The Rise of the Pledge Fund

Angel investing has existed since the very beginning of what we consider the modern age of venture capital. Indeed, long before there ever was much of a venture capital community, loose groups of semi-retired execs assembled regularly to discuss interesting young technology companies to fund. Routinely, there would be a “passing of the hat,”  some cursory discussion of deal terms and, whammo, a seed investment would be made. Colorful stories of just such seat-of-the-pants financings of companies that later became tech industry juggernauts are now the stuff of venture capital legend.

Since the “institutionalization” of venture capital, beginning in the 1970s, angel investing has evolved quite dramatically. Sure, there will always be wealthy uncles and trusting friends willing to back energetic young entrepreneurs with intriguing business ideas, but finding strangers willing to do so out of their own pocket has become increasingly challenging. Indications are that it will become only more difficult as many “angels” have found themselves squeezed out of many opportunities and the prospect of backing companies in general increasingly fraught with risk and uncertainty.

To be sure, true angel investing is tough to do – and even tougher to do well.  For this reason, even many successful retired venture capitalists steer clear of angel deals. The reasons for this are many. For one thing, it is not often that an investment comes along that matches one’s direct domain expertise, skillset, and network of contacts. As such, many angels get into the dicey business of investing out of one’s comfort zone and away from a relevant knowledge base that can actually help the company. This is fine when things are going well, but when things hit rough patches many angels find themselves unable to really be of much assistance. This can be enormously frustrating for both the angel investor and the company experiencing troubles and needing sound guidance from its investors.

But this is just the tip of the iceberg when it comes to the challenges of being a good, successful angel investor. For every Andy Bechtolsheim or Ron Conway there are a thousand well-meaning angels who made their money in shopping centers or tanning salons only to lose a chunk of it backing technology or life sciences ventures where they had no expertise or understanding of what was really going on at the companies.

However, even with the risks, prospective angels understand that participating in early stage deals can bring staggering rewards for those fortunate enough to come in on the next Google, Skype or YouTube. And thank goodness for that, because angels provide a critical and increasingly valuable service to the venture and start-up community. As venture capital fund sizes have generally increased in recent years, many venture firms have moved upstream into more developed opportunities where more capital can be deployed and where the classic early stage risks can be somewhat mitigated. The result of this has been a dwindling universe of investors that still specialize in truly raw, early stage opportunities. 

For years, the options available to individual investors determined to participate in venture were not terribly attractive. Option one: Become a limited partner (LP) in a top-performing venture capital fund. Sounds good, but in truth many venture funds have increased their average fund sizes dramatically in recent years and, as a consequence, have focused almost exclusively on big institutional investors (endowments, pension funds, etc) to make up their LP base. In many cases, individual investors need not apply — unless, of course, you were in that particular VC firm’s last few funds and have an established relationship with the partnership. Secondly, the need for a venture capital firm to openly solicit funds outside a narrow group of previous limited partners is proportionate to an extent with how successful it has been historically. In short, the more successful and renown the firm the less it probably requires or wants your investment commitment (again, unless you are already a known quantity with that fund and there is a relationship already.)

Option two: Become an angel investor. For reasons cited earlier, this is tough. Even with a technical background and some operating or investing experience, how does a prospective angel begin to create deal flow? How will entrepreneurs of promising companies even find the angel or learn that he or she is interested in making early stage investments? Of course, the prospective angel can try to join a prominent angel fund to gain access to their deal flow, but such groups are often very exclusive, require one to go through a lengthy and competitive membership process that can take months, and are often closed to new members for years at a time.

Now, fortunately, something of a third option which can mitigate some of the inherent risks in angel investing has begun to emerge. Enter the Pledge Fund.

What is a Pledge Fund?

A Pledge Fund is essentially a non-committed venture capital fund, or a fundless VC firm if you will, that operates as a bit of a cross between a traditional venture firm and a loose confederation of individual angels making early stage investments together. The logic is fairly simple: take the best elements of both structures to create a model that enables individual parties to make angel investments in a standardized, formalized way that eliminates many of the traditional pitfalls of angel investing on one’s own.

How it works:

The Pledge Fund is typically run by experienced angels or former (or even current) VCs. These individuals constitute the “GPs”, as it were, of the fund. The GPs handle all of the admin functions of the fund much as one would expect at a traditional venture firm: outreach to the entrepreneurial community; sourcing, vetting and presenting deals to the Pledge Fund’s “investors” (often called “Members” — more on that later); handling term sheet negotiations; drafting documents; and handling post-investment support by means of sitting on company boards, etc.

