Do tech entrepreneurs need VCs?

By Felix Salmon
August 16, 2010
Mike Arrington, today, repeats a very similar argument when it comes to angel funds:

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One of the least convincing and most annoying arguments against investing in index funds is the idea that if everybody did it, then the stock market wouldn’t be able to efficiently allocate capital any more. Well, yes — but there will always be people picking and buying individual stocks and funds. That doesn’t mean that you and I should count ourselves among their number.

Mike Arrington, today, repeats a very similar argument when it comes to angel funds:

Very few angel funded startups end up very big or interesting. “An entire generation of entrepreneurs are building dipshit companies and hoping that they sell to Google for $25 million,” lamented a venture capitalist to me recently. He believes that angel investors are pushing entrepreneurs to think small, and avoid the home run swings. And you don’t get a home run unless you swing hard, he says. When you play it safe you nearly always lose…

Some venture capitalists think that this “think small” attitude is driving entrepreneurs who may otherwise build the next Google or Microsoft to create something much less interesting instead, and then everyone loses. No IPO. No 20,000 tech jobs. No new buyer out there for the startups that don’t quite make it.

And without those occasional but huge exits, the entire ecosystem can fail. Venture firms need big returns to raise new funds. Without venture money a lot of the innovation in Silicon Valley would end.

So in effect, the argument goes, the angel investors are like a quickly growing cancer. Without radically invasive surgery, Silicon Valley will eventually flatline.

All of this doom-mongering is based on the existence of angel funds adding up to $200 million, tops, when you put them all together: chump change compared to the kind of money that the big VC firms control.

It is true that as barriers to entry in the tech space get lower, that reduces the amount of money that entrepreneurs need, and can result in venture capitalists being left out of the funding equation altogether. Doesn’t your heart just bleed.

But the idea that an uptick in angel-backed companies will result in fewer huge successes is just silly. Yes, it’s possible that angel-backed companies are happier with smaller exits than their VC counterparts. But if the VCs see an opportunity there to become the next Google, they’re more than welcome to buy the company themselves: they certainly have $25 million lying around to do just that. More realistically, VCs can certainly take over as and when original investors feel like cashing out, just as public stockholders take over when VCs cash out in an IPO.

Reading columns like this, though, does make me a bit more hopeful when it comes to the tech startup scene in second-tier cities like New York. In California, it seems, the funding architecture is incredibly rigid and inflexible, and any threat to that architecture is met with wails of pain. The rest of us, I think, are lucky to live in a world with a bit more optionality when it comes to funding. And who knows — maybe in the future starting an online company will be so cheap that it can be done entirely on debt, with no equity investment at all. That won’t help the people dreaming of getting rich through getting lucky with tech investments. But it might well help company founders avoid a lot of the poisonous funding politics that Arrington talks about.

7 comments

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It’s ironic that a VC is whining about entrepreneurs trying to build small companies and avoiding dealing with VCs, for they are the primary reason for that shift. The VC funds have become so big that they can only invest in large projects, and the number of multi-billion dollar opportunities is much smaller than the number of engineers who want to start their own company.

The mobile app space is ideal for super angels, and makes little sense for traditional VCs, as very, very few of them will ever get big enough to justify $20M series A investments from VCs. If a company can develop an app that sells for $5 and they sell 5 million of them each year (pretty successful, considering how fragmented the mobile app market is), the $17M in revenue they generate from that app each year will not interest any VC.

The only thing that will limit the number of big startups is the risk-averse nature of VC firms. There will always be engineers with big ideas who want to work on them; getting them funded is another story.

Posted by OnTheTimes | Report as abusive

For a practical demonstration of the comment on mobile development, just look at Occipital:
http://www.feld.com/wp/archives/2010/06/ ebay-acquired-redlaser.html

I met these guys when they were at rock-bottom, almost out of money, unable to get funding, but with very little capital they were able to get a million-selling mobile application out of the door.

Most company founders would be happy with a $25m exit, but even if that doubles a VC’s investment their model forces them to push for a much larger and riskier exit down the road. Angels are a lot more aligned with a typical founder’s interests.

My feeling is that VC investment only makes sense in exotic, risky industries with high barriers to entry. As the web has matured, the need for that sort of funding model has diminished.

Posted by petewarden | Report as abusive

Man Felix, you are so wrong about index funds (and ETFs (and HFTs)). Market correlation is at a record high. This rewards bad companies and hurts good ones.

While you say there will always be someone buying individual stocks, when they are so greatly outnumbered by the other volume, the signal is lost in the noise.

You need to seriously re-examine your position on this, because the possibility you dismiss is already starting to happen.

Posted by mattmc | Report as abusive

What do you mean, “in the future”? It was perfectly possible to start a technology company in 1990 funded entirely by credit cards and daytime consultancy. I should know. I (and four stalwart colleagues) did it.

The best advice I ever heard came from Colin Clive in the early 1980′s. Ironically enough for a venture capitalist, he said that none of the companies he himself had founded had ever sought external financing other than for expansion after they were established.. Your business idea will either make money or not. Whichever it is, it’s better to know at the end of five months than at the end of five years.

The problem I see with the “think small” approach is that you effectively end up with an investment blunderbuss. Because smaller sums are involved, the investors perhaps don’t think too carefully about what they are investing in (Chris Hoare’s Zeroth Law: “Never attempt to manage technology you don’t personally understand”), but they don’t realise that the start-ups themselves haven’t done so either.

Posted by Ian_Kemmish | Report as abusive

Another reason to seek/accept VC money is to be able to hit a market window. If your research shows that you need to have a product with X features on the market in 18 months, VC funding may be the only way to ramp up fast enough.

And there are still areas with high barriers to entry that require substantial funding to get started. Hardware and biotech come to mind.

Posted by Curmudgeon | Report as abusive

Guess what?! Google was angel funded before any of the mainline VCs showed up.

Ironically, it may be VCs who are thinking small these days by selling off companies quickly to achieve a modicum of return.

Posted by tortoro | Report as abusive

Very good question, it’s difficult to decide between angel investors, micro-funds, venture capital when you are a start-up entrepreneur. All business people keep thinking about great companies such as Microsoft or Google and the big funds they needed and still do to develop and become what they are and, at the same time, most of the entrepreneurs do not aim that high as they do not trust their ideas that much or are simply realistic about what they can do. They do not want to be the big lottery winners and are fine with lower returns and popularity. That is why I think the above mentioned business capital sources should coexist, so entrepreneurs could choose what’s best for them. What is the use of an Angel-VC “fight”, I’ve read so many articles mentioning this notion. I agree with OnTheTimes who said that VCs prefer large projects, but, at the same time, tortoro is also right, some successful businesses can get angel investment funds at the beginning and venture capital in the following rounds.

Posted by Len.Williams | Report as abusive