How Do Venture Capitalist Justify Doing Angel Deals To Their Investors?

Q: It seems that many VCs do angel deals on the side. For early stage (or even mid stage) VCs, how is this justified to their LPs? Wouldn’t VCs have the ability to select the best deals for their own cash and leave the LPs to invest later (through the fund) on at a higher price?

A: (Jason) This isn’t a problem with reputable VCs. Here is why:

First, most fund agreements say that VCs can’t engage in this type of behavior. This can be achieved in a number of ways from the LP advisory board having to sign off on all angel deals of the partners to a provision in the LP agreement that says VCs can only do angel deals that the fund would not consider for investment.

Second, assuming that the VCs do invest in angel deals, most don’t have enough money, personally, to fund a company through its life cycle. In fact, many only fund the angel round and don’t continue funding future financings. Bottom line, they are going to need outside capital – probably from their own fund. In this case, the only legitimate way to deal with the fund investing in this company is to buyout the VCs personal stake at his / her cost – no markup or cost of capital. In this case, the fund is actually getting the advantage of buying shares at a lower price with less risk because the company is later staged.

Third, remember what VCs are in business for: to raise additional funds to provide above market returns for their investors. If VCs were to hoard all the good deals in the personal portfolios, their main funds would perform poorly and they would not be able to raise future funds.

  • Ryan

    So are you saying that VCs don’t invest in Angel rounds separate from their own fund?
    It seems to me that VCs might invest in companies that don’t fit the profile of the fund without conflict.
    I can’t say I know of any deals happening this way, but it sounds like the person who asked the question is aware of many cases of VCs playing Angels on the weekends.

  • Jason

    Yes, VCs DO invest in angel deals that the fund wouldn’t do. See point one in the post.

  • I don’t think of these as competing investments.
    A VC participating in an angel round is complementary to the fund, and if I were the LP I would almost encourage it. By getting in early and establishing a relationship with the company, the VC is more likely to be involved in subsequent rounds of capital. And, because the VC has been involved from an early stage, the LPs should feel better about the subsequent investment.
    (Not even considering the cost of the equity at this point but that’s obviously an advantage as well).

  • It’s the exception rather than the rule.
    I’d recommend researching what typically happens with deals the VC individually backs. Depending upon how much the fund focuses on partner alignment, the individual investment can actually complicate getting their fund to invest — particularly if the fund values the company lower than the angels did.
    At the least, it’s worth asking the VC up-front exactly what happens to their holdings if their fund wants to invest in the future.