May 2, 2012 · 8 minutes

So, you've got a great idea for an iPhone app that could be the next Instagram. You need some money to pay your developers. You decide to raise an angel round, and even though some VCs clamor to get in with their "talent" and "discovery" funds, you decide to stick to pure angels.

So you call up the successful entrepreneurs you know and your friends who know others. You get meetings. You get some $10,000-$50,000 checks. Bam! Mission accomplished. You have $500,000 in the bank and no VCs in your life.

Or do you?

We're hearing very credible rumors of a new trend in the venture capital world. One that, unsurprisingly, no one will talk about on the record. VCs are essentially paying "network rich, cash poor" entrepreneurs to act as independent angels or "deal scouts."

These entrepreneurs source deals and ostensibly invest their own money in promising companies. But the reality is they're actually investing the money of a major VC firm. And typically, the entrepreneur at the end of all this has no idea it has happened.

I was stunned when I first heard about this a week or so ago. I've covered venture capital in the Valley since 1999 and recently raised my own angel round and had never heard of anything like this. But after a week of reporting, we've had it confirmed from multiple well-placed sources that at least two of the top five venture firms are doing this. And when the top firms do something, the rest of the industry tends to follow.

I decided not to name the firms or individuals, because I haven't seen hard documented proof, and an allegation of specific firms misleading entrepreneurs is a hell of a thing to make. I'm working on tracking down that smoking gun (email me if you have it), but in the meantime, consider this post an urgent heads-up. Entrepreneurs need to starting asking a question that it certainly would have never occurred to me to ask my angel investors: Is this actually your money you are investing in my company?

There are several macro industry trends that have conspired to make this development possible and even -- some VCs would argue -- necessary:

  • Over the last decade, the amount of money it takes to get to an initial product has plummeted. This has been widely reported, but it's an ongoing issue for a venture capital industry that was built when startups needed "fabs" (semiconductor fabrication plants) and armies of engineers and sales people to get going. Today's entrepreneurs need VCs far less at the early stages. Some VCs have shrugged and accepted they'll just have to invest later. But others have fought the trend tooth-and-nail. The earlier you get into a company, the more money you make. Once a company is already taking off, the fight to get in turns into a sheer war of valuations.
  • In many cases, VCs' efforts to compete with angels have fallen flat. VCs have tried to combat the rise of angels in a few ways. Some make their own angel investments on the side, but most limited partners in venture funds frown on that as "cherry picking." Many of the major firms don't allow it. Other firms have established smaller seed "funds" or separate angel portfolios. The idea is they can move more quickly and make smaller bets, but in exchange they don't get as personally involved in each deal, and the bar is somewhat lower for what they will fund. The problem with that is not everything that makes the cut in a firm's angel portfolio makes the cut for the series A. And when a firm invests in the seed, and then doesn't invest in the Series A, other potential investors wonder what they are missing. With each strategy showing serious flaws, VCs obsessed with seeing everything at the seed level are in a bind.
  • An explosion of angels. The Valley is just lousy with angels these days. There are the angels who've been enriched by the glory days of the Web. There are the angels who spun out of Google post-IPO. Then there are the angels created by the wave of mid-2000 Web 2.0 flips, as Google and Yahoo swallowed up anything remotely innovative. In these cases, entrepreneurs didn't sell for much, but also didn't raise much, so each founder made millions. And then there are the angels created by the trend of partial liquidations and secondary markets, where you didn't even have to exit or be at a company that exited to make millions.
  • Total obfuscation over who has made money and who hasn't. Also, because of the partial liquidations and secondary sales, nearly anyone who has worked at any startup that's ever had an up-round could be a millionaire. When its plausible that nearly anyone could be a millionaire, entrepreneurs don't ask questions like, "Wait, your company failed… How do you have money?"
  • Deal flow is more lateral in the Valley than it ever has been before. Entrepreneurs used to go up and down Sand Hill Road when they had an idea as a rite of passage, in part because starting a company was so expensive. Culturally, that's changed over the last ten years. Because of the dramatic rise of angels, they talk to trusted friends first. The networks for deal flow have been completely remapped as a result. Even the best firms aren't seeing a lot of the deals they want to see. VCs have to be where the entrepreneurs are now -- witness the rise in the importance of demo days and startup competitions and founder hang out areas, so VCs can easily find them.
In the last week, I've spoken with angel investors who are furious at the "scout" trend, and VCs who honestly don't see the harm in it. Let's look at the arguments of the latter group first.

First off, these are mostly early experiments and a rounding error in the angel world. VCs doing it are selecting very established entrepreneurs who are great mentors with more recent and relevant experience than a lot of VCs. They view it almost like a micro-cap angel fund. No one goes around asking VCs who their investors are… So why should it matter where the money is coming from?

And it eliminates the problem with negative signaling. Frequently firms aren't interested in investing in a Series A because of competitive portfolio reasons or too much market exposure in a certain area. An otherwise promising startup gets tarnished for no reason. This way, a VC gets to invest without inflicting unintentional reputational harm.

There's also the opposite signaling issue. If the venture firm is allowing the entrepreneur to act autonomously as an angel, they may not want that portfolio company running around saying they are part of the VC's portfolio. Just like no one runs around saying Harvard's endowment invested in them, just because Harvard invested in a VC that backed them.

At the end of the day, these people argue, more money is going to entrepreneurs who may not have direct access to VCs. Is that such a bad thing?

Long term, yes, it may be, not necessarily on an individual company level but on an ecosystem level. There is just a glut of angel money right now, and more money isn't always good. More money can drive valuations up to unsustainable levels, and that doesn't help anyone in the long term. For the last year, entrepreneurs have been complaining that companies that shouldn't get formed are pulling talent away from companies who may have a better shot at building something sustainable. Not everyone in Silicon Valley can be a founder. Someone has to work at these companies, if they are going to succeed.

Also, some angel investors I spoke with ask what exactly are VCs getting in exchange for giving scouts hundreds of thousands of dollars to invest? It could be a percentage of the proceeds, like any limited partner. It could be influence with the entrepreneur. It could be a heads up when a series A is in the offing. Or some worry, the scout could be a sieve of confidential information. With the whole arrangement not disclosed, how can anyone police it?

A lot of this trend -- the unquestionable ingenuity of it and the concern over the ramifications -- goes back to the hacking culture that birthed Silicon Valley more than fifty years ago. It's a place that likes to live in the grey area. I go to a conference called the Lobby almost every year, and there's always some elaborate scavenger-style hunt game. All the very type-A, competitive entrepreneurs and VCs who attend go crazy doing whatever it takes to win. Each year there are more rules, because unless it's explicitly stated in a rule, it's not considered cheating. The fun for most of the attendees is hacking the game.

That's Valley culture in a nutshell. Most of the icons of tech hacked phone lines, cracked game codes, and engaged in other border-line illicit behavior growing up. It's that same belief that you aren't bound by the normal rules and conventions of the world that enable people to become entrepreneurs to begin with. Without it we wouldn't have Intel, Apple, PayPal, Facebook, or myriad other tech giants that have changed the world.

But this is also a place that's held together by tenuous relationships of trust between those with millions of dollars and those with million-dollar ideas. Angel investing is the purest form of that. It's one person who has made it and believes in you, putting his hard earned money behind your dream. As an entrepreneur and an advocate for entrepreneurs, I worry about anything that violates that trust, well meaning as the intentions may -- or may not -- be.