Let’s start by agreeing on a simple fact: growing a company is easier if you have money. Some companies choose to run as a small business, taking occasional loans to help them expand. Others seek financial backing from professional investors. Still others (like ours!) choose to never raise money and bootstrap their way to profitability. There are points to take into consideration with each, but people often wonder what the difference is between angel investors and venture capitalists (VCs).
No Wrong Answers
The first thing to understand with raising money is that not everyone has everything figured out. Many companies have started on one path and then shifted to another, not only in their product but also in their finances. They may have tried to raise funding from investors and then found that bank loans were a better option. Conversely, some companies may not have gotten the capital that they needed from bank loans and so they opted for investors instead.
The answer to “which path is right” comes down to many different factors. These could include how the founders structured the company, what the goals are for the money they are raising, and how averse or excited the company is to having someone else have a say in its operations.
A Quick Overview on Investors
Before we dive into the differences between the classes of investors, we should talk about the aspects that are alike. The first thing is that individuals are all accredited investors. According to Regulation D of the Securities Act of 1933, this means that an individual has an income greater than $200,000 in the two most recent years, or over $300,000 if including their spouse. Alternatively, the person could have a net worth over $1 million, not including their primary residence. Sometimes, people who hold broker, investment advisor, or private securities licenses may also qualify as accredited investors.
There are ways for people of lesser means or licensure to invest. Crowdfunding regulations allow individuals to gather together and invest through an intermediary. A company can raise up to $5 million through crowdfunding over a 12 month period, and there is a cap to how much an individual, non-accredited investor can contribute.
Both angel investors and VC funds will exchange capital for ownership in the company. This ownership can come through shares of stock, or it could come as convertible debt. Companies often opt for convertible debt when they believe that their share prices will increase in value because that debt will mean that the company maintains more ownership in the future.
While there is no obligation to “pay back” money that a company raises from angel investors or VCs, they expect a return on that investment. This return generally comes from an event that puts cash into the company’s hand, known as a liquidity event. This could mean that the company sold, larger investors put money into the company, or the company has an initial public offering.
What is an Angel Investor?
The first, most important differentiator about angel investors is that they invest their personal money. Angels are often high net worth individuals, sometimes with exits of their own in the same areas where they like to invest. It’s not uncommon to see an angel investor who finds success as an entrepreneur and then wants to “give back” by funding companies and potentially making money for themselves.
Because they invest their own money, it’s not uncommon to find angels investing in passion projects. They will also spread out smaller amounts of money among many deals. They prefer this approach because most startups fail. Spreading out their investments increases the chances of finding success.
Angel investors have a straightforward path to making money. They exchange funds for ownership in the company and wait for an exit. However, since the angel investor is usually an early contributor to the company, it is also common to see them provide consultation to help the company succeed. Angel investors may help the startup by making connections, providing technical advice, or even introducing them to higher-level investment.
One area where there is a lot of variance is in board seats. Depending on who you ask (and where you are) you may find that it is either common or uncommon for an angel investor to take a board seat. It is far more common for angels in the San Francisco and New York areas to insist on a voting position. Those in other locales may very well be satisfied to be an observer. Famed investor Mark Suster has a good breakdown of how and when a startup should expand its board. In his path, a seed investor (who is commonly an angel) should hold a seat when the company closes an A round of funding.
What is Venture Capital?
You can say that angel investing is relatively straightforward and driven by people. Venture capital sits on the other end of the spectrum. As you might expect, with larger deal sizes and more interested parties in each transaction, the entire system is more complex.
To start, it’s important to understand that most venture deals happen through a group of people rather than an individual. While each person in a venture group might have a high net worth, and your company may work with a single person, who represents the VC group. That group invests money from a fund, which is money that the group raised from outside sources.
