S4:E156 The Weekly Venture Update and How Angel Capital and Venture Capital Differ

S4:E156 David opens with the weekly update in Venture, and then Paul joins for a discussion of the differences between Angel Capital Investment and VC Investment. 

The discussion arose from an article posted on LinkedIn proposing that founders who can't get VC funding shouldn't expect to be able to get Angel funding because they're basically the same. We disagree and present our argument for the difference. 

https://www.linkedin.com/posts/dc-palter_why-angels-are-not-the-answer-for-startups-activity-7285007063242420224-qAk0/

https://www.venturesouth.vc/resources/angels-vs-venture-capitalists-substitutes-or-complements

(recorded 1.21.25)

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Chapters

• 0:12 The Weekly Venture Update
• 9:05 How Angel Capital and Venture Capital Differ

Transcript

0:01

Welcome to Venture in the South. These are the stories of innovation and success in the southern US that make money, have fun, and do good. All right, so now our audience gets to see us instead of just hear us. And so that may be a win or maybe you all want to turn off the video. I don't know. But today we're talking about a fairly specialized topic, which is the question about angel investing in terms of what kinds of targets you should be aiming for and whether Every startup is a candidate for angel investment and what the crossover is between angel investing and VC investing. Paul, the article we're talking about is why angels are not the answer for startups that can't get VC funding. It's posted on LinkedIn by DC Paltor and you had picked up on this and had some thoughts about it as do I. And so tell us a little bit about who is DC Paltor. Well, honestly, I know him. I think he's a West Coast angel investor, but I don't know much about his background. I don't really know why the algorithm served me this content from him, but it did. It was interesting. I thought it was interesting. It was different from what I think about mostly. So, always good to have some new points of view and talk about them. Yeah, and so what is the argument that he's making in this paper Yeah. So the post, as you said, is called Why Angels are not the answer for startups that can't get VC funding. his main argument is that angel investors make exactly the same investments that VC investors make. And therefore, if you're trying to raise money and you're not having success in the VC space or people are telling you that your company is not really a fit for a venture capital investment, then there's really no point going to angels because they do exactly the same things that VCs do. That's the main thrust of his argument. So run us through exactly what he's saying and your rebuttal. Okay, so I mean, I don't think I'm oversimplifying what he's saying, just to maybe throw in a couple of quotes. And these are right from the article. He says the economics for angel investing is identical to venture capital. Any startup that isn't suitable for VC funding isn't suitable for angels either. Angels and VCs do the same deals. That's his pretty clear proposition. I mean, at a very superficial level, that's true. Angels and VCs are generally speaking investing in early stage technology based high growth companies. So at a very kind of superficial level that's true. But I mean, it's just simply not true that we do the same deals. At Venture South, we've got a portfolio of over 100 companies we've invested in a good proportion less than 100 % of those have a VC fund involved in them in some way. So just you know, From the deals that I do, I know it's not true that they're the same deals. And I'm pretty sure that the same would be true for you, David, on the deals that you do. Don't know if you track exactly how many follow-on rounds and what proportion of those are VC funds and all of that, but I bet it's not 100%. Yeah, I've not looked at that, but it's a very interesting question, but also very difficult to ferret out sometimes because you have to have access to an updated cap table to know who's who's invested in these follow up rounds. And honestly, I don't really care who's investing in the follow up rounds. I have no influence over that. It doesn't change anything that I do. In fact, it dilutes my influence. And so by the time a company's at a series B, I have such a small share on the cap table that I have no influence in the company. There's nothing you can do about it. If you are a major investor at the beginning, you sometimes at least can see what goes on later on. Most of the time, what goes on later on is, well, a substantial portion of the time, a company doesn't go on to raise more money. That might be deliberate. The plan is not to raise more money. It might be accidental that the plan was to raise more money from a venture capital and they couldn't do it. Or it could be the company was acquired too quickly before it even became suitable for a venture capital round. All of which goes to say that we're doing deals that don't involve venture capital investment at the beginning of our investing activity. So, I mean, I think just from pure personal experience, we know that's not true. That angels