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Angel or Venture Capital Funds? Which is Better?

written by: N Nayab•edited by: Jean Scheid•updated: 6/27/2011

When comparing angel investors vs. venture capitalists, both invest funds in businesses with substantial element of risk and uncertainty, expecting high returns. Although similar in purpose, differences exist in structure and the way they involve the entrepreneur.

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    Difference

    Angel Investors vs. Venture Capitalists Venture capitalists are investment firms who try to leverage returns for their depositors by identifying and investing in businesses having potential to reap high returns. The origins of venture capitalism traces to post World War II days, when Georges Doriot, former dean of Harvard Business School, Ralph Flanders and Karl Compton, former president of MIT encouraged private sector investments in businesses run by soldiers returning from World War II.

    Angel investors are high net worth individuals who invest a portion of their assets in high-risk, high-return ventures. The term “angel" originated in the early 1900s to refer to investors who made risky investments in theatrical productions.

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    Involvement

    When entrepreneurs approach venture capitalists for funding, they analyze the business plan and conduct independent research to determine the viability and potential of the plan. Having contributed, they offer their expertise gained from having made investments and involving in several other ventures, to the entrepreneur to determine the best marketing strategy, set up distribution networks, and other crucial aspects of running the business. The combined efforts of the venture capitalists and the entrepreneur, with the terms for what constitute optimal performance by both parties written in a contract, very often creates a synergy that increases the chance of success significantly.

    Angel investors may be either a single rich individual or a group of wealthy individuals investing in a firm. They depend on personal contacts to screen deals, conduct due diligence, negotiate terms, secure additional rounds of funding, and execute an exit strategy.They usually have some connection with the industry to be convinced of the potential and prospects of the business, but rely more on their gut feelings and individual perceptions when making decisions compared to the purely objective analysis on which venture capitalists base their investment decisions.

    Nothing prevents angels from becoming involved in businesses they finance just as venture capitalists do, but in practice they usually remain passive investors, not adding much value to the firm, and leaving the entrepreneur to utilize the funds in the manner they deem fit. Their very nature, being independent investors rather than a professional investment company with extensive industry experience, places limitations on their ability to add value, even if they wish to involve themselves in company operations.

    The stricter due-diligence made by venture capitalists make such sources of funds harder to come by compared to angel investor funds. Industry trends reveal that only about one firm secures venture capital funding for every ten firms securing angel funding. Many start-ups may not have a proven business model to attract venture capital funds, and as such, may have to start by enticing an angel investor, and as the business kick-starts and the vague idea translates to genuine potential, the entrepreneur may explore venture capital options. An entrepreneur may source funds from both venture capitalists and angel investors simultaneously.

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    Structure

    Both venture capital and angel investor financing may take the structure of convertible debt or preferred equity, but in practice, venture capitalists invariably finance through convertible debt, and angel investors prefer equity financing. Both seek a high rate of return for their investment over a specified time, after which they exit the business leaving the entrepreneur free to run the business. Some investors may either seek a permanent relationship with the firm, but most sell equity back to the entrepreneur or anyone else after a specified time.

    Venture capitalists usually have rigid, fixed, and inflexible terms that entrepreneurs need to agree to before availing funds. Angel investors usually do not have stringent terms specified by venture capitalists, as they invest a much smaller amount than venture capitalists do, and do not have the same negotiating power or the ability to become involve in company operations. Angels preferably seek a good deal with poor terms rather than a poor deal with good terms.

    The venture capital contract usually specifies a fixed income component and a warrant or “upside" component every month. The fixed income portion provides downside protection to the investor and the warrant component motivates the venture capitalists to put forth optimal efforts to add value to the firm.

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    Performance

    A comparison of angel investors vs. venture capitalists shows both have withstood the test of time as successful and workable models, and today represent credible alternatives to bank loans or the committing of the entrepreneur’s personal assets. The expected and actual rate of return remains more or less similar, and depends on factors such as industry conditions, size and extent of funds invested, and more.

    Analyzing past data, venture capitals usually finance firms such as knowledge and technology firms, where both the potential to add value, and risk remain high. In contrast, angel investors tend to finance firms where risks remain low, even if the potential to add value also remains low. Taking such preference to its natural conclusion, venture capital powered firms have provided greater returns to stakeholders than angel powered firms.

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    References

    1. Leshchinskii,Dima. “Indulgent Angels or Stingy Venture Capitalists? The Entrepreneurs’ Choice." http://www.hec.edu/var/fre/storage/original/application/52e2d5d6d1944697479fb6a6162679c5.pdf. Retrieved June 23, 2011.
    2. MIT Entrepreneurship Center. “Venture Support Systems Project: Angel Investors." http://ocw.mit.edu/courses/sloan-school-of-management/15-975-special-seminar-in-management-the-nuts-and-bolts-of-business-plans-january-iap-2005/readings/angelreport.pdf. Retrieved June 23, 2011.
    3. Chemmanur, Thomas J. & Chen, Zhaohui. “Venture Capitalists versus Angels: The Dynamics of Private Firm Financing Contracts."https://www2.bc.edu/~chemmanu/paper/angel5302003.pdf. Retrieved June 23, 2011.

    Image Credit: freedigitalphotos.net/renjith krishnan