Angel and venture capital markets are two sides of one coin in a hopeful entrepreneur’s pocket. In Friends or Foes? The Interrelationship between Angel and Venture Capital Markets, Thomas Hellmann and Veikko Thiele discuss how the two investor types are “friends” in that they rely on each other’s investments, but “foes” later on. The paper derives an equilibrium for the flow of money across the two markets accounting for exit rates, market sizes, competitive structures, and valuation levels. Legal protection also plays a role for angel investments.
Angels, though wealthy individuals, have limited funds and usually need VCs to provide next stage funding so that their companies can thrive.
This interdependency is crucial to a company’s growth in its infancy, but problems can also arise. The paper’s main concern is that VCs abuse their market power by offering unusually low valuations which then affects the willingness of angels to invest in early stage start-ups, resulting in “burned angels”.
To better understand and prevent such conflicts, Hellmann and Thiele seek to quantify this interdependency through analyzing key aspects of the funding process. In the “friends” stage, output of successful deals in the angel market constitute the deal input in the VC market. Then at the VC stage, the utilities of the entrepreneurs and angels affect the entry rates of entrepreneurs and angels at the angel stage. However, with this growth and movement comes friction, as the VCs no longer need angels to make an investment, meaning they are no longer valuable to the company. These “friends” become “foes”.
Hellman and Thiele find that while a monopolist VC would have a lot of power over angels, such bargaining power gets dissipated as competition grows. Increased competition for VCs can thus serve as protection for angels. The paper also accounts for effects of the bargaining strengths of the entrepreneurs and angels, though that is a more legalistic discussion. However, protecting angels from being “burnt” may not always be the best option for young companies. Interestingly, weaker angel protection often leads to better entrepreneurial incentives. Another possible solution presented by the paper is early exits for angels, as various challenges of securing follow-on investments from VCs can be avoided. However, entrepreneurs and angels could fail to reach their full potential.
This “friend-foe” funding cycle and structure will remain as angels and VCs control the bulk of funding.
It’s the strategy entrepreneurs bring to the funding table that will influence how their investors see each other and therefore the company’s success.
To learn more about the relationship of VCs and angel investors, please click here.
Contributed by Sabrine Griffith.