on VCs do exactly the same deals. And then if you look at any kind of data out there about this stuff, The number of deals that are done by angel investors are 10 times the number of deals that venture capitalists do. Obviously, all the data in early stage investing is bad data for them, almost always. But if you just take Carter data, they have 5,000 deals on their platform from 2023. And the Center for Venture Research, which deals with angel investment activity, has 57,000 deals. You can argue about the accuracy of both of those sources of data. But one thing it's hard to conclude from those stats is that they're the same X number of deals. So the data just does not support the proposition that angels and VCs are doing exactly the same deals. Yeah, and you've underscored some of the key principles related to successful angel investing. That is early exits, few funding rounds, and small funding rounds that are less dilutive. those are not the foundation of venture capital. Venture capital, because they have larger amounts to invest, they need to spread across a lot of different companies and they need to write large checks. And their pressure is to get a return on the fund from these large checks. Whereas with angel investors, with an early exit and less dilution, you can have the same returns with a much smaller exit than what's required for a $50 million fund in order for them to have an impact on the fund. Yeah, I mean, don't actually agree with all of what you just said there in terms of the foundations being the way you described them. and explain what you don't agree with. Well, so I think there's multiple ways you can be an angel investor. You can be a DC paltor, swing for the fences, only invest in deals that could return a thousand X and ignore everything else. You can do that. And lots of people do. And obviously this guy thinks that's the way you should do it. That's not the way that I think angel investing works in the Southeast United States. And it's probably quite different again from what the South Eastern angels that operate in Southeast England think is the right way to do it. There's just not one way to do it. Now, the way you articulated it there in terms of looking for deals that generally speaking have a lower payoff but lower risk is something that resonates with me because it fits. What I think is the reality of the Southeast, but I wouldn't go as far as say it's the only way to do it and it's not all the right way to do it necessarily. It just seems to fit pretty well with the reality of over here. Now on the VC side, think you're probably right. I mean, VCs do need to find a way to return their fund. And they need to probably take bigger swings to get to the bigger outcomes that you need, which becomes harder to do the bigger the fund is. But isn't actually that different from angel investing on the smaller end of early stage VCs and smaller funds. It's kind of the same calculus. So I think again, it varies. think just coming up with one comparison between angels for VCs is probably too far the other way. Polzer's argument is exactly the same. That's obviously wrong. Another answer is they're totally different. And I think that's also not right either. There's a spectrum along that early stage investing kind of activity. And whether it's called an angel or an early VC or a VC is, it's really similar, but it does have some nuance difference along that spectrum. Okay, so you've made a pretty good argument that the statement that they're the same is not true, but is there any validity to his argument at all that the calculus for angels and VCs are the same? So the method of getting to their end result is the same. Honestly, I don't think there is, but I'm happy to look at the evidence that he tries to marshal to that proposition and see if I agree with it. He talks about a couple of different things in the article about the distribution of returns and failure rates and maybe different groups of angel investors that are an exception to his general rule. Maybe it's worth digging into those a bit to see what things we agree with or not in the thinking there. Yeah, so tell us what, is that wrong? Well, on the let's take sort of failure rates and distributions of return. First of all, he says for a venture capital fund, nine out of 10 deals failed to provide a positive return to investors. That means that one out of one start out of 10, does succeed needs to return 10 X just to break even for the portfolio. Also not completely true for a couple of reasons. The first is the nine out of 10 failure rate. That is, it's very hard in his defense to get good data about failure rates. Nobody defines failure in the same way. All the data out there on these different things is sort of contradictory. Nine out of 10 is the sort of lazy shortcut way to say, know, lazy shortcut outcome statistic. It is just not true that nine out of 10 VC deals fail to provide a positive return for investors. It varies a lot depending on what you're doing. think that's a really good point that the data is hard to come by. However, I'd like to show this graph here, which is the startup failure rate versus the funding round size from four different data sources, which