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October 2010  
  
After barely changing at all for decades, the startup funding business is now
in what could, at least by comparison, be called turmoil. At Y Combinator
we've seen dramatic changes in the funding environment for startups.
Fortunately one of them is much higher valuations.  
  
The trends we've been seeing are probably not YC-specific. I wish I could say
they were, but the main cause is probably just that we see trends first—partly
because the startups we fund are very plugged into the Valley and are quick to
take advantage of anything new, and partly because we fund so many that we
have enough data points to see patterns clearly.  
  
What we're seeing now, everyone's probably going to be seeing in the next
couple years. So I'm going to explain what we're seeing, and what that will
mean for you if you try to raise money.  
  
**Super-Angels**  
  
Let me start by describing what the world of startup funding used to look
like. There used to be two sharply differentiated types of investors: angels
and venture capitalists. Angels are individual rich people who invest small
amounts of their own money, while VCs are employees of funds that invest large
amounts of other people's.  
  
For decades there were just those two types of investors, but now a third type
has appeared halfway between them: the so-called super-angels.  And VCs
have been provoked by their arrival into making a lot of angel-style
investments themselves. So the previously sharp line between angels and VCs
has become hopelessly blurred.  
  
There used to be a no man's land between angels and VCs. Angels would invest
$20k to $50k apiece, and VCs usually a million or more. So an angel round
meant a collection of angel investments that combined to maybe $200k, and a VC
round meant a series A round in which a single VC fund (or occasionally two)
invested $1-5 million.  
  
The no man's land between angels and VCs was a very inconvenient one for
startups, because it coincided with the amount many wanted to raise. Most
startups coming out of Demo Day wanted to raise around $400k. But it was a
pain to stitch together that much out of angel investments, and most VCs
weren't interested in investments so small. That's the fundamental reason the
super-angels have appeared. They're responding to the market.  
  
The arrival of a new type of investor is big news for startups, because there
used to be only two and they rarely competed with one another. Super-angels
compete with both angels and VCs. That's going to change the rules about how
to raise money. I don't know yet what the new rules will be, but it looks like
most of the changes will be for the better.  
  
A super-angel has some of the qualities of an angel, and some of the qualities
of a VC. They're usually individuals, like angels. In fact many of the current
super-angels were initially angels of the classic type. But like VCs, they
invest other people's money. This allows them to invest larger amounts than
angels: a typical super-angel investment is currently about $100k. They make
investment decisions quickly, like angels. And they make a lot more
investments per partner than VCs—up to 10 times as many.  
  
The fact that super-angels invest other people's money makes them doubly
alarming to VCs. They don't just compete for startups; they also compete for
investors. What super-angels really are is a new form of fast-moving,
lightweight VC fund. And those of us in the technology world know what usually
happens when something comes along that can be described in terms like that.
Usually it's the replacement.  
  
Will it be? As of now, few of the startups that take money from super-angels
are ruling out taking VC money. They're just postponing it. But that's still a
problem for VCs. Some of the startups that postpone raising VC money may do so
well on the angel money they raise that they never bother to raise more. And
those who do raise VC rounds will be able to get higher valuations when they
do. If the best startups get 10x higher valuations when they raise series A
rounds, that would cut VCs' returns from winners at least tenfold.   
  
So I think VC funds are seriously threatened by the super-angels. But one
thing that may save them to some extent is the uneven distribution of startup
outcomes: practically all the returns are concentrated in a few big successes.
The expected value of a startup is the percentage chance it's Google. So to
the extent that winning is a matter of absolute returns, the super-angels
could win practically all the battles for individual startups and yet lose the
war, if they merely failed to get those few big winners. And there's a chance
that could happen, because the top VC funds have better brands, and can also
do more for their portfolio companies.   
  
Because super-angels make more investments per partner, they have less partner
per investment. They can't pay as much attention to you as a VC on your board
could. How much is that extra attention worth? It will vary enormously from
one partner to another. There's no consensus yet in the general case. So for
now this is something startups are deciding individually.  
  
Till now, VCs' claims about how much value they added were sort of like the
government's. Maybe they made you feel better, but you had no choice in the
matter, if you needed money on the scale only VCs could supply. Now that VCs
have competitors, that's going to put a market price on the help they offer.
The interesting thing is, no one knows yet what it will be.  
  
Do startups that want to get really big need the sort of advice and
connections only the top VCs can supply? Or would super-angel money do just as
well? The VCs will say you need them, and the super-angels will say you don't.
But the truth is, no one knows yet, not even the VCs and super-angels
themselves. All the super-angels know is that their new model seems promising
enough to be worth trying, and all the VCs know is that it seems promising
enough to worry about.  
  
