Essays

If angels are so important, why do we hear more about VCs? Because VCs like publicity. They need to market themselves to the investors who are their "customers"—the endowments and pension funds and rich families whose money they invest—and also to founders who might come to them for funding.

Angels don't need to market themselves to investors because they invest their own money. Nor do they want to market themselves to founders: they don't want random people pestering them with business plans. Actually, neither do VCs. Both angels and VCs get deals almost exclusively through personal introductions. [2]

The reason VCs want a strong brand is not to draw in more business plans over the transom, but so they win deals when competing against other VCs. Whereas angels are rarely in direct competition, because (a) they do fewer deals, (b) they're happy to split them, and (c) they invest at a point where the stream is broader.

Some angels are, or were, hackers. But most VCs are a different type of people: they're dealmakers.

If you're a hacker, here's a thought experiment you can run to understand why there are basically no hacker VCs: How would you like a job where you never got to make anything, but instead spent all your time listening to other people pitch (mostly terrible) projects, deciding whether to fund them, and sitting on their boards if you did? That would not be fun for most hackers. Hackers like to make things. This would be like being an administrator.

Because most VCs are a different species of people from founders, it's hard to know what they're thinking. If you're a hacker, the last time you had to deal with these guys was in high school. Maybe in college you walked past their fraternity on your way to the lab. But don't underestimate them. They're as expert in their world as you are in yours. What they're good at is reading people, and making deals work to their advantage. Think twice before you try to beat them at that.

Because most investors are dealmakers rather than technology people, they generally don't understand what you're doing. I knew as a founder that most VCs didn't get technology. I also knew some made a lot of money. And yet it never occurred to me till recently to put those two ideas together and ask "How can VCs make money by investing in stuff they don't understand?"

The answer is that they're like momentum investors. You can (or could once) make a lot of money by noticing sudden changes in stock prices. When a stock jumps upward, you buy, and when it suddenly drops, you sell. In effect you're insider trading, without knowing what you know. You just know someone knows something, and that's making the stock move.

This is how most venture investors operate. They don't try to look at something and predict whether it will take off. They win by noticing that something is taking off a little sooner than everyone else. That generates almost as good returns as actually being able to pick wi

Investors always say what they really care about is the team. Actually what they care most about is your traffic, then what other investors think, then the team. If you don't yet have any traffic, they fall back on number 2, what other investors think. And this, as you can imagine, produces wild oscillations in the "stock price" of a startup. One week everyone wants you, and they're begging not to be cut out of the deal. But all it takes is for one big investor to cool on you, and the next week no one will return your phone calls. We regularly have startups go from hot to cold or cold to hot in a matter of days, and literally nothing has changed.

There are two ways to deal with this phenomenon. If you're feeling really confident, you can try to ride it. You can start by asking a comparatively lowly VC for a small amount of money, and then after generating interest there, ask more prestigious VCs for larger amounts, stirring up a crescendo of buzz, and then "sell" at the top. This is extremely risky, and takes months even if you succeed. I wouldn't try it myself. My advice is to err on the side of safety: when someone offers you a decent deal, just take it and get on with building the company. Startups win or lose based on the quality of their product, not the quality of their funding deals.

Venture investors like companies that could go public. That's where the big returns are. They know the odds of any individual startup going public are small, but they want to invest in those that at least have a chance of going public.

Currently the way VCs seem to operate is to invest in a bunch of companies, most of which fail, and one of which is Google. Those few big wins compensate for losses on their other investments. What this means is that most VCs will only invest in you if you're a potential Google. They don't care about companies that are a safe bet to be acquired for $20 million. There needs to be a chance, however small, of the company becoming really big.

Angels are different in this respect. They're happy to invest in a company where the most likely outcome is a $20 million acquisition if they can do it at a low enough valuation. But of course they like companies that could go public too. So having an ambitious long-term plan pleases everyone.

If you take VC money, you have to mean it, because the structure of VC deals prevents early acquisitions. If you take VC money, they won't let you sell early.

The fact that they're ru

VCs don't regard you as a bargain if you don't need a lot of money. That may even make you less attractive, because it means their investment creates less of a barrier to entry for competitors.

Angels are in a different position because they're investing their own money. They're happy to invest small amounts—sometimes as little as $20,000—as long as the potential returns look good enough. So if you're doing something inexpensive, go to angels.

VCs admit that valuations are an artifact. They decide how much money you need and how much of the company they want, and those two constraints yield a valuation.

Valuations increase as the size of the investment does. A company that an angel is willing to put $50,000 into at a valuation of a million can't take $6 million from VCs at that valuation. That would leave the founders less than a seventh of the company between them (since the option pool would also come out of that seventh). Most VCs wouldn't want that, which is why you never hear of deals where a VC invests $6 million at a premoney valuation of $1 million.

If valuations change depending on the amount invested, that shows how far they are from reflecting any kind of value of the company.

Since valuations are made up, founders shouldn't care too much about them. That's not the part to focus on. In fact, a high valuation can be a bad thing. If you take funding at a premoney valuation of $10 million, you won't be selling the company for 20. You'll have to sell for over 50 for the VCs to get even a 5x return, which is low to them. More likely they'll want you to hold out for 100. But needing to get a high price decreases the chance of getting bought at all; many companies can buy you for $10 million, but only a handful for 100. And since a startup is like a pass/fail course for the founders, what you want to optimize is your chance of a good outcome, not the percentage of the company you keep.