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Why venture capitalists need guardian angels

Angel investors are an essential component to any healthy entrepreneurial economy. But it's a point that many in the venture community appear to be forgetting right now. Isn't it about time that we as VCs stopped to think about how our behaviour is affecting the financing chain, says MTI's Ernie Richardson.

There is no doubt that things have been tough for venture capitalists over recent years - and it's a struggle that has been pretty well documented along the way. But with all these difficulties to contend with, we are in danger of ignoring the biggest threat of all to our industry - the potential destruction of the angel financing chain.

Most successful technology businesses will require, during their formative years, several rounds of funding at different stages, each reflecting the maturity of the company. This funding chain allows for the inevitable ‘weeding out' that goes on in any new technology market before the real winners emerge. The persistent theme at each stage is that different groups of investors bring different skills and different types of financing structure to bear as a company develops. Critically, all these investors should (if the business proves to be successful) make valuation gains along the way and should probably all benefit from the eventual public market status or trade sale of the company.

Broken chain
But this chain can only be kept intact if angel investors - the first links in the chain - continue to see value in supporting new businesses. At the moment, many of them are beginning to doubt whether lending their support is worth it. Angel investors, in particular, have seen their position most damaged over the last two years. This is partly because of the wider economic situation in which many have lost large sums of money. But it is also down to the behaviour of venture capitalists.

VCs are nursing their wounds from the losses of the late nineties. But the hardest hit have been the independent angel investors and entrepreneurs - they have historically tended to be last in line when it comes to preserving equity stakes, after all. The demise of these groups will damage the VC industry at its roots. Unless VCs find a way to make it profitable for angel investors to invest, they risk destroying the seed corn for the entire tech VC industry in the UK. VCs are in a position to help preserve the fragile relationship. But instead, many persist in demanding funding terms that weaken these early funders significantly. They are insisting on investment term provisions that they brought in to ‘protect' themselves during the mid-nineties, even though they are clearly inappropriate and actually detrimental in today's environment.

The terms
The two main culprits are down round protection and liquidation preferences. Down round protection typically ensures that, if a future funding round was done at a valuation less than that paid by the VC in the current round, then an adjustment would be made to limit or remove the dilution which would otherwise apply to the VC. Liquidation preferences were designed to ensure the preferential exit of a VC, prior to other shareholders, in the event of an exit (originally a solvent liquidation - hence the term). Under the pressure of the late nineties, VCs would ensure that such returns were not only a ‘first in line' process, but hard-wired a guaranteed return before any other investor (particularly the angel investors and entrepreneurs).

In the hot-house atmosphere that was the late nineties, some kind of argument might be assembled to justify both these provisions. But their use has been carried forward into the profoundly different market conditions that now apply. With all valuation measures in rapid reverse, the effect of these provisions is to accentuate the breakdown of the funding chain.

These are the wrong measures being applied at the wrong time.

Still investing
There is evidence to suggest that angels are continuing to invest, even today. A recent report by InvestorPulse, The UK Angel Attitude Survey 2003, pointed to this. But my fear is that angels will seek to fund businesses in ways that do not require VCs to be brought in. This will constrain the development of these companies. It already appears that the angel industry is consolidating into strong national and regional networks and these may become self-sufficient of the VC industry.

Even the most die-hard VC would acknowledge that young technology companies can and do grow, simply through investment by founders and angels. Yet they run the risk of creating sub-optimal companies whose growth is constrained by the availability of capital rather than lack of market opportunity.

Increasingly, technology is a global business, even at the earliest stages. If any European VC is seeing a deal aimed at an emerging technology market then it is highly likely that at least two or three similar companies are being founded in the US with two to three times more start-up finance. (During 2001 to 2002, the average round A for technology companies in the US was $7m; in Europe it was $2m). It is these well funded, parallel start-ups that should concern the ‘angel only' funded company. A company might be established - and even generate some success - on the basis of sweat equity and angel funding. However, by far and away the biggest risk (assuming that everything else goes right) is that they will lose out on the big worldwide opportunity to their equity-backed cousins in the US.

The solution
So what are the characteristics of the perfect angel/VC relationship?

• Firstly, recognising that different investors bring different things to the table at each stage. At the seed stage, personal relationships are critical simply because there is little else to go on; no product, no market just bags of hope. This is why family and friends are so often the source of seed money. Even where business skills are available (from the angel) and are necessary, they are best applied as a form of mentoring and encouragement. Done well, angel financing can mean that the business arrives at Round A better prepared for the more rigid application of business structures and processes that a VC will require.
• Maintaining continuity. Our best seed to Round A transitions have been done by keeping the angels in place and continuing to contribute, often acting as an interface or interpreter between the entrepreneur and the VC.
• Recognising where value has been added. Every investor at every stage (seed, early, development, etc) is convinced that they alone have transformed a particular business. In practice it is much more a collective effort.
• Focusing on the exit. VCs don't make money at the investment stage, they make it at the exit stage. And, given the valuation multiples that will apply at a successful exit, fretting too much over deal terms and structure at investment is almost certainly a waste of time and probably counter-productive.
• Allowing for slippage. Virtually all deals go wrong at some time and virtually all deals will probably require some further finance before moving fully on to the next stage. It is typically at this supplementary funding stage that VC/angel/entrepreneur problems develop. The angel investor therefore needs to make some allowance for further commitment to the deal even when the VC has become an investor.

So what's the answer? Ditch down-round protection and ‘liquidate' liquidation preferences. In place of these, the industry needs provisions that allow success to be carried through the entire chain of investment to the benefit of all investors, from whatever stage.

Finally, get real. The period 1998 to 2001 is at best a once-in-a-generation experience (and at worst a once-in-a-lifetime one) and the industry cannot plan on the basis of a quick return to those halcyon days. All investors need to get real about returns, timescales and exit valuations.

Ernie Richardson, is a senior partner at MTI, a UK early-stage hi-tech venture capital firm that is now commencing its third decade of investing.

Copyright © 2003 MTI