Raising Angel Money

angel moneyThis post is part of a series of posts called “Pitching a VC” that explains how to get access to VC’s, what to say when you get there and what will happen afterward.  The series outline is here and the first post “what goes in a VC presentation” is here.  But you can read this stand alone.

A friend of mine who lives in Silicon Valley called me lastt week to talk about his new company.  He’s been a very prominent member of the technology community for 15+ years and is deeply respected by both junior and senior members who have worked closely with him.  This is the exact kind of guy who as a VC you would love to invest in provided he can deliver on a well rounded team (getting there) and a great idea (done).

We had a lengthy conversation about whether he should take angel money, which has been offered to him.  The investment money he’s been offered has been “priced” (meaning the value of his company at which the angels would buy stock has been set at the recommendation of the angel investors) and he was wondering whether he should take the money.

His alternative is to hold out for “convertible debt” that would not immediately be priced.  The purchase price for investors in this type of investment is set in the future when he would raise his first round of venture capital money.  (Quick side note for explanation: when you raise money as convertible debt it means that the money you raise is in the form of a loan and not given as equity.  It is called convertible because it usually automatically converts to equity when you raise your professional round of venture capital.  It typically gets a discount to the price that the VC pays.  The discount can be any % number but in my experience is usually between 15-30%).

The conversation about angel money is one I have all the time with entrepreneurs so I thought it would make for a good post on understanding angel investing – how they think, how you should think and how the first round venture capital firm will think by the time the deal gets to them.

How Angels Think – OK, let me start by saying that I rarely do angel investing since I mostly think it’s a sucker’s bet unless you have very deep pockets or unless you’re in a tech bull market (’97-00, ’05-’08) where exits can happen without a lot of follow-on rounds of funding.  If you want to know more about why I feel this way feel free to ask in the comments section and I’ll elaborate.  I have had the discussion about whether angels should pricing their investments or offer convertible debt with many professional angel investors in the past and 2 in particular that I’ll use in this discussion.

ron conway

Ron Conway

One side of the argument – angels should price:  18 months ago I sat on a panel with Ron Conway, the legendary angel investor from Silicon Valley who invested in Google, Twitter, Digg and many other early-stage Silicon Valley success stories.  The topic of angel pricing came up.  Ron said he never likes to do convertible debt deals and always insists on pricing his investments.  His rationale was clear, “If I invest in a company I open my Rolodex for them.  I help them with business development introductions.  I introduce employees.  I give them credibility in the fund raising process.  Let’s say the company was worth $1 million when I met them and I’ve helped them with both my Rolodex and my cash and they can now raise a round of venture capital at a valuation of $6 million.  I would be hurting my own interests.  A $500,000 investment at a 30% discount to a $6 million round is still priced and more than $4 million and is certainly worth much less than my investing at a $1 million pre-money where I could own 33% of the company.”

This is how I believe angel investors should think.  You’re money helps the entrepreneur get through a very difficult period and your money has a lot more risk since you don’t know whether VCs will really want to back this idea or team.  Your biggest risk is what we call in the industry, “funding risk” and it is especially prevalent in tough economic times like now where VC money is harder to come by.  Now more than ever I think angels should be pricing rounds.

The other side of the argument – angels should not price if the deal is “hot”:  I had breakfast in Palo Alto recently with a friend of mine who is a very well known angel investor.  He actually invests angel sized rounds on behalf of a larger VC fund.  He told me the following in private (versus Ron’s comments on a public panel) so I’d prefer not to reveal his name since I didn’t ask for authorization.

His argument was simple, “The best deals in Silicon Valley are very competitive and I only want to invest in the best deals.  If I have to spend weeks debating valuation with entrepreneurs then my probability of getting into the best deals is decreased.  I’d much rather be in the deal at a 30% discount to the VC round then to out of the deal altogether and miss investing in the best deals.  If the market conditions worsen then I’ll ask for a larger discount.  Maybe 40%?  Maybe 50%?”


Jeff Clavier

He has a point.  This individual really does have access to the best deals in Silicon Valley at formation stage based on his solid reputation for working with entrepreneurs in a hands-on way to help them with their business strategy before raising money.  People like working with him and feel he gives credibility.  His view is that if he gives the entrepreneurs more time to get around to meet all the angel stars in Silicon Valley (Ron Conway, Mike Maples, Jeff Clavier or any of the other host of angel investors who have sterling reputations and once under their spell it may be harder for my friend to close the deal.

