Founders: Why VC Funds are not Angels (and why this is important!)

If you are a founder, it is important that you understand the difference between the angel and Venture Capital (VC) models as this might impact the type of funding that you will consider taking on.

As an angel investor for 20 years as well as an advisor to VC firm Playfair Capital, I have struggled with the animosity that sometimes exists between angels and VCs, particularly when they have invested in the same company and are supposed to be working towards a common goal.

Some angels view VCs as cold, heartless, excel monkeys who will ‘do-over’ the angels at the first opportunity. Some VCs perceive angels as well-intentioned but unprofessional amateurs who may do as much damage as good to a fledgling business and should be removed from the share register of a VC-backed business as quickly as possible.

So, why the animosity? The short answer comes down to differences in time, focus and return expectations from both groups. Here I will try to cover why timing is a big factor in the difference, illustrating with examples from my own angel portfolio. (I will discuss differences in focus and return expectations in a future post.)

VCs are capital allocators. Angel are capital diversifiers.

We all know the deal: the General Partner (GP), or manager, of a VC fund is given a pot of money by their Limited Partners (LPs). Over a fund period, typically ten-years, the GP has to generate enormous deal-flow and get a place on the share register of the fastest-growing companies. GPs are allocating capital on behalf of third parties which is a difficult and full-time job.

Angels are generally capital diversifiers. They might already have the house(s), car(s), pension and share portfolio but they also have a surplus of capital that they would like to invest in private companies. Angels invest their own money for fun and enjoyment as much as for the return and are often only part-time investors.

However, the typical 10 years of a VC fund period is deceptive as, in practice, a fund is only allocating capital (often up to half its total fund size) in the first four or five years of its life. In years five to ten, the fund will often not make new investments. Instead, it will be focusing on follow-on investments into current portfolio companies, looking for exits and beginning to fundraise for their next fund.

This last point around a GP’s own fundraising is critical for both angels and founders to remember as a GP wants to return several times the LPs’ money through exits from portfolio companies. After all, this is what they have been given the money to do. At the very least, a GP needs to show that they are investing in companies that will eventually exit profitably as this encourages existing or new LPs to supply funding for the GP’s next fund. If a GP doesn’t fundraise successfully, unfortunately they will be looking for a new job at the end of their current fund….

If a profitable exit for an investment can’t be found within a fund’s lifetime then the next best thing for a GP is for a portfolio company to raise more funding at a higher valuation. This has a two-fold effect:

• It allows VCs to allocate more of their LPs’ committed capital into those better performing companies in the portfolio and therefore increase its likely overall return. LPs also do not like GPs who are not investing regularly.
• It ‘locks-in’ a better implicit internal rate of return (IRR) on the original portfolio investment, which is a function of both time and value. A funding round, preferably validated with external/new capital, can allow the GP to recognise the increase in value of the portfolio business in the performance statistics presented to LPs. Irrespective of the underlying performance of the business, VCs can find it difficult to increase value in a business unless it’s been validated by a funding round

So, what does this time pressure mean in practice for founders with VC vs angel funding?

VCs want to see fast growth and quick exits. They will therefore often encourage promising companies to spend invested funds quickly as they will want these companies to raise equity financing again — from the VC — at higher valuations.

Conversely, angels don’t have the same time and reporting pressure as VCs and often do not have the capital to invest in many rounds of even a strongly performing business. This can mean they may want invested cash to be spent frugally, so the company does not have to keep on going through multiple funding rounds before exit, even if the exit is not at the same valuation level required by VC investors (I will cover this in a future post). An ideal angel investment is often one that shows strong growth but doesn’t need multiple rounds of equity financing before exit.

Founders have to balance these, sometimes competing, interests out.

QED…

Looking back at my own portfolio, I have seen a few real-life examples of these differences.

• Back in the early 2000s, I made a £150k angel investment into Bybox, a software logistics company. At the time, it had a turnover of approximately £100k/annum. When we exited, to a PE fund at an equity value of £105M, turnover was £79M. Crucially however, after my initial investment Bybox did not raise any further equity funding, so I could not have shown an IRR if I had been looking at it from a VC reporting basis. It also took us 15 years from initial investment to sale — well over the typical VC fund length period. By any metric, I made a very good return on exit but, given the reasons listed above, our journey didn’t fit with VC funding. We might have had to take a different path if we had used the VC funding model.
• Another company had banked £2.5M after a VC raise, was ahead of its cash forecast and was spending frugally, with 18 months runway and with a venture debt facility as well. Despite this, the VC was adamant that they should raise more equity financing at a higher valuation and gave the founder options to make up for the equity dilution. The company didn’t need the money but it suited the VC to lock in a higher valuation for its internal reporting purposes.
• Finally, I had a company which had raised VC money but ran into trouble at about the same time that one of the VCs involved was raising its next fund. The VC was extremely keen to avoid a failure during this crucial fundraising period. Rather than invest more into the troubled company (which would have been wrong in my view) or let it fail, the VC managed to arrange an all-equity sale to a private company, but with the acquiring company’s equity valued so that the sale did not need to be booked as a major loss by the VC at the time it was fundraising.

Advice to founders:

1. Ask a prospective VC which year of the fund they are investing from. Years 1–3 is better than years 4 and 5 as you’ll have longer to show progress before the GP needs to start raising money from LPs again and being under pressure to show return from exiting investments.

2. Appreciate that once you take VC funding, you’re locked into a race to show fast growth. This is not a bad thing but it doesn’t suit every business and/or founder.

3. Understand that subsequent VC funding rounds may not just be driven by the internal requirements of the portfolio business.

4. Understand that angels may be reluctant to encourage multiple rounds of funding as their shareholding/likely return will be diluted if they cannot commit more capital.

VCs have a much more difficult job than angels because of their reliance on 3rd party funds, but their pool of capital makes them a better source of capital than angel investors for fast-growth businesses that need plenty of funding and have the potential for exit within relatively short time periods.

At Playfair, we have the same reporting requirements as a traditional VC but, with only one LP who’s an angel himself, we have the flexibility to act like an angel if that is what is required; hopefully we can cover the best of both models!