However, I don't consider myself a venture capitalist. Instead, I am what is known as an "angel investor".
This week has also seen a new topic enter the blog zeitgeist: the topic of reforming or reinventing venture capital. This topic was initially raised by Dave Winer, followed by Robert Scoble, Doc Searls, Jeff Nolan, Michael Arrington, Thatedeguy and many more.
All types of venture investment -- seed, angel, venture, and institutional alike -- carry with it great risks and great rewards. But before we can reinvent venture capital and related venture funding methods like angel capital, we need to understand how it works.
So What is a Venture Capitalist?
A venture capitalist is a partner or associate in a venture capital management firm, which manages money on behalf of large institutional investors.
Basically, a large institutional investor (such as a pension fund or an insurance company) can statistically afford to invest a small part of their portfolio -- perhaps from 1% to as much as 5% -- in high-risk, long-term investments. If they lose the money outright, their other more stable investments have a good chance of making up the loss. But if the high risk investment does well, they can substantially improve their IRR (internal rate of return). To a certain extent they can't lose if they are careful. So these institutional investors invest in a number of types of high-risk funds, including such investments as venture capital funds.
A venture capital management company will manage one or more of these funds, investing in private companies. These VC management firms operate off of a management fee, from 2% to 3% of the capital invested to date. Thus all of the salaries for the staff of a VC management firm are paid, even if the investments are a failure. In addition, if any of the investments are successful, the VC management company earns 20% off of the top of the gain (called a "carry"), which is distributed to all of the full partners in the VC management firm, and sometimes a little of it to the associates.
It is the VC associates that do the brunt of the work for a VC management firm. They make a good salary, but the real return is if they are able to do well in identifying, managing, and selling new startups; then they are invited to become a partner the next time the VC management firm raises a fund. Then if the fund that they are a partner in does well, they can make a true fortune, or even start their own VC management firm.
However, the odds are against the VC associate. It's common wisdom that an associate can't easily manage more the 7 firms at a time. Other common wisdom says that 1 in 5 investments will survive to break even and that 1 in 20 will "make the fund", i.e. pay for all the losses in the other 19 investments. Some newer firms say 1 in 10, but I'll go with the older more conservative numbers. Thus associates are incentivized to try to manage more then 7 investments and to be smarter than their peers in the firm, so that at least one of their investments will be the 1 in 20 that makes the fund. This makes it easier for the associate to become a partner in the future, as at best 1 in 3 or 1 in 5 associates becomes a partner. Cutthroat competition between associates exists in some firms. This pressure often adds the perception that associates don't give enough attention to companies in their portfolio; they want their startups to do well, but the odds are it is another company that will make it, or a startup managed by peer associates. So they divide their attention. This is not unrelated to the Dunbar Triage problem.
Another problem that VC management firms face is the number of investments they are able to effectively handle. If there are 5-6 associates and 2-4 partners, there is probably a max of 50 investments that they have time to manage. If they are managing a $500 million dollar fund, that means that they have to invest at least $10M in a company, but in fact that is more likely to be $25M over time. If 1 in 20 makes the fund, that $25.0M has to give a return of $250M. Thus when entrepreneurs complain that VCs will not invest in their company, it is often because the VCs can't figure out how to invest a minimum of $25M and turn out at the end with $250M. A related problem is that a startup that might have a successful business model that could grow into a profitable $50M annual revenues will be encouraged to take a more risky route so that they can go public, which requires a minimum of $100-200M annual revenues.
There is a lot of variety in VC management firms; some VCs have smaller funds under management, others give their associates more of a share, others have different management fees or carry percentages, and most specialize in some way: either vertically in a particular field, or horizontally in a particular stage of investment. For instance, there are some VC firms known as mezzanine firms that only invest in your company right before they think it can go public.
This is the way most VC management firms work. Periodically a new VC management firms will explore and push the limits of the above boundary conditions, but the more edges they attempt, the more likely they will fail.
My Three Angels
So what is an angel investor? I learned a lot of what I know from the 3 angel investors that invested in my software startup, Consensus Development.
Gifford Pinchot -- Partner Angel
Gifford Pinchot, with his wife Libba, was my first angel investor in Consensus Development. We met at a Maxis meeting where Gifford had been asked to facilitate the formation of a new startup to create simulation software. At the end of the meeting we left frustrated with the results of the meeting, but Gifford liked what he heard about my broader vision. Gifford flew me to San Diego, where we walked the beach and discussed my vision for collaborative software. He liked what he heard, and later in the month flew me to his home in Connecticut, where I stayed for a month in a barn guest house near his home while we worked on our first business plan.
