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Summary:

The current economic meltdown and its effects, which are expected to be felt for at least the next year, require entrepreneurs to find investors with deep pockets and a long-term investment horizon starting from a company’s earliest days. In other words: venture capital.

Recently two separate posts ran here that argued in favor of technology entrepreneurs who need early-stage money taking it from angels. I, however, believe they should seriously consider taking it from people in my profession: venture capitalists. The current economic meltdown and its effects, which are expected to be felt for at least the next year, require investors with deep pockets and a long-term investment horizon starting from a company’s earliest days.

Entrepreneurs seeking funding usually turn to one of two sources: angels and venture capitalists. And given that I fall into the latter category, let me go on record as saying that both sources can provide exceptional outcomes. In fact, in many cases, some of the best deals that we see in venture capital come from angel investors. So angels and venture capitalists are not mutually exclusive sources of funding, as one can lead to the other. However, with the economy as it stands today, entrepreneurs need to think clearly about how to solve their funding needs from now all the way until better economic times.

I have known many entrepreneurs that have worked with angel investors and had great outcomes. Generally, angels are exceptionally smart entrepreneurial individuals who make fast investment decisions, take a smaller ownership percentage than venture capitalists in startups they fund and opt to have minimal involvement in the operational aspects of the business. On the other hand, some entrepreneurs note that angels are not focused enough on their business (anecdotally I have heard of some angels spreading their investments over 30 or more startups) and some have a fairly short expectation on the investment horizon for returning their capital.

For an entrepreneur, working with a venture capitalist is a different experience. Investing our limited partner’s money generally requires us to have a more diligent and lengthy investment process than angels, to work with a very limited set of companies (at Panorama Capital we limit our full-time involvement to 5-7 companies for each partner) and thoroughly study a market before investment. As venture capitalists, we would argue that this focus and investment commitment should equate to more ownership in a startup than is typically taken by an angel investor.

After the initial investment, we also give access to syndicates for additional financing, study the market landscape for partners and competitors and help with team building. In other words, while we are more focused on our investments, we are also working on behalf of our limited partners to provide a return on their investment and that, in some instances, can admittedly result in a conflict of interests between us and the entrepreneur. In my experience, this conflict happens less often than one might think, typically when there isn’t a strong and productive relationship between the investor (angel or venture capitalist) and the entrepreneur.

While there are objective reasons to take capital from both an angel or venture capitalist, in my mind the current economic downturn means that an entrepreneur needs an investor who will commit to a startup over a much longer time period than a typical angel investor. For example, before we commit, we ask ourselves if this is an investment that we would be excited about being involved with for 10 years.

The technology IPO market is dead and many predict it will stay that way for at least another 18 months. Debt financing for larger firms to use for mergers and acquisitions is practically non-existent. So unless you’re an entrepreneur working at a startup that is narrowly focused on getting bought by a company that is flush with cash (and there are a few of these, such as Google, Microsoft and Cisco), you’re going to need an investor with a long-term commitment to your business.

While I do know some truly remarkable angels who can help on all of these fronts, overall it seems clear to me that now, more than ever, is the time for venture capital.

Allan Leinwand is a venture partner with Panorama Capital and founder of Vyatta. He was also the CTO of Digital Island.

  1. Yes i fall into the latter category too..

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  2. There’s an amazing amount of money out there waiting to be invested. Just because the fractional-reserve banks aren’t willing to lend to each other or lend to anyone else (due to their reserve ratios annihilated from over-leveraging) doesn’t mean that individuals aren’t ready and willing to dive in if a small company’s prospects look good.

    I do believe, though, that the next blossoming market will be in some sort of micro-lending groups that affiliate to make multiple investments in a variety of markets, with each individual investor only putting a small percentage of their overall investment in any individual company or market. While this lessens the risk it also lessens the reward, but with inflationary pressures killing the dollar and debt-ridden large capital market corporations returning no dividend or profitability, I’d say the venture capital market could have some excellent opportunities to profit.

