Angels vs. Venture Capitalists

[This blog post is by Ben Horowitz, the Horowitz of Andreessen Horowitz.]

At our new venture fund, we’ve been spending time looking into new ways that will make the lives of entrepreneurs seeking funding easier. To that end, we’ve linked up with Ted Wang who has been working on an open source legal project called the Series Seed documents. We’re impressed with his work and are going to use these standard funding documents as part of our seed stage investments wherever appropriate.

We have to give a big shout out to Ted: he nailed this. It’s exactly in step with our intention of letting entrepreneurs focus on building businesses in today’s environment, without having to follow old VC rules.

In a nutshell, entrepreneurs and the businesses they are starting have evolved. Start ups today don’t need to build a manufacturing plant (as DEC, the very first high-tech VC investment, did in 1957) to start a business. They need less money to build a product and prove that it works before scaling the business. Yet, the paperwork involved in funding entrepreneurs hasn’t changed to meet these needs. Series Seed is the first to establish this new way of supporting funding suited for today’s entrepreneurs – and we’re big fans.

Let us know what you think: check out the Series Seed documents, and share your thoughts.

Here’s more background on our thinking behind how entrepreneurship has changed, creating the need for these simplified funding documents. I’m speaking here from the point of view as both an angel investor and a venture capitalist, two very different kinds of investors.

Angels vs. Venture Capitalists

Why do angel investors exist?

Before answering these questions, it’s useful to ask and answer a related question: why are there angels and why have they become more prominent in the last 10 years? After all, doesn’t the definition of venture capital include all of the activities that angels perform?

The answer lies in the history of technology companies and the differences between how they were built 30 years ago and how they are built now. In the early days of technology venture capital, great firms like Arthur Rock and Kleiner Perkins funded companies like Digital Equipment Corporation (DEC) and Tandem. In those days, building the initial product required a great deal more than a high quality software team. Companies like Tandem had to manufacture their own products. As a result, getting into market with the first idea, meant, among other things, building a factory.  Beyond that, almost all technology products required a direct sales force, field engineers, and professional services. A startup might easily employ 50-100 people prior to signing their first customer.

Based on these challenges, startups developed specific requirements for venture capital partners:

  • Access to large amounts of money to fund the many complex activities
  • Access to very senior executives such as an experienced head of manufacturing
  • Access to early adopter customers
  • Intense, hands-on expert help from the very beginning of the company to avoid serious mistakes

In order to both meet these requirements and build profitable businesses themselves, venture capitalists developed an operating model which is still broadly used today:

  • Raise a large amount of capital from institutional investors
  • Assemble a set of experienced partners who can provide hands-on expertise in building the product and then the company
  • Evaluate each deal very carefully with extensive due diligence and broad partner consensus
  • Employ strong governance to protect the large amount of capital deployed in each deal. This includes requisite board seats and complex deal terms including the ability to control subsequent financings
  • Manage own resources effectively by calculating the amount of capital/number of partners/maximum number of board seats per partner to derive the minimum amount of capital that must be invested in each deal

It turns out that building a company has changed quite a bit since the early days of venture-backed technology companies. Building a company like Twitter or Facebook is quite different from building Tandem. Specifically, the risk and cost of building the initial product is dramatically lower. I emphasize product to distinguish it from building the company. Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks and has raised hundreds of millions of dollars to build their business. But building the initial Facebook product cost well under $1M and did not entail hiring a head of manufacturing or building a factory.

As a result, for a modern startup, funding the initial product can be incompatible with the traditional venture capital model in the following ways:

  • Lengthy diligence process. Venture capitalists take too long to decide whether or not they want to invest because they are set up to take large risks and have complex processes to evaluate those risks.
  • Too much capital. Venture capitalists need to put too much capital to work – often a VC will want to invest a minimum of $3M. If you only need 4 people to build the product and get it into market, this likely won’t make sense for your business.
  • Board seat. Venture capitalists often require a board seat and, for that matter, a board of directors be formed. If 100% of the company is building the product and the team knows how to do that, then a board of directors may be overkill. In addition, it may be too early to decide who you want to be on the board.

As a result of the above, a venture capitalist usually requires a serious commitment from the entrepreneur to pursue an idea that is highly experimental. If the product doesn’t stick, it might make sense for the entrepreneur to pursue a totally different idea or drop the business altogether. This is much easier to do if you’ve raised $300,000 than if you’ve raised $3,000,000.

As entrepreneurs needed someone to bridge the gap between building the initial product and building the company, angel investors stepped up.

Angel investors are typically well-connected, wealthy individuals. They generally use their own money and come with none of the above VC constraints describe above: they don’t go on boards, they don’t need to put in lots of capital (in fact, they usually don’t want to), they prefer dead simple terms (as they often don’t have legal support), they understand the experimental nature of the idea, and they can sometimes decide in a single meeting whether or not to invest.

On the other hand, angels do not manage huge pools of capital, so entrepreneurs need to find someone else to fund the building of the company (as opposed to the product) and most angels do not plan to spend a great deal of time helping entrepreneurs build the company.

One more thing before answering the original question

Before getting back to the need for the Series Seed documents, it’s important to distinguish venture rounds and angel rounds from venture capitalists and angel investors. It’s possible for a venture capitalist to invest in an angel round and vice-versa. Sometimes this is a great idea and sometimes it’s tragic. We’ll first examine the rounds and then the investors.

When should you raise an angel round and when should you raise a VC round?

This question really comes down to the company’s development. If you are a small team building a product with the hope of “seeing if it takes” (with the implication being that you’ll try something else if it doesn’t), then you don’t need a board or a lot of money and an angel round is likely the best option. On the other hand, if you’ve developed a strong belief in your product or your product idea and you are in a race against time to take the market, then a venture round is more appropriate. You will benefit from both the extra capital and extra support that comes with a serious and large commitment from your investors.

So who is qualified to invest in each?

Obviously angels can invest in angel rounds, but what about VCs? Is it safe to have them participate? The answer turns out to be “if and only if they behave like angels.” What does it mean for a VC to behave like an angel? Well, they must:

  • Be comfortable investing a small amount of money, e.g. $50,000.
  • Be able to make an investment decision quickly, e.g. in one or two meetings
  • Be able to invest without taking a board seat
  • Not require control of subsequent funding rounds
  • Not impose complex terms

If the VC wants to be in the angel round, but refuses to behave like an angel, then entrepreneur beware. Having a VC who behaves like a VC in the angel round can jeopardize subsequent financings.

Angels can be great participants in venture rounds, but it’s generally better to have a VC lead those deals as they have more financial and other resources required to build the company.

What does this mean about Andreessen Horowitz and the types of investments we’ll do?

As I stated above, at Andreessen Horowitz, we invest in both venture rounds and angel rounds. When we invest in angel rounds, we behave like an angel. As angel investors, we can invest as little as $50,000, we do not take board seats, and we do not require control.

Rooted in this desire to help germinate quality ideas, our support for Seed Source legal docs will allow both us as investors and the entrepreneurs we fund to focus on building a winning product rather than scrutinizing legal docs.

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