Angel Investing: Skill 3 – Relationships with VCs

Posted on Sep 15, 2010 | 32 comments


This is the third article in a series on what it takes to be a great angel investor (and why this should matter to entrepreneurs).  Part 1 – Access to Great Deal Flow – is here.  Part 2 discussed the need for domain knowledge since merely “joining the right club deal” will in no way determine success.

Not everybody agreed on the need for domain knowledge.  Paul Kedrosky made the case for “naive optimism” being an important part of startup success.  Chris Dixon made the point that he thinks investors should look for the founders to have the domain knowledge rather than them having domain knowledge themselves.  Me?  I’d rather be Roger Ehrenberg with a thesis around data-centric companies and base my investment decisions on the skills I’ve developed in my career.

And if I were an entrepreneur I’d rather find investors who understood “my space” so that in tough times they felt comfortable about “doubling down” rather than following the masses toward the exit door.

I should say that I agree that naive optimism in entrepreneurs can produce higher beta (upside or flops) and that’s good from an investment standpoint if you’re looking for big returns.  I have often argued that case and paralleled it to America itself – we often don’t know what “can’t be done” so we just plow on and do it.  But while I prefer a certain naive optimism in founders I can’t see the logic that this extends to angel investors.  I think being knowledgeable about your sector can be important.  One of the biggest problems is when “you don’t know what you don’t know.”

For that reason I don’t even look at deals in the biotech or clean tech fields.  I could see a Phd from Stanford and still not know whether there was a foundation of whether what they were proposing would be possible or laughable.

To some extent Keith Rabois agreed with me about domain knowledge and argued that most of his investments are in the consumer Internet space as a result.  That’s what he knows best.  And he argues that you need to have some “comparative advantage” as an investor. Obviously I agree.

But knowing the right people and knowing a market only works well for angel investors in bullish tech markets in which IPO’s happen quickly (97-99) or where larger companies are actively scooping up little tiny companies at sub $50 million valuations to drive innovation (05-08, 10-?).  If we head for a period of no to slow growth (Japanese “lost decade”) or even worse, a double-dip recession, I fear these boom days will end imminently .

Either downside scenario requires angel deals to be funded further.  This is where VC comes in and why it’s needed in the industry no matter how much populist sentiment exists against the VC industry.  It’s fun to have a villan – less fun when you need them.  I know that in late 2010 it’s not as popular to say this because we’re in the era of “super angels” and feel-good startups.  But I promise you I’ve been here before and know that this is temporary.  Deep down I’m still an entrepreneur “fighting against the man” but I’m still a pragmatist.  Always have been.

So what else matters when one considers history?

3. Relationships with VCs who “protect your investments” – In poker you can win a few hands and feel like you have the magic touch.  But really we’re all dealt some good cards from time-to-time.  You can’t mistake that for being the one who wins the poker tournament or even comes home with more money than you brought to the game.

The lucky cards some angels are dealt with mostly have to do with the timing of their investments.  Let’s call these cards 1996-99, 2005-08 and 2010+.  In the first instance many angels made beaucoup bucks by getting in on deals that IPO’d quickly.  In the latter cases many companies (Flickr, Delicious, Blogger, Writely in 05-08 and  lately Invite Media, Aardvark, Dodgeball, etc.) got picked up early without raising a lot of VC.  We’re back in the “feel good angel” phase.

In these scenarios angels made great returns precisely because they didn’t need to dip their hands into their pockets a second or third time, their companies didn’t go bankrupt and they didn’t get buried in the cap tables by large VCs who put in “pay to play” provisions in tough times.

So where are we now?  It’s hard to say.  If 2011 & 2012 look like 2010 then the current crop of angel investments will look great.  There has been a preponderance of early-stage deals that have seen quick exits.   My thesis on why this is happening is that large tech companies didn’t invest enough in R&D between 2008-2010 (Google even went through layoffs!!!) and now they’re all buying their way into innovation and talent.  This is cheaper for them than waiting for big competitors and buying companies at big prices.

But if 2011 & 2012 look more like 2008-2009 than 2010 then one of the most important skills of angel investors will be whether they can get their companies financed (or ramen profitable, but this is harder to sustain over a long period of time).  That is why I find it curious when angels start shouting that VC’s are dinosaurs, evil, money-grubbing and non-value-add.  This is easy to say in times where VC’s aren’t needed but will be regretted in times where longer runways are needed.

