Angel investors (angels) and venture capital (VC) investors are both important sources of financing for entrepreneurial firms, but some critics, particularly VCs, often believe that angels are less able than VCs to perform due-diligence. However, an alternative view holds that VCs and angels are equally adept at adding value to startups. For example, a recent article by AngelList mentions that the presence of top VCs in a seed funding round of a startup does not affect the probability of its success. It is therefore important to empirically analyze and compare the value added to startups by angels and VCs. However, the existing finance literature has yet to do so, and we aim to fill that gap in a new paper,“Angels and Venture Capitalists: Complementarity versus Substitution, Financing Sequence, and Relative Value Addition to Entrepreneurial Firms.”
In our paper, we use several private-firm data sets to address three important research questions. First, we compare the extent of value addition by angels versus VCs. We use several important measures to capture value additions: probability of successful exits (IPO or acquisitions); the quantity and quality of innovation output; sales growth; employment growth; and the net inflow of high-quality inventors to startups. Second, we analyze whether VC and angel financing are complements or substitutes. Third, we examine the effect of financing sequence – the order of investment – by VCs and angels on the likelihood of a startup’s successful exit.
We compile our private-firm data from various sources. We collect round–by-round financing information on U.S. startups from CrunchBase and VentureXpert. While Crunchbase provides information on aggregate funding per investment round at startups, VentureXpert provides information on investment made by an individual VC in each investment round. We obtain the fraction of VC investment in an investment round using the above two datasets. The successful exits of startups in terms of initial public offerings (IPO) or acquisitions are also obtained from CrunchBase, which also provides information on founding years of startups. We use the National Establishment Time Series (NETS) dataset to obtain information on the sales and employment levels of private firms. Our patent and inventor data come from the United States Patent and Trademark Office (USPTO) dataset shared on PatentsView. Our main sample covers 5,586 U.S. startups financed between 1990 to 2015.
We find, first, that firms with a higher fraction of angel investment in their first financing round are associated with a smaller likelihood of successful exit either through an IPO or an acquisition. Our results are statistically and economically significant. A one standard deviation increase in the fraction of angel investment (relative to VC investment) in the first financing round is associated with a decrease of 11.1 percentage points in the average probability of an IPO. Second, we show that firms with a higher fraction of angel investment in their first financing round are associated with smaller sales growth and smaller employment growth. Third, we show that firms with a higher fraction of angel investment in their first financing round are associated with a smaller quantity and quality of innovation output. Fourth, we show that firms with a higher fraction of angel investment in their first financing round are associated with a smaller net inflow of inventors and a smaller net inflow of top-quality inventors. All of our results are statistically and economically significant.
Our baseline analyses may suffer from a common endogeneity concern in the entrepreneurial finance literature: “selection” versus “value-addition” (or monitoring). In other words, are VCs better than angels at selecting startups or are they better at monitoring, or do both factors play important roles? To disentangle the selection versus value-addition effect, we use two methodologies: instrumental variable (IV) analyses and switching regression analyses. Our IV analyses show that angels add less value to startups than VCs do. Our switching regression analyses support our IV analyses.
Next, we study the relationship between angels and VCs: We test whether angels and VCs are “complements” or “substitutes.” For example, does a startup receiving a larger fraction of angel financing in its first round make it more or less likely to receive VC financing in a subsequent round (complements)? For this analysis, we include firms financed by syndicates consisting of not only VCs and angels but also other types of investors such as accelerators and governments. We find that having a greater fraction of VC financing in the first round makes a firm more likely to have a larger fraction of VC financing in its next round. However, having an angel investor in the first round of financing also makes a firm more likely to receive a higher fraction of VC investment in the next round. Our result stands in contrast to the findings of Hellman et al (2021) using British Columbia (Canada) data on startups; they find that angels and VCs are substitutes and invest in different industries. Our findings support the prediction of the theoretical model of Chemmanur and Chen (2014), who suggest that angels and VCs are complements and that angels prepare startups for future VC investments. However, we also find that a greater fraction of VC investment in the first round is associated with a smaller likelihood of angel investment in the next round, while the presence of angels rather than VCs in the first round is associated with a higher likelihood of having angels in the next round of financing. Overall, the above analyses suggest that angels and VCs cannot be classified solely as complements or substitutes in the financing of entrepreneurial firms. Further, our findings suggest that the relationship of angel investors and VCs is complex: Angels and VCs may act as either complements or substitutes.
We also examine the relationship between startups’ financing sequence (the order of investments made by angels and VCs in various rounds) and their probability of subsequently successful exits (IPOs or acquisitions). In this analysis, we include firms that received only angel or VC investments (or both) in their first two rounds of financing. Thus, we are able to define a dominant financier based on the fraction of investment in a funding round, i.e., we define VCs as a dominant financier if the fraction of aggregate VC investment in a round is greater than 50 percent, and similarly for angels. We categorize four financing sequences based on the first two rounds of investment: from angel-dominated to VC-dominated (angel-to-VC), from VC-dominated to angel-dominated (VC-to-angel), from VC-dominated to VC-dominated (VC-to-VC), and from angel-dominated to angel-dominated (angel-to-angel). We find that firms with VC-to-VC or angel-to-VC financing sequences have a greater likelihood of successful exit compared with angel-to-angel and VC-to-angel financing sequences. The above results are consistent with the theoretical predictions of Chemmanur and Chen (2014), who argue that VC investments in early rounds are positive signals of a startup’s quality, resulting in a higher chance of a successful exit, while venture exits in later rounds convey negative signals about firm quality, leading to a smaller probability of successful exit.
Chemmanur, T.J. and Chen, Z., 2014. Venture capitalists versus angels: The dynamics of private firm financing contracts. The Review of Corporate Finance Studies, 3(1-2), pp.39-86.
Denes, M.R., Howell, S.T., Mezzanotti, F., Wang, X. and Xu, T., 2020. Investor tax credits and entrepreneurship: Evidence from us states (No. w27751). National Bureau of Economic Research.
Hellmann, T., Schure, P. and Vo, D.H., 2021. Angels and venture capitalists: Substitutes or complements?. Journal of Financial Economics, 141(2), pp.454-478.
Samila, S. and Sorenson, O., 2011. Venture capital, entrepreneurship, and economic growth. The Review of Economics and Statistics, 93(1), pp.338-349.
This post comes to us from Thomas J. Chemmanur, a professor of finance at Boston College’s Carroll School of Management; Harshit Rajaiya, an assistant professor of finance at the University of Ottawa; and Jiajie Xu, a PhD student at Boston College’s Carroll School of Management. It is based on their recent article, “Angels and Venture Capitalists: Complementarity versus Substitution, Financing Sequence, and Relative Value Addition to Entrepreneurial Firms,” available here.