Should Angel-Backed Start-ups Reject Venture Capital?

My new Essay Should Angel-Backed Start-ups Reject Venture Capital? challenges the conventional wisdom that venture capital is a necessary – and even desirable – source of financing for all start-ups.  In particular, this Essay argues that some start-ups that attract angel investors should stop there, rejecting proffers of venture capital that may follow. The Essay challenges the notion that venture capital is a necessary condition for start-up success, and argues the counterintuitive proposition that venture capital may actually be harmful to entrepreneurs and angel investors in some situations.

At the outset, I observe that angels are now able to fund certain start-ups from their early stages to exit both because start-ups need less money and because angels can provide more of it.  After describing new realities that make angel-only financing of start-ups possible, I explore three reasons that also make them more probable going forward.  First, with the negative and perhaps lasting changes to IPO markets over the past decade, trade-sale exits have taken on increased prominence.  Venture capitalists (VCs), however, may actually impede smaller-dollar trade-sale exits that would be desirable to angels and entrepreneurs because they do not produce a large enough return on investment for VCs.  As angels and entrepreneurs experience the “lock-in” effect of venture capital (i.e., illiquidity from the VC’s desire to “swing for the fences” on exit), they are more likely to pass on VC involvement in future deals.

Second, from a corporate governance perspective, angel-only start-ups can lower the transaction costs and agency costs of VC involvement.  VCs create these problems by investing in preferred stock, as opposed to the entrepreneur’s common stock.  Angels, on the other hand, have long held the same common stock as entrepreneurs, which aligns their incentives.  It is only with the recent rise of professional angel groups that angels have moved into preferred stock – a move motivated in part by the need to protect themselves from VCs. Without VCs, angels would only have to worry about protecting themselves against opportunistic entrepreneurs, and angels have informal means of protection available to them that reduce the need for preferred stock’s formal protections.  Moreover, without VCs, start-ups could even begin to organize as LLCs rather than C corporations, which would increase investor tax advantages on losses (although increase tax burdens on certain gains).

Finally, from a social-welfare perspective, angel-only start-ups allow broader geographic distribution of innovation-based gains beyond Silicon Valley.  Angel-only start-ups do not have to move their headquarters and operations to be close to VCs.  Instead, these start-ups can remain anchored in the states where they began.  Indeed, many states have economic development plans that emphasize entrepreneurship.  This Essay argues that angel-only financing should be an important part of that conversation.

After exploring these three upsides of angel-only financing for start-ups that can get by with less capital, this Essay concludes with two caveats for start-ups that consider going this route – one related to tax advantages VCs can bring start-up employees, the other regarding the availability of venture debt to angel-only VCs.  Despite these caveats (which I show are less worrisome than they initially appear), I predict that we will see more angel-only start-ups going forward, given the previously-unexplored advantages that rejecting venture capital can bring.

The full text of the Essay is available here.