Venture Capital / Angel Funding

We have opined before on the "Equity Gap", that amount of money - c $0.5 to $2k- between comfortable Angel funding and comfortable "trad" VC funding that the New Techspace is increasingly spotlighting, since the New New Technology also has some New New Economics:

(i) Moore's law and Open Source software has dropped the Capex spend for any startup by 1-2 orders of magnitude
(ii) Modern hosting, bandwidth cost reductions and offshoring software development has dropped Opex costs
(iii) Much higher online penetration and higher willingness to spend - plus better transaction processing - means companies can attract customers far earlier in the lifestage, so they become self funding far earlier.

Net-net this means that the amount of funding such companies require is lower than VC's traditionally put in, and they (theoretically*) need to change their business models to reduce the cost of doing deals at these order-of-magnitude lower funding levels.

Others have already spotted the gap - Y Combinator and Charles River Ventures for example; and now comes the WSJ with an analysis of how Peter Thiel has been operating:

Mr. Thiel, the former CEO of online-payment company PayPal, is making waves in Silicon Valley with an investment strategy that differs significantly from the traditional approach. His company invests only modest amounts of money, sometimes just a few hundred thousand dollars, and focuses on entrepreneurs Mr. Thiel and his partners often know personally. He also takes an uncharacteristically hands-off approach to company management.

Already, the gambit has yielded several potential winners like Facebook.

The venture-capital world "definitely needs to be shaken up," says the 40-year-old Mr. Thiel...

The approach of hands off is no doubt necessary so the transaction costs of bankrolling any one company do not push the deal into deficit. However, there is also a shift in power between The Money and The Talent in Small Companydom, as in many other areas when surplus cash floods in:

Most traditional VC companies want to invest larger sums, several million dollars, say, for large stakes in start-ups and then exert control over the companies' operations. Some demand "liquidation preferences," or guaranteed returns if companies are sold.

But.....

With so much money chasing deals in Silicon Valley these days, start-ups can afford to be choosy in picking their financial backers. They are increasingly turning to companies like his that offer less of a "command and control" model, he says.

Added to that is the issue of adding value in a low budget world - old models no longer work as the costs are too high:

Venture capitalists often can be too quick to fire start-up founders and replace them with professional managers, Mr. Thiel says. He blames a cultural divide: Many VCs "have these very cushy jobs, they get paid a lot," and often can't relate to founders, he says.

However, to us this is the fiddling at the edges, any moderately smart VC could adapt to this world - the real shift is in allowing Entrepreneurs to partially avoid the lousy game theory of being a founder - aka the Founders Discount

Significantly, the fund often buys only a 5% or 10% stake in a company and sets up a special class of stock that start-up founders can sell while they are building their companies -- and before venture-capital investors see profits. That way, the thinking goes, the company founders can reap some financial reward and stay motivated to build the company before an IPO or company sale, which can take years.

Now that is revolutionary, as a prime tenet over the years has been for funders to rig the game so the Entrepreneur (and their house if possible) is lashed to the helm of the Enterprise. Shifting the game makes startups attractive to a whole new group of people - ie those very talented people who until recently could actually do better by being in employment, or were strapped to family needs etc.

This world is going to get very interesting now methinks.....

*Theoretically......our experience is the hassle for a $50k Angel deal can be as time consuming as a $500k or even a $5m deal

Mike Butcher has written a very good article on the London VC / startup scene over at TechCrunch UK. Some excerpts and some comments:

A few VC firms are starting to realise they have boards packed with people who don’t contribute anything to the bottom line of the firm and aren’t actually able to keep up with the fast pace of developments in the market today. If you are a startup looking for VC backing, look into who is on the board. If the board has people on it who reflect the right kind of knowledge about the broad issues of entrepreneurship and the tech market then this is a good sign. If it is stuffed with a lot of old suits who did well in the 80s but barely understood Fax machines when they launched, think again. Perhaps that sounds harsh but these are the people your personal VC contact may have to convince about your startup.

I think this is a very pertinent point, I would add that an entrepreneur should also be very wary about who they wish to put on your board, and also who they may want to send in as advisors - I have seen some serious damage done in this way - still makes me cross thinking about some of 'em

Advertising, despite many nay-sayers, is going to be a deeply interesting business model for some time to come. The simply fact is that there remains billions of dollars which have not been spent online, but which economic issues like the credit crunch will start to push online. Why? Because online is measurable, off-line it is not.

