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Angels vs VCs

Angel investors and Venture Capitalists square off

There’s a growing tension in the early stage investing game. Angel investors and Venture Capitalists (VCs) are becoming increasingly antagonistic towards one another.

By Michael Volker [email protected]

Earlier this week, I attended the National Angel Organization’s (NAO) – see http://www.angelinvestor.org – annual summit conference in Calgary. This was attended by active angel investors across the country as well as angels from Silicon Valley, notably from the well-known Band of Angels. This VC – Angel tension was quite apparent.

In one presentation, a well-known Vancouver VC made a presentation comparing angels to VCs. After her talk, an angel in the audience said, "You sound just like a Venture Capitalist!’. She responded by saying, "That’s because I am a Venture Capitalist"!

This is a revealing comment. It tells me that perhaps angel investors don’t have an appreciation of how VCs work and what their mandate is. That’s why I thought I’d muse on this with a view to elucidating the subject for entrepreneurs seeking investors.

Venture Capital is an industry that is run by professional managers – MBA types who understand investing and whose mandate it is to maximize the return on their investors’ capital. ROI is their primary motivation.

Angels are successful entrepreneurs who’ve made a few bucks in their businesses and are now willing to support nascent ventures by providing them with capital and often, also with mentorship and guidance.

Some guys, like Mike Satterfield of Yaletown Ventures, started off as entrepreneurs then became angels and are now VCs. Others like Mike Brown started off as VCs (creating Ventures West) and then became angels. Now Mike hates VCs. What’s going on?

Unlike most VCs, Angels know what it is like to be an entrepreneur. They understand what it’s like to take huge financial risks, mortgage one’s home, spend countless hours working for peanuts in anticipation of a big payout. They understand the tradeoff between personal income and building a tangible asset of value.

Because Angels identify with their proteges, and because Angel investing is more of a hobby than a business, they tend to be far less demanding with respect to their ownership stake and other rights pertaining to their investee company.

The most common mistake angels make relates to the "valuations" question. They rarely drive a hard bargain. Because they expect many-fold returns – in the 10X to 100X range – why sweat about getting 10% vs 5%? They also don’t demand certain shareholder rights or require founders’ vesting provisions and the like. In short, their too easy.

You’ll often hear VCs – a good example is local VC firm – BDC (funded by us, the taxpayers), claim that they do indeed invest in early stage companies. This is not the same as investing in a start up. What’s the difference? In a startup there’s little more than a body or two with a great idea and a vision. In an early stage company, there may not be any revenue, but there’s a team, solid intellectual property and a detailed business plan. VCs will invest in such a company. They will not invest in a startup – that’s angel territory.

So, what’s happening is that angels and founders work together to get companies to the point where they require substantially more capital. That’s when they start talking to VCs. Of course, VCs being more focused on ROI generally drive a much harder bargain with respect to valuations. Indeed, their valuations are often lower than those previously agreed to by angels.

When angels invest $500K (a typical number) in a startup, they can expect to get 10%-40% of the company. But when VCs enter the picture, they usually invest a minimum of $1 million and more likely $3 or $4 million (much higher south of the border). Hence, it’s very unlikely that they’ll give a firm more than a $5 million valuation – regardless of what the company has to offer. In fact, one VC speaker at the NAO conference flatly stated that "all" of their "Series A" (aka first round VC investment) investments are done at $5 million!

This means that for the angels who went along with higher valuations will feel squeezed ("crammed-down") and will end up being substantially diluted and will even suffer a paper loss on their investment, blaming VC greed for their misfortune.

Then, VCs will go on to extract very onerous terms (the notorious "terms sheet’) which give them – to the exclusion of the early angel investors – all sorts of rights with respect to future financings in order to protect their interests. Often, when an exit does occur, they can exercise these rights and end up with taking 80% of the value that’s been created. But, hey, that’s their job.

That’s why VC firms are flush with capital – even though many have suffered from poor performance – to the extent that the proven ones are turning investors away. Vancouver’s Ventures West recently raised another $250 million to invest. This is large by Canadian standards but considered a small fund in the USA. Where will they find enough deals in which to place that capital?

And, that’s another problem – deal flow. VCs complain about the lack of quality deals in which they can invest. Well, no wonder – if no one other than angels is seeding the startups, where will the deals come from? That’s why Angels are so important in this continuum!

There’s a view that angel investing, like VC investing, might become an "industry" in its own right. What concerns me greatly, though, is that as angel returns go, the results are very disappointing. In one presentation, it was noted that of 180 angels in the Band of Angels, more than 120 have yet to enjoy any return on their angel investments! It turns out that, on average, angels invest in three of four deals. Therein lies the problem! In order to get the big winners, my own experience (and that of research firm, Thompson Venture Economics) has shown that you have to have a portfolio in excess of 15 deals!

The solution? I believe that (and this is emerging as a trend) angels are starting to work together in groups on specific deals. Angel capital pools or angel funds are another way to go. Such funds can better play the numbers game while still allowing their investors to co-invest alongside their deals. That’s the model that I’m using in WUTIF Capital (VCC) Inc (see http://www.wutif.ca), a small angel fund based in Vancouver that will invest in dozens of tech startups over the next few years. Another startup fund, BC Advantage Funds (VCC) Inc. will also invest in pre-VC companies. BC Advantage’s capital comes from public investors – similar to those that invest in labor sponsored funds – but who wish to get in "earlier".

One item of business for these startup funds is to develop a standard "terms sheet" for startups to avoid some of the affore-mentioned issues when larger investments are required. Speaking of terms sheets, there are some really goofy ones going around. On one day last week, I saw three terms sheets that all used a convertible debenture or convertible preferred share form of investment. These are becoming, regrettably, more common. This goes back to the valuations issue. Because entrepreneurs and angels shy away from dealing with the issue, they defer to the Series A round valuations. Here’s how it works: Angels put $500K into an instruments which converts into shares when a first VC-round investment is made at a pre-determined discount, say 20% or so. The rationale is that this gives angels some benefit from being first in.

I don’t like it. It can cause even greater problems and anxieties down the road. It also runs contrary to giving angels the 10X to 100X returns that they deserve by capping that figure. It makes more sense to me to agree to a "reasonable" valuation at the outset. When I first started doing angel investments in the 80’s, I used a very simple approach which worked very well. I was negotiating with a couple of Waterloo companies – now very successful (one was RIM). For the capital that I offered, one company suggested a 10% stake. I agreed that 10% was reasonable of they could "guarantee" the company’s business plan. After all, an angel investor is trading a present cash value for a future promise. I suggested that the company give up 15% but that if certain business plan milestones where achieved, I would be amenable to returning 5% to treasury. This worked. In 18 months the company was doing well and we both ended up with a "fair deal". Company founders were rewarded by their performance. Instead of them worrying about dilution, I worried about "accretion" – a far more positive approach!

Finally, for entrepreneurs seeking an angel, a must-read book is Guy Kawasaki’s, the Art of the Start – a book which neatly and refreshingly summarizes what most angels already know and what entrepreneurs ought to know when pitching their deals to angels and other investors. Guy spoke at the NAO conference and struck a cord with angels. For more info on the book and Guy, check http://www.garage.com. Entrepreneurs take note!

Footnote – September’s Vancouver Enterprise Forum event focused on early stage investing. Two local entrepreneurs – Richard MacKellar and Glenn Bindley shared their experiences in dealing with angel investors and VCs. Their presentations are available on the VEF website at http://www.vef.org.

For the full article which contains many insights: http://www.bctechnology.com/statics/mvolker-oct0104.html

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