Gifford only invested a low 5 figures, which got me started. However, it wasn't his money that was his most valuable contribution -- it was his time. Over the years he probably put 5-10% of his into time as Chairman of Consensus Development working with me, talking to me, advising me, and coached me. When our first software effort, InfoLog (a folksonomy tagging program like del.icio.us that was a decade too early) failed, he didn't walk away and instead encouraged me to continue. I dug deeper into the problem, discovered that trust and security were a key obstacle, and created a profitable consulting business. But Gifford encouraged me when I said we were going to take the risk of dropping all of our profitable consulting and focusing on a product, SSL Plus. Later, when this company was being shopped around to various buyers, Gifford spent lots of time doing due diligence, and ultimately came on half-time as CEO so that I could concentrate on selling the business.
In the end, Gifford earned probably 7 figures on his initial 5 figure investment, close to a hundred-fold return on the dollars he invested. However, his real investment was the time he spent with me -- almost 10 years of never giving up.
Scott Loftesness -- Seed Angel
I met Scott Loftesness when he was the executive vice president at Visa International. We learned of each other through CompuServe, where we both were sysops in the 80s. I did some consulting for him at Visa in the groupware area over a couple of years and we grew to respect and trust each other. I came to him when I branched out from groupware consulting and began to include consulting on cryptographic security. I'd seen an opportunity--I had a potential contract from RSA Data Security to be a distributor of RSAREF--but in order to take advantage of this opportunity I needed some seed capital.
Scott invested over twice what Gifford invested, but still 5 figures. However, like Gifford, what I gained from my association with Scott was a lot more then the seed capital. He had a respected name in the industry -- a friend at Visa USA told me "Scott is where all innovation at Visa flows from." He joined my board of directors, supported our risky choice to drop all groupware and cryptographic consulting to focus on our SSL project, helped tremendously in doing due diligence on potential buyers, and was pivotal to the negotiations to close our final sale of Consensus Development.
In the end, Scott Loftesness also did quite well in his investment in Consensus Development. His involvement on the day-to-day operation of Consensus Development was significantly less, but he was always around to support and advise us when we needed him.
Jim Bidzos -- Hands-Off Angel
Jim Bidzos was the CEO of RSA Data Security, whose firm had a critical patent on almost all meaningful cryptographic security. Over the years I did a lot of consulting for him to support various projects like RSAREF in standards, to create client tools for their Certificate Services Division, and to help with the founding of Verisign.
One day I told Jim that RSAREF would never be successful in his goal of promoting the RSA algorithm in security standards as long as it could only be sold through RSA salespeople. They preferred to sell RSA's premiere toolkit, BSAFE. I somewhat jokingly proposed that maybe Consensus Development should sell it instead. To my surprise, he agreed.
A couple of years later I leveraged the fact that Consensus Development had the only RSA toolkit available other then RSA's own to get the contract to develop the reference implementation of SSL 3.0 for Netscape. I took this Netscape contract back to Jim and said that I needed some investment to make this successfully. He invested a middle six figures in Consensus Development in return for a percentage that was roughly equivalent to that of Gifford and Scott, but because of his involvement as CEO of RSA Data Security he could not be on our board of directors.
After this investment, Jim had very little to do with Consensus Development. In fact, he had spread his angel money so widely in the cryptographic security industry that he was also invested in a couple of our competitors. In the end his investment was worth roughly 10 times what he invested, but the cachet of being able to tell others that Jim Bidzos was an investor made Consensus Development much more "legitimate", which also added significant value to us.
Founding of Alacrity Ventures
After I left Certicom, the company that had purchased my firm, Consensus Development (see Bad Business of Fear for more info), I wondered what I should do next. I could theoretically retire if I abandoned the Bay Area, but I was not ready for that and I thought I had maybe enough capital to start one more business of my own instead. Under a non-compete from Certicom, I was not sure what type of non-cryptographic business I wanted to start. So I decided that one thing I could do was some angel investing. In part this was to make money, but a larger part of it was that I enjoyed working with entrepreneurs. I wanted to do for others what Gifford Pinchot had done for me.
I did some study about how venture economics works, how angels and venture capital firms invest, and became concerned. I saw that being an angel investor in many ways is much harder then being a venture capitalist.
One of the biggest challenges is that angels share all the problems of the institutional investor, of the VC management firm, and of the VC associate.
The first challenge is deciding how much to invest. The institutional investors only risk 1%-5% of their capital. If I limited myself to that amount I could maybe invest in a couple of companies. I decided I was still young and could risk investing more.
The second problem was no management fee -- unlike a VC firm, angels don't get a management fee to cover salaries, legal fees, other expenses.
