Angels Look Around the Table

“If you don’t know who the sucker is at the poker table, the sucker is you” is a great metaphor for angel investors to consider when placing bets on startup opportunities. With the explosion of startup accelerators, syndicates, and crowdfunding platforms, angels are investing in companies on much different terms than those closest to the deal. Angel investors should consider the economic interests and motivations of all those participating (or not participating) in any fundraising round before investing.


When the postmortem is written on the startup funding environment at the early part of this decade, we may look back at these valuation accelerants as having contributed to the highest startup valuations since the dotcom bubble:


Startup Accelerators – Accelerators afford entrepreneurs mentorship and networking through two-month to four-month in-person or virtual boot camp programs. The startup receives a nominal investment and the accelerator benefits from a very low valuation. For example, Y Combinator invests $125,000 for a 7% fully-diluted ownership. This equates to a $1.79 million post-money valuation.


Granted, accelerators provide critical services, networking, and early, risky capital to startups and should receive a discount from the market for their sweat equity. However, the most significant service accelerators provide to startups is at the end of the program when the “graduating” startups need to tap the capital markets.


At this time, the accelerator and the startup spin how great the business is, which may still be pre-pre-revenue and/or pre-product. They work in tandem to justify how a low to no-traction business is now worth $5M – $10M because the founders went through a 12-week program.


Ask if any of those folks closest to the startup – the management team, the accelerator’s staff, the mentors, advisors, and board members – are investing in this round on the same terms as you.


Syndicates — A syndicate works through a special purpose vehicle (“SPV”). Typically, a limited liability company is formed to invest in a startup so investors can invest together in a promising company and only take one line on the capitalization (“cap”) table.


Usually, the syndicator is someone well-entrenched in the startup ecosystem and either engages full-time or part-time in the pursuit of finding investable startups.


Frequently, syndicators also have their own funds, and they make a small investment in the startup symbolically to show they have “skin in the game.” For example, a syndicate may have received an allocation of $250,000 in a $2M equity round. The syndicator will then invest $5,000-$25,000, with the rest of the money coming from angel investors, tourist investors, and/or high net worth individuals.


The sales pitch the syndicate gives the startup is “I will pitch your company to my broad network of angel investors, and we will raise capital for you in a short period at attractive terms.” In consideration, the syndicator receives a management carry of 20% of the upside generated from the investment.


Unlike an investment fund with a downside to the general partners for investing in a company that fails, the syndicator has no downside other than the nominal investment they made in the company. As mentioned earlier, the syndicator usually doesn’t put their personal money into the syndicate, but instead invests a token amount from a fund they raised.


In the past, syndicates were better at grounding startups and reasonable valuations and structures because the syndicator is a market maker bringing together buyers (the investors) and sellers (the startups). However, syndicates rarely push back on valuation and structure in a frothy market for fear of being carved out of a transaction.


As a result, angel investors lose their perceived advocate and accept deal terms that are less than ideal. The syndicator has upside but no downside except the nominal amount invested.


Crowdfunding – There has been a proliferation of crowdfunding platforms created over the past decade providing small investors with the opportunity to access an alternative asset class.


The problem with crowdfunding deals in general, especially during The Great Inflation, has been that startups have pegged their valuations and structures to whatever suits their fancy, frequently void of any reality. Even worse, there are very few professional investors (people who make a living investing full-time in early-stage companies), so there is no due diligence done on the startup.


Instead, the angel investor gets a one or two-page teaser complete with all the promising aspects of the deal and devoid of all the hazards associated with the opportunity. Not only is the angel investor starved of information before investing, but many startups don’t provide information rights to the crowdfunding investors as a practical matter as they may add hundreds of small investors to the cap table.


As a result, the angels frequently will not have access to the same information as the major investors post funding. This puts them at a disadvantage when it comes to follow-on rounds, which is often the place where investors see the greatest risk-reward profile.


Angel investors coming through a crowdfunding platform are often excluded from receiving pro-rata rights, which allow existing investors to invest in future following around at the same terms as the other investors based on the percentage of ownership.


Management teams – Frequently, startup management teams are filled with young, energetic entrepreneurs who don’t have two nickels to rub together. In these cases, it’s understandable for the management team not to be putting capital into the business.


Ideally, these young guns will be working on below-market salaries and/or have convinced family members or friends to invest in the earliest rounds. If you see a management team, particularly one formed from former big company executives, raising capital so they can continue earning the same high salaries they were previously, run for the hills.


And, as an angel investor, if you see a deal with a management team of “serial entrepreneurs with successful exits” who are in their 40s or 50s and haven’t written any checks, ask why.


Party rounds – a party round is a round where there is no lead investor who conducts due diligence, negotiates the terms, or coordinates the preparation of the legal documents.


In a party round, the startup takes the initiative to set terms. Because party rounds are usually an amalgamation of time-starved high net-worth individuals, each writing small checks ($25,000 – $50,000 is very common), no one has enough influence on the deal to negotiate on behalf of all angels.


As a result, angels who ask many questions or want more favorable investor terms are simply excluded from the deal and replaced with angels who accept as proposed by the startup.


A Final Thought


When investing in a start-up, look around the room and assess whether you are being taken for a ride. Ask this question to the fundraising CEO, “If this is such a great opportunity, how much is your management team, your board of directors, board of advisors, and existing investors putting into the round?”

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