Angels and Vultures

You mostly know me as a writer, musician, poet, rapscallion or scoundrel, but in real life, I’m a corporate executive. I work for a small company that I founded with a couple other guys back in 1996. My job is Alpha Geek. I control the technology platform on which our business is built. Over the years, I’ve learned first-hand how small companies get funding, and I’ve noticed that when I explain a lot of this stuff to people, they are surprised. So I thought it might be interesting to lay it all out.

Starting a technology business is tricky. You need to develop things to sell, but until you’ve developed them, you don’t have any money coming in to pay salaries and rent and the minutiae that comes with creating a business. You need some seed money to get going. Sometimes people use their savings or a second mortgage on their house as that seed money, but that generally isn’t going to work for a technology startup. These need more money than that.

Raising money for a startup is particularly tricky because almost all startups fail. It’s a terrible investment.

Back in the late ’90s, the popular way to get started was with “Angel Investors.” These were basically rich old white guys who had been in business forever. Angel Investing was a little like charity work, because most of the businesses these angels invested in would often fail. They’d never finish the product, or they’d find there was no market for the product, or some big established company would bring basically the same thing to market, or the founders would just be really bad at running a business. Whatever the reason, most startups fail, so investing in them is either really stupid or really nice. Angels aren’t stupid, so we have to assume they are just nice. The ones I know are all incredibly nice people. You have a hard time reconciling how nice they are with how absurdly wealthy they are.

Although most businesses would fail, a couple of them might succeed. The definition of “succeed” is a little weird though. It usually means to move on to the next stage of funding: Venture Capital. Back in the ’90s, there was a lot of Venture Capital (VC) money looking for a place to invest, so they’d often overpay for small technology companies. Since the Angel Investors would own a large portion of these companies, they would make a really good return on their investment when the VCs bought them out. Like, a really good return. Like, they invested $100K, and they got a few million back. Really, this only needs to happen once, and it’s paid for all the businesses that failed. These rich old white guys are rich for a reason.

The other definition of “success” for a small company was to be acquired by a big company. That was more rare back in the ’90s, but not unheard of. It still happens today, like when Facebook bought Instagram. It tends to happen when a big company’s stock is ridiculously overvalued. That allows the company overpay for things.

Venture Capital is a lot like those Angels, except on a bigger scale. The way a VC firm works is that they start a “fund” by getting a bunch of really rich people to invest. Sometimes they also get institutional money, like pension funds. Each VC fund has three phases and lasts a few years. First, they raise the money, then they invest it in small companies, and then they sell or kill the companies. When they sell or liquidate a company, they plow the proceeds back into the other companies in the fund. At the end, they need to show a 20% annual return on investment for the people who invested. If they can’t, then things get really, really, really bad for the VCs. As in, the individuals running the funds have to come up with their own money to make good and stuff.

Back in the ’90s, running a VC firm required absolutely no skill. As long as one of the companies in your fund managed to get to IPO (Initial Public Offering—selling stock in the company to the public), you’d make such a killing getting people to overpay for the company in the stock market that you’d easily cover your 20% commitment. As a result, VCs at that time were run by people who knew about money and relationships, but didn’t know anything about business. Building a business you can get to IPO is a completely different thing than building a real business. It was all about crafting a great story of what the company might be able to do. Almost all the VCs I’ve ever encountered were old-money guys. People who had never really worked a day in their life. They inherited money, and used some of that to buy their way into a VC firm.

Then the dot-com crash happened.

At this point, it’s necessary to introduce the concept of the cram-down. Each investor in a company owns “shares” of that company. Let’s say the angels own 60% and the founders own 40%. Suppose we have 100 shares of stock, and the VCs come in. Let’s say they decide the company is worth $10M. They could give the angels $6M and the founders $4M, but it doesn’t work that way. Instead, they give $10M to the company, which then issues new stock. Let’s say 900 shares of new stock. So now we have 1000 shares worth $10M, or $10K per share. The VCs own $9M worth, the angels own $600K worth, and the founders own $400K. That’s called a cram down, because the issuing of new stock resulted in the value of the original investors’ stock getting crammed down to a much lower value. (In reality, the VCs would also give the founders some new stock too, so that only the angels get screwed, since you need the founders around to get to the IPO.)

A typical company will take VC money three times before getting to IPO, so that cram down happens 3 times. On the next round, that $600K angel value is crammed down to a value of $60K, and the next round crams it to $6K. The angels’ original shares become essentially worthless.

Before the dot-com crash happened, valuations were a lot higher, cram-downs were a lot less brutal, and there were fewer rounds of VC investment. But after the crash, it became impossible to IPO. So the VCs found that they needed to have actual operating businesses in their stable. Except, funny story, they have no idea how actual operating businesses worked, and they kept accidentally killing them off. Too bad that 20% requirement still loomed. The VCs saw their own fortunes at stake, and they got really mean, really fast. That’s when everyone started calling them “Vulture Capitalists.”

So angels are, for the most part, now extinct.

If you hear someone say they have Angel Investors these days, that’s probably a euphemism for “I borrowed money from my dad.”


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