basically shows pre-seed, seed, series A, and series B failure rates by percentage. And it goes from around 80 % for pre-seed groups to around 60 % for seed. and then down to about 50 % for series A and about 30 % for series B. Those are the failure rates averaged across a very large number of startups. Not a perfect data set, but I think it's more valuable than just an opinion. And it corroborates what you said that the facts just don't support this idea that 90 % of all startups fail. kind of... depends on other factors. So it's more complex. It depends on the funding stage, obviously, which I just showed, but it also depends on the diligence you do. So the companies you pick and it also depends on the team. that kind of relates to the diligence that the team is a very important part of the deal. And ultimately it depends on funding. So They need to execute. The team needs to execute. And if they can't execute, it doesn't matter how good of a startup it is, they run out of money. Agreed. There's a lot of things that go into figuring out what the outcomes are. There's also a definitional problem. mean, what does failure rate mean? Does it mean the company is no longer in business? Well, okay, that might be the definition, but is that because the company was acquired? And if so, that's not necessarily a failure. That in fact might be a good outcome. It might be the company shut down. That would be a failure. One of the other data sets that people use a lot is Bureau of Labor Statistics data on new company formation and dissolution. That says that companies last for five years. More than half the companies gone after five years. But it doesn't tell you whether the gone is good or bad. Doesn't tell you if it was out of business or shut down or was acquired. Doesn't tell you what kind of businesses we're talking about. So all of this stuff about failure rates. I do not believe that 80 % of pre-seed deals fail. I think it's probably a good bit lower than that. They may not be a stellar success that generate a 10X return, but if you consider failure being you don't get your money back, you get less than what you invested in it as an investor, let's say, then the Angel Capital Association data says that 50 to 70 % is the failure rate if you use that definition, which is a good bit less again than 80%. You get less than you invested. Yeah. So I mean, all of this stuff is, hard to parse. It's not easy being a startup. know, we can agree on some baseline things. Some companies will fail and we will lose our money on some deals, but it's not 90 % go to zero. And there's another piece, you know, he then assumes in that math that you need the one to produce 10 X return. That means you've assumed that on the nine, you've lost your money entirely, which is again, not true. may. You you return less than you invested, but that's not necessarily the same as saying you lost all of your position in a deal. And in fact, there's things built into angel investing that make it more likely that you get more than nothing back in a deal situation. We talked about a one X liquidation preference before on the podcast. The point of a one X liquidation preference is that in a failure scenario, the investors get more than their pro rata ownership of the business or the cash that's left. And so potentially could get close to one X their investment back even in a failure scenario. The reality is a bit more complicated. It doesn't always work out like that. And companies do fail with a zero at the end, you know, a lot. But you shouldn't assume that a failure in this data set means a total loss of your investment. Yeah, it seems like he's making an argument for the spray and pray approach for large funds where they need to have wide coverage of multiple verticals in order to capture some unicorns critical to success of their fund. these large funds, they need to have these big winners. They have to have big winners in order to return the fund. So they have to spread the net very wide, whereas that problem doesn't exist for angels. there's definitely a tangent we can go on about how the structure of VC funds and the structure of angel investing impacts what you need out of an individual deal for sure. Yeah. But let's assume that we're both aiming at a 20 company portfolio. It's just wrong to say that we have to generate 10x our return from one out of the 10. And then he goes on to say, For angel investors, it's even worse because we're doing pre-seed. So our failure rate is even, is twice as bad. 19 out of our 20 investments are going to fail. And so our one winner needs to return 20X. Again, that's not true for the reasons we've already talked about, but it's, it's particularly not true to compare the VC and angel failure rates because the failure rates don't double between those two levels. And And it doesn't also take into account the price you paid. So the outcome of the company might not be very successful, but if I've invested a third, price, the VC round is coming at. Maybe it's a win for me, not a failure. So that's the other thing that gets left out of that sort of arbitrary math. Not sure I explained that very well, hopefully you get the point that failure depends on how