Exactly...the issue right now is not metrics per se (there are gazillions of 'em, if anything its the choice that confuses) but understanding what those metrics actually mean, which are key, how to use them predictively etc. However, there are some things to know:

- The global Ad industry is a c $0.5tr industry - Telcoland is c $2tr for comparison - ie there aint enough Ad money for everyone, even if 100% spend is online
- The Ad revenue values for sites that can't deliver volume or targets will not be linearly less, but geometrically less - ie the revenue will likely be distributed by a power law stronger than actual attention distribution, due to the transaction frictions of Ad-serving

In other words, advertising in a me-too will not work unless there is serious traction - for e.g our analysis show that Web TV is getting CPM's nearly 2 orders of magnitude higher than Social Networks (thus its odd that the relative valuations are inverted - fashion plays a bigger role in this arena than many acknowledge)

But the smart ‘western’ startups are finding ways of working in a pan-European manner. I have lost count of the startups I have met in continental Europe who say things like “Our head offiice is in Copenhagen, but our developers are in Warsaw, our VCs are in London and we have a biz-dev office in San Francisco”. Outside of the US, all of these people are an hour or so away on a plane (remember to carbon offset your flight though!). It is precisely this “Think Europe” attitude which I personally would like to see more UK startups take on board (I will not bother lecturing my Irish friends about this - by and large they already do it).

I don't know if anyone has read "The World is Flat" or books of similar ilk, but the real advice is to Go East, but don't stop at Slovakia - keep on going, that's where tomorrow's customers are.

But let’s be in no doubt that the era of turning up to an OpenCoffee event in a loud shirt, talking loudly about “Web2″ and your social networking startup for owners of three-legged dogs is pretty much over. The same goes for the guys who have a great idea marketing to Gap year students who want to blog their trip…

Did I tell you about our silent mode startup selling loud shirts to Gap year students via social network blogs

Fred Destin, VC with Atlas Ventures, says “brace yourselves for a tough 2008“. His view is that investors have done a lot of deals in the last two years and now what faces them is a period of uncertainty. That means entrepreneurs need to get tough and “make their cash work even harder.”

In other words getting funded is still going to be like getting blood out of a stone .......... we shall see, I was at a research presentation recently that was saying that the Valley is moving from Fear Mode into "Greed Mode" when silly money is thrown at sillier companies.

Couldn't possible happen here of course....

Its an interesting balance...a McKinsey survey of the dotcom boom noted that no money was made (on a net basis across the industry) in SV VC after c 1998 - it was the people in early, taking the flyers when things were very unclear, who made the real money.

A little recession is no bad thing for the internet entrepreneur. Less able to fritter their time and money away in the real world, more people arrive online to swell the ranks of the potential audience. Plus office rental gets cheaper. And Europe’s base of angels and investors is likely to grow exponentially, as pointed out by Nic Brisborne of DFJ Esprit.

Give me another bubble any day (check out this song)......I recall trying to get funding for stuff in 2002/3 that were funded a few years later (and too late). I recall one conversation where the VC was concerned that the proposed business had (gasp) no profits yet. When we pointed out politely that if there were indeed profits, then taking VC money would be an unnecessary option, it was clear we were in Deep Fear country

Just one request......can we have company names without double-vowels and missing "e"'s before the obligatory "r" at the end.

Update - to be fair, I don't think the VC community is really where the UK's problems lie - imho its at the "Equity Gap" between "friends and family" and VC's - ie at Angel level - where London (and the UK) is broken, plus the unwillingness of the funders to help mitigate the Entrepreneurs Discount in the UK - so be keen to read Mike's post on that arena.

At the FOWA conference last week, Paul Graham talked about the commoditisation of startups, and as an aside he noted that this would increase rather than reduce the influence of Silicon Valley (see our post on this at the time here). Needless to say, this went down well in London (not ) and there were earnest rebuttals, to which Paul has replied here. Sez he:

The idea that startups would do better to move to Silicon Valley is not even a nationalistic one. It's the same thing I say to startups in the US. Y Combinator alternates between coasts every 6 months. Every other funding cycle is in Boston. And even though Boston is the second biggest startup hub in the US (and the world), we tell the startups from those cycles that their best bet is to move to Silicon Valley. If that's true of Boston, it's even more true of every other city.