The third problem was my time. Most angels still work for a living -- being an angel investor is part-time, a venture capitalist typically works full-time. If only 1 in 20 investments "make the fund", but I could at most manage 7 investments, that meant that I had a 2/3rd's chance of losing my entire investment. I might be able to argue that for some kinds of businesses I might more informed than the average VC, and thus might be able to make better choices, but not that much better.
The key, I decided, was to work with at least 2 other angel investors. That would theoretically allow us to invest in 21 companies, diversify our portfolios, and split the work. I approached my first angel investor, Gifford Pinchot, and he agreed to be one of the partners. The second was Harold Shattuck, who had done some due diligence and operations consulting for Consensus Development, and had been VC once before, but enjoyed being closer to the actual building of a new company with some operating interaction. I was the managing partner for files and accounting, but we all brought to the table our "deal flow", performed due diligence together, and worked closely with each other.
Lessons from Alacrity Ventures
Alacrity Ventures is over 6 years old, and I have learned many lessons from it.
First, I feel that we did a good job selecting our investments, during a time in which being an angel investor was very difficult. I discovered that Gifford, Harold and I were really good at due diligence; our differing skills, Gifford's in coaching and evaluating the management team, Harold's in operations and business models, and mine in technology truly complemented each other.
For a long time I could say that the good news was that that out of 13 investments, all but 1 were still in business. However, we were never able to invest in the 21 investments that we planned because we discovered a significant problem in angel investing: the VC.
The angel investor can only really afford to invest early on, as a seed investor, or in an early investment round such as series A. However, the firms we invested in needed more money along the way; in fact, almost all firms need money at more then one point. The venture climate at the time was such that the VCs required in their term sheets that previous investment rounds lose their liquidation preferences, and ultimately their investment.
Let me give a specific example -- we invested in a first round of an enterprise software company in 2000 that is still around today. In 2002 they needed more money, and because of the difficulty in getting VC investment, the lead VC insisted that the preferences from the previous rounds be removed, effectively making us common stock, unless we participated in this subsequent round. We reluctantly did invest some more, but because we don't have the funds that a VC has, we were only able to protect some of our preferred stock. A year and half later, the software company needed more money, and the VC did it again. This time, all our stock was converted to common. Now it is 2006, and the company might be acquired this year; however the VCs, because of their liquidation preferences, will get the first $65 million (or more). As I doubt the firm is worth more then $50M, we will not get anything, nor will any of the other founders that are no longer involved with the firm.
This has repeated itself over and over again. We made a decent choice and did our due diligence well, but subsequent VC investors have pushed us out. A few of our ventures have failed outright. That is understandable given our original 1 in 20 expectations. But what we didn't expect was how difficult it was going to be to participate in the upside. Yes, we had preferences in our early rounds that should have protected us, but they didn't.
So of our 13 investments, only 2 remain that may "make the fund": a very innovative high-tech titanium powder manufacturer ITT, and a high-tech manufacturer of ceramic devices Vapore. But even as these two investments survive, they are still vulnerable to requiring additional investment and possibly forcing us out.
Of the rest: one of our early investments sold to VeriSign at a 50% premium, our investment in Salon.com will give us a small return, MG Taylor paid off its loan, and Skotos may someday pay back its original investment. The other 8 are being written off as a loss.
Advice to Angels
So in spite of the odds, you still want to become an angel investor? Here is some advice...
Collaborate with other angels: Going it alone is dangerous -- there are a number of angel investor networks, such as Gathering of Angels, Band of Angels and others in listed the Directory of Angel-Investor Networks. Be careful, though, the enthusiasm of others can be contagious -- don't always go with the herd.
Do your own due diligence: I can't emphasize this enough. Talk to the entrepreneurs and meet their staff. Read their business plan and tear it apart. Find the hidden assumptions. Understand their business model. It needs to feel realistic. Try to get more eyes on the job: different people see different things. Don't follow others; they may have different investment criteria then your own.
Be an advisor first: Be an advisor first -- if the entrepreneurs don't listen to your advice, don't invest. If you have to invest to become an advisor, invest only a small amount, or have part of the money be contingent on a meaningful goal.
Guard your upside: When negotiating terms, don't worry about the downside. It is the VCs that need items on the term sheet for when things go wrong -- what you need to guard is for when things go right. Watch for changes in the executive staff -- they may be incentivized differently than you are.
Consider a secured loan: Somewhat contrary to the "guard your upside" advice, rather then investing only in stock, consider investing via a secured loan as well. The security can not only be on hard company assets, but intellectual property such as copyrights, trademarks or patents. Your return will be lower on the loan, but if you can get all of your investment back early and get a small percentage of the company, it can be a good way to balance risk. Just remember to file the property documents to make sure that the assets are properly secured, and be prepared that someday you may own that asset.
