Investing Outside Conventional Markets: Angel Investing vs. Venture Fund Investing
February 14, 2018
Author: Bernie Batt, Analysis SWO Angels
Often, high net worth individuals looking to make their first foray into investing outside of conventional markets (the stock market or real estate), may have a financial advisor unfamiliar with angel and venture capital investments. This article is meant to help guide where these investment opportunities fit into a portfolio, what kinds of people would be interested in each, and how these sources are essential to fostering innovation in the Canadian economy.
The Early Stage Funding Ecosystem
Companies looking for early stage investment will typically look for funding from a combination of government sources, family and friends, angel sources, venture capital firms and crowdfunding campaigns. It’s important to talk about the early stage ecosystem as a whole to pinpoint the timing and motivations of angel investors and venture capital firms.
The National Angel Capital Organization (NACO) provided the above graphic, which describes the early stage funding ecosystem.
- At the Ideation phase, companies typically “bootstrap” in order to finance operations, which means that they are supported by friends and family, government grants and incubators and crowdfunding. These early sources allow the entrepreneur to maintain control of the company and direction.
- In the Proof of Concept phase, individual angel investors will provide capital to carry companies to the point that they are ready to raise a Seed round.
- Angel groups will typically start to support companies in the Seed round, with syndicated groups of angels carrying the companies through most of the Growth phase.
- In the Growth or Maturity phase, companies are ready for a larger raise, referred to as a Series A round, which will usually see interest from venture capital firms, as well as some of the investors from prior rounds.
While angel and venture capital funding are similar because they provide startup funds, they differ in structure, stage, and in tolerance for risk.
Angel investors are high net worth individuals that qualify as accredited investors in accordance with requirements by the Canadian Securities Commission. This means that with their spouse, they hold $1M in financial assets, along with their spouse they hold over $5M in net assets, or they make income of $200K individually or $300K together with their spouse. Angel investors can invest individually or syndicate.
Many angel investors are current or former executives that have achieved success and have amassed experience they wish to pay forward to young companies. These angels have often cashed out from their ventures and are looking for something to do. The capital and time availability are prerequisites for angel investment. Some angels are looking to buy their way into an exciting job in an expanding sector, while some are looking to supplement their income with angel investments. Still, others are hoping to learn from the experienced group and network with like-minded investors. Angel groups provide deal flow and facilitate due diligence efforts by working together and sharing resources.
Angel investments are illiquid investments that will typically take at least three years to see an exit, with some companies taking well over 10 years. In the Canadian economy, especially in companies requiring significant research and development, companies have been relying on angel investment as a means to fund their early stage business.
As most companies that are funded by angels will fail, angels will have a high appetite for risk and a high requirement for return. Angel investing is a game of averages, with average returns in the range of 27%, according to Dr. Gedeon’s book, “A Practical Guide to Angel Investing: How to Achieve Good Returns”. Angel investors will usually invest 10-20% of their net worth in angel investments in order to have a total portfolio that is risk adjusted for their age, stage of life, and investment goals.
In order to maximize chances of achieving the average return, angel investors would be advised to diversify by investing small amounts into more companies, with an angel investment portfolio of 10 companies or more. A diversified angel portfolio can also be achieved by investing in an angel investment fund, although these funds would usually have some fees for managing the portfolio.
Venture capital (“VC”) firms create venture funds supported by investment. VC firms often have sector specific expertise and provide business consulting in order to maximize the value of fund companies, leveraging experience, connections, and often enhancing the management team with experienced professionals.
VC firms have a high tolerance for risk, but also expect a return that is commensurate with the risk. VC firms are structured with a general partner or investment committee making investment decisions. The investor group are limited partners of the fund who receive a portion of the returns, but because they are providing the capital, the limited partners bear almost all of the risk. The venture capital firm has full-time staff motivated to realize a high return from the portfolio.
Investors in VC funds are either institutional or accredited investors. Some funds only take on institutional investors, and the funds that allow individuals to invest usually have high minimum investment amounts. These investors buy into the expertise of the VC firm. VC funds have a set lifespan and accordingly have phases including the fund-raising period, growth phase with low or no liquidity, and close of the fund when returns are passed to general and limited partners.
VC investors would be advised to view the track record of the VC firm looking for the historical return to VC limited partners and not the total return which includes the general partner’s portion. After fees, many venture funds underperform the market return as determined by market indices, while top funds can achieve returns much higher than market rates.