A capitalist economy can be divided into two fundamental elements – capital and labor. Labor is the collective body of time expended by individuals in work. Employment contracts are used to formalize the exchange of labor for an hourly wage or annual salary. This simple agreement allows teams of people to organize themselves in an efficient way, to put their strengths to use.
Capital represents the materials, buildings, equipment and other assets which are productively used within an economy. All of these items are interchangeable for cash (at the right price), which broadens the definition of capital to the ‘material wealth’ of the economy.
In the modern day, virtually all business operations require a combination of capital and labor. Consider that even a labor-intensive business such as hairdressing requires property, fixtures & fittings and tools. However, a drawback of the capitalist model is that individuals are born into this world without capital. As such, many young adults don’t have the financial firepower to be able to fund their own start-up businesses. This is where venture capitalists and business angels have a part to play. These two types of financiers have plenty of capital at their disposal and have the discretion to make equity investments into start-up enterprises.
An equity investment sees the financier provide vital cash which the business will use to pay wages, develop products, rent a property and otherwise establish themselves. In return, the entrepreneur cedes a portion of their shareholding to the financier. In case of company’s shares, investor or financier gets voting power and the right to receive dividend.
An entrepreneur relinquishes the element of control and financial return by entering into a transaction with an equity investor. However, they hope that a smaller share in a possibly larger business will be more valuable than holding a 100% share of the current business.
This article will explain the differences between venture capitalists and business angels. From the perspective of a layperson, it can be difficult to differentiate between these two groups of investors. However, there are key and clear differences that will lead entrepreneurs to prefer working with one over the other, depending on their personal circumstances.
Definitions and meanings
A venture capitalist is a catch-all term used to describe a senior employee of a venture capital fund or firm. He will usually have a title such as ‘partner’ or ‘senior analyst’.
A venture capital (VC) fund is a collective investment vehicle that makes equity investments in early-stage businesses with high growth prospects. It pools cash from external investors and uses this to invest in a selection of diversified investment opportunities. By delegating the investment management process to venture capitalists, investors can access private equity returns passively.
A common legal structure for venture capital sees the executives form a partnership using their own personal money. This partnership then invests capital into each VC fund launched by the group. This personal financial commitment sends a signal of confidence to prospective investors. It also elegantly aligns the incentives of the venture capitalists with the investors. If the funds succeed, the VC partners will also see a positive return alongside the external investors.
A business angel is a private investor who provides capital to businesses, typically small or fledgling businesses, in exchange for an equity stake.
Business angels can form investor groups, known as a syndicate that perform research, due diligence and investments in tandem. By pooling their resources, they reduce the burden of professional fees and, therefore, reduce their overall cost of investing.
However, please note that angels investing as part of a syndicate are still investing as individuals in their own right. Their own name would appear on the shareholder certificate, rather than the syndicate itself, which is not usually incorporated.
Difference between venture capitalist and business angel
Three key points of difference between venture capitalist and business angel are as follows:
1. Agent & principal
A venture capitalist is a finance professional acting as an agent rather than as a principal directly. The deals struck by a VC professional will involve the capital of many other investors. A venture capitalist will often receive a salary or bonus in return for performing his role. His own indirect stake in the deal, via the VC partnership, may not be particularly material. As such, venture capitalists have a duty to act professionally as responsible custodians of the assets under their management. In the UK, they must subscribe to code of ethics such as the BVCA Member Code of Conduct. This requires venture capitalists to:
- “… be accountable to their investors and keep their investors fully and regularly informed, including the provision of regular financial reports.”
- “… respect confidential information supplied to them by companies looking for private equity investment or by companies in which they have invested.”
In contrast, business angels are principal investors in any transaction they make. Having self-financed the investment, their sole interest is in maximizing the return they achieve from their investment.
2. Level of influence
Venture capitalists tend to invest during formal fundraising rounds during the high growth phase of a business. They invest alongside other corporate investors. To ensure that they can spread their funds across a number of start-ups to achieve diversification, they usually limit their exposure to each investment. This means that a VC fund may hold only a small percentage of the outstanding shares in a company. These shares may or may not include voting rights.
As such, a venture capitalist does not usually exert significant influence over the strategic or day-to-day operations of a start-up. As the best venture capitalist books often conclude, VC funds are effectively passengers for the duration of their investment journey.
Business angels tend to be more active at the very beginning of business germination when businesses carry a lower valuation. Due to high transaction costs of investing as a private investors, these investors also tend to diversify less and choose to invest a higher proportion of their investment portfolio into each investment.
Consequently, business angels generally cut deals that see them receive a large share of the investee than a venture capital fund. Business angels may also have a seat on the board of directors, or the right to participate in any future fundraising round.
3. Time investment
Venture capital firms spend time monitoring their investment and may hold periodic meetings with management. During these updates, they will discuss historical financial performance, challenge the growth plans of management and enquire about future fundraising or exit strategies.
Business angels are known for making an explicit promise of consultancy and managerial support to a business alongside the cash on offer. Because of having experience in business and finance, and with access to teams of professionals and consultants, they are often well-placed to share their wisdom with entrepreneurs
The TV shows Shark Tank and Dragons Den feature investors who carry the ‘business angel’ label. These formats clearly state that the business angels will give some of their personal time and attention to the investee. In some cases, they offer training and accountancy assistance to help professionalize one or two-person businesses that currently lack financial expertise.
Venture capitalists are professional investment managers who raise funds from wealthy investors and make small equity investments across a broad variety of start-up businesses and sometimes invest their own money alongside.
Business angels are private investors who act as individuals in offering cash and expertise to start-ups in exchange for a larger equity stake and some influence over the business. The direction and advice provided by a business angel could de-risk the venture and provide it with some contacts and support otherwise not freely available to a small business.