Save $2 for every $1: Almost every company you invest in, even if successful, will need additional funding. Make sure that you keep on hand $2 for every $1 initially invested. This will also help you from being squeezed out by later VC investors.
Invest in acquisition targets: Let the VCs take companies public -- the companies that you should be interested are the companies that will eventually be acquired. Creating an acquisition target requires the management to think differently -- coach them to do so.
Understand the founders dilemma: There are many founders dilemmas, however, one is particularly important to the angel investor. A founder may be incentivized to sell sooner then his early investors. Remember that most often, the only significant asset that a founder has is his company. If the founder has an opportunity to sell early and buy a house, he might, even if it may not be enough return on investment for the risk that the angel took. Find ways to keep your interest aligned with that of the founders, which may include even buying some stock directly from the founder.
Consider alternative exits: There are lots of boutique opportunities that are too small for VCs. I know of a local Berkeley software company that was number one in their market, but too small to go public. They had $20M in annual revenues, and profits of almost $10M, but little opportunity for growth -- early investors could have gotten their money back in dividends rather than sale of the company.
Time the cycle: We didn't invest at the ideal time for the angel investor. We picked well considering the times, but had we waited for a few years it would have been easier. Not to say that timing is everything; we'd have lost our titanium powder opportunity if we'd waited for better market timing.
Respect people: Treat the people you invest in like a paying client. Respect their time and concerns.
Be prepared that the plan will change: I've never been involved with a business where the business plan doesn't significantly change. As an angel investor you need to help your businesses to plan for those changes.
Advice to Entrepreneurs
So you want investment from an angel investor? Some advice...
Recognize the odds: The angel investor is taking a substantial risk investing in your company -- you need to be able show a scenario where the investor might be able to make 10x or 20x their investment. So if you are looking for $100K, you need to show how the angel can ultimately have stock worth $1M to $2M.
Consider their advice: Angel investors may not always be right, but show them that you are listening. If you use angels for more then just a source of money, you'll get a lot more value from them.
Draft your business plan: An angel investor does not need as complete a business plan as a VC does, but they need to see how you think. You should clearly identify what the product or service is, who is going to buy it, what is the marketplace that those buyers may find it in, what differentiates your product or service and why your team is good enough to deliver. Angel investors know that your plan will change, probably drastically, but if they understand your thinking process they can be more confident that your company will survive change.
It takes time: Don't count on the money from an angel investor (or any investor) until you get the check. Investors are always selecting from a number of choices, often very competitive choices. No matter how optimistic you are, it is likely it will take 6 months or likely more to raise angel money.
Team with Many Hats: Angel investors don't recruit new team members for you. You don't necessarily have to have your whole team in place, but there at least needs to be someone who has experience managing, someone with development experience, someone with marketing experience, and someone with sales experience. Whatever team is there, they need to be able to juggle all of those hats. Financial, HR, and administrative positions can all be part-time or farmed out.
Advice to Venture Capitalists
Value the angel investor: The angel investor serves a point in the marketplace that you are not able to serve. Rather then driving them out, find some way for them to continue to participate so that they can find other ventures for you.
Angels are not VCs: The angel investor can't afford to invest in later rounds -- their model is different than yours. It may make sense to force participation in subsequent rounds by other VCs, but carve out some room for angels.
The future of Alacrity Ventures
Though I've enjoyed some aspects of being an angel investor, I enjoy working with creative people to innovate new products more. I expect to spend most of my time in the next few years continuing to explore social software and collaboration tools, and the new product opportunities that may evolve from them.
Thus I expect that any future angel investments I make will be more along the lines of Gifford's style of investment in Consensus Development: a small investment of money and a large investment of time. Harold and Gifford both feel the same way. Currently we plan to continue monitoring our existing investments, but don't plan any new investments unless we can take a more active role in the firm -- for instance Harold is a board member in Vapore.
Gifford is now dedicating his life to building a better world by transforming business education. He is a co-founder and President of the Bainbridge Graduate Institute, which provides an MBA program integrating sustainability, green economics, the internet, and open source within a traditional MBA program. As an open source school, he helps other schools to use BGI’s curriculum. Check out his blog entry on Angel Philanthropy.
If there's one thing we've learned from six years of angel investing, one thing that may be more valuable than all the nuts and bolts I describe here, it's that Gifford Pinchot's partner-style of angel investment is what suits our investing style, not Jim Bidzos' style of hands-off angel investing, and that's a lesson that we're going to carry forward with Alacrity Ventures.