In my estimation he has done good investments in the past 2 years but obviously we’ll need to judge that later when we see whether these investments make money.  My bet is they will.  Two observations here: 1) he has very unique access to the some of the most proprietary deals in the world and 2) he has only been a VC for 2 years and therefore might see a side benefit of increasing reputation by being in “hot” deals.

For everybody else I believe angels should price.  So why do many angels agree to fund with convertible debt?  Maybe there are more sophisticated reasons than I am aware of so feel free to weigh in with comments if you think I’m missing something.

I believe most convertible debt deals by angels are done by people who are not professionally investors.  There are many groups of angels who like to pool their money together to invest in technology.  Sometimes they are ex Tech execs who have made a bit of cash and sometimes they are groups of wealthy doctors, lawyers, real estate professionals – whatever.  But I believe they don’t price either because they don’t know better or they want proprietary access to deals they think they otherwise wouldn’t have been able to invest in without agreeing this structure.

How entrepreneurs should think – So now that you know how angels think about pricing early-stage deals, how should this affect your decisions in the fund raising process?

As an entrepreneur you should raise money from the most experienced people possible – period.  If you have the opportunity to raise a small amount of money from a group of experienced investors who have a track record of helping companies get from that tricky idea stage to being a well-formed company with a good product and solid market-entry strategy I would take the money – even if it were priced.  Worrying about giving up an extra 10% of your company at this stage can be meaningless if the ultimate outcome is either success or failure.  Even VC’s think this way, which is why Fred Wilson when describing his decision to syndicate a portion of his invesment in GeoCities to another investor says, “I learned that good partners are worth every penny of returns you give up to get them.” (whole article here if you’re interested)

Don’t worry about getting “screwed” by sage angel investors.  If they really are well regarded and serial investors they won’t likely screw you.  Why?  Because if they try to take 50% of your company for $500,000 then they know it will be very hard to raise VC because we’ll know that too much of the value has been taken away from the founders before our investment.

People like John Greathouse and  Klaus Schauser in Santa Barbara have a great track record both in building companies themselves and also in helping the companies that they angel fund pull together  great management teams, launch great technology products and importantly raise VC from top-notch VC’s.

Generous offerIf you’re the kind of person that Ron Conway, Klaus Schauser or John Greathouse would be willing to fund then you’re probably the kind of person who could string together a group of wealthy real estate professionals to give you a convertible debt financing and avoid taking as much dilution at this early stage of your company.  Should you take the “cheap” and easy money?

I’ve obviously laid out my case in the argument.  Most companies have binary outcomes: you’re either really successful as a company or you’re not.  Unfortunately the overwhelming majority of companies end up in the latter category.  You know the old saying, “a larger percentage of zero is still zero.”  So my advice is to stack the odds as much in your favor as possible by taking the experienced money from people who have a reputation for really helping entrepreneurs.

If you’re struggling to raise money at all then you should obviously take the money from wherever you can get it and many times that is reality.  If you believe you have a great idea and are passionate about trying to build a company around it then the only thing worse than raising money from inexperienced people is raising no money at all.  Go for it.

If you can raise money from prominent angel investors AND get the investment done as convertible debt – knock your socks off!  Take the money. (note: this advice does not include taking convertible debt from VC investors, which I generally advise against.  (Again, if you want me to elaborate I’m happy to do so in the comments section).

How do VC’s think about your angel money structure? – First, let me state that many VC’s have done many earlier-stage, angel-like deals in the past few years.  It takes less money to start companies than it did 10 years ago and these VC’s had seen the best deals get done by über-wealthy angels.  As a result many VC’s were getting into the game of writing $500,000 – $1 million checks.

Will this continue?  I don’t know for sure.  On the one hand I believe many VC’s have realized that this early-stage investing is riskier than they had perceived and they’ll just end up doing the $3 million rounds down the line when the business has more proof points.  So I think many VC’s may pull back to their traditional roles of letting angel investors take the early stage risk.

On the other hand, it is true that it takes significantly less capital to get companies off the ground these days and given Cloud Computing I believe this trend will continue (see my experiences and views here).  It is also true that many VC fund sizes going forward will likely be smaller as LP’s come to realize that smaller fund sizes for VC funds (as opposed to growth equity funds) better aligns the interests of the VC and the LP.  So I suspect some VC’s will continue doing deals that are on the border between what an angel would do and what a VC would do.  I am personally in this camp.  And Andreessen Horowitz certainly is as well, announcing their willingness to deals as low as even $50,000.

