Angel investor valuations fly off to heaven
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.