The $4 Million Line

I wrote about two startups today that raised angel-sized financing rounds of around $1 million each: Hipmunk and Alphonso Labs. What caught my eye about both deals is this – neither had involvement from the so called “super angels” (except Hipmunk, which took an investment from SV Angel).

Hipmunk raised from traditional individual investors. Alphonso Labs raised money from venture capitalists.

Super Angels are investors who previously invested only their own money but at some point raised small funds and started investing third party money. That makes them indistinguishable from traditional venture funds in most respects.

Unlike angel investors, super angels have limited partners to answer to. And if returns aren’t competitive, those limited partners go elsewhere. Which is why we’re seeing so much stress emerge in the sector. Competition is fierce, and valuations are rising.

In fact, valuations are rising so quickly that a crucial psychological milestone has been reached – the $4 million pre money valuaiton. That was the primary reason that led to the formation of the AngelGate group, say multiple sources who attended those meetings.

For the first time this year the valuation on early stage deals started to average more than $4 million, say our sources. And that is the threshold where super angels’ valuation models start to break.

In a typical super angel round a company will raise $1 million on, say, a $4 million pre-money valuation. That gives investors 20% of the company, which is worth $5 million after the transaction is closed (the $4 million valuation plus the $1 million they just received)

Unlike old school venture capitalists, super angels are only counting on small exits of $15 million – $30 million. They need 7/10 or more of their companies to have these small exits to make any money. Any less and they won’t be able to raise new funds. Traditional VCs only count on 3-4 deals even returning capital. The rest are losses. But at least one of those ten deals is a huge home run, returning 10x the initial investment. Or more.

But with valuations rising, say investors we’ve spoken with, even 7 or 8 “wins” out of 10 won’t be enough to sustain the funds, given how small the acquisitions are. So exit valuations must increase, which is unlikely given the small number of buyers competing for deals, or valuations need to decline.

Some investors are just paying the higher valuations – Dave McClure is a notable example. Others are sitting on the sidelines and not investing much.

But all are griping.

The rising popularity of convertible notes, which are actually debt rounds that convert to equity later on, is increasing stress on the system. In some cases there aren’t any price protections for investors in those deals at all.

What happens next? Some of the super angel funds need to disappear, say Silicon Valley insiders. And maybe that’s for the best. The ones that are left standing will have an easier time making money down the road.