But to the question of how a VC thinks about your angel money if you do raise it, here are my thoughts:

  • Your chances of raising money from a VC are significantly greater if you have raised money from prominent people.
  • In most cases we probably don’t care whether the deal was priced or convertible debt.  We would, however, look to make sure that you didn’t take too much dilution, which would be a negative.
  • If you did convertible debt at a large discount (say 30%) and it was done only 2 months before you’re talking to a VC they will probably grumble about the discount that the previous investor is getting.  But ultimately I believe most VCs will get over this because the dilution taken from the discounted convertible debt will likely come from the founders and not the VC
  • If you have many angels (say a group of 10-15 people) and if these people are not sophisticated serial angel investors it could cause problems.  VC’s will be a bit wary of having small investors who try to hold the company hostage during future financing rounds.  Anyone who has been around the industry long enough would have seen this happen at least once.  If you do round up money from a load of small unsophisticated investors please make sure to get a great corporate lawyer with experience in doing VC deals to structure the deal to minimize the amount of signatures you need to get for approvals and to ensure that every angel has signed an accredited investor statement.

If you ever see me in person ask me to tell you the story about the pig farmer who seed-funded my first company.  I have all the scars from F’ing up the formation of my first company to write blog posts like this.

Next VC post – how do you value private companies?


26 Responses to Raising Angel Money

  1. Dave Young says:

    In my experience in the vast majority of cases the primary factor in determining whether or not an angel round should be equity (priced) or convertible debt comes down to timing and transaction costs. There are significant transaction costs associated with creating and negotiating a Series A term sheet and set of transaction costs for an angel financing (probably $10,000 to $15,000–and signficantly more if the investors are also engaging counsel–as compared to $2,000 to $5,000 for a convertible note financing). Unless the initial closing is at least $500,000 (and ideally more than that), an equity round generally doesn’t justify the transaction costs. Plus, it probably takes two weeks or more to close on the transaction. With a convertible note, the documentation can be as simple as a two-page note, and can be closed within a couple of days rather than a couple of weeks. An early stage company is at its most vulnerable when raising its initial financing, so the ability to close quickly and to preserve the capital for operations as opposed to transaction costs can be critical. On the flip side, if raising $1,000,000 or more, it is preferable to price the round, as that amount of convertible notes (cash already spent) can complicate the cap table in negotiating a deal with VCs.

    • marksuster says:

      Thanks, Dave. Very valuable points and much appreciated. Some thoughts: you talk about “timing risk” which is one of the biggest risks I warn entrepreneurs about and is useful to keep in mind in every deal (VC funding or customer deals). But with regards to whether it should be equity or convertible debt … I think the entrepreneurs are usually better with convertible debt and the angels are usually better with equity that is priced. Do you generally agree with this? But the problem I point out is that if you have a choice of great angels and priced versus OK angels that are convertible debt – I would counsel people to take the former. Thanks again for your thoughts and any readers looking for a very wise early-stage lawyer for advice I can tell you from personal experience that Dave is awesome.

  2. […] (Cross-posted @ Both Sides of the Table) […]

  3. Dave Young says:

    Mark, To your point that “entreprenuers are usually better with convertible debt and the angels are usually better with equity that is priced”–I agree 100% (provided that the angels are sophisticated and paying attention to valuation, such that the round is appropriately priced for early stage risk). Also agree that going with the value add investors (even if taking some dilution) is the right answer in almost every case.

  4. scott walker says:

    Mark, another solid post – thanks. As a corporate lawyer who has closed a number of angel financings, I echo Dave’s comment re equity/pricing. Indeed, transaction costs can often exceed 10% of the investment and valuation becomes a painful, arbitrary exercise – and rarely are both sides happy. Needless to say, every deal is different – different players, different risks, different timing, different market conditions – but, as a general rule, speed and efficiency should trump other factors (unless, of course, you have a Ron Conway who is willing to invest).

    Scott Edward Walker
    Walker Corporate Law Group, PLLC

    • marksuster says:

      Thanks, Scott. Good points and I didn’t adequately address the cost side of the equation in the post. It is a consideration. I guess if you can do with a simple set of fund raising docs you should be able to get the deal done for $10-15k so if you’re raising $200k+ it seems like the equity financing threshold would be met. Thanks again.

  5. Bill Bryant says:

    Dave’s comments are right on the money – a convertible note structure is both more timely, and you avoid/defer the transaction costs associated with a Series A. If you’re raising $100-500K, it doesn’t make sense to either the investor or the company to spend a large portion of that on attorneys.

    Its instructive to note that VCs normally “price” bridge financing in exactly the same way as an angel convertible note. The bridge converts typically converts into the next priced round at a discount/with warrants attached. A bridge is often much larger than a seed convertible note.

    What’s good for the goose….?

