How To Do it..

by: William H. Payne

The environment for entrepreneurs starting companies has been changing rapidly in the past decade, affected by significant changes in the primary sources of equity capital at the seed and startup stages of development. 

These changes are impacting the availability of capital from both angels and venture capitalists, as well as how these two sources of capital interact in funding entrepreneurs.

Venture Capital Invested at Later Stages

In 1995, there were no venture capitalists managing assets of $1 billion or more (Venture One). Today, nearly half of venture capital is invested by funds with at least $1 billion in assets under management. During this period, total venture capital has expanded ten fold; however the number of principals managing venture funds has not increased proportionally. Funds, on average, have more money to invest and fewer VCs per dollar under management. Consequently, the average round of venture investment has increased from $3 million in 1995 to over $7 million in 2003 (see chart #1). VCs are committing more money per investment.

As companies mature, meeting important development and growth milestones, they often need greater amounts of investment. It is common for such high growth companies to raise money in a series of investments, and these rounds of investment escalate in size as the company matures. The average size of VC investments at the Seed/Startup stage is $2 to 3 million, while later investment in these same companies is substantially larger. As can be seen in Chart #2, the average Early Stage investment in 2003 was $4.5 million, while the average VC investment at the Expansion stage of development was $7.3 million.

Since VCs are investing more money per round of investment than a decade ago, one would expect to find that VCs are making fewer investments in seed and startup companies and more investments in Expansion stage and Later Stage companies. Chart #3 shows this trend. Venture capital invested at the Seed/Startup stage of development has dropped precipitously since the mid 90s, with fewer than 200 companies per year receiving funding from VCs during the past three years (see Chart #4). The economics of scale of venture investing has resulted in VCs abandoning seed and startup investing.

Angel Investors Continue to Focus on Very Early Stage Investing

There is no robust database on angel investing. However, according to the Center for Venture Research (CVR) at the University of New Hampshire, angels have invested $15 to $30 billion per year in new companies for the past decade with average rounds of investment between $250,000 and $750,000 during this period. The number of companies receiving angel investing over this period has ranged from 30,000 to 50,000, depending on the year.

Furthermore, estimates indicate that over half of angel funding is invested in seed and startup companies, with most of the rest invested in existing portfolio companies at later stages of development (subsequent rounds in those companies, in which these angels have already invested). In 2003, CVR estimates than angels invested $18 billion in 35,000 companies with 60 percent of these funds invested in seed and startup companies.

The following direct comparison can be made for the current environment for U.S. Seed/Startup stage companies:

While these numbers of angel investment are estimates, the comparison is startling. It is clear that angel investors are the primary sources of seed and startup capital in the United States.

Funding Gap

With angels investing in rounds of less than $1 million per deal (relatively unchanged over the past ten years) and VCs tending to invest much more money per round (now over $7 million per deal), the funding gap between typical angels rounds and VC rounds is widening. This funding gap (reported previously by CVR and others) is alarming to entrepreneurs and investors alike. For entrepreneurs who need $2 to $5 million to start and grow their companies, very few sources of capital are available. Trends impacting this gap will be discussed in greater detail below.

Angels are Joining Angel Groups

In recent years, angels have been forming angel organizations at a rapid rate. There were very few organized angel groups a decade ago, but the Kauffman Foundation and CVR estimate that 200 angel groups were in operation in 2003 (see chart #5). Unlike solo angels, who prefer to operate below the radar, angel groups tend to promote deal flow by publishing investment criteria and application processes. From the entrepreneur's perspective, it is much easier to find angel groups than individual angels. This access to angels by entrepreneurs is an important trend in the emerging sector.