I was in Atlanta this past week and spoke at an event about raising capital. One of the questions from the audience was really interesting:
What’s the difference between angels and seed VCs?
If you had asked that question 5 years ago, the answer would’ve been really different. It would’ve been something like:
- Use his/her own money to do investments
- Write small checks
- Mostly sole decision maker
- Use 3rd party money to do investments (from limited partners)
- Write large checks
- Multiple decision makers and a concrete process
But today, some of these things have changed.
A lot of new micro VCs have popped up (500 Startups is one example). They write small checks – typically between $50k and $300k. They also make decisions really fast because they typically have only 1-3 decision makers in their process.
Through the rise of syndicates, angels are now more akin to VCs. They can write much bigger checks through essentially a band of angels coming together on a deal. A couple of Gil Penchina’s AngelList syndicates, for example, rival big series A firms; he has millions of dollars to do a deal.
On the surface, there is seemingly little difference between angels and micro VCs these days.
There is one big difference: where the money comes from.
As entrepreneurs, we don’t usually think about where our investors’ money is coming from, but in this case, it matters a lot.
Let’s say I start a VC firm called Hippo Fund. Whether it’s a micro fund or not, I need to raise money from 3rd party investors (Limited Partners) and convince them that Hippo Fund is going to make them A LOT of money. Like I mean A LOT. Potential limited partners are weighing their options – “Should I invest in Hippo Fund or in NYC real estate? Or should I invest in someone else’s VC fund?” The decision is not about whether investing in Hippo Fund will be profitable; it’s about whether it is THE BEST INVESTMENT for your money.
This means that in running Hippo Fund, I need to make big big bets that could either go nowhere or be the next Google. Entrepreneurs often complain about why VCs seem to make stupid investment decisions – i.e. pass on profitable growing businesses but bet big on companies that make you wonder what people are smoking. This is where these decisions comes from.
On top of that, because Hippo Fund needs to swing for the fences, most investments will fail. If 9 out of 10 portfolio companies fail, then the 1 winner will need return a LOT in order to make up for all our losses. A winner who returns just 10x will get us to not quite break-even on the whole portfolio; this is bad. (As a side note: lots of entrepreneurs pitch their company to me saying they will make us 10x our investment. Please do not do this . You will lose us money.) We need our winning companies to be returning 100x-1000x.
Ok, now let’s say we dump Hippo Fund and instead create an AngelList Syndicate. I round up a whole bunch of my rich friends to back this syndicate. So now, for every deal I do as an angel, I share it with my friends, and they can decide whether they want to do the investment. If I get enough friends to back my syndicate, collectively, we can invest as much as Hippo Fund.
In this capacity as an angel investor, I can invest however I want. I can decide to invest in companies where I just love the product and think the market is small. I can invest in companies who have proven nothing (zero traction, etc.). I can invest in companies because I like the logo. I can do whatever I want.
My rich friends can decide to join me in my investment decisions or not; that’s up to them. I no longer have to be concerned with trying to make the most money ever.
Follow the money
Lastly, it’s important to follow the money and see how fund managers are incentivized.
As a VC, typically, I’ll get 20% of the upside on my entire portfolio. So let’s say I have a fund size of $10m and I have:
- 10 companies in my portfolio
- Invested $1m in each
- 9 of them failed
- 1 winner that made me $20m.
My upside as a fund manager is roughly ($20m – $10m fund size) * 20% = $2m.
I would personally make $2m for this type of portfolio (assume no management fees.)
Now, what does this look like when running my AngelList syndicate? Let’s assume the same situation with the 10 deals I did in Hippo Fund.
I still get 20% upside but now it’s per deal and not by portfolio, since my backers can decide for themselves which deals they want to be a part of. Look at my one winner – the one that made me $20m; now I get ($20m – $1m invested in that deal) * 20% = $3.8m.
So in running an AngelList syndicate, I would personally make $3.8m, because upside in syndicate deals is on a per-deal basis, not a portfolio basis. I no longer have to consider the losses of the other companies. This means that I don’t need to think about my one winner trying to cover for all my losses and can invest in the growing profitable companies and not just the “shoot for the moon” companies because I will still make money.
It’s important to understand where the money comes from because this tells you a lot about how fund managers are incentivized. And as an entrepreneur, you can use this to your advantage in how you message or pitch your company to different investors.
Special thanks to my colleague (and basically brother) Tim Chae for shaping a lot of my thoughts around this when I first jumped into venture.