    • marksuster says:

      Thanks for the comments, Bill. WRT to raising $100-$150k I agree with your comments. I didn’t properly address the minimum threshold question in my blog and on reflection I think the $200k level seems about write so that the deal costs are 7-7.5% max of round costs.

      WRT VC’s – I actually don’t think the analogy of “good for the goose” really holds. VCs, as you know, often do internal rounds as convertible debt rather than pricing but this is in my experience for a wholly different reason. VCs are loathe to price internal rounds because they have a conflict in doing so. On one hand they would be happy to do a down round which gives them more ownership in the company but on the other hand they don’t want to show LPs a down round. They don’t want to do a major up round or how could they justify to their LPs that they priced it appropriately and don’t have insider bias. The solution to remain objective for both LPs and management is to avoid pricing it until an unbiased 3rd party steps in and sets the value. I totally agree with you that this is how internal VC deals are priced but I don’t believe that this is an appropriate analogy for how people should think about angel rounds.

  6. Adrian Ionel says:

    Thank you for a great post!

    I’m curious, why do you think Angel investing is a sucker’s bet?

    • marksuster says:

      Adrian, angel investing in not always a sucker’s bet but I believe it usually is. If you have deep pockets and/or are a professional investor then ignore my comments. But here are my issue: let’s say you invest $50,000 in an early stage company for 10% of the company (e.g. the post money is $500k) and the company is on track to raise VC money. The next deal they do is raising $2 million at a $4 million pre-money (e.g. $6 million post). In order to do your pro-rata investment you’d need to pony up $200k so it’s starting to get into “serious” money for most individual investors and yet this company will largely still be pre-revenue (sub $1 million). So to keep your 10% you’re in for $250k all in. Now 15 months later the company might be just doing OK and is looking for an extra $1 million to get to its next milestone so you’re in for another $100k. Or they’re now really hot and want to raise $5 million on a $10 million pre and your share is going to be a cool $500k and most companies who raise at this level will still not be successful.

      Ah, but you say I can just not take my pro-rata investment and keep a small stake. In my optimistic scenario above your 10% becomes 4.4% after taking 1/3 dilution twice. Not bad, you say, for $50k. But hold on. First, this is the optimistic scenario. Second, you have investors who have liquidation preferences above you on an exit. Third, you have no guarantee of no future financings – there are probably some coming. When the financings come for businesses that are not “home runs” out of the box they often have punishing terms for those that don’t write follow on checks. These can include down rounds, pay-to-play provisions, wash-outs, etc.

      In summary, there are always success stories where somebody’s $50,000 investment in Google is worth $200 million some day. There are also cases where your $1 lottery ticket turns into $100 million. But they are the exceptions. Carving out the great years (97-00, 05-08) I believe most (not all) angel investing is a sucker’s bet.

      However, I have one carve out rule. If you believe you’re investing in a business that will never be hugely consumptive of cash. Let’s say that you put in $100k to a company that says it will never raise more than $1-2 million because they aspire to build a company doing $20 million in revenue some day but never want to be the next Google and certainly don’t want to raise VC money – then I think it could actually be a nice investment. In fact, I’ve done 2 of these in the past year personally.

      • Mark – I agree with your math and analysis, but isn’t this the exact same math (and “problem”) for founders? I.e., they typically cannot afford to “participate” in later rounds (and worse, are rarely given the opportunity unlike angels) and end up with the same dilution math. They also have the same liquidation preference, down round, etc. issues above. In that sense, angels seem somewhat akin to founders in terms of economics, vs. VCs. In my limited experience, they tend to act more like founders too in terms of how they view liquidity events …

        • marksuster says:

          Thanks for your comments, Jason. As you know from years of chats we see the world the same way. I agree with you that founders have the same math, which is why I routinely counsel entrepreneurs not to raise too much money. Most of the times the founders regret it. I love meeting teams that tell me that they hope that the money they take from me will be there last (even though often it may not). I want our incentives aligned. BTW, for readers who may not know this – there are two big differences between founders & angels that I want to point out:
          1. Founders can get increases in ownership through stock option plans to “make them whole” and …
          2. Unfortunately many VC’s aren’t bothered by diluting angels whereas they are loathe to over dilute founding teams (please hold any cynical responses ;-)

  7. Ryan says:

    An Entrepreneur should critically evaluate investment through (3) discrete lenses.

    Determine the “right” Amount.
    Is it the “Right” investor?
    Is is the “Right” time.

    When these converge, the ability to retain a controlling interest will prevail.

    Sweat does not equal equity.

