Angel investor valuations fly off to heaven

January 31, 2011

By Robert Cyran
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Internet start-ups have needed less cash and left the venture capital industry out in the cold. The latest response to this growing conundrum comes from Yuri Milner, the Russian founder of DST Group, which has invested in Facebook, Zynga and Groupon. He has decided to back dozens of start-ups sight unseen. It shows just how far power has shifted to digital entrepreneurs.

The cost of everything from servers to software to Internet bandwidth keeps falling. And businesses can grow very quickly these days if an idea catches on. The result is that it’s cheap to give birth to online companies and they can command high valuations while still young. So there’s a push by investors to get into start-ups earlier in their life cycle, but at higher valuations.

That backdrop helps explain Milner’s decision. He and co-investor SV Angel are offering $150,000 in convertible debt to all 43 companies in a current batch of fledgling firms backed by seed fund Y Combinator. The terms are extremely generous. If a company completes a follow-on round of financing, the debt will convert to equity at the same valuation. Normally, convertible debt from angel investors includes a cap on a firm’s value and offers the holders a discount on equity pricing. Both work to increase the value of equity received by debt holders in a conversion.

There may be a method to Milner’s madness. His due diligence hasn’t so much been scrapped as it has been outsourced to Y Combinator. Even though the firm is young, its returns have been strongly positive, according to people familiar with the situation.

What’s more, the generous terms reduce adverse selection. It would be hard for any start-up to refuse the offer, meaning there’s a better chance a few choice investments get included with the bad seeds. For a hit-driven industry, this is important. Finally, Milner’s DST Group will be hoping the sweetheart deal gives it an inside track if any of the firms should need additional funds.

Still, there’s no escaping that the prices attached to start-up companies are going up. It’s a heavenly situation for those looking to finance fresh ideas. For the angels, however, it probably means their historic returns will be pulled back down to Earth.

Comments

This is always so hard to hear since in the Mid-Atlantic we have reasonable valuations with great companies all being bought up outside of the Silicon Valley world where according to blog and PE lore, is a valley where the private equity family tree is a wreath! We have seen over the last year several very smart people come to the Mid-Atlantic and Northeast regions (conferences, angel group memberships from afar) looking for great companies needing funds, with great prospects. Why buy at 10x the value when you can purchase an interest at 2x the value? It is the same with housing… things are just cheaper here. And, since it appears Washington really runs everything these days, set up shop in Washington, DC and you’ll see that you can invest in early and seed-stage start-ups in this area without getting pummeled on values.

Remember: We always educate entrepreneurs/company founders to be careful about the “money” they accept because it should come with more than just cash… but it should come from a “shop” that can provide mentors, potential customer leads, some sort of expertise and is motivated to participate and get your company to the next level.

Which brings me to this question that never seems to get answered: If a VC wants to invest in a company that has other offers, how does a VC “shop” differentiate itself to the entrepreneur to win the right to invest? It explains it has not just the funds but the ability, the internal talent, the connections, the industry expertise and can align with its interests to those of the founder(S). The question you ask? IF a VC “shop” is so valuable and can take a new company to the next level, then can’t it do that for a company that is from the East Coast, while investing at a much less pre-money valuation, thereby almost guaranteeing it will be able to produce for its fund investors a greater return on their investment?

The opposite question is relevant also: If it is only about money, and the VC talent and connections have no bearing on the outcome of the company, then Left Coast VCs will have to throw more money at a founding company to win the bid to invest, increasing entrepreneurial hubris in my humble opinion.

ANSWER: Come East as many very smart VC shops are doing. Join local angel groups in different cities for somewhere between NOTHING and $5K/year. Get on their Angelsoft back-office software and watch what deals they are seeing. Let them use your name as having joined. it will increase their memberships therefore and increase the ability to attract more angel investors. Invest $25K in a few things as a loss leader, but those deals you might like to have a “first look” at before some other VC shop.

This is the answer. Some are beginning to figure out that a couple of well-run Angel Groups (ACA probably a best bet) is a great membership for a year or two, from a distance or fly in for monthly meetings, to “see” deals before anyone else does. If you’re that good when it comes to taking a small scalable company to the next level, then quit paying huge prices (increased chased-up pre-money valuations!) to invest while using your contacts and talent to be able to invest and take the same type of great company to the next level!

How hard is it to figure this out if the blog above has any real truth: that valuations are out in space these days with possibly too much money chasing too few deals. Basic economics says increase the deals in which you invest, but focus on the East coast. I can’t speak for the mid-west and their tentacles to greater connections (like we have in Washington, DC, Philadelphia, NY and Boston and all angel groups in between), but I’m sure the same applies, but with less hits for your angel membership dollar.

These are just my thoughts, but as Dennis Miller says, I could be wrong.

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[...] That backdrop helps explain Milner’s decision. He and co-investor SV Angel are offering $150,000 in convertible debt to all 43 companies in a current batch of fledgling firms backed by seed fund Y Combinator. The terms are extremely generous. If a company completes a follow-on round of financing, the debt will convert to equity at the same valuation. Normally, convertible debt from angel investors includes a cap on a firm’s value and offers the holders a discount on equity pricing. Both work to increase the value of equity received by debt holders in a conversion.  Source [...]

 

I used to consider Reuters as a reliable source, one with professional journalistic integrity. I’m disappointed after reading this piece.

First, the writer basically paraphrased TechCrunch’s breaking news without crediting the source. Note the similarities here:

http://techcrunch.com/2011/01/28/yuri-mi lner-sv-angel-offer-every-new-y-combinat or-startup-150k/

Yes, a lot of subpar writers do this but I didn’t expect it from Reuters, a respected company that encourages professional journalism.

Second, the writer obviously has no knowledge of the angel market and basically just rewrites TC’s piece without questioning its facts. This so-called rising valuation is only happening in venture hotbeds like say, Silicon Valley.

Angel investing is a $20 billion market in the US. What’s happening in the Valley only makes up a small percentage point of the angel market. These super angels don’t have enough market power to raise valuation in the venture ecosystem.

Want prove? There have been lots of talks about rising valuation and angel bubbles since early 2010 because everyone suddenly wanted to be an angel investor, because people were investing in crazy valuations. But, according to the latest 2010 angel market report, deal size actually shrunk by 10%.

Reuters, please remind your writers what makes a professional journalist or even columnist.

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