This is about cities, not countries.

This is an interesting point, and fits other research (eg Porter's theories of industry clusters). He goes on to say:

The difference between cities is a matter of degree. And if, as nearly everyone who knows agrees, startups are better off in Silicon Valley than Boston, then they're better off in Silicon Valley than everywhere else too.

I realize I might seem to have a vested interest in this conclusion, because startups that move to the US might do it through Y Combinator. But the American startups we've funded will attest that I say the same thing to them.

I'm not claiming of course that every startup has to go to Silicon Valley to succeed. Just that all other things being equal, the more of a startup hub a place is, the better startups will do there.

And that is really the nub of it - what cluster of skills, infrastructure, services etc does a start-up hub need - and thus, if London is to be a hub, what does it need to do?. Being in similar industries helps:

If your startup is connected to a specific industry, you may be better off in one of its centers. A startup doing something related to entertainment might want to be in New York or LA.

Or London for that matter...but the point is taken - what does each city have as initial suppliers/customers. London is very cosmopolitan, but its not exactly the centre of the universe for deep infrastructure - finance, retail and media R us, however.

But the main thing is access to people with money:

In fact, the quality of the investors may be the main advantage of startup hubs. Silicon Valley investors are noticeably more aggressive than Boston ones. Over and over, I've seen startups we've funded snatched by west coast investors out from under the noses of Boston investors who saw them first but acted too slowly.

At the risk of annoying my UK VC friends, I would suspect that this is a UK issue too....does this ring true?

West coast investors are confident enough of their judgement to act boldly; east coast investors, not so much;

And of course its about the f2f socnet:

In addition to the concentration that comes from specialization, startup hubs are also markets. And markets are usually centralized. Even now, when traders could be anywhere, they cluster in a few cities. It's hard to say exactly what it is about face to face contact that makes deals happen, but whatever it is, it hasn't yet been duplicated by technology.

And finally, a very interesting point:

(If another country wanted to establish a rival to Silicon Valley, the single best thing they could do might be to create a special visa for startup founders. US immigration policy is one of Silicon Valley's biggest weaknesses.)

So...Four things London needs to be a startup hub:

- A skill cluster in the city that forms a first market for startups
- Access to bold investors
- F2F contact networks that are "always on"
- Access to smart, ambitious people from wherever

To these I'd add (based on research I've seen elsewhere) top class universities, infrastructure that is Good for Geeks

Now Ryan Carson, who organised FOWA, has written a rebuttal here - this is a part of it:

I just spent 14 days travelling around various cities in Europe on our FOWA Road Trip. I shook a lot of hands and had a ton of great conversations with folks who are building web startups.

It was amazing how many people are launching web apps outside the US / English speaking market. They’re excited, motivated and many have already launched their apps. These folks are getting more and more support from movements like Seedcamp and investors like 3i, Index, Advent and Accel.

Events like FOWA, dConstruct, Mix and Max are also equipping people in Europe - the level of support is skyrocketing. There are also a ton of BarCamps and Open Coffees sprouting up. Not to mention the excitement around mobile (Mobile Mondays, Swedish Beers, etc).

It seems crazy to discourage that growth by saying that people should move somewhere else. How can we get to that critical level of support here in Europe if we always have people saying everyone should move to Silicon Valley?

Look at last.fm (£140 Million!) and moo - if you ever needed an example that you don’t need to move to Silicon Valley, they’re surely it. I’d like to also humbly put forward DropSend. We’ve managed to succeed and we’re not even in London.

In the nicest possible way, this argument doesn't negate Paul's points - loyalty, enthusiasm and effort are very good things, but what Paul is talking about is working out where the tide flows before starting out paddling the canoe. As Gartner points out on its "hype curve", the first people to make money in any new technology area are conference and network event organisers, but their existence does not in itself imply that there is a firm base for a cluster of startups to be founded on. Seedcamp is different, it is the start of something new if it spreads - the big issue in the UK has not typically been the VC per se, but the "equity gap" between Angel and VC - the $0.5m - $2m funding.

But I do think Ryan is reporting something else implicitly - these people would not all be trying if they did not think it was "game on". And I do recall what Esther Dyson once said - it is very easy to get a startup funded in Silicon Valley - the hard bit is competing with the other 4 in the same space who also got funded. In Europe its far harder to get money, but if you do its an open field (until one of the US players comes in). The point about last.fm is telling too - it is in one of the sectors that the UK is good at - music. Moo to me is not a webservice per se - (I see it as the Starbucks of business cards ) but again it is in a UK strength - graphic design.

