Most startups desperately need an investor and thus you may feel that you are willing to consider any source of funding, regardless of the type of investor. Both so-called “angel” investors and venture capitalists (VCs) are able to provide the financial resources that your startup requires. I have found, however, that the decision process for choosing the best investor is very complex so it is especially important to make well-informed and carefully-timed choices as these can have a major impact on your long-term success.
The basic distinctions between types of investors are simple. Angels are typically high net-worth individuals who invest their own money, for which they are primarily interested in early or “seed” financing of amounts that start as low as $25K. Venture capitalists are professional investors who invest other people’s money from a fund. Their interest lies in larger investments of typically $2M or more. Between these extremes, there is a spectrum in which there is room for a large overlap.
Beyond the numbers, there are many factual and subjective issues that you should factor into your decision-making process. These include the following:
- Investment control. Angels typically have simpler term sheets, allow greater flexibility in valuations, and are more realistic on time frames. VCs, on the other hand, tend to exert more control over the team and assert financial management of the company, its strategy, and its exit plans. Ultimately a larger VC investment can also narrow exit options.
- Type of startup. Venture capitalists seek to fund businesses with the potential for a significant return on their investment. In addition, most venture capitalists want startups that have clearly defined economies of scale (such as software companies) rather than ones that scale linearly with some factor (such as service companies). Angels are more open to a variety of company types.
- Expected return rate. Most venture capitalists look for 30% annual return, 10 times their initial investment in 3-5 years, or 50% IRR (a discounted cash flow calculation). Angels are willing to consider lower-return opportunities. Both types of investors recognize that many ventures fail, meaning the target returns are high to improve the average.
- Total money needed. If you are looking for a specific raise of less than $2M, you will most likely seek angel investors. The picture is a bit more complex, however, because if the total money you’re looking to raise over the life of your company to be cash-flow positive is greater than $3M, or you will likely need money to scale, you will need to look to VC for resources.
- Team experience. Successful serial entrepreneurs usually find it easier to raise money from venture capitalists. If you are a first-time entrepreneur it will be difficult but not impossible to get traction with venture capitalists.
- Founder network. If you do not know any venture capitalists and none of your colleagues have built companies with VC funds, you probably will have more difficulty securing a VC investor. In contrast, if you have personal contacts with a CEO of a Fortune 1000 company, this may offer some advantage in finding a valuable set of angels.
- Value-add. This is the most debated but most important item. The value-add of both angels and VCs is dependent on the individuals involved in the process, but on average VCs are likely to add more value than angels. Venture capitalists focus on specific business areas, have multiple deals running concurrently, understand deal flow, and usually have more current insights, connections, and resources.
Finding the right type of investor all comes down to the investor fit and the stage of the start-up enterprise you are in. It’s definitely better to have people who have prior experience building businesses on your side. If you plan to exit in the near future, it’s important to have investors who have backed high-growth businesses.
In every case, the relationship between the startup and the investor is the key ingredient to a successful deal. It is essential to communicate with your investors openly and honestly. If there is mutual respect between you and your investor, it will be much easier to survive any potential challenges your startup encounters. It’s tempting to avail yourself of any financial resources available to your startup, but in the end, it can be more costly than it’s worth.