When angels reach too high, startups can fall

October 3, 2013, 8:09 PM UTC

FORTUNE — Silicon Valley is living in the age of angels. And it is beginning to cause some problems.

Here’s the troublesome scenario: A young tech entrepreneur raises some angel funding to begin building his business. Maybe $100,000 or so at an entirely-reasonable valuation. It was a good experience. They return to the angel market for a bit more funding, believing that institutional VCs won’t be interested until a few more kinks are worked out. But they raise this new money at a VC-level valuation (>$4 million). After all, why accept lots of dilution if someone is offering you less?

Now it’s time to pitch VCs. And the entire thing falls apart. Not over product or promise, but over price.

The VC wants to invest, but just can’t get over the valuation hurdle (nor would he even bother trying to convince his partners to do so). In theory, the VC would invest at a lower price if the entrepreneur would recap the company, thus providing the startup with deeper long-term pockets and a more involved investor. But the VC is very wary of being portrayed as a villain in blog posts written by the disenfranchised angels (since that could hurt the VC’s rep among other entrepreneurs). Moreover, the entrepreneur is unlikely to cram down the angels who took a chance on him at the beginning.

So the VC doesn’t ask, the entrepreneur doesn’t have to make a difficult decision and, in the end, everyone loses. Including the original angels, because the company either folds or doesn’t achieve its true potential.

To be clear, this is not the “Series A crunch” we’ve heard so much about, where there are more angel-funded companies than the VC market can accomodate. This is a situation where the VC wants to invest, but is unable to do so because the earlier angel investment was priced too high. Sure, the VC could suck it up and take the PR arrows. But that isn’t what’s generally happening. For entrepreneurs, it’s an important scenario to consider before pricing that next angel round.

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