much you paid to get in the deal in the first place. And if I paid a low price, then. failure for me is a much lower barrier than it would be if I paid a much higher price. Yeah, that's a really important point, I think, because one of the strengths of a non West Coast market is the deals are typically less expensive to get into. And it is a little bit self selecting because there's more capital on the West Coast to invest in. So perhaps there's a greater supply chasing a smaller demand and in Smaller markets like the Southeast, there's much less capital chasing larger demand, and so we get better prices. And so that's a really important feature of our market. But that may be true for VCs as well as angels, but typically the price that angels are gonna pay is gonna be less than what VCs are gonna pay for a variety of reasons. And you had an example for that. Well, so yeah, whenever you see a big high profile failure or IPO, you can usually trace through who invested in it and at what prices. And there was one, think fairly, I guess it was sometime last year when There was a lot of discussion about Instacart and you looked at the prices of their funding rounds. And even though things had not gone very well recently, the early investors made plenty of money. later investors did not. In fact, they lost quite a lot of money. So even within the same deal, because of the timing and the price that different people went in at, it was a different failure or win for the different investors. And that can be a fairly typical scenario that if you pay a high price at the end, then your potential return is not so good and you're sort of first in line to lose money if the acquisition outcome's not great. Yeah, that's a great example. for sure, I think that's a great example. was personally invested in Instacart. I think it was in the Series C and I ended up breaking even on the IPO. sat on the stock for, I don't know, a year or so and made some money because it appreciated after the IPO, but it was a modest return. I mean, it was probably like an 8 % IRR. And so I think that's a great example of how early investors can do a lot better than later investors, even though It's quote, a successful exit through an IPO. Right. Yeah. I mean, the opposite scenario happens sometimes too, that the early investors get crushed by later investors and don't make any return and the later investors do make returns. So it's not the only scenario for sure. But I guess it's just illustrating the wider point that there's no such thing as a single failure on a deal. It can be a win or a loss depending on what round you're in. And it's a bit harder to say where you are because the price is such an important determination of whether your investment is a win or a loss. Yeah, that's a great summary of the issue. So he didn't convince you. Tell us about the three exceptions that he talks about. Yeah. So he does, he does admit that there are some exceptions to his rule, that there are a couple of different groups of investors that the angel investors that don't necessarily have the same calculus as VCs. One of those is what he calls supporters. it's some kind of inside, you know, in the industry, they have some particular affinity for that thing that the company is doing. you know, like you're a, your spouse has cancer, you're more likely to want to invest in a cancer curing startup because you have a direct sort of personal connection to that problem. And that's undoubtedly true. There are a lot of those. you can absolutely see why, you know, if you have people with devastating diseases, you are more likely to overlook the economic calculus of an angel investment because the sort of karmic payoff is much higher and you can actually help people like people that are suffering around you. So I think that's actually a pretty. Yeah, mission investing, some kind of personal investing. people do that a lot. do that. You know, I think a lot of people do that. And I think it's a perfectly good thing to do. Even if it means investing in deals, whether you haven't mass, you know, completely optimized for your financial risk reward return. And, know, this guy mentions that I think that's actually a pretty big determinant of why there's a difference between angels and VCs. I don't think it's the only one, but I think it's definitely one of the, one of the major reasons why. His proposition is wrong, but I think the reason why Angels and VCs are different is this is a good reason for that. Okay, what about the others? of related. Yeah. So another bucket is that he talks about operators, people who want to buy a position in a company. That company might be a later stage or cashflow producing. it's worth doing. You basically buy yourself a job out of doing the angel investment, which I think is a pretty small scale activity. That doesn't happen as much, but I think it does happen. I mean, we've certainly got companies in our portfolio where somebody invested a chunk of money with a view to being in the team. So that does, that does happen to be determined whether that happens successfully or not, but it does, it does happen. And then the third bucket is what he calls dumb money, which I guess is where I