**Rounds**  
  
Whatever the outcome, the conflict between VCs and super-angels is good news
for founders. And not just for the obvious reason that more competition for
deals means better terms. The whole shape of deals is changing.  
  
One of the biggest differences between angels and VCs is the amount of your
company they want. VCs want a lot. In a series A round they want a third of
your company, if they can get it. They don't care much how much they pay for
it, but they want a lot because the number of series A investments they can do
is so small. In a traditional series A investment, at least one partner from
the VC fund takes a seat on your board.  Since board seats last about 5
years and each partner can't handle more than about 10 at once, that means a
VC fund can only do about 2 series A deals per partner per year. And that
means they need to get as much of the company as they can in each one. You'd
have to be a very promising startup indeed to get a VC to use up one of his 10
board seats for only a few percent of you.  
  
Since angels generally don't take board seats, they don't have this
constraint. They're happy to buy only a few percent of you. And although the
super-angels are in most respects mini VC funds, they've retained this
critical property of angels. They don't take board seats, so they don't need a
big percentage of your company.  
  
Though that means you'll get correspondingly less attention from them, it's
good news in other respects. Founders never really liked giving up as much
equity as VCs wanted. It was a lot of the company to give up in one shot. Most
founders doing series A deals would prefer to take half as much money for half
as much stock, and then see what valuation they could get for the second half
of the stock after using the first half of the money to increase its value.
But VCs never offered that option.  
  
Now startups have another alternative. Now it's easy to raise angel rounds
about half the size of series A rounds. Many of the startups we fund are
taking this route, and I predict that will be true of startups in general.  
  
A typical big angel round might be $600k on a convertible note with a
valuation cap of $4 million premoney. Meaning that when the note converts into
stock (in a later round, or upon acquisition), the investors in that round
will get .6 / 4.6, or 13% of the company. That's a lot less than the 30 to 40%
of the company you usually give up in a series A round if you do it so early.
  
  
But the advantage of these medium-sized rounds is not just that they cause
less dilution. You also lose less control. After an angel round, the founders
almost always still have control of the company, whereas after a series A
round they often don't. The traditional board structure after a series A round
is two founders, two VCs, and a (supposedly) neutral fifth person. Plus series
A terms usually give the investors a veto over various kinds of important
decisions, including selling the company. Founders usually have a lot of de
facto control after a series A, as long as things are going well. But that's
not the same as just being able to do what you want, like you could before.  
  
A third and quite significant advantage of angel rounds is that they're less
stressful to raise. Raising a traditional series A round has in the past taken
weeks, if not months. When a VC firm can only do 2 deals per partner per year,
they're careful about which they do. To get a traditional series A round you
have to go through a series of meetings, culminating in a full partner meeting
where the firm as a whole says yes or no. That's the really scary part for
founders: not just that series A rounds take so long, but at the end of this
long process the VCs might still say no. The chance of getting rejected after
the full partner meeting averages about 25%. At some firms it's over 50%.  
  
Fortunately for founders, VCs have been getting a lot faster. Nowadays Valley
VCs are more likely to take 2 weeks than 2 months. But they're still not as
fast as angels and super-angels, the most decisive of whom sometimes decide in
hours.  
  
Raising an angel round is not only quicker, but you get feedback as it
progresses. An angel round is not an all or nothing thing like a series A.
It's composed of multiple investors with varying degrees of seriousness,
ranging from the upstanding ones who commit unequivocally to the jerks who
give you lines like "come back to me to fill out the round." You usually start
collecting money from the most committed investors and work your way out
toward the ambivalent ones, whose interest increases as the round fills up.  
  
But at each point you know how you're doing. If investors turn cold you may
have to raise less, but when investors in an angel round turn cold the process
at least degrades gracefully, instead of blowing up in your face and leaving
you with nothing, as happens if you get rejected by a VC fund after a full
partner meeting. Whereas if investors seem hot, you can not only close the
round faster, but now that convertible notes are becoming the norm, actually
raise the price to reflect demand.  
  
**Valuation**  
  
However, the VCs have a weapon they can use against the super-angels, and they
have started to use it. VCs have started making angel-sized investments too.
The term "angel round" doesn't mean that all the investors in it are angels;
it just describes the structure of the round. Increasingly the participants
include VCs making investments of a hundred thousand or two. And when VCs
invest in angel rounds they can do things that super-angels don't like. VCs
are quite valuation-insensitive in angel rounds—partly because they are in
general, and partly because they don't care that much about the returns on
angel rounds, which they still view mostly as a way to recruit startups for
series A rounds later. So VCs who invest in angel rounds can blow up the
valuations for angels and super-angels who invest in them.   
  
