizes. Typical max for a syndicate or angel group will be ~$1–2M, with the average closer to $200–300k.
- Lone Angels — Unless you are dealing with UHNWIs, most angels cut relatively small checks: $5–100k. It is possible to get more from a single angel but pretty rare. With angel investors, don’t forget legal work required to process checks and update cap tables. Often small investments, under $5–10k don’t make a ton of sense, especially after initial Friends and Family round.
3. Price and Valuation
Dilution is a big problem for founders, potentially. When negotiating, remember a small piece of a big pie is better than a personal pan pizza. Startups are all about outsized returns. 1% of Uber would still be worth $700M today (unless they crater — I think Uber’s in big trouble, here is why).
In terms of valuation however, startups can get screwed. So let’s look at how each class of investor handles valuations.
- Lone Angels — Angels are often the least price sensitive. Many are involved not for economic reasons but to give back, or even for their ego — “Yeah, I invested in XYZ startup!” Because of this startups can often get higher valuations when negotiating with individual angels as opposed to other groups. The investors have less negotiating power and generally less insight into the industry and comparables. NOTE: do not take advantage of angels. Raising at too high of valuations can hurt downstream financing opportunities. No one wants to have a downround.
- Angel Groups — Angel networks are more sophisticated than your average angel and often able to lead a round. They will be more realistic about valuations than lone angels as they place a larger focus on returns for their members. And as they cut larger checks, they can negotiate for better terms.
- Syndicates — Syndicates, even more so than angel groups have pricing power. Because syndicates invest faster, typically with similar or even larger check sizes, they hold more power than angel groups. Syndicates are very focused on returns, especially upside as the carry is the incentive that syndicate leads really benefit from.
- VCs — Venture capitalists usually are the most valuation sensitive (although some recent firms like Andressen Horowitz frequently overpay to get in on the best deals). VCs need to provide returns to their investors to increase AUM and subsequent management fees. In the past VC was dirtier, and much less founder friendly. Today however the valuations are not that dissimilar from a syndicate.
4. Control requirements
Most founders hate giving up control. Between potential conflicts on direction and being forced into unfavorable terms, it makes sense. And if you look at some of the most successful tech companies of today, many like Zuckerberg and Bezos have maintained their control over their companies, allowing them (and not investors or board members) to steer the ship and drive returns.
NOTE: This is not to say governance is bad. Board members can be incredibly helpful, especially for accountability and future focus.
- Lone Angels — Most early angels will not take a board seat or have much in terms of control. They will offer guidance when needed (and occassionally not), but all in all they leaving running of the startup to the founders.
- Angel Groups and Syndicates — Both angel networks and syndicates require more terms and control than individual angels, but still typically very little. Some may require board seats and most will push for pro rata, information rights and updates — but it is much less of a confrontational relationship. Angels groups and syndicates instead get out of the way and leverage networks and experience wherever possible to help.
- VCs — Surprise surprise. Venture capitalists are the most picky when it comes to terms. They have fiduciary responsibilities to their LPs and partners and will do whatever it takes to drive outcomes. Most VCs, especially from Series A onward will require boards and possibly even board seats. This can work out great. It can also result in founders getting ousted. And pretty much any VC will demand pro rata, information rights and other clauses to protect their investment.
5. Outside help
Investors always talk about adding value to founders and being founder friendly. Sometimes this is the case, sometimes it isn’t.
- VCs — At least on paper, VC firms have the most resources to help founders. With management fees, many firms hire advisors and technical specialists work with founders on their business. It can be a very hands on investment and the best VCs (like Social Capital) go to work for their founders. They leverage network and help with hiring and intros, including future fundraising opportunities. That isn’t always the case though.
- Angel Group — I ranked angel networks slightly ahead of syndicates as their members are typically more engaged. Members invest in fewer deals and are often locally present to work with and help founders. This creates strong regional support networks that can be vital to growth.
- Syndicates — Syndicates, like angel groups have large member bases and skills sets. The best syndicates deploy their members’ networks and skills for the greater good of the portfolio. Unfortunately many investors don’t meet their investees. The relationship can still be quite good, tapping networks and helping with growth but has room for improvement.
- Lone Angels — Last and certainly least is the individual investor. They will likely tap their network, help where they can and be able to meet for coffee — but two heads are better than one. There is only so much a solo practitioner can do for startups.
6. Industry experience
Much like outside help, industry experience is essentially the same. The one difference being that syndicates and angel groups would score the same.
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7. Ability to follow on
You are probably going to need more money. Investors that follow on fuel growth and make fundraising much easier.
- VCs — Venture capital portfolios are usually predicated on follow on investments. Funds typically reserved 50–75% of the fund for follow on investments (although this varies by firm). The reason is simple. In a world of power law returns, doubling down on your winners drives the biggest ROI. And because VCs have the biggest chip stack, they can keep doubling down.
- Syndicates — Because syndicates are composed of a large pool of investors, there is a lot of capital at play. Syndicates will typically at least exercise pro rata to maintain their equity position. And since every investor only contributes a small percentage of the round, it is relatively easy to raise some follow on funding.
- Angel Groups — Angel networks are less likely to follow on than syndicates. Between the time commitment of pitch events and reduced focus on ROI, many groups will pass on pro rata.
- Lone Angels — Individuals investors only have so much cash. And most either do not think through follow on funding strategies or reserve capital. As such it can be hard for founders to get early investors to contribute more or float a bridge round.
Raise your hand if you like politics and drama…
- Lone Angels — Solo investors definitely win this category. They have no accountability and can cut checks over coffee. Plus there is no politics over who gets funding or carry.
