Your ecommerce business is one year old and sales are growing. You need money to expand, but you can’t afford the interest expense of a bank loan. So you decide to find an outside investor. Should it be an angel investor or a venture capital investor?
While both types of investors provide funding to early stage companies, the two types of investors operate in different ways and serve different niches in the startup marketplace. Here is how these forms of funding work.
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What is venture capital investment?
Venture capitalists invest in promising young businesses, typically in exchange for an ownership stake. Venture capital investments in individual companies typically range from $1 million to about $20 million, although they sometimes invest less or significantly more.
Most venture capitalists work in firms that partner with institutional investors such as pension funds, college endowments, and insurance companies. Money from the partnership members is pooled into a venture fund to invest in a broad portfolio of startups. Among the biggest US venture capital firms are Sequoia Capital, with about $85 billion invested, and Andreessen Horowitz, with $35 billion.
Securing venture capital investment is no easy feat. One study of almost 900 venture capitalists found that, on average, of about 101 proposals a VC fund considers, only one of them gets funding.
Jonathan Weins, co-founder of Dah Makan, says, “[You] need much more time to be able to raise for the VC because ... most of these guys are managing other people’s money, so they have a much more structured approach there. They need to do due diligence. They need to get approval from their LPs, from their limited partners. So it takes much longer.”
Venture capitalists are very selective because it’s a risky business: an estimated one-third of all VC investments cost the backers all their money, and as many as 95% don’t produce the projected pay off. Funds count on gains from the few big winners—such as Amazon or Google—to compensate for the others, which perform poorly or end in failure and cost the venture investors much or even all of their money.
Once a venture firm commits money and takes a stake in a business, the managing partner often advises the founder in running the business. If the business has a board of directors, the venture firm typically gets a board seat.
What is an angel investor?
An angel investor is typically a wealthy individual, often with a record of business success, who invests money in very early stage businesses in exchange for an ownership stake—typically before a venture capital firm would consider investing.
Angel investments tend to run from a few thousand dollars to a few million dollars. Because angel investors often invest alone or in small groups, they have less money to invest than venture capital firms. As such, a new ecommerce business might have an easier time finding a willing angel investor than a venture fund.
Well-known angel investors include Peter Thiel, a co-founder of PayPal and an early Facebook investor, and actor Ashton Kutcher, who invested early in AirBnb, Foursquare, and Uber.
Similar to venture capitalists, angels know most of the companies they invest in will underperform or fail. They hope to recoup their investments with a few big winners.
How are venture capitalists and angel investors similar?
Venture capital and angel investing share several key features:
- Private equity. Both are forms of private equity financing as opposed to raising funds in public markets. Both types of investors take an ownership stake in a startup business in return for their capital.
- Early stage companies. Both focus on companies in the early stage of development, with high potential for growth thanks to innovative products and services.
- Failure rate. Both understand the risk-reward trade-off, and that most of the businesses they invest in will fail or underperform, though a few may become spectacular successes, yielding huge gains for the investors.
- Long investment timeline. Angels and venture capitalists usually plan to cash out and sell their investments in three to 10 years. This is called an exit strategy and is the time when the investor hopes to recoup their money.
- Offering expertise. Both angels and venture capitalists can offer expert advice to startups. Angels often have background and experience as entrepreneurs, so they understand the challenges of a startup. Venture capitalists generally have track records of successful venture investments in the past, and they can draw on a wide array of experts to help guide a startup.
- No repayment required. Angels and venture capitalists usually don’t require repayment if the business venture fails. In contrast, bank loans must be repaid unless they are wiped out by court order in a bankruptcy and liquidation of the business.
How are venture capitalists and angels different?
Similarities aside, these two types of investors have noteworthy differences, including:
- Individuals vs. funds. Most angels are individuals, typically designated by the Securities and Exchange Commission (SEC) as accredited investors with sufficient personal income and wealth to tolerate the risks. They use their own personal funds to invest. In contrast, venture capitalists operate funds—often with billions of dollars in investment capital— that include many large institutional investors.
- Investment size. Venture capital investments are generally larger than angel investments.
- Timing of investment. Angels invest earlier, sometimes even before a business is operating. Venture funds typically wait until a business gets established and begins to show some promising results.
- Risk. Because angels invest so early in a business, they understand and accept a very high risk of failure. Venture funds not only invest later in a business’s life cycle, when the odds of success are somewhat higher, they also must consider how much risk tolerance is acceptable for the venture partnership’s investors.
Benefits and drawbacks of venture capital investment
Venture capital investments can provide startups that are already up and running money to expand, but there are some strings attached.
