This week we continue one of the themes from last time’s post, diving deeper into how angel investments and venture capital investments have in the past been structured differently. Today’s paper for discussion is Are Angels Different? An Analysis of Early Venture Financing by Brent Goldfarb, Gerard Hoberg, David Kirsch, and Alexander Triantis from 2013. Paper available here.
Goldfarb et al look at 182 Series A preferred stock deals from 1993-2002 made into high-growth / tech companies from the records of a defunct law firm saved in a “Closed Archive” in the Library of Congress – an interesting set of source data for sure! – documenting the varied deal terms and participation from investors. The records cover 458 founders (across 165 companies), 482 different VCs (across 150 deals), and 2,528 angels (mostly individuals, but also including non-VC institutions like universities or banks, across 144 deals). They also crunched the usual sources for internet presence, later rounds, and exit data.
“We find support for the conventional wisdom that angels invest with fewer protections than do VCs” (p.2). These are deals involving a prominent law firm, so the angels are most likely to be “sophisticated” and “most like VCs” (p.3). Even being sophisticated, they accepted fewer downside cash-flow and control protections than VCs.
Why did they do that? In section 2, the authors outline prior scholarship about why, despite the earlier-stage, “higher-risk” investments angels make, they do not require more protections than later-stage VC investors. This has been a puzzle for some time.
The authors consider three potential explanations: 1. transaction costs – legal fees are expensive, and on smaller deals no-one can afford them, so the deals have fewer terms including protections; 2. “preferences” – angels are often entrepreneurs, and are more closely aligned with entrepreneurs, and can influence them socially rather than contractually (or are just more naïve); 3. “selection” based on some kind of unobserved variable (which, honestly, I don’t get!). And conclude that #2 (angels align with entrepreneurs more than VCs do) is best supported by their data.
Let’s quickly review what these protections are. The first is dividends: VCs have them, angels do not (p.18, and none of the angel-only deals had them per p.20). The authors argue this suggests VCs are less patient and use this tool (“a strong incentive for the firm to accelerate to a successful exit event” (p.18)) to get things moving. Not sure we agree this is really that powerful a tool – though maybe that proves the authors’ point!
Second is liquidation preference. Honestly we don’t quite follow what the descriptions here mean – they don’t seem to describe “liquidation preferences” as we understand them. But whatever exactly is being measured, here the protections for angels are “much less favorable” (p.20) – with the difference looking fairly stark (0.579 for VC, 0.125 for angel-only, significant at the 1% level) on Table IV.
Lastly, redemption rights. Again VCs have them (72 of 150 deals), angels do not (4 of 32 angel-only deals) (p.20).
Today, we would expect 1x liquidation preference on all deals, no dividend, and sometimes (perhaps 20-40% of the time) a redemption right in angel deals. Why are the structures in this dataset so different from that expectation? Have things changed over time, so that angels have learned the lessons from forgoing some protections (liquidation preference), or have angel investors’ preferences become less aligned with founders as angels have become more “professional”? Have VCs learned to be more investor friendly (forgoing redemption rights)? Is the sample misleading?
At VentureSouth we propose “VC-style” structures in our deals – priced preferred equity rounds using NVCA model documents – even if (in the wisdom of some) that is “overkill” for what’s needed in an angel round. We try to avoid SAFEs and convertible notes, wholly avoid common stock, and judge equity rounds lacking protections harshly. Not all funds do. Whether this leads to better or worse returns, we’ll leave for you to judge – but this paper definitely suggests limited protections can lead to worse returns.
This is a fascinating paper overall, and leaves us with more questions than when we started! In addition, there are some random interesting nuggets that we thought you would enjoy:
- The superior performance of VC-only, larger deals is only present when the board of directors is not firmly under the control of either common or preferred shareholders. (p.4). A balanced board of directors is the way to go. We mentioned this in Episode 99 of the Venture In The South podcast here.
- Warrants were also sold in 15% of the rounds, and more so in the smaller deals (20%) (p.17). How does that square to how often your deals include warrants? Seems high to me. Wonder why?
- We find that the average time between first and second closings is 153 days, though it is much longer for large deals (198 days on average) (p.17). It’s absolutely standard practice for rounds to take some time to fill entirely (despite FOMO and overnight deals you might read out), but this length is surprising even so.
And any attorneys reading might be interested to learn the average billing was for 169 hours of work (p.17). Ooof.