    Being an entrepreneur for 21 years, I’ve always said one thing: save during a Fed-induced boom, and start new businesses during recessions. If you can weather the Fed-induced bust, you can come out well ahead when their next boom cycle begins. All of my most stable businesses were started in recessions, after a period of heavy savings during the previous boom cycle.

    Right now, with the business market in chaos, is an excellent time to reach out to those with money. There are hundreds of billions of dollars sitting in safe but unattractive investment forms that are waiting for a decent risk/reward ratio. If you’re not considering either VC or AI for your business venture, you’re going to miss a wonderful stage of the business cycle: the death of debt-laden competition, the resistance of the risk-adverse from expansion or startup, and a relatively aggressive small capital investor group that really wants a decent return on their money but is willing to take some risk.

    That’s why I’ll be contacting some angel investors in the next month for the business I’ve been nurturing for two years to profitability. Recession? Only for those who didn’t save during this last boom. For those who increased their savings of capital, this could be another boom market, but with less competition and fewer barriers to entry.

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  3. So no easy IPO or M&A exits on the horizon. Whatever happened to the idea of running a business for the profit it generates? Apparently, our economy has become dominated with the idea of selling businesses to investors rather than selling products to customers. I guess this is a natural consequence of the increasingly top-heavy distribution of wealth in our country. You go to where the money is, and that is in the hands of other investors, not consumers. And so we have one speculative bubble after another as investors shuffle their wealth among each other creating fantasy valuations.

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  4. I completely disagree with this phony write-up. Apparently, it is sad to learn that people like these are running venture funding companies or are involved thereof. This is a time where we all need to step back and rethink what the whole situation is about. The financial meltdown doesn’t necessarily equates to technology market, and neither it boils down to the bare minimum or pulling capital from the market. It’s the BS created by BS companies and their BS practices. Greed is the evil of all. Understanding where the money is and where it can be utilized best is the source of inspiration. Unfortunately, like many others on Wall Street people in the Silicon Valley have chosen to walk with their blinders on, which purely sucks. These are the times for innovation, and creating value for the dollar. Instead, Wall Street greed is bringing it down. No fault of the common man, but hell yeah, we’ve to pay for it now.

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  5. @A.B. Dada – agreed that it is best to buy low and sell high. If invested correctly, it does appear that VCs can make good profits on investments done today.

    @Tim – Building a business to run it off profits is absolutely a valid business model. That being said, I don’t think that those businesses are those that are started by entrepreneurs looking for VC funding.

    @Josh Seth – I do think that the financial meltdown does equate directly to the business of startups and their funding. If the economy continues to worsen then there will be fewer consumers of products and of the companies themselves. I’m agreeing that time is now for innovation and assert that startups need to think about how they are funded between now and eventual economic recovery.

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  6. Thank you for the comments, as this post was worrying me:
    1. There is a 3rd option for entrepreneurs which is to get cash from customers, this is what business is about in the end.
    2. For info, Inc Magazine recently published their top 5000 list, and the median capital needed to start one of these fast growing companies is $25,000, and only 3% of these fast growing companies took VC money.
    To say that VC is the best choice is ignoring that 97% of the top 5000 fastest growing companies exist. What lenses do you use to miss that much?
    3. Despite what you say: “we are also working on behalf of our limited partners to provide a return on their investment and that, in some instances, can admittedly result in a conflict of interests between us and the entrepreneur”, there is a HUGE conflict of interest between a VC and an entrepreneur:
    – the VC is paid by investors to generate for them as much of the value as possible from a given business
    – The Entrepreneur is trying to generate value from the business for himself.
    To say that you could work in the middle to keep both happy cannot be true, if you are a VC your job is to generate value for your LPs and nothing else. What is probably true is that you may try to make it as painless as possible for the Entrepreneur, but this is a very different proposition. And in the end, we know where the value generated goes: LPs first.
    4. Thank you @AB for mentioning the micro-lending option: “I do believe, though, that the next blossoming market will be in some sort of micro-lending groups that affiliate to make multiple investments in a variety of markets, with each individual investor only putting a small percentage of their overall investment in any individual company or market”. I am a big believer of this, to the point where I started the Entrepreneur Commons to do just that: http://www.entrepreneurcommons.org
    This is a time of opportunities, and one opportunity is to try something different…

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  7. Allan, as a member of Panorama’s technical advisory board, a limited partner in a couple firms, and a veteran of 4 venture backed companies with 3 successful exits (one TBD), I absolutely agree that VCs add value to startups beyond the dollars they invest, at least if the partners have real operational experience and useful relationships. Some VCs with limited operational experience don’t add a lot of value.

