Why Startups Should Carefully Consider Angels vs VCs

Why Startups Should Carefully Consider Angels vs VCs

Many startups face a dilemma when seeking funding - should they take money from venture capital firms or angel investors? This decision can have major implications down the road. For early-stage startups, nothing beats generating revenue and retaining earnings to fund growth. But when external capital is needed, angel investors can often be a better source than traditional venture capital. Angels align incentives by investing their own money, offer founder-friendly terms and provide hands-on advice. Meanwhile, VCs must balance multiple portfolio companies and incentive structures are often skewed. This mismatch can result in oversized funds, excessive dilution, and lack of value-add support.

The key is to evaluate all funding options through the lens of incentive alignment and value creation, beyond just capital provision. With thoughtful strategy, startups can craft the optimal fundraising roadmap. Venture capital firms offer larger investments, but come with many strings attached. They take an equity stake and often acquire board seats, seeking substantial control over decision-making. This dilutes founders' ownership and authority. VCs expect rapid growth and outsized returns - at least 20X their investment within 5-7 years, through an IPO or acquisition. Angels offer smaller investments, usually at earlier stages. While they seek returns, angels allow founders to retain more control.

Here are some potential things to consider:

  • Incentive alignment with founders. Angels are typically investing their own money, so they are incentivized to help the startup succeed. VCs are managing other people's money in their fund, so their incentives may not fully align with founders.
  • More founder-friendly terms. Angel deals typically have simpler term sheets without onerous provisions that favor the investor over the entrepreneur. VC deals often include terms like liquidation preferences and anti-dilution protections that can hurt founders in an exit.
  • Advice and connections. Many angels are experienced entrepreneurs themselves. They can provide hands-on advice and tap into their networks to help the startup recruit talent, find customers, etc. VCs manage multiple portfolio companies so have less time for this kind of involvement.
  • One key difference is management fees. Venture capital funds charge management fees, typically 2% of assets under management, to cover operational costs. This provides a guaranteed revenue stream to VCs regardless of whether their investments succeed. Even if the fund's returns are lackluster, the general partners still earn ample fees. This reduces their incentive to pick only the very best deals. Meanwhile, angel investors do not charge management fees. Their only compensation comes from profitable exits or dividends. This better aligns angel incentives with entrepreneurs' incentives.
  • Asymmetric funds. Some funds, especially in Europe, have government money invested in their funds. This further reduces their accountability towards LPs, as government LPs are less driven by financial returns. With less pressure from their LP base, these funds have even more leeway to make investment decisions that meet their own incentives but may not align with entrepreneurs' long-term interests. The infusion of non-profit-motivated government capital creates further asymmetry in the VC model.
  • Bigger VC funds come with bigger management fees. A $500 million fund charging a 2% management fee will extract $10 million in fees before making any investments. That's $10 million. For entrepreneurs, this incentive misalignment worsens with larger VC funds. The partners still earn substantial fees even if their startups underperform. Their income relies less on success. Compare a $20 million fund with a $200 million fund - the partners of the larger fund enjoy 10x the fixed fees. Thus, they have comparatively less skin in the game for each investment to succeed. For early-stage startups, smaller VC funds often provide better incentive alignment. The investors are hungrier as their upside is more tied to carried interest. When evaluating partners, assess their motivation and whether fund size distorts the ideal win-win relationship. When considering VC funds, founders should always research the fee structures and fund LPs to get the full picture.

In later stages, VC-backed startups often hit roadblocks. If growth stalls, you might become a VC Orphan or VCs may force recapitalizations or sales to "exit" and return capital to their limited partners. But this may not align with founders' wishes. VC firms also face "mark-to-market" pressure - they value holdings on their books at the current perceived market price. Write-downs hurt VC fund performance and ability to raise future funds. So VCs may block recapitalizations or sales that would trigger write-downs, even if desirable for the startup.

Startups that raise primarily angel funding avoid these pressures. Without VC board members pushing for premature exits or IPOs, angel-backed companies can stay private longer and recapitalize or sell on their own terms. However, less VC funding also sometimes means slower growth. Startups must balance control versus access to capital and resources that supersize growth.

Potential downsides of angel investors

Angels may not have as much experience supporting startups or as many resources as VCs and their priorities may change over time as well. Can't assume interests will remain aligned. Need to evaluate how much and what kind of support you actually need. Angels may have limited capital for follow-on rounds, forcing the startup to find new investors anyway.

Overall, there are tradeoffs between angels and VCs. The importance of aligned incentives and adding value beyond capital remains key when evaluating any source of funding. The key is finding the right investors whose incentives align with yours as founders. This may be angels, seed funds, or VC firms you trust. Evaluate all options to build relationships with investors who will add value beyond just capital.

Ultimately, founders should consider long-term goals and optimal funding partners. Angels offer patience and autonomy, while VCs provide fuel for rapid expansion. But the VC train may derail later stage startups if growth stalls. For founders playing the long game, angels may be the wiser choice.

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