Why Angels Chase Electrons

A handful of angels recently turned their nose up at a company making a useful, well-targeted and well-validated computer peripheral product. An extremely smart entrepreneur who’s new to the organized angel game asked me a pretty fundamental question in response: “why do angel investors (and to some extent, VCs) turn up their noses at real, down-to-earth physical product companies and instead chase etherial web and process flow services businesses?”  Good question, and one that comes up frequently, so here goes…

Angels look at the world differently than VCs. VCs have huge funds, so they are looking for outsized opportunities in which they can put lots of money to work. Finding “venture scale opportunities” is their main focus. Some angels similarly focus on finding the next Google or Facebook, but most angels think a little differently. Many angels think more like runners trying to steal bases. They want to make progress and score runs without getting out. Angels are like two-legged evergreen funds. Since they are using their own money, they don’t have at-bats to waste – realistically they can only write so many checks a year.

As a result, angels view capital efficiency as paramount. They want companies which will get something done with their money – achieve some milestone that will significantly de-risk the business. Angels want to invest in runners who can get on base and drive runs in. Big home runs are surely sexier, and many angels will swing for the fence every once in a while, but for the most part, they are trying to get on base and coax home the runs. And they look for ways to stretch their dollars, mainly by focusing on businesses they know something about and where they can help out with advice and introductions.

As a side note, this is probably a good spot to acknowledge that angels are sometimes criticized by VCs for not thinking big enough. The idea behind this criticism is that it takes a real VC to build a game-changing company and boys and girls in short pants shouldn’t mess around with a grown man’s [woman’s] game. Most of that silly posturing is easy to ignore, but one inference sometimes made is worth refuting: VCs will sometimes imply that working with angels can hurt a company by reducing the scope of its ambitions. This is plainly non-sense when you consider that it is much easier to put extra money into a company at any time it suddenly becomes necessary, than it is to take excess money out if it. Over-captializing companies is as least as pernicious as under-capitalizing them (for the entrepreneur as well as the company), but at least under-capitalizing is easy and instant to fix. Thus the angel focus on putting in the resources needed to get on base, and then reevaluating the field position once you are there.

How does that translate into preferences in terms of types of investments? It’s pretty straight-forward equation. Since every company makes lots of mistakes in the early days and inevitably takes more time than expected to achieve their forecasts, the basic and fundamental nature of the business they are pursuing has a lot to do with how much cash they consume while they thrash and iterate. If you build a web-based business and you don’t quite get the product right, it takes two pizzas, a six pack of beer, and a weekend to modify it. If the business you are in requires you to build a factory and a supply chain and crank out enough widgets to fill a distribution chain before you can discover the error of your ways, you have burned a lot more money in the process. (Update: though as Adrian Gonzalez notes in a follow-up piece to this post, outsourcing can reduce those costs significantly.)

As a result, angels are drawn to businesses that require relatively little capital. And within that category, they are especially drawn toward businesses with the potential for rapid expansion of margins as the company grows and scales. Why? Again, because they don’t want to get thrown out at second base. If the company burns more money than the angels can provide before it has created something of real value, it is game over – you are looking at either a total write-off or a cram-down distress financing where later investors badly dilute the earlier investors. Businesses with inherently expansionary margins quite simply provide more room for error. Even a little sales success gives meaningful relief in terms of the capital burn. The supply chain is simpler. Distribution over the web is virtually free rather than having to go through tiers of distribution. Factors like these drive the powerful capital efficiency the angels crave.

To illustrate the point, let’s look at a business at the opposite end of the spectrum, a professional services business. These people-based businesses have their costs grow linearly with their revenue because, to grow, you need to add people. (From an attractiveness perspective, it doesn’t help that their main assets can quit any time they want, either.)  Companies which manufacture products fall in the middle, but still contain some scary aspects. They need to put together longer and more complex supply and manufacturing chains. They have to carry inventory which has high costs and huge risks of obsolescence in the event of a necessary pivot, and they have to figure out and pay for distribution, which further erodes margins.

Web services and software products, in contrast, cost relatively little get started. And then once you produce the first “copy” of your product or service your first customer through the site, the second and subsequent copies and customers are so much less expensive as to be virtually free. It is pretty typical to see traditional packaged sofware companies with product gross margins as high as 99%.
It is true that these electron-based businesses sometimes seem fluffy and trivial. And since they are relatively easy to start, they are not always focusing on solving the weightiest of problems. But they can iterate and evolve extremely quickly and many of them go on to become pretty important. Who could have foreseen that a service initially derided as a platform for broadcasting what you had for lunch and a system for “poking” your friends and “liking” your favorite brand of soda pop would have ended up contributing to the downfall of repressive regimes in the Middle East?
So even if these electron-based business seem lighter-weight in comparison to solid, down-to-earth product businesses with real assets, they are not necessarily more risky on an adjusted basis. When you factor in the cost of mistakes, even a really solid, obvious, useful product like this actually ends up representing as much capital risk as the seemingly riskier, flimsier, web-services company. The no-asset, electron-based web services company may seem higher risk, but (i) it consumes less capital which (ii) gives it more room for error which (iii) it has a higher alpha: if it does work, it works big, its margins expand explosively and it generates a big return on the modest capital invested.

Comments, questions or reactions to this post? Leave a note below and I will respond to your questions.

If you enjoyed this, you might enjoy: What I Look For In An EntrepreneurAre Entrepreneurs Wild Risk-Takers?Pick Your Founder/Co-Investors Carefully & Reflections on the Nature of EntrepreneursTop 20 Dos & Don’ts with Angel Groups & Early Stage FinancingDelusional EconomicsThe OvertureThat Vision ThingThe Power of An Advisory BoardLoch Ness, Unicorns & The First-Mover AdvantageShould I Wait For A Technical Co-Founder.

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  1. Christopher says:

    In anticipation of the obvious comment, I will address the electron metaphor here: yes I know all businesses are based out of atomic matter involving electrons. I was referring to the free electrons whizzing through copper wires and computer circuit boards….

  2. Thomas Friedman says:

    Chris – Thanks for this excellent analysis. I would contend that a macro examination of capital efficiency would test your argument. I would argue new technologies for designing, prototyping and finalizing physical products prior to production (from printed circuit boards to harden objects) are beginning to de-risk the product business much like your weekend example of a software work around. I would suggest companies such as Quirky.com and DailyGrommet are de-risking products through crowdsourcing and thereby determining winners early in the game. Moreover, marketing, manufacturing, supply chain product support and guarantees (so-called “landed costs”) are well documented by among others, Amazon.com, and should make early calculations simpler. Last, I would propose a longitudinal electron-to-electron ROI comparison of physical product to internet sites/services to begin to put “meat” on this discussion. Your turn …

  3. Chris,

    Very interesting topic; thanks for getting the conversation started.

    You make some valid points about why angel investors view companies that produce Web-based products and services as being more attractive (less risky, more capital efficient) than companies that produce and distribute physical products. But I would argue that the risk and capital efficiency gap between the two models is narrower today than just a few years ago, and getting narrower by the day. I share some of the reasons why in a blog posting:


    I also suggest an idea for kick-starting the make economy: getting third party logistics (3PL) companies to become “vested partners” with entrepreneurs at the front end to address any risks/concerns investors might have.

    Just my two cents. Again, thanks for the thought-provoking posting.

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