- Syndicates — Although not as nimble as lone angels, syndicates are pretty straightforward. A syndicate lead finds deals and offers them up to group. In these instances, often the lead’s reputation plays a big role in how many members invest. The lead also has to encourage their investor base to join, without underselling the risks. This can be tricky, as syndicates only earn carry — meaning reputation aside, they are encouraged to do as many deals as possible.
- Angel Groups — Between the processes of angel networks, dynamics between members and potential rules/guidelines on investment criteria, location etc… angel groups are a bit more complex than syndicates. Often this complexity corresponds to slower investment decisions — not ideal for founders.
- VCs — Most venture firms are great, but there are certainly politics at play between GPs (general partners — ie managers of the firm). These vary from firm to firm, from how voting occurs to differences in incentives. An obvious example: If part of a GP’s carry/incentives comes from deals they source themselves, clearly there is a conflict of interest. That GP is always more likely to vote to fund their own deal flow… Similar issues can occur with partners having veto power, and/or control of a firm. When raising from VCs, expect a minimum of 3 meetings (and understand how decisions get made). Typically founders won’t get a YES before pitching at full partner meeting.
9. Liquidation preferences
You would think that all parties are aligned here — just build a big business and the rest falls into place. Unfortunately it isn’t that easy.
There are many classes of stock and terms affecting outcomes. The most important to consider are Preferred and Common classes of stock. In a nutshell, preferred means I get my money out first and usually win (or lose the least) even in bad outcomes.
NOTE: Founders and early employees have Common shares, whereas some investors demand preferred shares (to protect against downside risk).
That can mean founders sell the business and still end up with nothing. For a more detailed explanation on liquidation preferences and share classes, see this post.
- Lone Angels — Individual investors are often least savvy and/or cutthroat when it comes to liquidation preferences and terms.
- Syndicates and Angel Groups — Both of these investor networks have more experience and battle scars from past investments. This puts both groups in a good position to both understand risks and leverage capital to receive more favorable terms, and often Preferred Shares. These will be less “preferred” than future Series A Preferred, Series B Preferred etc… shares, but still provide a measure of protection for investors in event of that things go south.
- VCs — Venture capitalists are the toughest on terms and liquidation preferences. Most will fight the hardest to secure their investments, often with additional icing on the cake in the form of multiples (2x multiple: invest $1M and receive $2M) or participation rights (double dipping — receiving money back plus equity % of leftover capital). As a rule, avoid participation rights, especially pre-Series A. These terms can cripple startups ability to raise and leave founders out to dry.
NOTE: This isn’t legal advice. Talk to a startup attorney, protect yourself.
10. Common problems
VCs are the only real troublemaker in the group. Angels almost universally write off investments, assuming every check will go to zero.
Unfortunately as VCs have LPs, many venture firms play hardball. Venture funding is fuel, you either take off or get burned.
Things to look out for:
- Full ratchet anti-dilution — Stipulates that investors will retain their equity position while founders/team will suffer all dilution — creates horrible situation where founders lose equity and motivation to continue
- Board seat control — When VCs or external parties control the board, founders find themselves at mercy of board/investors. This can cause problems, from firing the CEO to acting in the investors (and not founders/company’s) interest
- Unsustainable growth focus — VCs need investments to be able to return the fund. This can force startups to try and grow at unsustainable rates and ultimately handicap the businesses.
- Liquidity requirements — Most VCs operate 10 year funds, with an additional 2 years of optionality.
- Too much capital raised — Yes, you read that right. Startups can raise too much money, greatly reducing liquidity options. The more you raise, the more you NEED to be able to sell or IPO for or investors lose.
11. Help with future fundraising
- VCs — As full time professional investors with resources and network of the entire firm behind them, VCs are incredibly for future fundraising. Between follow on checks and warm intros to later stage firms, a VC’s business is built on connections.
- Syndicates and Angel groups— While VCs are typically closer with other VCs, syndicates and angel networks have lots of members, each with their own broad network. And for angels that do this for a living, they focus on building the same connections to later stage funding.
- Lone Angel — You don’t know who you don’t know.
So, who comes out on top? Adding up the points, here is how they stack up. The fewer points, the better.
- Tie: Lone Investor & Syndicate: 23 points
- VC: 24 points
- Angel group: 25 points
If this seems counterintuitive, it is because it is. There is no one best way to define an ideal investor. Each group brings something important to the table.
Arguably invidual investors will be the earliest and VCs will come in last. From a funding perspective (arguably the most important variable), angel groups, syndicates and VCs are all on par in the earlier rounds (pre-Series A). After that VC money is a must if you need to continue raising.
Of the two most comparable investor classes: syndicates and angel groups, our analysis would lead us to believe that syndicates are a slightly better funding partner. I would tend to agree. As a syndicate lead myself, I see syndicates as the future of investing. SPV’s won’t kill venture, but syndicates will continue to take an increasingly large chunk of early stage investments.
And as angel groups generally have little to no upside but come with increased complexity for investing, one would assume more and more angel networks will go the syndicate route.
Hopefully this breakdown gave you a better understanding of the venture landscape. Knowing the players, how they work and what to look out for is critical to startup success.
So, look through our list. Which of the 11 are most important? Certain criteria like decision time, investment size and control requirements are often make or break for founders. The same is true for investors.
Pick apart your priorities and plan your fundraise accordingly.
NOTE: Have good investors in different classes of venture is recommended — don’t put all your eggs in one basket.
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Originally posted on Medium