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.