Angel, VC, or Bootstrap?

Note: I wrote this piece a couple of weeks back, inspired by Greg Linden's blog post (see below). Inc then picked up the piece and asked me not to publish it until it appeared on the Inc website. The article appears on the Inc website today with some minor edits.

Greg Linden was one of the key developers behind Amazon's famous recommendations system -- the system that recommends books, movies, and other products to Amazon customers based on their purchase history. He subsequently went to Stanford and picked up an MBA. In January 2004, he launched a startup named Findory to provide everyone with a personalized online newspaper. You cannot imagine anyone who could be more qualified to make a startup like this a success. Yet Findory shut down in November 2007. In a brilliant post-mortem, Greg says his big mistake was to bootstrap his company while trying to raise funding from venture capital firms; he just couldn't convince them to invest. He should have raised his funding from angel investors instead.

This is an important decision every startup founder has to make -- where to raise their funding. The three viable sources at the very early stages of a company are:

• Friends and family. Yourself, if you can afford it.
• Angel investors. Usually wealthy individuals, but includes outfits such as Y Combinator. (My firm Cambrian Ventures is also in this category, although we are currently not actively seeking investments; we're too busy running our own company Kosmix.)
• Venture Capital (VC).

To understand which option is best for your startup, you need to understand how investors evaluate companies. While investors evaluate companies across a range of criteria, three that stay consistent are: Team, Technology, and Market. Angels and VCs evaluate them in different ways. Here's how.

How Venture Capitalists Evaluate Startups

• Market. Venture Capitalists want to invest in companies that produce meaningful returns in the context of their fund size, which typically is in the hundreds of millions of dollars. To interest a VC firm, a company needs to be attacking a large market opportunity. If you cannot make a credible case that your startup idea will lead to a company with at least $100 million in revenue within 4-5 years, then a VC is not the right fit for you. It's often OK to use consumer traction as a substitute for market opportunity -- many VCs will accept a large and rapidly growing user base as sufficient proof that there is a potentially large market opportunity.

• Team. Venture Capitalists use simple pattern matching to classify teams into two buckets. A founding team is deemed "backable" if it includes one or more seasoned executives from successful or fashionable companies (such as Google) or entrepreneurs whose track record includes a least one past hit. Otherwise the team is considered "non-backable."

• Technology. Venture Capitalists are not always great at evaluating technology. To them, technology is either a risk (the team claims their technology can do X; is that really true?) or an entry barrier (is the technology hard enough to develop to prevent too many competitors from entering the market?) If your startup is developing a nontrivial technology, it helps to have someone on the team who is a recognized expert in the technology area -- either as a founder or as an outside advisor.

Here's the rule of thumb: to qualify for VC financing, you need to pass the Market Opportunity test and at least one of the other two tests. Either you have a backable team, or you have nontrivial technology that can act as an entry barrier.

How Angels Evaluate Startups

There are many kinds of angels, but I recommend picking only one kind: someone who has been a successful entrepreneur and has a deep interest in the market you are attacking or the technology you are developing. Other kinds of angels are usually not very high value. Here's how angels evaluate the three investment criteria:

• Market. It's all right if the market is unproven, but both the team and the angel have to believe that within a few months, the company can reach a point where it can either credibly show a large market opportunity (and thus attract VC funding), or develop technology valuable enough to be acquired by an established company.

• Team. The team needs to include someone the angel knows and respects from a prior life.

• Technology. The technology is something the angel has prior expertise in and is comfortable evaluating without all the dots connected.

Here's the angel rule of thumb: you need to pass any 2 out of the 3 tests (team/technology, technology/market, or team/market). I have funded all 3 of these combinations, resulting in either subsequent VC financing (e.g., Aster Data, Efficient Frontier,  TheFind), or quick acquisitions (Transformic, Kaltix -- both acquired by Google).

I've written about the stories behind the Aster Data investment and the Transformic investment previously on my blog. In both cases, notice how my personal relationship with the founders, as well as my passionate belief in the technology, played big roles in the investment decisions.

