The Difference Between an Angel and a VC

Recently there has been a food fight in Silicon Valley over the behavior of certain Angel investors. Perhaps you’ve seen some of it playing out in the blogosphere. Riveting stuff to be sure. What gets me though is that a lot of the angst seems to center on whether leading Angel investors are acting like VCs or Angels. My first thought was “well, who cares?” But, on reflection, I thought it was revealing of a continued disconnect in the usage of these terms, and what they actually represent.

I think that it is important to clear this matter up because as I have mentioned many times over the last four years, the VC industry is bifurcating. One part of the industry focuses on raising and managing larger funds, and providing expansion capital for software businesses and capital for intellectual property driven businesses that require significant capital investment to get to market. These funds seek exits of $200M or more, to allow them to deploy large amounts of capital and generate venture returns. This part of the industry is well established.

The second part of the industry is rapidly developing. It’s made up of smaller funds, like my fund Amplifier Ventures, that focus on providing seed capital for software businesses and other opportunities to support capital efficient businesses. These smaller funds seek exits in the $10M to $50M range, and look to generate venture returns from a small amount of capital deployed in each deal. Over the last year a number of well publicized funds have been raised in Silicon Valley in this part of the industry. In many instances, these funds are raised and managed by successful individual investors – or, in other words, successful Angel investors.

As Angel investors become venture fund managers there is a natural inclination for them to hold themselves out as something different from venture investors. In light of the bad reputation that venture investors can have, this isn’t surprising. It’s good marketing to be sure. Also, as I will discuss below, a good Angel investor approaches investing differently from a good VC. Therefore, the values that a good Angel investor can project are attractive to an intelligent entrepreneur. Where this positioning breaks down for me, however, is that once an Angel takes other people’s money to invest he isn’t an Angel investor any more. He is a venture capitalist. And, this is where I think some clarification is necessary.

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As you can see above, the Angel investment transaction is a two-way transaction. The place to start is to understand that the most important characteristic of any Angel transaction is that the investor is providing HIS OWN MONEY. This means that an Angel investor is free to assign an economic value to a broad range of reasons for making an investment. The investment can be about making money, but it can also be about the joy of working with an entrepreneur, or providing mentorship or merely being in a “hot deal.” All these things can be equally or unequally important – it’s up to the Angel. But, if an Angel assigns value to something other than merely making a return, this will generally result in the Angel giving the entrepreneur a better price for his capital. It simply stands to reason – best price is less important if there are other benefits. This is what makes Angels attractive investors for entrepreneurs. It is not just about the money. The picture below shows how ancillary benefits can drive down the cost of capital for the entrepreneur.
The situation becomes more complex when a venture capitalist is involved. A venture investor is an individual who has aggregated commitments from various limited partners to make investments ON THEIR BEHALF. When a venture investor makes an investment it is NOT HIS MONEY. When an individual takes on responsibility for managing money for a passive participant he takes on special legal duties called fiduciary duties. These duties are serious and can create personal liability for an individual that ignores them. This is why venture investors are (or should be) careful when they make investments – they have a legal obligation to do so. The venture capital transaction is accordingly more complicated than the Angel investment transaction, as shown below:
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The resulting transaction is one where there are three parties, each of whom provides benefits to the other. The entrepreneur gives cheap stock and a high return potential investment to the venture fund’s limited partners. The limited partners give the manager of the venture fund (a/k/a the venture capitalist) fee income, participation in the limited partner’s investment gains and cash to make investments. The venture capitalist gives the entrepreneur cash, experienced help, access to relationships and validation. When all parties get what they need from the transaction it works very well. It’s when it doesn’t go well, say for example where the entrepreneur doesn’t get good help, then the transaction breaks down. Giving up cheap stock for nothing other than cash tends to rankle even the most even tempered entrepreneur.

Importantly, unlike in an Angel transaction, the ancillary benefits that a VC receives from an entrepreneur – working with someone he likes, being in on a “hot deal” or other ancillary benefits – do not affect the pricing of the venture capital deal. This is not surprising – the limited partners do not receive any of these benefits. Therefore, the only benefit that they value is maximization of return. And because of a venture capitalist’s fiduciary duties to his limited partners, he is obligated to do his best to maximize their return.
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This is where things get interesting, because a good venture capitalist understands that a venture transaction has two customers: the fund’s limited partners and the entrepreneur. How does a good venture investor take care of both customers? The answer is that he makes sure that the entrepreneur receives something of value from the VC – help, support, commitment, access to a broader network, judgment – whatever the entrepreneur can reasonably request. He has to make sure that he does his best to make his limited partners money, so to make sure that the entrepreneur doesn’t feel taken to the cleaners he has to provide value on the limited partners’ behalf

 

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If you parse though the axis of Angel and venture capitalist as I have described above, you can see how easy it is to clear up the confusion. As an entrepreneur looks at an Angel investor or a venture capitalist, he should look at them, and hold them accountable, in the following ways:


Angel Investor

An Angel is investing his money. Therefore, pricing can be improved if entrepreneur provides ancillary benefits that matter to Angel investor. The investment process can be smoother and quicker, because there are no fiduciary duties. A good Angel investor understands that the entrepreneur is a customer and provides ancillary benefits to the entrepreneur.


Venture Capitalist

A venture capitalist is not investing his money. Therefore, pricing cannot be improved by providing ancillary benefits to the venture capitalist. The investment process will be harder because there are fiduciary duties. A good venture capitalist understands that the entrepreneur is a customer and provides ancillary benefits to the entrepreneur.

The definitions that I have provided in this posting are independent of stage of investment, size of fund, or sector of investment. By applying these simple rules entrepreneurs can understand the nature of the investor they are dealing with, what they can reasonably expect the investor to do and how that investor should act. People at a dinner in Silicon Valley fixing terms doesn’t make them venture capitalists, and venture capitalists that care about entrepreneurs are not Angel investors.

I have often stated that the best way to raise money is to know what you want, and who you want it from. Appreciate the differences and strengths of Angels and venture capitalists structurally and then you can evaluate them on the most important characteristic – what will they do to help you grow your business?