Yes, the VC industry was over funded and too many non value-add people entered the industry.  But VC is also a very important part of the technology ecosystem – like it or not.  And the best early-stage investors know this.

First Round Capital & True Ventures seem to spend as much time cultivated relationships with “second round capital” as they do entrepreneurs.  Keith Rabois (mentioned in my previous posts on angel investors) is on record on GigaOm as saying how important VC backed deals are to him.  Why?  Because he doesn’t look to invest in quick flips.  He believes that returns are derived by industry-changing companies and as an investor in LinkedIn, Yelp & YouTube (to name a few) I guess he’s got the credibility to say that.

And in my interview with Howard Morgan on This Week in VC he said (paraphrasing), “First Round Capital views our early-stage investments as ‘babysitting’ but we spend a lot of time working with later-stage investors who can ultimately ‘take ownership of the day-to-day oversight’ of the companies once they are looking to scale.  That’s our model.”  New entrants to the angel space should take notice.  First Round Capital requires Second Round Capital.

And I can tell you that FRC invites prominent VCs to all their CEO events and mixers.  They don’t send Tweets asking if all VCs took August off or call VC’s lazy.  To be a great angel you need great dealflow, sure.  And being populist helps that.  But make sure you got the other side of the equation covered.

Do you have solid VC relationships?  The kind where the VCs are likely to want to invest precisely BECAUSE  you provide social proof that this is a worthy investment?  In the long-run it is a critical skill to being a successful angel investor.

It’s one thing to exit early in good times and early M&A markets.  It’s another to make money in times where exits are more elongated.  There is a strategic differentiator in the ability to find VC followers.  If you’re an angel – I suggest that a portion of your time go into cultivating these relationships.  And resist the temptation to extend thy middle finger.  As tempting and as deserving as it might be ;-)

  • http://www.howardlindzon.com howardlindzon

    ok i may have a shot…phew

  • http://www.howardlindzon.com howardlindzon

    this has been a rollercoaster series for me. edge of my seat for 4 and 5 as i may double down or quit based on the skills. I think I am 1.5 for 3 so far.

  • Joelyoung7

    How can an angel know his founders have domain expertise if he doesn't? Research / due diligence helps, but is only valuable set against the nuanced understanding of a space. Without the understanding it's tantamount to a white belt trolling the streets for a fight.

    Agree with the “naive optimism” take, though. If it weren't for that, I'd never have attempted the things I've been successful at — not with my lack of pedigree. Can't help but feel that even with domain expertise, a certain amount of naive optimism is requisite. After all, if your aim is to be wildly successful, you're likely doing something somewhat new.

  • http://walkercorporatelaw.com Scott Edward Walker

    You're cranking this stuff out, man – love the energy. Agreed that “extend[ing] thy middle finger” generally doesn't make good business sense in the long run; however, angels always need to avoid the flip-side: getting in bed with certain VC's. We need angels helping to create a competitive environment for the Series A, not steering startups to their VC buddies for back-scratching purposes. Cheers, S

  • http://twitter.com/ramparte Sam Schillace

    I think you are correct that the recent spate of acquisitions won't last.

    I'm one of the Writely founders, and I sat on the other side of the table for a bunch of deals once I was at Google (JotSpot, Zenter, Anteros, etc). There was a lot of activity in 2006-7 and then not much in 2008 and the first half of 2009.

    Everyone is “at war” right now, so they feel threatened and are buying things “just in case”, but this will pass soon. It's very hard to do an acquisition well (I know this from both first and third hand), especially a smaller company which tends to get lost no matter how welcoming the bigger org is. I predict a lot of indigestion and a pause before too long as the buyers deal with what they've bought.

    Nice series, looking forward to the rest. Even having been through this a few times (being bought and doing some buying), I feel like the current environment is very, very hostile to naive money.

  • http://bothsidesofthetable.com msuster

    LOL. Skill 4 = humor. Skill 5 = marketing guru. So you're set for life ;-)

  • http://bothsidesofthetable.com msuster

    Not too tough to extrapolate who has been successful in your field through a bit of research

  • http://bothsidesofthetable.com msuster

    re: cranking – I wrote it all as one post for a prominent website but they were too slow to publish so I broke it up and am releasing it over a week rather than wait.

    re: angels vs. VCs on A's – respectfully disagree. They fill different roles, take different risks, have different skills. We need both to work well together. Having Series A VCs compete with other Series A VCs is enough competition at that stage. The fact that there is less VC money is a good thing in the long run. Less companies funded is not necessarily a bad thing overall. Despite what people currently think. Time will tell (and will call Arrington right).

