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There is No Angel Bubble. There are Many Angel Bubbles..html
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There is No Angel Bubble. There are Many Angel Bubbles..html
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<p>
A common meme floating around right now is that there is an Angel
investing bubble.
</p>
<p>
In the sense that an enormous amount of capital is being placed at risk,
and its popping will have grave macro-economic consequences, No.
</p>
<p>
The total amount of additional capital flowing through the Silicon Valley
early-stage ecosystem, thanks to Super-Angels and newly minted
millionaires, is on the order of half-a-billion dollars or so. It’s no
more than a middling-sized VC fund. Would the emergence of a new VC fund
be considered a bubble? Would the collapse of one signal disaster?
</p>
<p>
Furthermore, most of this capital is replacing traditional Series A deals.
As we say around here, “Seed is the New Series A.” The same companies that
needed $3M to launch now need $30K-$300K to launch. So, it’s not
surprising that there are many more of them.
</p>
<p>
Ok, but could that mean that the amount of capital for funding startups in
the old environment is too much for the new environment? That the total
supply of early-stage funding dollars should come down by a factor of ten
rather than the number of companies being funded go up by a factor of ten?
</p>
<p>
This one is harder to ascertain, but my sense is that if there’s too much
capital, it’s not an overwhelming overhang. Most of the small companies
being funded will fail, but the ones that hit will generate fantastic
returns. And because of their small size and operating costs, a greater
percentage will be able to get “ramen profitable” than was traditionally
possible. Of course, actual exits might still be rare. The volume of small
M&A deals hasn’t scaled with the volume of Angel investments in small
companies. I think we’re all going to have to become even more comfortable
with failures, re-starts, and the kind of team re-combination that one
sees from one Y Combinator Demo Day to the next.
</p>
<p>
One thing that has been happening is that Angel investment valuations have
been climbing very quickly – un-sustainably so. Twenty companies in an
Investors’ portfolio carried at a valuation of X might now suddenly be
twenty small bubbles at a valuation of 2x. They may not be able to clear
their valuation in a micro-acquisition, or lead to a down-round in a VC
financing, or just give a sub-par return for what might otherwise have
been a hit. Prices on the margin <em>have</em> been rising, and that will
hurt returns.
</p>
<p>
Prices have been rising not because of a huge influx of money (no big,
macro bubble), but because of a modest influx of price-insensitive money.
Prices get set on the margin. On Wall Street, it doesn’t take an influx of
$5 Trillion into the stock market to move the total market capitalization
of all of the companies from $15 Trillion to $20 Trillion. (In fact, money
never moves into the stock market – it moves <em>through</em> the stock
market, but that’s another post). Rather, a small series of secondary
transactions at the margin, done by price-insensitive buyers at high
prices, can move the quotational value of each stock considerably higher.
Similarly, a small number of high-profile Angel investments, moving small
amounts of capital but at very high valuations, can make the entire market
look overvalued.
</p>
<p>
So what’s driving the new, price-insensitive bidders? It’s three things:
</p>
<ol>
<li>
<p>
VC Funds – Every VC that announces a $20M seed fund is basically a
price-insensitive Super-Angel. They’re buying first looks and options
to finance companies in the future, so they’re not particularly price
sensitive. When you have $1B under management, $20M is pocket change.
</p>
</li>
<li>
<p>
Entrepreneurs Set Pricing – Leaderless “party” rounds often end up
with the entrepreneurs setting the valuation. And clever entrepreneurs
are getting the less price sensitive investors to sign off on the
initial terms, and then taking those terms, social proof in hand, to
Investors who would have been traditionally more price sensitive.
</p>
</li>
<li>
<p>
New Angels – People who have had modest exits and are now angels are
just building their portfolios. They don’t have enough exits under
their belts to understand that price does matter. Not as much as in
other businesses, because a Power Law distribution here means that one
winner can dominate your whole portfolio. But it still matters because
a lower price allows you to pick more startups in the hope of finding
that one winner. New angels often hear that “If it’s the right
company, price is irrelevant.” That’s true, but that gives too much
credence in your own ability to pick the right company. If you’re
informed just enough to know how un-informed you are, then you doubt
your ability to consistently pick winners, and a low price will give
you more attempts to figure it out.
</p>
</li>
</ol>
<p>So does this always end in tears?</p>
<p>
For VCs, they will look back at these seed funds and find that (a) their
seed efforts didn’t have the best returns and that (b) they didn’t always
get the first look options that they always wanted. But it will probably
still pay off. Seed is the new Series A, and if you don’t do Seed, you’re
basically retreating to later stage.
</p>
<p>
For Angels who are price-disciplined, things will be fine – we are
undergoing an incredible renaissance in technology, with smart phones
taking computing to local arenas and social networks taking it into the
mainstream populace. There’s a lot of opportunity and great companies will
be built. For un-discplined Angels, there will be pain (unless they find
their one big winner early), but it’s part of the learning curve inherent
in the business.
</p>
<p>
Entrepreneurs win big, all-around. There has been some concern that all of
these small companies are going to get orphaned – who will fund them
downstream? I don’t necessarily view this as a negative, though. Even
failed, these entrepreneurs are going to be much more employable than
those who never tried or had the opportunity, and given that the minimum
efficient scale of businesses is getting smaller and smaller, more of them
will succeed than in any previous generation.
</p>
<p>
Entrepreneurs sticking to the old model of hiring are getting hurt. The
old model used to be that after a Series A, you could hire an engineer and
give him 0.25% of the company. Good luck hiring a great engineer for that
in Silicon Valley now, for a freshly-minted startup with a small seed
round in your pocket. The opportunity cost for that engineer is now to go
join a Seed Combinator or raise some Angel funding. So, we’re going to see
the equity gap narrow between the founders of raw startups and early key
team members. Only the best startups with high valuations and tremendous
traction can recruit under the old formulas anymore.
</p>
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