Friday, September 10, 2010

Party Rounds: How The Crappy Economy, Y Combinator, Angel List, and Super Angels Have Changed Fundraising

In a prior post, I discuss how Party Rounds differ from Led Rounds, and how to raise a Party Round.  In this post I explain what is driving Party Rounds and discuss their implications for entrepreneurs, angels, and VCs.

In the last 12 months two big shifts have happened:
  1. Seed valuations for many companies have gone up dramatically (e.g. 50-100%)
  2. More and more seed rounds do not have a lead investor.  I.e. the terms are being set by the entrepreneur as part of a "Party Round" (a term first used by Rafael Corrales).  
As I explain below, this shift is one with implications to angels, VCs, and entrepreneurs.  This shift has been in part driven by Y Combinator, AngelListthe rise of super angels and the changing economy/lack of good investment opportunities.  

Why Are Party Rounds Suddenly So Common?
Two years ago, it was rare to have an entrepreneur set his or her own terms.  The following things have changed:
  • More Angels.  There are more angels actively investing in private companies today than at any other time I have seen.   This is driven by three things:
    • Y Combinator.  Y Combinator has been holding days such as Angelcon to educate people about angel investing and to connect them to super angels or others who have good advice and insights on investing to pass on.   Y Combinator also invites a wide range of angels to demo days, where they have a chance to interact with and invest in startups they potentially would never have met.  This opens up a whole new pool of capital and expertise for the angel investing world and I think this is a very positive trend for the overall entrepreneurial ecosystem.  With increased angel demand, entrepreneur supply is worth more.
    • AngelList.  AngelList has further democratized fund raising.  By tapping into a broad network of angels for every potential investment, AngelList similarly makes it easier for entrepreneurs to raise more money from a wider range of people then they could have previously reached.
    • "Its the Economy, Stupid".  A lot of rich people don't have a good place to put their money that will provide a great return.  The stock market has been flat to down over the last N years, bond yields are poor, and there is not a good place to park cash (this is increasingly true for pension funds etc. as well as even overall venture returns are poor).  This means that angel investing is a way for people with a lot of money to deploy capital with the hope of a better return.  (Thanks to George Zachary from CRV for pointing this out).
  • Super Angel Funds.  Super Angels investment strategies typically support Party Round emergence as -
    • Many super angels won't take many board seats (some exceptions exist, e.g. First Round Capital, Harrison Metal, and Floodgate have all taken board seats in a number of instances - they also tend to invest much larger amounts in fewer companies then the average micro VC / super angel).  The reason is that if most super angels make 20-30 investments a year and have e.g. 50+ active investments, the individual super angels don't have time to sit on any boards.
    • Smaller capital deployments.  One class of super angels invests $50-$250K per round.  This means 3-4 super angels and 10-15 regular angels can invest in a $750K round.   No one has enough skin in the game or individual bargaining power to set terms.
    • Lots of capital suddenly in the market.  Super Angels have recently raised a crap load of capital to invest.  I can think of $X00 million in funds that have closed recently - all this capital needs to go somewhere.
  • VCs acting as super angels.  In order to get option value on a broader set of companies, some VC funds are investing like super angels in seed rounds.  VCs are even less valuation sensitive then super angels for seed investments in which they invest small amounts (e.g. $100K), which means valuations can be driven even higher and even more capital is available for the same deals.
The net takeaway is that there is not just more money chasing the same deals, but rather, there is more money that (a) won't lead rounds or ask for a lead or board seat and (b) in some cases (e.g. new angels flooding in) doesn't understand angel economics in a very sophisticated way (i.e. most of these people will lose money in the next few years).

Implications of Party Rounds For Entrepreneurs, Angels, VCs

Implications for Entrepreneurs:  Net positive.
  • Upside:  More capital = more negotiating leverage = better deal terms and control for the entrepreneur.
  • Downsides: 
    • All the capital flooding in means some not-so-great companies are getting funded.  Rather than get locked in to a bad idea via successful fund raising, some entrepreneurs' time may be better spent on other products or ideas.  This is especially true for the oversubscribed company that raised $1 million instead of $500K and ends up spinning it wheels for 6-12 months longer than it otherwise would have (the flip of this is it gives more time to pivot as well).
    • The increasing number of less sophisticated angels may mean more hand holding / time spent managing an investor who is on over his or her head - do your diligence and only take money from people ready to lose it investing in your company.
    • High valuations in seed rounds may negatively impact future fundraising dynamics.
      In 18-24 months lots of companies are going to go under as their existing investors don't have the capital or where-with-all to re-up for the company.

Implications for VCs:  Net Positive
  • Upside: Despite all the press about super angels vs VCs, all this capital sweeping into the seed stages is good for the venture community.  I cannot think of a single major internet company that has not needed to raise multiple rounds of funding - which is where the VCs come in.  All this activity means in 12-24 months VCs will be able to cherry pick the very best companies for series A/B investment.   The others will likely wilt on the vine.
  • Downside: The valuation inflation in the seed rounds will lead to inflated expectations by entrepreneurs for their Series A.  It will be interesting to see how this will play out once bargaining power shifts back to investors in later rounds (since there is a small set of collusive players in the traditional venture world).

Implications for Angels:  Net negative (but they don't realize it yet)
  • Upside:  Angels who are not as well networked now have more access to companies and investments.
  • Downsides:  
    • Party Rounds are hurting angel economics.   Seed rounds are starting to hit low series A valuations - but with seed level risk.  A lot of small fry angels will likely lose quite a bit of money in the coming years - or their return on investment will be lower then it would have been without the Party Round dynamics.
    • Party Rounds also means angels are less likely to have an investor take a board seat to work with the startup on key issues.
    • Many Party Rounds are being done as capped notes.  This means if the company raises at a valuation lower then the cap then the angel will convert at the low market cap - even though they took on all the early risk.  Even worse, if the company gets acquired and there is straight conversion with acquisition, the angel will *lose* money on the exit (as opposed to an equity financing, where the angel will often get their money back).
I leave you with this quote from Keith Rabois, which has interesting implications for the above:
"The companies I have traditionally seen do best over the long term had lead investors for their seed rounds" - Keith Rabois

What do you think?
a) What other trends are feeding all the Party Rounds?
b) Is this a good or bad thing for entrepreneurs, angels and VCs?

You can follow me on Twitter here.