Ask me if there is an Angel investment bubble and I will say no.  On the other hand, I will also say that there are a bunch of angel investors out there that are going to get slaughtered in the next two years and may never Angel invest again.

Why no bubble? Because there is natural supply and natural demand.  These are genuinely good companies that deserve to be backed by investors who have the means to do so.  There are not too many catfood.com companies getting funded.  Valuations have gotten a little rich, but not too bad and that is coming from the top down much more than the bottom up.

The financial crisis in 2008 caused economic contraction.  A bunch of good, smart people lost their jobs and couldn’t find new ones.  They did what people of ingenuity might do… they created their own job by starting a company.  Lots of smart, skilled people yielded lots of  interesting, viable companies.  There’s your supply.

In October of 2007 the Dow Jones was at 14,066.  By March of 2009 (18 months later) it was at 6,626.  That’s a decline of about 53%.  Since that time it has recovered slowly to about 13,000.  That means there are investors that after 5 years who could still be under water.  The Dow is supposed to be safe, or at least safer.  Over the past decade it hasn’t been.  Investors are saying, forget it.  The risk return is out of whack.  Let’s find something else.  They look at alternative investments.  Angel is an interesting asset class.  There’s your demand.

Natural supply.  Natural demand.  No bubble.

Then why are many Angels going to give up and walk away?  There’s a number of reasons including:

  1. Not enough follow on capital from VCs to keep these investments alive.
  2. Higher barriers to investment exit including high costs of startups going public.
  3. Angel investing is harder than it looks with high failure rates. Lots of first time angels will simply bail out.

A less obvious reason and the one I want to focus on is ‘under funding’.

Here’s a common case study: a company comes into the office.  They show me their technology.  It is top-notch, high-end, built-to-last, datacenter class technology that has real value.  I love it! It is obvious why the idea deserved to get a seed round of funding.  The product is just completed, or close to it.  The team is still just the founders and some technical people or contractors.  The product is about to go into beta testing and has no customers.  There isn’t much of a marketing or a go-to-market plan yet.  They have been heads down building a good product.  The founders say “we either need another $500,000 in convertible debt, to take this product to market, or we need to raise a proper Series A (call it $1.5 million on a $5 million pre). And oh, by the way we gave away 20% of the company to the first round seed investors.”

Guess what? As a VC I cannot invest in this company.  The company did not make enough progress with the seed round to stay on the natural funding progression track.  They were almost there, but ran out of gas before completing the last mile.  They needed to gain a strong expression of interest from the customer for me to invest.

I could blame this on the entrepreneur, but I won’t because it is their job is to know about the technology, and they did a good job with that.  No, this is the fault of the seed stage investor.  They are supposed to know about the capital side of a startup and this company has been left underfunded.  The seed stage investor didn’t tell the entrepreneur what she/he needed to accomplish with the funding proceeds.  Common or not, that is a mistake on the part of the investor.  The result is that the company has been left in funding no-mans-land.

Most likely the current angels aren’t going to step up for a follow on.  They are not geared for that.  New angels will want some percent of the company, meaning 30% or more could be gone before the Series A.  That would mean at least 50% would be in the hands of investors by the time a Series A is done.  The entrepreneur would have taken all this risk for very little return in the end.  On the other hand, a VC is unlikely to want to do this deal.  He/she has no proof that market wants this product.  He/she is unlikely to give the company a valuation that would be palatable to the founders with no customers and no revenue.  If the entrepreneur does except a bad deal to keep the company alive, the personal incentive, again, will be too little.

What are the outcomes:

  • Some of these companies might get saved because the technology is just so awesome that someone will take a flyer on it.
  • A lot of these companies, awesome technology or not, will fall through the cracks. Certainly the ones with average technology won’t make it.
  • Angels, who are sure they backed a winner, will become disillusioned with this process and stop angel investing.
  • Entrepreneurs will take it as a lesson learned and hopefully go on to create something even more awesome, or be flushed out of the system.

So my premise is, it’s not a bubble, but there will still be a lot of Angels forced out of the game.  There are a lot of reasons.  But at least one of them will be their own fault. Underfunding.

If you are an entrepreneur view this as another cautionary tale and beware of who your seed investors are, what they are giving you, what they expect, and what you need to deliver to continue to be funded and successful.