What are the fundamental differences in investing mentality between VCs and angels?
This question originally appeared on Quora, the knowledge sharing network where compelling questions are answered by people with unique insights.
Answers by Yuval Ariav, Edvard Boguslavskij, Paul Cohn, Alexander Jarvis,
Gordon Miller, Kamal Hassan, Andrew Ackerman, Alexander Kleydints, Howie Schwartz and Miles Fidelman.
Let’s say I gave you $1000 and told you it was your job to invest them, and that you’d be accountable to me on how well you do. Would your mindset be different vs. if that was your money?
That is at the base of the difference.
Angels invest their own money, and are accountable only to themselves, and have no formal fiduciary responsibility to anyone. They came into their wealth, and they have a right to decide what to do with it. That is why, for example, many angels will back founders that they know and like with relatively little due diligence, or sometimes not at all. It’s their money and they can do what they want with it.
VCs invest OPM — Other People’s Money — and have a fiduciary responsibility, which means they are legally obligated to act solely in the best interest of their limited partners, i.e. the people whose money it is. This means that VCs usually follow a stricter investment process that the typical angel, and must prioritize their investors’ interests above their own.
Angels make money when their investments grow in value. VCs, on the other hand, make some money from their investments growing in value (at the aggregate portfolio level), but VCs also make money from management fees on the funds they invest.
This means, among other things, that VCs typically have a limited period during which they must make their investments, whereas angels don’t have these kinds of limits.
Some points to consider:
Scale of thought: I’ve met many angel investors, they invest early, with a lot of uncertainty, and usually write smaller check size compared to VCs. What essentially is different is the magnitude of thought put in once considering the investment opportunity. VCs tend to deep dive and perform an extensive intellectual diligence on the company, market, team, performance, competition, etc. Some angel investors do absolutely the same, but they do not put in so much time and human resource to do it.
Check size: most angel investors write way smaller check sizes compared to VCs. This could range anywhere between $10k-250k. Super angels might invest up to $2M into the startup. Micro VCs usually write small checks as well, compared to big VCs, which could invest between $1M–$5M at Series A round and write large checks for follow-on investments.
Source of money: angel investors invest their personal money compared to VCs that invest capital raised from LPs (limited partners). This could be pension funds, insurance companies, university endowments, HNWI, etc. The accountability follows along. VCs are accountable to LPs to make sure they return a solid multiple on the fund. Angel investors are accountable to themselves, essentially they manage their own portfolio and capital allocation.
Investment risk: most angel investors invest early in the startup lifecycle and their money is used to develop a product, initiate marketing strategy, iterate, etc. VCs invest capital for growth. They need to make sure that their capital will fuel your startup with a warchest that would be resilient enough to take you from point A to point B exhibiting solid growth. At later-stage VC investing a lot of attention is put to eliminating financial risk and having solid, healthy margins.
At a high level the difference comes down to time and resources.
VCs are full-time investors and have and expend significant resources in their deal-generating and screening efforts and in due diligence.
VC firms have multiple partners and sometimes junior staff who all have full-time jobs focused solely on generating investment opportunities, screening opportunities, conducting due diligence, structuring investments and working with portfolio investments post investment.
Angels are part-time investors and don’t have time or resources to do the heavy amount of screening and due diligence that a typical VC does. Angels sometimes invest through organized groups that can somewhat institutionalize the investing process, but it still typically isn’t as organized and intense as process.
And…what Yuval Ariav said!
Let’s just break this down into points for each side.
Angels
Core drive: Fun, however defined (being pragmatic)
Motivations:
– Country club show-off: Talking about deals they did and “are in” is fun.
– “Altruism”: The notion of giving back to the community. It was hard for them so they want to help others, etc.
– Keep in touch: Investing in companies helps them keep on the pulse of the times.
– Vicarious living: They get to have fun and help build startups without the boring work.
– Financial: The idea they might get their money back (statistically you need to invest in 20 startups)
– Boredom management: It’s something to do when you don’t want to start a new company, or join a big one.
– Coolness: Being an angel is cool in certain circles.
– Prestige: Again, some people want to say they are in a deal.
– Find a new idea: Call yourself an angel and you get decks. This helps you figure out the next opportunity.
Investment size:
– As little as $10k up to maybe millions. Most are on the small end. Therefore happy to hand out checks much faster.