Friends and Family or Bootstrap

This is the only option if you cannot satisfy the criteria for either VC or angel. But beware of remaining too long in this "bootstrap mode." An outside investor provides a valuable sounding board and prevents the company from becoming an echo chamber for the founder's ideas. An angel or VC can look at things with the perspective that comes from distance. Sometimes an outside investor can force something that's actually good for the founder's career: shut the company down and go do something else. That decision is very hard to make without an outside investor. My advice is to bootstrap until you can clear either the angel or the VC bar, but no longer.

Back now to Greg Linden and Findory. By my reckoning, Findory passes the team and technology tests from an angel's point of view -- if you pick an angel investor who has some passion for personalization technology. The company doesn't pass any of the VC tests. Given this, Greg should definitely have raised angel funding. My guess is that this route would likely have led to a sale of the company to one of many potential suitors: Google, Yahoo, or Microsoft, among many others. Of course, hindsight is always 20/20! I have deep respect for Greg's intellect and passion and wish him better luck in his future endeavors.

For further reading, I highly recommend Paul Graham's excellent article How to Fund a Startup.

Comments

[Prateek Dayal]

Interesting article. Sometimes your idea has a decent market and you have put together a prototype (or more than it) that proves the viability of the model. However writing a b-plan with numbers for next 5 years is still something a lot of people are not able to do. How open are angel's to such cases?

Regards
Prateek

[Anand Rajaraman]

Prateek: Actually, I don't believe in forecasting numbers for the next 5 years, or even the next 2 years. It is very hard to forecast accurately in our fast-moving industry.

What I'm looking for is an instinctive sense that the company has a "big" market opportunity a few years down the line, measured in the hundreds of millions of dollars.

[Edward Dorrington]

Your observations imply the assumption that a startups end goal is acquisition. If, however, your goal in starting a business is simply to grow and run that business, then using bootstrapping as your sole funding source can be a viable way to go.

[Anand Rajaraman]

Edward: I'm talking here about the conventional forms of liquidity for investors and founders -- either an acquisition or an IPO. If your goal is neither, but the income stream from the company, then bootstrapping is just fine. In fact, it may your only option.

[Ragnar]

VCs seek "$100 million in revenue" potential? I had no idea they had their sights set *that* high. Part of that equation would be the general buzz, too, right? I mean, there are probably plenty of web-based businesses that (1) aren't run by proven names and (2) aren't especailly technologically advanced; yet their popularity alone gives them some sort of decent valuation.

Found you on Twitter, btw. Glad I clicked to follow you. -RD

[jeremy liew]

Anand,

Nice post. I think for consumer internet companies like the ones I invest in, since there is often very little technology barrier, there is a shift towards looking for meaningful user adoption as a "barrier", especially for social media companies where there is a network effect. This is separate from the market size question which focuses on revenue potential.

I'd argue also that many backable teams have not previously worked at a successful or fashionable company, or had a prior hit. But they do need to demonstrate an insight into the market that goes beyond that of the average person and blog reader!

[Anand Rajaraman]

Jeremy: Great point, coming from a real VC. One way to look at this is that for consumer-focused internet companies, meaningful user adoption serves both as proof of a significant market opportunity AND as an entry barrier in lieu of technology. Therefore startups with meaningful consumer adoption pass the VC test.

[Anthony Kuhn]

A great primer on the world of startup funding and one that I linked to today in my blog post at the Innovators-Network in hopes of sending more readers to Datawocky to read the piece for themselves in its entirety. Thanks for this gem!

[cor madera]

The Inc. article has mangled your
name to "Rajmaran" = King of fools ?

[Andreas Ramos]

The truth about VCs: they don't know much about technology, but they must invest their money. So they look for certain-results projects, let the founders get it off the ground, and then throw out the founders and take over to maximize their profits. Quite simply: they steal the idea. Talk with Silicon Valley engineers who've led startups: very few will ever work with VCs again. I've worked in a number of startups; I've seen this over and over.