    • marksuster says:

      Right investor – check. Right amount – usually slightly more than you think you need but be careful of not “over” raising. Angel investments between $250k-$1 million I would say take as much as you can get. Above that be careful. But … obviously never “one size fits all” as some businesses would require more capital early on. Right time – always sooner rather than later. The death of many companies was waiting until they could prove more value. Can you say March 2000, Sept 2001, Oct 2008? Time is the enemy of all deals. Take the money and go build your business. Thanks for your input.

      • valto val says:

        I started to wonder. Why does everything need to be custom? How far could this actually be fixed. Like Y-combinator in their way of doing this, by offering one model and then fit/select start ups to match that?

        That could be extend that to have more than one fixed version ie. S/M/L sizes? To make it easier, select only industry like web/mobile.

        I feel there are too many variables in the area that they dont seem to add real value to the process. “custom deals” in many other industries are considered “niche”, that don’t scale that well ;)

        And I think Startups would be happy to fit themselves to fixed terms as long as those are fair.

  8. […] This post was Twitted by jeremyalmond […]

  9. scott walker says:

    FYI, Bill Reichert of Garage Technology Ventures spends about five minutes on the topic of convertible notes vs. Series A in his podcast with Frank Peters (see http://www.thefrankpetersshow.com/2009/05/eban_at_stanford_with_garages_1.html at the 22:11 mark). Among other things, he points out that: “[I]f you’re putting a few hundred thousand [dollars] in, it’s just not worth all the brain damage to price the round and do the Series A.” He also adds that it’s “not worth spending too much on the lawyers.” Thanks again for the solid post (and comments). Cheers.

    Scott Edward Walker
    Walker Corporate Law Group, PLLC

  10. aproductguy says:

    Great post Mark. What are your thoughts on seed stage funds like First Round who actually tout the fact that they rarely do follow on rounds so it won’t imply vote of confidence (or lack thereof) to future investors? Is their model fundamentally flawed? It makes sense that there are a new breed of funds (like Freestyle Capital) that do small investments in companies that don’t expect to raise more than $2-5m as you mentioned, but it seems like there are still a number of seed funds that want to get in early on potential home runs.

    Also would love to hear your thoughts on determining valuations. I remember Ron Conway saying they’re always between $x & $y million, so just pick one and get a deal done. How much do you base your valuations on fundamentals like TAM, SAM, revenue etc. how much is it based on competition from other VCs? Is it foolish for an entrepreneur to focus on a few VCs that he respects at the risk of getting fewer competitive term sheets?

    • marksuster says:

      Thanks for your comments.

      re: First Round Capital – I can’t claim to be an expert in their current strategy but I believe that in their newest fund the strategy is to do more follow on rounds. But more generically if one had a strategy to “never do follow ons” it is easier for the entrepreneur to explain their lack of participation but the problem is if the VC gets a “hot” company that they can’t resists. If you break the rule then by definition every other deal that one doesn’t follow isn’t hot. So I don’t like the model you outline (which I don’t believe is FRC’s strategy).

      re: new breed of funds – I see many in SoCal that have the model you outline. Crosscut and Baroda are both examples of funds that seek to get smaller $ in, less total money to be raised and expectation of smaller exit sizes. Slightly higher up the food chain in terms of deal size and expectation of outcome (but still I believe the same strategy) are DFJ Frontier and Rincon Venture Partners. All 4 of these SoCal firms are great investors.

      re: valuation and how many VCs to pitch … I’m going to do separate posts on each topic so I think I’ll hold off if that’s OK. If you know someone who has a pressing need to discuss this topic have them contact me. Catch you soon. Best, Mark

      • aproductguy says:

        re: valuation – yup…just putting in some requests for the valuation post you mentioned you were going to do :)

  11. Shane says:

    Thanks for the insight Mark! I have a question, though. Is there a general level of equity an angel investor is looking for when they are considering a deal? We are currently looking for angel investment, and we want to be realistic with respect to how much we should be ready to sell.


    • marksuster says:

      No, there is more variability with angels. If they are “professional” angels there will be more of a sophisticated demand but I see angel deals done at huge variance in price points and sometimes a lack of sophistication in knowing the right terms to ask for. I think with any investor round that is priced people will be looking to own between 20-40% of your company with the VC sweet spot being 25-33%. Angel rounds can get done at 20% or if it is an outlier deal maybe 10-15%.

  12. […] one of his lates post “Raising Angel Money” there is a great quote by Ron Conway, the legendary angel investor from Silicon Valley […]

  13. […] to a post that I don’t think I could improve upon much. See Mark Suster’s thoughtful post for a discussion on pricing your first round, or taking convertible […]

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