  • http://bothsidesofthetable.com msuster

    Thanks, Sam. I'm sure we could share some Salesforce.com stories as I've heard some of the stories about the discussions with Writely (and honestly may have benefitted a bit from it).

    I agree exactly with your assessment. I know it's not populist to say it now. But neither was it the case when VC was booming and everybody thought it clever to be a VC.

    Love the name Restartle. Clever ;-)

    Would be fun to be in touch.

  • http://www.howardlindzon.com howardlindzon

    oh thank @jesus and @god for that.

    now for an ambien.

  • dshen

    I also think the reverse is true; great VCs cultivate great relationships with angels as well. We often find deals that are way too early for them and do a lot of work, as well as put in early capital, to validate an idea. I think that we angels provide a great source of validated deals for them, but only if they know us and are in constant contact with us on a friendly basis. Otherwise, we may end up shopping our startups to someone else simply because someone else was more top of mind…

  • http://informationarbitrage.com/ infoarbitrage

    mark, thanks for penning this important and informative series on seed stage investing.

    I firmly agree with your contention that domain knowledgeable, value added investors are important at every stage of the financing life cycle. in fact, in a recent post “can micro vcs go the distance” http://informationarbitrage.com/post/1004046712/can-micro-vc-go-the-distance, success in scaling is predicated upon relationships with, as you call them, sources of “second round capital.” an integrated ecosystem is needed to take companies from inception to IPO, requiring investors (and, needless to say, the company staff) possessing different skills, resources and capabilities at each phase of the life cycle.

    the investing community shouldn't be promulgating fear and loathing towards others in the ecosystem simply because they exist. larger vcs by their nature aren't bad; it's only that some of them have engaged in bad behavior. so have many angels; simply carrying the name does not make it so. rather than generalizing, i think it is better to build connective tissue among those who truly care about and are skilled at helping turn young ideas into big companies – angels and vcs alike – and establish a life cycle chain among firms who like to work together and are successful at doing so. at least this is my mission.

    roger

  • http://dreamtigerco.com/ Dan

    Mark, this is a great series of posts and should be required reading. I especially like the bigger economic context that you've introduced here and in the past. Rare to see. I wonder, how do you think a period of deflation or zero-inflation would impact venture investing, and for that matter the VC-angel dynamic? Cash, in such an environment, has relatively greater value, near-term equity has less, and costs diminish further still. We may or may not enter such a cycle, but would be interesting to contemplate.

  • http://hdemott.wordpress.com Harry DeMott

    Don't you mean $jesus and $god?

    I hear $god is trading well

  • Len_Williams

    Great article. I agree with you and I also believe that the super-angel trend is temporary and can not replace VC funds, at least not for providing capital to already successful companies that intend to expand or develop other products. I doubt any super-angels could compete VCs when huge amounts of capital are required.
    What do you think about the micro-VC trend?

  • http://hdemott.wordpress.com Harry DeMott

    I think I may have written this the other day – but I'll write it again – because it is apropos here as well.

    As a professional investor, no investment is a successful investment until you exit and the money is in the bank.

    In other words, the second you write the initial check – full of optimism and promise – you now have to understand what the potential for an exit is. In fact, you better damn well understand those scenarios before you commit the capital.

    What you are saying here is that you not only need to see the right deals that fall within your circle of competence – but you also need to have the right connections to effectuate an exit – or a non crushing hand-off to the next lead steer. If you get in with the right angels – some of this will take care of itself (lots of connections with firms who are buying) – but if you are getting in bed with a guy who is pissing everyone off – well then you had better be right – and awfully capital light.

    To get all esoteric on you – angel investing is kind of like riding a bicycle in a high end road race. You need to get yourself in the correct breakaway – do your time at the front of the peleton or grupetto – and move to the back of the line – ready to take your pull again if necessary.