Stage:
– Most have small check books so go in at… “angel stage.” They take on the most risk as they can’t afford later stages. They are first money in.
Need for return:
– You don’t “need to make money.” It’s nice if you do so you can do more (it’s like a drug).
Entry valuation:
– If you know math, this really matters. A $1million difference in valuation makes BIG difference in ROI.
DD
– I’ve heard Dave McClure try invest in someone not long after shaking hands… He wasn’t allowed and technically not an angel, but you get the point. Angels don’t need to do any DD if they feel like it (and trust someone).
Terms:
– Don’t need many terms and may not get them either. Even if they get terms they may get screwed out of them. It’s not really in their interest to have too many either. Do they necessarily want a board seat and info rights to action on? If they have cash, pro-rata is nice.
Need for exit:
– Only needed so they can recycle cash. Their wives gave them a budget to spend and are over it already. They need exits to blow more cash on new investments.
Exits
– Exits give them cash to blow more. They don’t have a timeline necessarily. It’s more like evergreen capital
Risk tolerance:
– They can only afford to get in early, so they justify a lot or risk in their heads 😉
VCs
Core drive:
– Raise a new fund to make more management fees and hopefully carry.
Motivations (not dealing with corporate VC):
– Make money: You professionally invest. It takes a while to get “caught out” but you need to make money to raise a new and larger fund (to get more MF).
– Stay relevant: If you don’t invest, people may assume after a while you are a zombie fund. You need to do deals to get more deals.
– Co-investments: Do deals to be associated with cooler funds which builds your brand.
– Logo shopping: A lot of y-com deals get done as new investors seek to create credibility.
– Coolness: Want to say you were in x deal to raise a new fund by showing you can get into cool deals.
Investment size:
– More complicated. Most funds allocate up to 50 percent for first checks. The rest is for follow ons. How funds plan this varies. The basic premise is chuck some cash about, then put more on what works (the 500s model, but more concentrated). There is no such thing as a VC. It’s a series of partners. Each partner has an allocation. They can maybe do 3 deals a year. So their dry powder is sort of pre-allocated. Therefore investment size is algebra on the fund size. It’s bigger than most angels anyway as a heuristic.
Stage:
– Depends on their investment thesis and fund size. Micro-VCs do seed and above. Growth funds do “growth stage” since they need to write bigger tickets.
Need for return:
– This is effectively all that matters if you want a new fund.
Entry valuation:
– Not as important, especially if you can do pro-rata or super-pro-rata.
DD
– This is meant to be something that was in your pitch deck as to why you can pick deals. You “should” check a lot, reference checks etc. When syndicates are done weird things happen though.
Terms:
– Terms matter. They need to do pro-rata to make their model work. They need liquidation preferences, anti-dilution etc to protect downside. They need a board seat to give the perception they are doing something and are in control.
Need for exits
– Critical. ROI calcs are based on time to cash. Distributions help for the next fund raise to show capital returned. The larger the fund, the larger an exit needs to be. If you are a16z with 2bn under mgmt., then a $50m exit doesn’t move the needle like it does for an angel. VCs will do all sorts to encourage founders to swing for the home run. They also have a “fund life” of 7-10 years (with maybe 1-2 year extensions) so they have to return cash.
Risk tolerance:
– More like PE — they don’t want to lose money if they can. Obviously earlier stage funds need to swing to get returns so are used to making losses. There are real reasons founders complain VCs want everything (traction, team, clarity etc) before investing.
Here is the fundamental difference between angel investors and VCs:
Angel investor gives you $100,000 for 20 percent equity:
He gives you the money. Provides good advice. Makes a few calls. Reaches out to his network. Helps you get things done. You land a huge contract for $10M a year. You are cash flow positive and grow to $20M a year with 20 percent margins. After 10 years in business, you sell for 7x EBITA on $4M a year profit for $28M. The angel investor makes $8.4M along the way over 10 years and in the end cashes out with you and makes another $5.6M. The investor makes $14M over 10 years or more than $1M a year on his $100,000 and time and effort. You as the founder have made over $54M over 10 years. Your wife and kids love you and life is good. This is the textbook definition of a home run. It almost never happens, maybe 1 in 100 deals. The others deals has the angel losing his $100,000 and getting nothing for it 69 percent of the time. The other 30 percent of the time, you take another round of funding and the angel gets “taken out” for 3x to 5x their $100,000 and they move on.
