Venture Capital Firms and Angel Groups – What are the Differences?

It seems that novice entrepreneurs believe that a Venture Capital firm and an Angel investment group are the same.

There is stark difference between them.  Yet I consistently encounter entrepreneurs who treat those two groups as if they are the same animal.

Angel investors are wealthy individuals looking to invest in the “next best thing.” Generally, they are loosely federated group of individuals who get together and listen to investment pitches. Even though wealthy, they will have limited capital to invest.  Most often than not, the capital being invested will be “loose change”, or disposable capital to use a term from first year of business school. Many angel groups are informal and focus on extremely local investments. They also invest for total rounds less than a million, even if collectively done.  One such example is the Virginia Active Angels group.  It is located in Charlottesville, Virginia, and meets monthly as a dinner party.  Unless the groups is paying some form of dues, the director is not compensated for running the meetings, etc.

For the entrepreneur, he/she might be required to pay an upfront fee to an angel group.  Lately there has been a progressive change in the informal structure in the Angel format. Some groups will charge an application fee to the entrepreneur in order to present to the group.  There has been a further systematization of this angel model with the creation of a national firm – one notable example, the Keiretsu Forum (“KF”). The KF has built a national presence with metropolitan chapters. The entrepreneurs are showcased nationally through a roadshow, they pay considerable fees, and undergo due diligence process, close to an investment bank quality. The KF members also pay a substantial fee to the association.  This business model borders closely to an investment bank, which is heavily regulated by the S.E.C. and State agencies. The members might be accredited investors as the group does have an air of formality and might be under the watchful eyes of the SEC.

The VC firm is a very different investment institution. As indicated in an earlier blog, the general partners are compensated by the limited partners.  For every dollar invested by the limited partner, the general partners are compensated between 2-3 cents.  Swiss banks also charge for deposits as well.  This compensation model covers the general partners’ time for reviewing suitable investment candidates. The general partners also receive two additional income sources.  For every company they invest, they get an additional percentage – 1%-3% — to compensate the partners for actively managing the investment.  They travel and attend the board meetings for the portfolio companies.  By implication, this management process suggests that VCs invest in more mature start-ups – those with traction and revenues.

Once the VC firm executes an exit strategy by selling all or part of the investment, the partners might well reap the benefits from the sale, usually about 20% of the gross revenue. The limited partners take the rest.

Since the general partners are being compensated, there is no reason why a VC firm will charge an entrepreneur for a pitch. They also have enough compensation to pay for professionals, attorneys and accounting firms to handle the due diligence for the investors/limited partners. In contrast, the Angel groups seek volunteers or effect their own due diligence on the potential investments.

Another important difference is the size of the potential investments.  Since the limited partners are sizeable institutional investors, having committed hundreds of millions of dollars, the VC firm is capable of investing millions of dollars for each investment. The trade press recently published some deals in the $20-30 million dollar range, in which a few VC firms participated.  Angels rarely close such sizeable deals.

The bottom line is that an entrepreneur needs to distinguish these two groups – Angels and VCs — and expect two major differences: one group, Angels, is informal, will invest less, and might demand a payment upfront for pitches.  The other, VC firms, is capable of throwing more capital, expects a more mature company, and will not charge for pitches. I have seen mature companies with traction pitch to Angel groups – and I cannot fathom why.  Just for the fact that the early stage company has revenues, it generally demands higher priced, sizeable funding rounds – not the province of Angel groups. And start-ups without substantial track record should not be wasting a VC precious time. Yet, I still see many entrepreneurs knocking on the wrong funding doors. Time is money, money is time. Startups would get to funding quicker if they know where they stand in the pecking order and can target the right investment firm.