Because venture funds represent more than one person, they invest in fewer deals with much more diligence done on each one. While there is still room for that “gut feeling” to show itself, venture diligence is usually rigorously structured and far more formal than what you will see in angel deals. This means that venture deals will also often move slower than angel deals. That research takes time, and the fiduciary responsibility is something that nobody inside of a venture fund takes lightly.
It is also common for venture capital to have funds that are specific to a purpose. For instance, Softbank’s Vision Fund focuses entirely on technology, while some other funds may have even more narrow scopes. These funds are often earmarked by deal size and capped by overall availability. A venture firm may have tens or hundreds of millions of dollars under their management, broken down into multiple different funds, each with their own goals.
Venture capital investors commonly require a voting seat to invest in a company, especially if they are the primary (lead) investor in a round of funding. They may also negotiate other benefits for themselves. It’s common to see VCs negotiate the right to invest in future rounds, or for rights to information about business results and progress.
Another big difference between angel investors and venture capitalists is how they operate daily. It’s not unheard of for an angel investor to take on the role as their only job, but it’s not common. Venture fund managers, however, are part of a larger business. The fund is an employer unto itself, with the requisite payroll, taxes, and other daily operations required. The daily work of a fund manager may include finding or managing deals, raising money for a new or existing fund, or simply operating the business.
How do VCs Make Money?
This answer is, predictably, more complex than that of an angel investor. To start, it’s worth understanding that there are investors, then there is the firm itself. Both entities make money from their investments, but they do so in different ways.
Much like the angel investor, the venture firm exchanges capital for equity. The firm itself makes money when it exits a deal and cashes out the equity that it has in a company. In rare cases the firm may make money because the company has turned profitable and pays dividends to its investors.
The individual venture investor’s most lucrative source of income is carried interest. If they are investing from a fund of $100 million, they commonly earn 20 percent interest on every dollar earned over the $100 million. So if the fund does well and earns a 5x return on the initial investment, the investor will earn 20 percent on $400 million.
The second way that an individual investor earns money is through management fees. Though to be more precise, the management fee is usually allocated to the firm itself and then a portion is split among the managers active in the fund. Management fees are, as the name implies, a small fee that is equal to a percentage of the fund total for each year that the fund is active. Two percent is common, though not written in stone. Firms will usually operate more than one fund at a time, so they are pulling management fees from several different funds each year.
Which One Is Right for Me?
As we said before, there is no wrong answer for choosing a funding option. However, there are some guidelines that you should know because they will make your life easier. If you are trying to secure VC-level meetings with little more than an idea, chances are that you won’t find success. An angel investor who believes in your proof of concept may be willing to take the risk.
The first thing that you need to ask yourself is what stage your business has reached. If you have not yet found product-market fit, you are too early for almost every venture capital firm. You should also know how much money you need to raise, and how much of your company you’re willing to part with in exchange for that cash. An angel investor may write that $250,000 check, but they may want 20 percent of your company in exchange. For many young companies, this lack of desire to dilute their ownership leads them to gathering funds from friends and family, or to turn to bank loans instead.
The eternal question is one of a gamble — if you raise money today, you’re giving up a share of your company at today’s valuation. But how much more could your company be worth in eighteen months if you had that operating capital? Many founders will accept dilution of their ownership in order to grow their company faster, raise their overall valuation, and reach a liquidity event sooner.
You will also need to be prepared for the level of meeting that you’re requesting. As we mentioned before, venture capital due diligence is far more rigorous than angel investors. These meetings will feature tough questions, and the VC will expect answers that are backed up by data rather than feelings.
Many founders who have been through the fundraising process will also tell you that who you raise from matters. Think of this as a new partnership. Your new investor may have a say in your business operations, so it’s best for you to find someone who is aligned with your company’s values and vision, rather than focusing on who will write the biggest check.
We’d love to get your input if you’ve been through the fundraising process. Or if you’re getting started we’d appreciate your questions. If you are getting started, grab yourself a free trial of TextExpander to make your email life easier. You’re about to reply to a lot of messages.