    However, here’s the problem with venture funding right now. In 2001, the last “dip” (as opposed to today’s crater), there was a reasonable expectation that exits, when they did happen, were big. Like $100m big. But with the markets where they are, and the increasing acquisition of startups in the $20m range, the economics of being VC backed don’t work as well as they should.

    A founder of a typical vc-backed startup might expect on average to end up with 7% equity at exit. That means about 4+ years of hard work at about $150k annual salary (for the first 2+ years), relatively high for a startup CEO. But if the exit is $25m, the equity is worth about $1.75m, if there is an exit at all. So over 4 years, salary + equity = $2.35m, not adjusted for risk. Risk adjusted, you’re looking at much less. Not so long ago, when exits were north of $100m, that number would have been $6.75m not adjusted for risk. Entrepreneurs accept the risk but want the rewards that match it.

    On the flip side, let’s say an entrepreneur takes a VP job at say Cisco. Base + bonus = $275k with maybe 100k options. Say the options increase in value $10 over 4 years (conservative). So over those same 4 years, this entrepreneur makes $1.1m salary + $1m in options = $2.1m, but the risk is much, much lower.

    More than one entrepreneur I know has looked at the current economics, the amount of hours a typical CEO spends, and the median exit values, and determined that a VC backed company isn’t compelling like it used to be. That said, it’s awesome to have enough money to last 18 months, and no angel is likely to do that, so Allan’s point is valid.

    But if the same entrepreneur raises $500k from angels, starves for a year, but maintains say 30% equity, and builds a company he can sell for $20m, the rewards match the risk.

    So that means that VCs – even the technically smart ones with operational experience like Allan – will have to work hard to convince entrepreneurs to accept the risk with the lower reward, or they’ll have to reduce the risk. The two ways to do that are to leave the entrepreneur with more equity, or to pay him more. Who knows, that may make for a more successful investment.

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  8. @Marc Dangeard – If you can build a business that can generate cash immediately from customers then I think we’re in complete agreement. I would not take VC or angel funding in this case, as an entrepreneur I would keep 100% of the company. On your second point, I have not seen the Inc. magazine list. Can you please post a link to the list? I would be curious to see how many of them are profitable and generating cash on the bottom line. Thirdly, you are right that we work for our LPs. In my experience, the best outcome for the company and the LPs are often the same outcome. It’s my experience that good VCs balance the risk/reward properly and work diligently to align their interests with the entrepreneur.

    @Dave Asprey – Thanks for the nice words and comments. But, ummm… why are you not taking a job at Cisco? :) You are right on the opportunity costs for the entrepreneur if they do not achieve a good outcome for their company – the risk does not merit the reward. Conversely, we both know entrepreneurs who did exceptionally well at VC backed companies. I think the bigger question, if the compensation between your two options is relatively equal, goes to motivation and work satisfaction. There is a reason that you, Dave, have not worked for a large company for some time and why you have done four early-stage venture backed companies…. My last point – you assume that CSCO will increase $10/share over four years. Their share price was $18.93 on 9/27/04 and closed Friday (ignoring today) at $23.82. You would have had to do some good market timing to get your $10/share increase (it did rise nicely in Oct 2007) on those shares that were vested to get the compensation you describe.

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  9. [...] Allan Leinwand, follows up with a counterpoint on why Entrepreneurs should prefer VC money over angel money. He claims VC’s will be better able to stick with the startup over the long term, if things [...]

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