Benefits of VC investment
- Larger investment. Venture capitalists bring more money to the table for the entrepreneur than angel investing does. This is because while angel investing is more about helping a business get off the ground, venture capital is about helping it grow.
- Regulation. Venture capital firms in the US are regulated by the SEC, as well as by banking regulations if they are subsidiaries of banks. This assures the entrepreneur of the VC’s legitimacy and reliability.
Drawbacks of VC investment
- Difficult to access. There may be lots of venture firms, but getting to any of them is a challenge—especially for businesses in low-margin industries, such as retail. Venture firms are inundated with cold calls and emails pitching business ideas, and they ignore most of them. You’ll probably need a mutual connection or referral to the firm to get their attention.
- A long vetting process. A venture capital firm’s review of your business will be long and in-depth before it decides to commit any money. Because the firm is investing more money than an angel, and needs the consent of its partners, it requires more time to vet your business—typically from three to nine months.
- Investment in stages. The VC firm may not provide funding all at once, but give some upfront and the rest in stages. It may also require your business to reach certain performance milestones before it releases more money.
- Diminished control. Venture capitalists often demand a large stake in your company, sometimes even a controlling stake, diluting your ownership interest. They often want a hand in running things, and they can even pose a risk of crowding you out of your own business if you have disagreements about its direction. “Some of them are extremely hands-on. They’re really keen to help operationally and potentially with the strategy,” Jonathan adds.
- Shorter exit timeline. The venture firm’s plan to profitably exit from your business may be quicker than you think is feasible, putting you under enormous pressure to meet growth expectations. The firm also may insist you sell your business so it can cash out.
Benefits and drawbacks of angel investment
If your business is in the earliest stages of operation—or isn’t even operational—you may want to seek an angel investor.
Benefits of angel investing
- Flexibility. Angels can invest however they see fit, because it’s their own money. They can help your business in its very early stages, in some cases even before it starts operating. This is in contrast with venture funds, which generally invest only in operating businesses.
- Personal experience. Angels often have a background and experience as entrepreneurs in the same kind of business as yours, and they understand and are sympathetic to the challenges of a startup. Jonathan says, “I think the best thing is really to try to find angels who have interests in the segment and try to get an introduction from a very warm person. Either an entrepreneur who has previously funded an angel or someone who knows the angel very well.”
- Retaining control. In general, an angel poses less risk than a VC when it comes to taking control of your business. The angel investor may offer you advice about the business in an informal role as a mentor or adviser, as opposed to a VC fund, which may take a seat on your board.
Drawbacks of angel investing
- Ownership dilution. Like a VC, an angel also will usually want a sizable stake in your business.
- Potential conflict. You and the angel might start with a shared understanding of your business’s direction, but irreconcilable disagreements can emerge as your business grows.
- Differing expectations for an exit timeline. Similar to a venture fund, the angel wants to exit and recoup their money and make a profit. That can mean more pressure on you to ramp up the business’s growth or even sell the business.
Venture capitalist vs. angel investor FAQ
How do entrepreneurs pitch to angel investors?
Typically a business owner planning to pitch to an angel investor develops a business plan. This document explains the idea for your product or service, how your business will produce it, and how it will be sold—for example, direct-to-consumer online, or through third parties such as retailers. Once you find an angel who agrees to invest, you can draw up a written agreement that describes the equity stake, the angel’s role in the business, and the angel’s expected exit timeline, in writing.
How do entrepreneurs pitch to venture capitalists?
To start, be sure your business aligns with the venture firm’s focus. If you run an ecommerce seller of men’s casual clothing, for example, you don’t want to pitch to a venture capitalist that specializes in high tech. Entrepreneurs pitch to venture capitalists with a more formal presentation than for angels. This could be a slide show highlighting your product and the features that make it innovative or unique, as well as your business’s growth, detailed financial statements, and forecasts for the next few years. The presentation also often defines the target audience, gives the number of potential buyers, and discusses competitors. Venture capitalists want evidence that your business won’t just survive, but grow beyond expectations.
What types of companies do venture capitalists typically invest in?
Venture capitalists usually are more interested in companies with products or services with disruptive technologies that can change how we live and work—think of Apple, Google, Facebook, and thousands of others.
What types of companies do angel investors typically invest in?
Angel investors may be more inclined to the types of businesses they understand well, based on their past experience. For example, the retired chief executive officer of a major consumer-products company might be an angel to an ecommerce retailer selling personal-care goods directly to consumers and advertising through social media channels.