What’s the Difference Between Early Stage and Venture Capital?
In 2010, Ben Horowitz of Andreessen Horowitz (AH) wrote a blog post on the difference between Angel investors and Venture Capital (VC), http://blog.pmarca.com/2010/03/02/angels-vs-venture-capitalists-1/. He made the point that VCs and Angels are not two different kinds of people, but two different styles of investment. The Andreessen Horowitz fund invests at all stages, from startups to Late Stage Venture, so they have a good basis to make a comparison.
Horowitz’s comments are largely repeated below, updated by us to reflect the current investing environment. In a nutshell, how Lateral Capital invests today is in many ways similar to the way Andreessen Horowitz approaches investing – but only when they are making investments in Early Stage companies.
“In the early days of technology, venture capital, great firms like Arthur Rock and Kleiner Perkins funded companies like Digital Equipment Corporation (DEC) and Tandem. In those days, building the initial product required a great deal more than a high quality software team. Companies like Tandem had to manufacture their own products. As a result, getting into the market with the first idea meant, among other things, building a factory. Beyond that, almost all technology products required a direct sales force, field engineers and professional services. A startup might easily employ 50-100 people prior to signing their first customer.
Based on these challenges, startups developed specific requirements for venture capital partners:
- Access to large amounts of money to fund the many complex activities.
- Access to very senior executives such as an experienced head of manufacturing.
- Access to early-adopter customers.
- Intense, hands-on expert help from the very beginning of the company to avoid serious mistakes.
In order to both meet these requirements and build profitable businesses themselves, venture capitalists developed an operating model which is still broadly used today:
- Raise a large amount of capital from institutional investors.
- Assemble a set of experienced partners who can provide hands-on expertise in building the product and then the company.
- Evaluate each deal very carefully with extensive due diligence and broad partner consensus.
- Employ strong governance to protect the large amount of capital deployed in each deal. This includes requisite board seats and complex deal terms including the ability to control subsequent financings.
- Manage own resources effectively by calculating the amount of capital/number of partners/maximum number of board seats per partner to derive the minimum amount of capital that must be invested in each deal.
It turns out that building a company has changed quite a bit since the early days of venture-backed technology companies. Building a company like Twitter or Facebook is quite different from building Tandem. Specifically, the risk and cost of building the initial product is dramatically lower. I emphasize product to distinguish it from building the company. Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks and has raised hundreds of millions of dollars to build their business. But building the initial Facebook product cost well under $1 Mand did not entail hiring a head of manufacturing or building a factory.
As a result, for a modern startup, funding the initial product can be incompatible with the traditional venture capital model in the following ways:
- Lengthy diligence process. Venture capitalists take too long to decide whether or not they want to invest because they are set up to take large risks and have complex processes to evaluate those risks.
- Too much capital. Venture capitalists need to put too much capital to work – often a VC will want to invest a minimum of $3M. If you only need 4 people to build the product and get it into market, this likely won’t make sense for your business.
- Board seat. Venture capitalists often require a board seat and, for that matter, a board of directors be formed. If 100% of the company is building the product and the team knows how to do that, then a board of directors may be overkill. In addition, it may be too early to decide who you want to be on the board.”
Unlike Venture Capital investors, Lateral Capital has none of the VC constraints described above: we don’t go on Boards, we don’t look to be the lead investor; we prefer dead simple terms and we understand that Early Stage companies don’t know everything, yet.
So, can VCs invest in Early Stage companies? Is it “safe” to have them participate? The answer turns out to be “if and only if they behave like Early Stage investors. To quote Horowitz, once again:
“They have to:
- Be comfortable investing a small amount of money, e.g., $100,000.
- Be able to make an investment decision quickly, e.g., in one or two meetings.
- Be able to invest without taking a board seat.
- Not require control of subsequent funding rounds.
- Not impose complex terms.
If the VC wants to be in the early round, but refuses to behave like Early Stage [investors], then entrepreneur beware. Having a VC who behaves like a VC in the early round can jeopardize subsequent financings. Horowitz invests in both venture rounds and Angel [Early Stage] rounds. When we invest early, we behave like Angels – literally and figuratively. As Angel investors, we invest as little as $50,000, we do not take board seats, and we do not require control.”