Conventional wisdom says startups should begin their funding process with friends and family, then raise an “angel round” before grabbing serious venture capital. However, crunched between the interests of the founders and the venture capitalists with only a thin slice of equity, investing in the angel round rarely leads to good outcomes and is best avoided.
If everything goes perfectly, the angel round has huge upside for investors. The company’s valuation should continue to grow round after round so that even while angel investors are diluted by later capital, the value of their shares continues to increase. When the company is acquired or goes public, the small, early investment is magnified a hundred-fold.
The problem is that the process from idea to exit never goes smoothly and when the inevitable hiccup happens, early investors get wiped out. Imagine XYZ Corp, a typical startup that raises a seed round from angel investors. The angel who led the deal gets a seat on the company’s board to represent the investors. A year later, the company is exceeding its milestones and ready for Series A. The angel investors are thrilled. Two VCs write big checks to take the entire round. The board is adjusted to replace the angel investor with a representative from the lead VC.
Over time, the company raises another round, or maybe two or three. Things are going great, until they aren’t. Sometime between Series A and Series F, there’s a bit of hiccup. Maybe a big customer cancels a contract, or a big competitor jumps into the field. Maybe one of the founders decamps for a retreat in India. Maybe the economy slows, as it periodically does.
The company is still solid, but its runway is shortening and it needs to raise more cash. Investors are more cautious now—they suddenly perceive the risk to be higher—and negotiations for the next round are fraught. Investors want guarantees to protect them before they put in money. So they demand a liquidation preference.
The liquidation preference says that when the business is eventually sold, instead of all investors sharing the proceeds equally, this investor gets their money back before other investors get anything. Or 2x their investment. Or 4x their investment. The more desperate the company is, the higher the liquidation preference new investors demand.
A 2x liquidation preference in an early round wouldn’t be such a big problem. But now that the company is nearing acquisition, the price is unlikely to be a huge multiple of the current valuation. If the company is sold for less than 2x the current valuation, other investors get nothing. During last year’s Covid panic, even 4x liquidation preferences weren’t unusual for companies desperate for funding to keep the lights on as revenues hit a lull.
Why would earlier investors agree to such unfair terms? It’s partially because it’s the only deal on the table. We can accept it or let the company fail. But more importantly, we don’t have a choice. By this time, angel investors have been diluted to a tiny slice of ownership, we don’t have a seat on the board, and any protections we originally negotiated have long since been eliminated. And in most cases, the investors in this newest round are the same investors who already the biggest investors in the company from the previous rounds. They’re negotiating a deal that’s in the best interest of their own funds without regard for the early investors. I’d do the same.
When the company does eventually get acquired, there’s a waterfall calculation. The final bridge round gets their 50% liquidity preference, the last equity round gets 4x their investment back, the previous round gets their 2x and so on down the line. By the time all the later rounds take their liquidation preferences, there’s nothing remaining for the seed investors. Even a nice exit at 20x the seed stage valuation may return zip to angel investors.
Nor is there anything left for the common shareholders, meaning the founders and employees. To give the management team a reason to the deal, a significant fraction of the deal value goes to employee retention bonuses. Founders and key employees may get nothing for their shares, but they’re offered millions in bonuses provided they stick around for two years. Acquirers like this arrangement, too, since it keeps the key employees taking their riches and bailing the day after the acquisition closes. Other employees get their options converted to that of the acquiring company.
This scenario has played out with every company I’ve invested in that’s needed more than three rounds of funding. Sometimes there’s been a little water left in the stream to reach my round, sometimes not, but with most of the acquisition value being sucked up by later investors, even with a successful exit I’m lucky to get my money back. I’ve learned the hard way to avoid making early stage investments in companies with huge dreams that will require tens of millions in capital to reach the finish line.
If you’re a startup that’ll need $50 million to reach scale, extend your friends and family round to get your product built, then go straight to the smaller VCs that can write a $1M check and continue to invest in you through many of the subsequent rounds.
If angel investors aren’t investing in the so-called angel round, what should we invest in? The answer should be obvious – opportunities that are too small for VCs and won’t require more capital to build than angels can provide ourselves. Startups with specialized products that can reach $50M – $100M in sales and can be built with 2-3 rounds of investment under $5M are too small for the VCs but ideal for angel investors. We can participate or even lead all of the funding rounds, remain on the board as the company grows, and even demand our own liquidation preferences without being squeezed under ten layers of heavy investors sitting on top of us.
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