But there is something else as well as the above that could play to Ryan's view.

I am reminded of a book Eric Beinhocker wrote a year or so ago, The Origin of Wealth - it treats firms (especially startups) as a form of Darwinian evolution. I've long held this view too (Eric and I were in the Business Dynamics practice group many years ago), and the reduction in cost to start-up just tells me that more firms will try to colonise any one ecological niche, so Silicon Valley probably just can't support all the firms that can now start up in a niche.

And in my view this means that access to capital is less necessary early on, ie small companies can show some early evidence of success at Angel level, rather than at VC level of funding. This means the Sand Hill Road mob are probably less necessary - or should be, since if our VC's can't fund startups with some evidence of traction then they shouldn't be called "Venture" capitalists and deserve to have their gonads cut off with rusty razor blades

Like all evolutionary niches, it can be shut off - and the UK Government needs to step up here - we also run a small company, the red tape, financial and tax laws in the UK for small startups are nuts compared to the USA (eg we can't write down R&D as capital investment, and the limits to what can be claimed as expenses are nitpicking considering the risk of setting up a startup)

But as far as I can see, London has much the rest in fairly good order (OK, need to work on the networking a bit more, but its coming on nicely - see the Broadsight theory of the role of Beer in Social Networking here).

Maybe one just needs to buy one's friendly neighborhood VC a drink...or 10

Last Friday morning I attended a session Sam Sethi held re creating a network to connect London's webscene together (the talent, the money, the beer....). I suggested at the time (somewhat tongue in cheek) that a Speed Dating system might be just the thing.

Mike Butcher's latest post today reminded me, so I did a search - turns out that someone is already doing it - this week - at Stanford.

Great minds.....

There has been concern in the UK for quite a few years that the VC community is not doing much venturing, certainly not in the new internet technology space. I (and many others) have certainly had some "interesting" discussions while working with VCs over the last 2 years on this subject.

However, Web 2.0 threatens to change all this, and put the funding as well as the technology back in the user's power. Since the cost of setting up a company today is far lower, and the impact if they are succesful is far higher, the risk/reward has shifted. In addition, many people's experience of VC's in the 2001-2003 period has made them fairly determined not to touch that sort of money until as late in the day as they can, and are thus going to Angels in preference or just bootstrapping.

This has led to an "Equity Gap" in getting funding in the UK New Technology circles, as reported succinctly here in Philip Wilkinson's blog at Crowdstorm.

Although not as pronounced in the US, clearly there are similar issues. But in the US, the VC community is responding, as noted today in TechCrunch , where venerable fund Charles River Ventures is firing up a "Quickstart " program.

The model is very simple...to quote:

CRV has created a standard template for investing, although in a phone call today they stressed that it is negotiable: target investment of $250k in debt which converts in an equity financing or acquisition. The debt will convert at a discount to what the new investors are paying, at a rate of 5% for every month until the new investment is made, up to a 25% maximum discount (this is considered a standard provision in angel financings). What this means in normal English: you don’t have to negotiate a company valuation now when taking this debt, making the negotiations a lot easier to finalize. An example transaction from the CRV website:

A simple example: if CRV loans your company $100,000 with a six percent interest rate, and six months later the company closed a Series A round, at that point the loan balance (with interest) would convert at a 25% discount (value = loan dollar amount plus interest / .75) into $137,333,33 worth of Series A stock. Given that seed funding amounts are typically very small compared to the amounts one might expect to raise in a Series A round, as the example illustrates, the aggregate discount amount, in this case $37K, is a tiny fraction of what is likely to be a multimillion dollar Series A financing.

The project is being led by CRV general partners George Zachary and Bill Tai, who estimate that they will do 25-50 Quick Start deals in the next two years. The hurdle to invest is low: just two of CRV’s five general partners need to greenlight the company, and the investment is made.

An excellent start for a streamlined approach to a portfolio play, but clearly less control per investment.

So, I wonder if any current UK VC's will follow this lead, or will it all be left up to angel networks? Perhaps this market gap will foster a new crop of VC's to fund these companies, maybe more akin to the Incubators of the 1990's?