Angels and VC’s are different breeds of cat. Let’s look at some of the macro criteria Angels and VC’s evaluate when deciding whether to make an investment. Understanding these investors’ different approaches will help you better determine which type of investment is right for your startup.
Your company’s business sector will play a major role in determining your funding. Many venture capital firms specialize in certain sectors, such as software, communications, biotechnology or health care. Within these sectors, VC firms usually look for technology companies, largely because technology companies have the ability to grow at a faster rate (i.e., they scale better) and to achieve a good exit (such as an IPO).
If your company is in the services sector or in some other less-scalable market segment such as retail or consumer goods, VCs may not be as interested. Retail, services and similar businesses (often called “lifestyle” businesses because running the business is a lifestyle outcome, rather than an exit opportunity) may be good investments, but they tend not to have the ability to grow or scale at the rate VC firms are looking to achieve. Angel investors can have longer time horizons and may not be looking for a big exit. For this reason, non-tech, slow- or no-scale businesses are solidly in the angel investor column rather than the VC column.
Notwithstanding the particular business sector your company may be in, the earlier your company’s stage of the development, the more you will look to angel investors. VCs often require that the company has achieved some “traction” before they will invest. Traction is usually thought of as having revenues (or, at least, beta customers) or having built a functioning prototype. Companies that have not achieved any of these important early-stage milestones usually have to find angel, rather than VC, investment.
The size of your capital “ask” is also important. For capital raises of less than one or two million, angel investors are usually the best bet. Many VCs will not participate in investments of less than one million, and many set the bar at two million or more.
One factor that many founders fail to take into account is that VC (and sometimes angel) investments come with fairly significant transaction costs, most (if not all) of which will be paid by your company. Transaction costs (also called “soft” costs) usually include lawyers’ and accountants’ fees, as well as other professional services, such as appraisals, surveys and environmental reports if real estate is involved. The company receiving the investment usually pays the fees of the VC’s lawyers, accountants and other professionals, as well as their own.
Professional fees can range in the hundreds of thousands of dollars, depending upon the stage of the company, size of the transaction, and due diligence requirements. VCs, because they are investing other people’s money, will always conduct thorough due diligence. Further, VCs tend to use lawyers experienced in start-up investments, and these lawyers are not cheap. The VC firm’s lawyers will usually prepare all of the legal documents, and their lawyers will drive the transaction. For this reason, it is very hard for the startup to control the legal costs incurred.
Some startups decide to control costs by relying on the VC’s lawyers instead of hiring their own. This is a mistake. VC financing documents strongly favor VC interests. Startups may leave much on the table by foregoing their own counsel and may end up with undesirable outcomes (which is a euphemism for losing majority control, being forced into forfeitures of equity or mandatory dilution, losing management control and other nasty surprises).
The VC side will also specify what financial documents are needed. If audited financial statements need to be produced for a company that up until then had no reason to prepare audited financial documents, this may be another significant expense.
The smaller the amount of funding, the larger the portion that is eaten up in professional fees. Be aware, too, that VC financing can take a considerable amount of time from initial talks to closing. If your company needs money quickly, a VC transaction may not be the best bet.
From a lawyer’s perspective, it takes a similar amount of time to do a small transaction as it does to do a large one, other than with respect to the due diligence process, which will be more involved the longer the company has been in operation. From a fee-efficiency standpoint, it may be better to do one or two larger transactions rather than a series of small ones. There are a number of ways transactions costs can be managed, such as having a single financing round with two or more tranches of investment that occur based on the achievement of milestones instead of doing two separate financing transactions.
Before going into a financing, it is worthwhile to consider and attempt to mitigate the impact of transaction fees on the overall amount of funding available.
Angel investors may insist on less due diligence than VCs for a similar amount of funding. Angels are often investing their own money, and they may not have the same fiduciary duties to others that VCs have. Many angels are also willing to cover their own legal and other professional costs. Depending upon the type of transaction, the angel may elect to forego separate legal advice it the investment is in a form with which the angel is familiar, such as a SAFE (Simple Agreement for Future Equity). This can result in big savings on transaction fees, resulting in a greater proportion of the investment actually being available for your company to use.
Most angel investors prefer to invest in companies close to home. Proximity allows the angel investor to interact more closely with the company founders, as well as to be better aligned with local economic goals. VCs also prefer to invest locally, although they tend to have a broader geographical range than angel investors. There are some VCs that will invest in companies in different regions of the country, but these investments tend to concentrate in particular industries such as gaming, an industry that exists only in states whose laws allow it. Generally, VCs invest within a couple of hundred miles (or less) of their offices. If your company is located in a market that does not boast a local VC firm in your company’s business area, angel investment may be your only option.
Many successful companies raise more than one round of private funding. It is very common to see startups that, following the exhaustion of founder funds and funds raised from friends and facility, first raise one or two rounds of angel investment followed by later rounds of VC funding. The angel funding gets the company through the initial development stage where a prototype is created, initial customers are obtained and the company begins to generate revenue. The company then seeks one or more VC funding rounds as the company gains traction and begins to scale its operations or product. Early VC rounds may be in the $2M – $3M range, followed by later rounds of $5M to $10M or more.
Private funding deals often come with critical terms with which the startup will need to wrestle, such as board seats, relative equity percentages, business matter vetoes, anti-dilution clauses and default triggers. These terms are not unique to one type of transaction over the other, and founders need to understand the terms of any financing documents they sign. Angel transaction terms can be less onerous to the company, but this is not always true. Realistically, funding transactions are like anything else – you frequently must give something to get something. If the company will not survive or grow without outside funding (which is the case will the vast majority of startups), it is reasonable to trade part of the company for future business gain. Investors can bring with them much needed business and subject-matter expertise and industry connections. In this regard, the value of the investment may be much greater than the actual dollars involved.
The above are critical criteria to consider when seeking investment for your startup. We hope this discussion helps your company focus in on appropriate sources of investment without unnecessarily wasting time. Angel investment may not always be as “buzzy” as VC investment, but it’s a critical source of early-stage funding that should not be overlooked. For new founders, angel funding may also provide a welcome and relatively less adversarial early education about funding transactions before the company gets involved with professional money managers having the advantage of experience, among other things.
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.