Friends or Foes: The Interrelationship between Angel and Venture Capital Markets

Abstract

This paper develops a theory of how angel and venture capital markets interact. Entrepreneurs first receive angel then venture capital funding. The two investor types are 'friends' in that they rely upon each other's investments. However, they are also 'foes', because at the later stage the venture capitalists no longer need the angels. Using a costly search model we derive the equilibrium deal flows across the two markets, endogenously deriving market sizes, competitive structures, valuation levels, and exit rates. We discuss how the model generates alternative testable hypotheses for the recent rise of angel investing.

Angel Financing and the Performance of High-Tech Start-Ups

“…Accordingly, potentially new entrant VCs would not perceive the need to invest in the start‐up when backed by a BA with an experience in later stages. This double attitude of VCs, which is likely to produce both friendship and rivalry effects, has been described in Hellmann and Thiele () and Hellmann, Schure, and Vo () . Given these premises, we expect that BAs' past experience in early stage investments is likely to be associated with a better interim performance and to be especially valued by entrant VCs.…”

“…Although previous studies suggest that BA financing dominates VC financing globally (Fenn and Liang ; Hellmann and Thiele ; OECD ; Wiltbank et al ) and that BAs are as important for high potential start‐ups as VCs (e.g., Freear, Sohl, and Wetzel ; Landström ; Mason and Harrison ; Shane ), limited attention has been paid to such field of the entrepreneurial finance literature. Due to the paucity of data on BAs, most of the extant studies are mainly descriptive or rely on small scale surveys.…”

“…Several reasons can be foreseen from both the BA and VC perspectives. BA investors usually have limited resources and typically need VCs to provide a growth option for their companies (Hellmann and Thiele ) and an exit route to realize profitable returns. Follow‐on finance by a VC (or co‐investment with a VC) is often the discriminant factor that allows a firm to grow to the point that an IPO is feasible or a sale is attractive to potential acquirers.…”

“…Available figures mainly refer to the U.S. market and generally suggest that BA financing dominates VC financing, both in terms of number of invested firms and of total amount of financial investment (Sohl ; Wiltbank ; Wiltbank et al ). According to Crunchbase, the U.S. angel market grew at an annual rate of 33 percent between 2007 and 2013 (Hellmann and Thiele ). Fenn and Liang () also reported that in the United States, for every one firm that raised VC, six raised a BA investment and that approximately one‐third of firms that went public were funded by VCs and two‐thirds by BAs.…”

“…The effect is more pronounced for single‐company BAs than for multiple‐company BAs, or for those that invest together through an angel fund. Hellmann and Thiele () develop a theoretical model of how BAs and VCs interact. VCs and BAs are “friends” because they rely upon each other's investments, but they are also “foes” because VCs no longer need the angels when later stages are reached.…”