Angels and Venture Capitalists: A Match Made in Heaven?

Thomas Hellmann is Professor of Entrepreneurship and Innovation at Oxford University. This post is based on two recent articles authored by Mr. Hellmann, Veikko Thiel, Assistant Professor of Business Economics at Queen’s University; Paul Schure, Associate Professor of Economics at the University of Victoria; and Dan Vo, Research Fellow at the University of British Columbia. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, by Jesse Fried and Brian Broughman (discussed on the Forum here) and Delaware Law as Lingua Franca: Evidence from VC-Backed Startups, by Jesse FriedBrian Broughman, and Darian Ibrahim (discussed on the Forum here).

Are angel investors and venture capitalists friends or foes? Are they synergistic partners in the process of funding entrepreneurial value creation? Or are they distinct funding mechanisms where entrepreneurs have to decide which camp they want to be part of? In a series of two recent papers (Friends or Foes? The Interrelationship between Angel and Venture Capital Markets; and Angels and Venture Capitalists: Substitutes or Complements?), we examine these questions both from a theoretical [1] and an empirical [2] perspective.

Over the last decade there has been a dramatic change in the landscape of entrepreneurial finance. After the collapse of the dotcoms the venture capital (VC henceforth) industry shrank significantly, and refocused its investment strategies onto later stage funding. However, later stage VC can only thrive on the backs of a strong early stage market. As VCs receded from the early stage market, new players filled the gap. In recent years angel investors have become the most important source of funding for early-stage ventures. In addition to high net worth individuals, we now have a large variety of angel investment vehicles, including angel funds, angel networks, and online crowdfunding platforms that enable small investors to invest.

The entrance of new players in the early stage market solved one problem and created another. The rise of angel investing bolstered start-up activity. However, early stage companies often hit a road block when it comes to later stage financing. At the market level, many seed stage companies simply cannot find follow-on financing—this is sometimes referred to as the “Series-A crunch.” At the deal level, conflicts about company valuation regularly erupt between angels and VCs. In some cases, angels even opt to sell companies early, in order to avoid taking on any VC.

As a first step, we provide a theoretical framework for understanding the challenges in the transition from angel to VC financing. At the core of the analysis we consider the three-way bargaining game for the later financing stage, involving an entrepreneur, an incumbent angel investor, and a new VC. Each of the three parties derives his/her bargaining strength from the value he/she contributes to the on-going venture, as well as his/her outside option. These are affected by an endogenous market structure, as well as legal framework conditions, such as the extent to which angel investors are protected as minority shareholders. In our theory we derive the endogenous ownership structure, showing that the company valuation is affected not only by the underlying prospects of the company, but also by the level of competition in the VC market, and the strength to the angel’s bargaining position. Of particular concern to the angel is the possibility of being squeezed out of the deal. For example, the VC could try to invest at a very low valuation that severely dilutes both the angel and entrepreneur, but then reinstitute the entrepreneur’s ownership stake (and with it the entrepreneurial incentives) by giving the entrepreneur a generous option package. The extent to which the angel investors can be left dry like this depends on many factors, including their own expertise, their networks, their financial resources, and the strengths of contracts and legal enforcement.

We embed this three-way bargaining game into a market equilibrium model, using a Diamond-Mortensen-Pissarides-style search specification. One theoretical novelty is the derivation of an equilibrium across two interrelated search markets, which allows for endogenous entry and imperfect competition in both markets. Within this framework we endogenously derive market sizes, competition levels, valuations, entrepreneurial incentives and exit rates. One of the most interesting results concerns the legal protection of angel investors. VCs benefit from weaker angel protection at the individual deal level. However, at the market equilibrium level, the VC community may ultimately be worse off with weaker angel protection. This is because lower angel returns discourage angel investing, which ultimately reduce the inflow of deals into the VC market.

In the second step of our research agenda we empirically examine the relationship between angel and VC financing. While systematic angel data is hard to come by, we exploit a unique data source from British Columbia, Canada, where thanks to a tax credit we can observe almost the entire angel and VC market. We empirically analyse the dynamic structure of financing rounds, paying special attention to the transitions between angel and VC financing. We establish two main empirical patterns. First, a company that has already received angel financing is more likely to receive more angel financing in the next round, even if we only count the funding received from new angels, and not any follow-on funding from incumbent angels. [3] Second, a company that has received more angel financing in the past is less likely to receive VC financing in the current round. Similarly, a company that received more VC financing in the past is less likely to receive angel financing. This central finding suggests that angels and VC are substitutes, not complements. [4]

Is the separation into distinct financing paths mainly driven by company characteristics (i.e., certain types of companies are better suited for angel vs. VC financing)? Or do investors also have an influence in steering companies deeper into their turf? Using variation in the availability of tax credits in an instrumental variable regression framework, we find some evidence of distinct investor effects. We also ask whether the substitutes patterns is mainly driven by poorly performing companies that simply fail to ‘graduate’ to the VC level, but actually find that the substitutes patterns holds true for across the entire range of company performances. We also decompose the angel category into three subtypes, and find a strong substitution pattern for less experienced angels and for angel funds, but no significant substitution pattern for more experienced angels.

If all one ever noticed were the iconic success stories, such as Google or Facebook, then one might think that angel financing is a stepping-stone to VC. However, our research suggests that these anecdotes of a harmonious progression from angel to VC financing are not representative of the way most start-ups are financed. Instead, we find both theoretical reasons and empirical evidence that point towards a more challenging relationship between the angel and VC communities.

The theoretical paper is available for download here. The empirical paper is available for download here.

Endnotes:

[1] “Friends or Foes? The Interrelationship between Angel and Venture Capital Markets” by Thomas Hellmann and Veikko Thiele, SSRN 2014, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2323553
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[2] “Angels and VCs: Substitutes or Complements?” By Thomas Hellmann, Paul Schure and Dan Vo, SSRN 2015, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2602739
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[3] This same patterns is also true for VC, i.e., a company that has already received VC financing is more likely to receive more new VC financing.
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[4] The empirical analysis controls for a large number of other factors, including company industry and location, funding amounts in past and present rounds, the time between rounds, and the time period under consideration.
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