Can an Angel Dance With a Venture Capitalist?
Angel investors are becoming a greater force in the startup capital market and protecting themselves against venture capitalists. Entrepreneurs can be caught in the middle
Angels and venture capitalists provide vital investment capital at different stages of a startup enterprise. Although critical to the success of entrepreneurs, the relationship between angels and VCs is both “mutualistic and parasitic,” says Veikko Thiele, associate professor and Distinguished Faculty Fellow at Smith School of Business. As Thiele and colleague Thomas Hellmann (Saïd Business School, University of Oxford) point out in a forthcoming paper, angels complain that VCs abuse their market power by low-balling the entrepreneur and offering unfairly low valuations. For their part, VCs have little use for angels when they make their investments. With their growing heft, many angels now use more sophisticated contracts that guard them against backroom deals between firms and VCs, causing many VCs to back off from potential investments.
In the ecosystem of startup capital, angel investors and venture capitalists theoretically should have their turf well defined. Angels, usually former entrepreneurs, invest during the early days of a firm’s development, essentially getting it to just beyond a launch state. Venture capitalists (VCs), lured by an attractive opportunity, then arrive with the funds to help the fledgling company scale up and thrive.
But while they co-exist, these two groups of investors can have a dysfunctional relationship and be at odds with each other. Although critical to the success of an entrepreneurial enterprise – and the profits of both investing parties – the relationship between angels and VCs is “mutualistic and parasitic” at the same time, says Veikko Thiele, associate professor and Distinguished Faculty Fellow at Smith School of Business.
Thiele and colleague Thomas Hellmann of Saïd Business School, University of Oxford, developed a theory of how angel and venture capital markets interact; their research is forthcoming in the Journal of Financial Economics.
Angel investors, who are responsible for providing the $50,000 or $100,000 that entrepreneurs seek when launching their businesses, have increased dramatically in recent years. In the U.S., according to the Organisation for Economic Co-operation and Development (OECD), this market grew at an annual rate of 33 percent between 2007 and 2013, and is estimated to be around US$17.7 billion.
Thiele and Hellmann attribute this growth to a greater degree of sophistication on the part of angels, the creation of national angel investor associations, and the rise of organized angel groups and networks.
Conversely, the venture capital market has moved almost entirely into the later-stage financing realm, providing the bigger dollars to businesses seeking an infusion of cash to maintain or expand their enterprises. This market is estimated by the OECD to be worth approximately $18.3 billion — marginally larger than the angel investing market.
(In Canada, the angel and venture capital markets are comparable in size. Angel investment stands at approximately $388 million while venture capital investment is worth $393 million.)
A Love-Hate Relationship
As Thiele and Hellmann note, the interaction between angels and VCs is complicated. Angel investors often need VC involvement to ensure their investment in an entrepreneurial firm can reach its full potential. Often, if startups are unable to attract VC interest, they will die on the vine, says Thiele.
At the same time, “venture capitalists rely on angels to make the first investment,” he says. “Without angels, they would have nothing to invest in.”
Despite their mutual need for each other, the researchers say this relationship can also be dysfunctional. “In practice, angels and VCs often see each other as foes,” Thiele and Hellmann note in their paper. Angels frequently complain that VCs abuse their market power by low-balling the entrepreneur and offering unfairly low valuations. The possibility of this happening can affect the willingness of angels to invest in early-stage firms.
For their part, VCs have little use for angels when they make their investments. The angels’ investment is sunk; they provide no further value to the company and can even be a distraction.
As Thiele and Hellmann point out, the venture capitalists' bargaining power depends on how competitive venture markets are and how well angels are legally protected.
Venture capitalists' bargaining power partly depends on how well angels are legally protected
The legal dimension, in particular, is a key driver in how well angels and VCs interact. With their growing heft, many angels now use more sophisticated contracts that guard them against backroom deals between firms and VCs.
When angels benefit from better legal protection of their investments, there are potential consequences for budding firms. A big one is that VCs tend to back off from potential investments, making it harder for early-stage firms to secure financing and thus threatening their survival. Frustrated entrepreneurs dub this the “Series A crunch” (referring to a company’s first significant round of VC investment, when preferred stock is sold to investors in exchange for their investment).
Thiele adds that in the current climate where more angel investors are protected, “it’s getting harder for entrepreneurs to finds VCs.” The end result is a larger number of smaller businesses and fewer big businesses.
Their framework raises a number of policy-related questions. For example, in a case where a government wanted to boost greater early-stage investments, would a subsidy to angels be more or less efficient than a subsidy to VCs? Such questions, Thiele says, are worth further study.
— Anna Sharratt
