By: Matt Ward
Originally published on medium.com
So you’re raising money for your startup. You have a product and a little traction, and 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 a marriage. You’re “stuck” together for life, and it can be awesome or awful — it depends on the partner. And since the average U.S. marriage before divorce is eight years, it equates very nicely to the startup-investor relationship.
I’m 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 a marriage, and they aren’t always fun.
Sources of Funding
Other than bootstrapping your business, money from friends and family, and loans or grants, there are four main sources of fuel for your startup:
- Angel groups
This article will cover everything you need to know about these four options.
The Four 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, and they typically have approximately 10-year lifespans (plus options for an additional two 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, the Middle East, and China, local governments invest in ventures as well to both drive ROI and boost the country’s economy.
2. Angel investors
Angels, unlike many VCs, start not as investors, but as operators in the industry. Whether as entrepreneurs or employees, angels are individuals that accrue significant wealth. They should have a minimum $1M net worth (excluding their primary residence) or greater than $200k per year in income for at least two years. They then reinvest their capital in upstarts. Some angels shoot for returns, and 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, and 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 per year 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 up to 99 investors to invest in startups via a single SPV — meaning only one addition to the cap table.
This 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’re 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 two and 20 model, meaning they get 2% management fees and 20% of carry.
Management fees are based on AUM (assets under management). For small firms with a $10M fund, that equates to $200k per year 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’s $2M per year. For a $1B fund, it’s $20M per year.
That’s 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 about carry. Carry is 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 they 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’s 100x return. If we assume the company never raised more money (just to simplify dilution, they probably raised more money), then 100 times $1M is $100M.
The difference between the initial investment and the 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’re ready to look at this from a startup perspective.
The Pros and Cons of Each Investor Class
For a detailed understanding, we should break down 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’ll work off of the average.
As a startup, you need money now. Although planning your raise in advance and having six 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’s their money. They can do what they want with it.
Syndicates — After angels, syndicates come in second. Syndicate leads can quickly decide on deals and share them with their investors. Typically, syndicates will run two to four weeks, but hot deals close fast. But as a founder, as long you know the allocation will be met, an extra two weeks isn’t a huge deal.
VCs — Venture firms are often slow and bureaucratic, but they 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, though, 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 every 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 down further.
While speed is great, you need runway even more. A $25k–$50k check might buy you a few months, but if you get $500k–$1M you’re suddenly set until your Series A. 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 percentage targets they need to make the 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 and Angel Groups — This one is a toss-up. It depends on the size of the syndicate and angel groups. Some syndicates on AngelList like Gil Penchina’s Flight Ventures have close to $10M in backing. They can cut big checks, but it doesn’t always work that way, though. The same is true for angel groups. Here, the 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 approximately $1M–$2M, with the average closer to $200k–$300k.
Lone Angels — Unless you’re dealing with UHNWIs, most angels cut relatively small checks — $5k–$100k. It’s possible to get more from a single angel, but it’s pretty rare. With angel investors, don’t forget the legal work required to process checks and update cap tables. Often small investments under $5k–$10k don’t make a ton of sense, especially after the initial Friends and Family round.
3.Price and valuation
Dilution is potentially a big problem for founders. When negotiating, remember a small piece of a big pie is better than a personal pan pizza. Startups are all about outsized returns. For example, 1% of Uber would still be worth $700M today (unless they crater — I think Uber may be in big trouble).
In terms of valuation, though, 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. They want to be able to say, “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: Don’t take advantage of angels. Raising at too high of valuations can hurt downstream financing opportunities. No one wants to have a down round.
Angel Groups — Angel networks are more sophisticated than your average angel and are 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 Andreessen 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, though, the valuations are not that dissimilar from a syndicate.
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. This allows the founders (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 occasionally when not needed). But all-in-all, they leave the 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’s still much less of a confrontational relationship. Angels groups and syndicates usually get out of the way and leverage networks and experience wherever possible to help.
VCs — Surprise, surprise. Venture capitalists are the pickiest when it comes to terms. They have fiduciary responsibilities to their LPs and partners, and they’ll do whatever it takes to drive outcomes. Most VCs, especially from Series A onwards, 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.
Investors always talk about adding value to founders and being founder-friendly. Sometimes this is the case, but 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 their 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 skillsets. 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 it 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.
Much like outside help, industry experience is essentially the same. The one difference being that syndicates and angel groups would score the same.
7.Ability to follow-on
You’re 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 reserve 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’s 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’s 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 are 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 the group. In these instances, the lead’s reputation often 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 that reputation aside, they’re encouraged to do as many deals as possible.
Angel Groups — Between the processes of angel networks, dynamics between members, potential rules/guidelines on investment criteria, location, and 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 — i.e. 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’s 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 three meetings (and understand how decisions get made). Typically founders won’t get a ‘yes’ before pitching at a full partner meeting.
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 the 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, and etc. shares, but they still provide a measure of protection for investors in event 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 an equity percentage 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.
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 — This stipulates that investors will retain their equity position while founders/team will suffer all dilution. It creates a 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 the mercy of the board/investors. This can cause problems, from firing the CEO to acting in the investors (and not the 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 two 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 the 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 incredible 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’s how they stack up. The fewer points, the better.
- Lone Investor and Syndicate (tie): 23 points
- VC: 24 points
- Angel group: 25 points
If this seems counterintuitive, it’s because it is. There’s no one best way to define an ideal investor. Each group brings something important to the table.
Arguably, individual 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. SPVs 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 fundraising accordingly.
Note: Having good investors in different classes of venture is recommended — don’t put all your eggs in one basket.