Some super-angels seem to care about valuations. Several turned down YC-funded
startups after Demo Day because their valuations were too high. This was not a
problem for the startups; by definition a high valuation means enough
investors were willing to accept it. But it was mysterious to me that the
super-angels would quibble about valuations. Did they not understand that the
big returns come from a few big successes, and that it therefore mattered far
more which startups you picked than how much you paid for them?  
  
After thinking about it for a while and observing certain other signs, I have
a theory that explains why the super-angels may be smarter than they seem. It
would make sense for super-angels to want low valuations if they're hoping to
invest in startups that get bought early. If you're hoping to hit the next
Google, you shouldn't care if the valuation is 20 million. But if you're
looking for companies that are going to get bought for 30 million, you care.
If you invest at 20 and the company gets bought for 30, you only get 1.5x. You
might as well buy Apple.  
  
So if some of the super-angels were looking for companies that could get
acquired quickly, that would explain why they'd care about valuations. But why
would they be looking for those? Because depending on the meaning of
"quickly," it could actually be very profitable. A company that gets acquired
for 30 million is a failure to a VC, but it could be a 10x return for an
angel, and moreover, a _quick_ 10x return. Rate of return is what matters in
investing—not the multiple you get, but the multiple per year. If a super-
angel gets 10x in one year, that's a higher rate of return than a VC could
ever hope to get from a company that took 6 years to go public. To get the
same rate of return, the VC would have to get a multiple of 10^6—one million
x. Even Google didn't come close to that.  
  
So I think at least some super-angels are looking for companies that will get
bought. That's the only rational explanation for focusing on getting the right
valuations, instead of the right companies. And if so they'll be different to
deal with than VCs. They'll be tougher on valuations, but more accommodating
if you want to sell early.  
  
**Prognosis**  
  
Who will win, the super-angels or the VCs? I think the answer to that is, some
of each. They'll each become more like one another. The super-angels will
start to invest larger amounts, and the VCs will gradually figure out ways to
make more, smaller investments faster. A decade from now the players will be
hard to tell apart, and there will probably be survivors from each group.  
  
What does that mean for founders? One thing it means is that the high
valuations startups are presently getting may not last forever. To the extent
that valuations are being driven up by price-insensitive VCs, they'll fall
again if VCs become more like super-angels and start to become more miserly
about valuations. Fortunately if this does happen it will take years.  
  
The short term forecast is more competition between investors, which is good
news for you. The super-angels will try to undermine the VCs by acting faster,
and the VCs will try to undermine the super-angels by driving up valuations.
Which for founders will result in the perfect combination: funding rounds that
close fast, with high valuations.  
  
But remember that to get that combination, your startup will have to appeal to
both super-angels and VCs. If you don't seem like you have the potential to go
public, you won't be able to use VCs to drive up the valuation of an angel
round.  
  
There is a danger of having VCs in an angel round: the so-called signalling
risk. If VCs are only doing it in the hope of investing more later, what
happens if they don't? That's a signal to everyone else that they think you're
lame.  
  
How much should you worry about that? The seriousness of signalling risk
depends on how far along you are. If by the next time you need to raise money,
you have graphs showing rising revenue or traffic month after month, you don't
have to worry about any signals your existing investors are sending. Your
results will speak for themselves.   
  
Whereas if the next time you need to raise money you won't yet have concrete
results, you may need to think more about the message your investors might
send if they don't invest more. I'm not sure yet how much you have to worry,
because this whole phenomenon of VCs doing angel investments is so new. But my
instincts tell me you don't have to worry much. Signalling risk smells like
one of those things founders worry about that's not a real problem. As a rule,
the only thing that can kill a good startup is the startup itself. Startups
hurt themselves way more often than competitors hurt them, for example. I
suspect signalling risk is in this category too.  
  
One thing YC-funded startups have been doing to mitigate the risk of taking
money from VCs in angel rounds is not to take too much from any one VC. Maybe
that will help, if you have the luxury of turning down money.  
  
Fortunately, more and more startups will. After decades of competition that
could best be described as intramural, the startup funding business is finally
getting some real competition. That should last several years at least, and
maybe a lot longer. Unless there's some huge market crash, the next couple
years are going to be a good time for startups to raise money. And that's
exciting because it means lots more startups will happen.  
  
  
  
  
  
  
  
**