A Year of Reckoning for Angels and Seed Funds

The last 5 years have seen the rise of angel investing and micro-seed funds and incubators.  All of these entities have been buying small pieces of preferred shares with $100K - $1M checks and have been doing phenomenally well when there was tons of Series A and Series B money to go around.  

The majority of the seed companies they funded went on to raise later rounds at often big markups.  On paper, I know of lots of angel investors that look like geniuses with 5x, 10x, 20x, even 40x markups on paper as their seed investments fetched ever-higher prices. 

But, this year we’ve seen the greed of the last several years switch to fear. We expect there to be an increase in down rounds, flat rounds, inside rounds and various pay-to-play scenarios. Many VCs we talk with fear that their portfolio is at risk and they have switched gears to encourage companies to cut burn and get to cash flow positive.  This is the year that every founder is talking about getting to cash flow breakeven and controlling your own destiny.  

Given the fear by many investors, it’s getting harder for companies to raise more capital.  

The great companies that are breaking out will be fine in any market.  They still have investors knocking on their door on a regular basis eager to put more money in.  

It’s the good companies that have yet to breakout that are affected most heavily. These solid companies are suddenly finding it difficult to raise capital from new investors.  These are the ones that will need to go back to their existing investors and ask for more capital to continue.  These inside rounds will lead to one of a few possibilities:

1) No insiders are supportive.  These companies shut down.  While these are painful outcomes for everyone, it’s a necessary part of the startup ecosystem.  These shut downs are likely to happen when companies are funded solely by seed funds and angel investors that have not reserved significant capital for follow-on investments.  Founders that raised party rounds are quickly discovering the downside of not having any larger, more committed investors. When an investor does 10+ deals per year, they are not really going all-in on a company and are unlikely to give the company more money when it’s needed most.  When a VC firm does 1-2 deals per partner per year (like JSV), they are deeply committed to each company and are more likely to continue supporting companies that are going through tough times as long as they still believe in the upside scenario.  

2) Some insiders are supportive.  I believe this will be the most common scenario.  If a startup has taken investment from 10 investors, what are the odds that all of them will decide to put more money into the company? Then the question will become how supportive are they.  If they are eager to put more money in, they are likely to just write a check on a convertible note to the next round with the standard protections and some discount and maybe some warrants to sweeten the pot a bit.  

However, if the portion of insiders who are willing to write additional checks are less optimistic, they may push for a pay-to-play scenario.   This means that unless a preferred shareholder pays in their pro-rata share of an inside round, their stock may be converted to common shares.  The investors that are willing to pay in their pro-rata share, protect their investment, gain overall better preferences because of reduced preferred shares, and of course keep the company going to the next milestone.  In addition, in the more dire cases, these investors may see their holdings crammed down by a reverse split where the preferred converts to common on a x:1 basis, so x shares of preferred go to 1 share of common.  A 5% equity stake could get cut down to 1%. 

The rub here is that seed funds and angels may need to protect their investment by putting in more money.  But, many of them do not have strong reserves for their portfolio.  They have no more money.  Or perhaps they’ve done so many deals in the past few years that their reserves are spread far too thin and they cannot protect all of their investments. 

The pay-to-play scenarios are not restricted to inside rounds – they are also likely to happen with some startups bringing in new investors but wiping out some of the existing ones.  This is extremely well summarized in Bill’s Road to Recap post

3) All insiders are supportive.  Well, this is a happy outcome.  The company lives through the cycle, all investors increase their ownership a bit, founders and early employees take some more dilution. 

If we are correct and this year has a lot of inside rounds and various pay-to-play scenarios, many seed funds will see their unrealized holdings plummet in value.  If we’re wrong, then we missed out on some great seed investments because we were too stubborn over the last couple years.  

And in case you were wondering – this time is not different. 

All of this has happened before. My partners at JSV have been in the venture business for 14 years and have had the good fortune to be involved in several very large successful companies.  Every single one of them had either a flat, down, or inside round during their history.  Truly great companies take 7+ years to build, so it’s extremely likely that every great company has lived through the cycles of the ups and downs of the market.   And this is precisely why one of our core values is – we’re in it for the long run.  

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