  • http://www.davidblerner.com davidblerner

    Mark- Another tour-de-force…. what a treasure-trove for the community…. As an angel since 2001, I had the same kind of experience reading this series of yours as lindzon did… what a rollercoaster ride…. definitely an elaboration on your mantra of “angel investing is typically a mug's game”!
    One thing I will add though sticking with the poker analogies…. sometimes it takes a while for a player to get to the right tables and although there are a number of paths to these tables, sometimes you have to just “play to Play” so to speak… in other words- if you ain't in the game, you'll never get to the Game….

  • http://twitter.com/PhilipHotchkiss Philip Hotchkiss

    Not only does Roger give good baseball tips, his reply and the bit about “connective tissue” is so right on.

  • http://bothsidesofthetable.com msuster

    Thanks, David. Great point. Totally agree. I spend a ton of time with angles / super angels / micro VCs / etc. And increasingly I try to spend time with Series B investors. You need to have relationships at all levels of the funding supply chain.

  • Edwin Oh

    On the VC vs. super angel debate, Fred Wilson just put out a good post http://bit.ly/c7jfE5 that points out that these are really two different types of VCs serving two very different markets segmented along two different upfront capital requirements.

    And the fact that a SaaS company can be super angel funded to cashflow breakeven does not mean they won't need VC money later. According to some SaaS experts I've spoken with, a SaaS company going into scale up mode may need 1.3-1.6 times MORE cash than via the traditional licensed software company. That probably won't be coming from the super angels.

  • http://bothsidesofthetable.com msuster

    thanks, roger. anybody reading this should click through and read roger's post – it's spot on. The concept of “lean hard into winners” vs. “spread your bets widely” is often misunderstood by people. I personally think you only make great returns by focused investing. I have a post on this coming one day but it's controversial in micro VC circles so I've been a bit gun shy about writing it. But all my posts start with topics that I debate all the time with people so I'm sure it will slip out onto my blog in a moment of weakness ;-)

  • http://bothsidesofthetable.com msuster

    thanks. I don't think deflation would overly impact VC investing. We're backing companies in nascent markets that are attempting to be disruptive. They often don't have to capture large markets to initially become successful. And let's not forget that many of the best Internet companies are deflationary by nature, bringing down the costs of markets. Think: CraigsList, Amazon, Google, Amazon AWS, etc.

  • http://bothsidesofthetable.com msuster

    I actually don't believe that the super-angel trend is temporary just that it will capture an important part of the market but that VC is still necessary to scale businesses over time.

  • http://bothsidesofthetable.com msuster

    Ha. Fun analogy. Based on your comments I think you'll like skill 5, but don't want to give anything away ;-)

  • http://bothsidesofthetable.com msuster

    What a great point. And I should make it more clear. When people ask about my personal angel investing I often tell people have have non-traditional motives. Of course I'd like to make good returns. But I often also want to learn about a market, get to know other investors, help promising entrepreneurs get their first break as I once did, etc. I tell my wife to assume that money is lost.

    So goes with poker. I don't play often enough to win when games are really competitive. But it's still fun to play sometimes.

    So with angel investing – if you're a “weekend warrior” it's OK. As long as you're not investing with large sums or expecting it to provide your primary future income.

    thanks for the reminder.

  • http://www.davidblerner.com davidblerner

    You've inspired me to respond and elaborate with a blog post… Standby…

  • http://bothsidesofthetable.com msuster

    Thanks for the link to Fred's article. I think it's even more nuanced than that.

    Fred correctly segments the two VC markets: software / Internet vs. biotech, clean tech, etc.

    But within software / Internet there is also a need for early stage, mid-stage and late stage (e.g. seed, A & B round investors).

    FWIW, as a 10 year veteran of the SaaS space I can tell you that it does take a lot of capital to become a large player given the deferred nature of the revenue. As you obviously know.

  • http://bothsidesofthetable.com msuster

    ;-) make sure to send me a link

  • Howard

    Mark, this series is great, and thanks for the shoutout. I did say the First Round tries to be the baby nurse (high involvement) at first, and then transition. But the world is going to elongate in terms of length of investment, and your points above are right on.

  • Joelyoung7

    Very true. Also agree strongly with your point that domain experience is still very important. Great post once again.

  • Edwin Oh

    Mark, thanks for the additional insights! Valuable as always.

  • http://www.davidblerner.com davidblerner

    Mark: Here it is: The first of a mini-series on “angel profiling”!

    Angel Profiling (1): A Moveable Feast of Mugs, Maniacs and Masters of the Game http://bit.ly/ac6DhK