Jul 3 2007

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.