This GP management layer, if you will, is critical because individual angels are just not set up to handle most of these functions. Even assuming an individual angel can find good deals (and that’s a big assumption), will that person even be able to properly evaluate it? Will he recognize the flaws? Can he properly size up the team and do thorough due diligence on the technology? on the market? Would he have access to broad groups of experts in various fields to help him vett the opportunity and the management team? Even after an investment is made, will the angel sit on the company’s board and, if so, can he really expect to make much of a contribution?

A good venture firm performs most, if not all, of these management, deal-making, and post-deal support functions. So, in a sense, a Pledge Fund does much the same thing on behalf of the angels. The key difference is that, unlike in a traditional venture fund, the Pledge Fund does not operate a blind pool of capital from which to invest in deals. The Pledge Fund can only source, vett, and scrub deals for its members. It is the members that ultimately determine what deals they participate in. Traditional venture capital firms, by contrast, typically offer their limited partners little to no say in what deals the fund invests in and in overall day-to-day firm operations.

On becoming a Member:

Most Pledge Funds have a straightforward process to gain admission to the organization. There are usually some questionnaires to complete and accreditation requirements to meet, but they are far less onerous than one would expect at many venture funds. Once admitted as a Member, the only commitment is a small annual management fee (usually to cover overhead and ancillary fund expenses) We’ve heard management fees in the $5k-$10k/year range. The thinking behind the fee is not so much to be a revenue generator as much as a way to cover basic costs and to weed out people who are not serious about actually making seed stage investments. The logic goes that if a prospective angel is considering $100k-250k in angel investments over the next couple years, paying $5-10k a year to see scrubbed and vetted deals should not present an issue; if it does, then the investor was probably not serious to begin with.

This management fee permits the Member to gain access to the Pledge Fund’s deal flow but does not commit him in any other way. Each month, the Pledge Fund’s deal review committee scrubs all that month’s deal submissions, meets with the most promising companies, conducts a preliminary due diligence process, and selects the top 3-5 deals. Those deals are then scrubbed again, executive summaries in the Pledge Fund’s standardized format are prepared, and the deals are submitted to the Members.

Members are then given a fairly narrow window (we’ve heard a few days, some as long as a week) to review the deal submissions and respond back to the Pledge Fund GPs about which deals, if any, they are most interested in. In short order, the Pledge Fund GPs can determine what syndicate, if any, they can pull together among their Members to make an investment.  If it can, then deeper diligence is commenced, the Pledge Fund’s attorneys are summoned to draft deal documents, and things move apace at that point.

Once an investment is made, another interesting twist occurs. In the past, angel deals sometimes suffered from a bit of a stigma within the venture community. Venture investors looking at an investment that was previously seeded by angels sometimes grew concerned that they might be inheriting unsophisticated investors on the board and/or otherwise involved with the company that could potentially cause problems down the road. Stories of neophyte “friends and family” investors throwing up roadblocks or being obstructionist when a professional investor got involved are fairly common in the venture community. For this reason, some venture investors are leery of angel deals unless the angel group is already well-known and respected within the venture community.

To get around this problem most Pledge Funds structure the investment by creating a separate limited partnership entity to make the investment into that specific company. The Pledge Fund’s Members are then LPs in that new entity that, in turn, makes the actual investment. The impact of this is two-fold: (1) for the purposes of the Capitalization Table, there will not be a list of every Tom, Dick and Harry angel investor and their individual investments; there will only be a listing of the Pledge Fund’s name and the name/number of the LP — i.e. Acme Pledge Partners, Fund I, etc. That keeps the Cap Table pretty clean; (2) If a board seat is part of the investment terms, then a member of the Pledge Fund’s GP group will take that board seat. Since the Pledge Fund’s GP group is often made up of former VCs or well-known angels, there is less concern from professional investors that the member representing the angels will be unsophisticated and/or obstructionist.

Obviously, it’s still early days for this new form of Pledge Fund and it will be some time yet before we can opine on whether this model will become commonplace in the venture community. That said, we have seen versions of this in the past and always found it intriguing for the reasons cited here. It appears that, at least in this current iteration, this modern Pledge Fund approach is presenting a well-constructed and well-reasoned model for those individuals interested in early stage investing while mitigating many of the classic pitfalls long associated with the practice.

[Updated Note: In light of the response to this post, readers interested in learning more about Pledge Funds and/or interested in being put in touch with funds pursuing this strategy are asked to contact me directly at jtower(at)citroncapital(dot)com for more information.]