sit. So I don't necessarily agree that that is a, exception. don't think people are actually doing this stupidly. I guess arguably if you're persuading your friends and family to do an angel investment, you are relying on the fact that they don't know what they're doing, but honestly, I don't think that's really a big, big, big section. We just disagree on what the way is to evaluate this stuff. I did a little reference to a book about stupid in terms of trying to define what's really stupid as opposed to silly or misguided or whatever. yeah, think, you know, stupid by that definition in the book I referenced is somebody who does something that doesn't bring them any benefit and hurts other people. So I'm not sure you can apply that definition to a naive angel investor because typically somebody benefits from that investment. And a lot of angels, they start out, they do uninformed deals or they make uninformed choices because they're learning the business. And that can be said of VCs as well. So I'm not sure dumb money makes sense. I agree, although I see on your point that some people do make mistakes. They do invest thinking about things the wrong way. Maybe they assume that startups actually do succeed at a 90 % rate instead of a 10 % rate turning around his flawed statistics there a bit. I'm sure it's true that some people are getting into this for the wrong reasons or don't know what they're doing yet and they're learning. and that's probably okay as long as they're learning as they're doing it. We do find that a significant number of people that join Venture South, as an example, only invest in one or two deals, despite everybody saying all the time that that is not a smart thing to be doing. so stuff happens and people make mistakes and do things in ways that perhaps aren't a best practice. But I don't think it's because a significant number of angel investors are just dumb money. Well, putting those three buckets of exceptions together, seems like that actually would be a significant number of deals or investors. I think it is a significant number. Yeah. I don't actually think it's a majority of that 10 X difference that we talked about. I mean, angels just have a different calculus for all kinds of different reasons. And those are three potentially, you know, two potentially good reasons and one arguable one. but, you know, I think there was a probably a half dozen others that you could come up with about why the, why the calculus is different. And we've given you one, know, the Southeastern investment thesis argument is that. We do deals differently here with different outcome expectations and therefore we can do different deals. I think that's a big chunk of the difference between those two deal sets. Well said. So was there anything in this paper that you actually agreed? Yeah, I mean, some of the things that he says are true. There are definitely people out there that are making investment decisions without good information. So I agree with that. He has a, a criticism of people throwing money into SAFEs that never get converted. We've talked about on the show, you know, that that is perhaps not a good idea. It's interesting that he particularly complains about SAFEs, which we talked about, I think in episode 88 about what SAFEs are and why they're good or not for angels. His specific complaint is that those SAFEs never get converted into stock, which is a fair complaint. Doesn't happen very often though in the Southeast because we rarely invest in SAFEs with no view to what happens next. It's not the top two reasons why I would object to a SAFE, but it was the reason he flagged and a legitimate one as well for SAFEs being a challenge. And then he says at the end, sometimes misguided investments pay off big anyway, so who's to say? And I agree with that. mean, a lot of this is luck. You can theorize about all this stuff all day. The next person you meet will say, yeah, I made a thousand X on a deal and everything else has been a loss since then. So your way of doing this is stupid. And you can't argue with people's experience and stuff happens all over the place in different ways. So that part I also definitely agree with. So there's clearly an alternative view. What is it? Yeah, I think it's sort of the southern US investment thesis that we talked about in episode 123. And just quickly to recap that, is looking at investments with a potentially lower outcome on that individual investment because it's not as risky, it's a bit more local, the price might be lower, the outcome upside is less, but the incoming price is lower and more predictable. And you can use that scenario or that characteristic set to get to a medium, median return that is as good as or better and has less variance around than the big swing West coast angel investment thesis. So that's sort of the short way to articulate that. And that's actually pretty funny on, on the other thing that LinkedIn serves me a lot of is people discovering that for the first time. And it's really pretty funny to see all the people saying. I just learned about this new investment thesis where you can do smaller scale angel investing in a local way with smaller investment outcomes. This is the way