Venture capital firm gives you $1M in a Series A:
Taking out your angel from the alternate ending above for $300,000 and giving you the $700,000 you need to survive. You finally manage to get traction. You close that $10M deal and then they double down and you get to $20M. The VCs own 40 percent of the company by now. You miss one more milestone and now they own 51 percent. You are voted out. They issue 100M more shares and you now own 8 percent of your own company. They go on to grow the company to $100M a year and sell out to a competitor for $500M. By then you own 4 percent. You made $20M but your investors and shareholders made $480M. Your are divorced. Your kids don’t speak to you and you have $20M in the bank, a $10M bill from the IRS, a drinking problem and 40 more years to go before the death panel under ObamaCare pulls the plug on you. Aren’t you glad you took VC funding?
Yuval has an excellent answer on the fundamental difference already.
I would add that the term “angels” is very broad. It can encompass everything from members of the Sand Hill Angels group to your Uncle Patel and your granny.
Just your granny and your Uncle Patel may have two very different investing mentalities, so it’s hard to say that angels have “a” investing mentality.
To the answers already given, I will have one personal anecdote from my time at Dreamit to add.
As some of you may know, a typical arrangement between an accelerator and the startups who participate in their program involves a small cash investment, for instance $50,000, in exchange for a small equity stake in the startup, for instance 8 percent. When Dreamit decided to work with later-stage startups, that offer was no longer attractive. A startup that had raised $2M had no need of an additional $50,000 and had no desire to part with that much equity.
But we struggled with dropping those terms. As an angel, if you invested $50,000 and got back $5M, that’s an awesome 100x return. Now that we are a VC, only I can watch her different. Most of the money we invest now comes from the investors in our fund. We have to earn back all of that money before we get a share in the upside. So for even a relatively small, say $25M fund, a $5M return is not as exciting has it seems to us as angels. We need 5 of them – 5 100x investments! – to just return the fund. As a VC fund, what really drives returns is the ability to invest much much more money in later rounds that the startup raises. This meant that we could give up the $50,000 investment in the pre-seed stage without impacting the overall fund returns that much, which in turn enabled us to modify the financial terms of our accelerator program to make it attractive to the later-stage startups that we now work with.
Angels generally don’t have the “dry powder” to invest in later rounds so they really need to get in early where the extremely high multiples make up for this fact.
Obviously there are big differences between VCs and business angels, when you simply look at check-size, due diligence, contracts, professionalism…
The fundamental difference however is that angels often over-value their knowledge and expertise in building companies and have a very controlling attitude towards companies they fund.
Investing is very personal for them and they tend to treat founders as kids.
This often coincides with very low valuations and horrible investment terms, forcing the founders to have boards very early on in the lifecycle of the company, when it doesn’t even make sense. Not for a tech startup anyway.
Angels often take irrational decisions driven by ego and short-term gains, because they have no one to keep them in check. I’ve seem companies go under because one angel wanted irrational things when a VC wanted to get in.
And although I’ve also seen VCs, especially in CEE, who also use such tactics, angels tend to be the worst. That’s why the traditional business angels are becoming less and less relevant.
You may want to check Alexander Kleydints’ answer to “What are the best-kept secrets about venture capital?”
From all sides – being an entrepreneur, angel investor, and a LP in multiple VC funds…
Angels just bet their own money as not to worry about what other people think about their deals.
VCs invest their reputation and the capital of their limited partners, and have to justify and answer for their portfolio.
Leaving aside that the VC mentality has changed a lot since the early days when folks like American Research & Development pioneered VC and knew what they were doing….
And, leaving aside that there’s a wide range of people who invest as angels…
VCs tend to invest later, for larger dollars.
Angels, by definition, invest early. The best of them are folks who have a lot of entrepreneurial experience (i.e., they’ve built a business or two, and are investing money they made from doing so). And, in the best case, you only want to take money from angels who are going to get directly involved, and bring a lot of value to the table beyond their cash.
This question, “What are the fundamental differences in investing mentality between VCs and angels?” originally appeared on Quora, the knowledge sharing network where compelling questions are answered by people with unique insights. You can follow Quora on Twitter, Facebook, and Google+.