of the future. It's like I'm impressed of your profound insight there, but that is angel investing investment thesis circa 2009. People have been doing this for a long time. glad you finally come back to, I'm glad that that thesis is now in vogue again, because it wasn't in vogue for a while. People are rediscovering it now. Yeah. it's pretty fun to watch that too. I covered that in my intro last week where there was a venture capitalist in the West Coast that was starting a new fund and that was his thesis that he was focused on early exits and acquisitions as opposed to IPOs at smaller valuations that he could make money. And I was going, wow, welcome to the Southeast. But this may be a good opportunity to show a couple of graphs, just share some data. The first is a graph of IRR versus investment stage. And this is from GitHub Research Vault. And looking at seed series A, series B, and series C, what the average IRR is that's available in the public domain of information. And this slide shows very nicely that you get a much higher return with the seed in series A than you do in series B and series C. CREC actually declines pretty prominently down to like 10 % while seed is up around 30%. And so this is why we talk about early stage angel investing being, if it's well diversified can be very rewarding investment. And then just to provide some backdrop to that, I also have a graph here showing hedge fund performance, which recently was published by Pivotal Path. And it's a 25 year report of hedge funds that, you know, it's not exactly the same as venture, but there's a lot of similarity. But the general public perception is hedge funds return huge profits to their limited partners. When in reality, this slide shows that the results are more likely around 10 or 12 percent on average. And in this slide, you see the the blue bar is 10 percent. And you can see a lot of the annual returns in the last 25 years were below 10%. And not that many were above and those that were above that far above 10%. And so all things are relative. And I think, you know, when you're looking at angel investing, one of the big attractions is early stage larger returns, but it requires the finesse to do great diligence and be diversified and you haven't have enough capital to be diversified because you can't invest in one or two companies and expect to have a good outcome. So this just kind of corroborates that logic. Yeah, it's always instructive to see what people's expectations are about things. the stock market doesn't return 20 % per year. Alternative assets don't generally return 25 % per year. It's all single digits or mid teens. It's hard to do this stuff consistently. It's nothing on average generates stellar returns. I honestly don't think the GitHub data about seed stage investing IRI is right either. I mean, do not believe that 33 % is the average. Some funds do do that. There's plenty of funds on Twitter that claim they do that, but I don't believe that those averages are anything like real. I think a 3X DPI fund at a 18 % IRR is a pretty good outcome for every alternative asset. including VCs and angels. So yeah, it's, it's a little hard to calibrate expectations. Everybody hears about the super rich guy that got super rich by doing something. you've got to look at the data and the averages and the medians of that, of the averages too, not just the means it's like, yeah. there's the lot of, a lot of misaligned expectations about what this stuff can do. And yeah. if listeners are interested, we did a recent interview with a, what we call the, lone wolf angel. And this is exactly somebody who on their first angel investment made a killing and then their subsequent angel investments did not. And, so they learned, in reverse sequence how to do angel investing. and it worked out for this particular person, but a lot of times and probably much more often it's other way around. first couple of investments are terrible outcomes until they get the hang of what the real important factors are. Yeah. Yeah. review of that article and that perspective on angel investing versus VC investing and what's different and what's not. So thank you for that. Yeah, thanks David. just to sum up, I mean, it's always good to disagree with people on the internet. It's not always a usually constructive use of time to do that, but it is interesting to see what people post. I think it's important. I felt it was important to tackle it because I don't want startups to get the wrong advice. If you're a startup in the Southeast and you're hearing that VCs are not for you, don't assume that angels are not for you. In fact, I would probably like to hear from you more if you're getting the advice that VCs are not the route you should be going. sort of a request, I guess, for listeners is try to evaluate your options and don't lump them together. Try to get to grips with some of these nuances because somewhere in there is the right funding partner for you. And I don't want you to be thinking it's not angels because you're reading the wrong LinkedIn articles. All right, thank you for that, Paul. Thank you for listening! Visit us at VentureInTheSouth.com for a complete list of previous and future shows!