Venture capital and angel investments are types of private-equity financing. These investors provide money to get a nascent business off the ground and keep it growing. They hope the startup will succeed and reward them with returns that amount to many times their original investment.
Both typically receive equity or an ownership stake in the business in exchange for their investment. And both types of investing involve high risk because most startups fail.
What is venture capital?
Venture capital firms raise their investment dollars from limited partners, usually endowments, insurance companies, pension funds, or other financial institutions. VCs pool the money to invest in promising young businesses. They take a management fee and a percentage of returns if the startup succeeds.
VC funds are run by professional investors. They want companies to show evidence of growth before they commit funds. This means VCs usually get involved in funding rounds after founders, associates, and angels have provided seed money—although recently some VCs have started investing earlier, at the seed stage.
Venture capital has launched some of the planet’s best-known companies—and made millions, and sometimes billions, for the partners. Facebook, Twitter, Zoom, Airbnb, and other household names got started with VC backing.
New York City-based Union Square Ventures turned a $5 million investment in Coinbase in 2013 into a stake worth about $4.6 billion when the cryptocurrency trading platform first sold shares to the public in April 2021.
The firm’s investment during the Series A round valued Coinbase at 20 cents a share. Eight years later, Union Square’s investment had multiplied more than 4,000-fold. (Coinbase had lost almost three-quarters of its value from its peak as of June 2022 as crypto prices plunged and high-flying stocks lost altitude.)
An individual who meets Securities and Exchange Commission criteria can participate in venture capital deals. These accredited investors, or those with a net worth of more than $1 million, income of $200,000 or $300,000 jointly, and certain professional licenses, can become limited partners in a VC fund.
An individual can also become a qualified purchaser. They must have invested at least $5 million of their money or at least $25 million of their money and that of other qualified purchasers. Qualified purchasers enjoy wider access to deals than accredited investors.
What is angel investing?
Angel investors, in comparison, are usually wealthy private individuals. They invest their own money, rather than funds collected from partners. Angels must be accredited investors. They often form groups to increase their range and clout while spreading out risk.
Angels typically invest in startups earlier than VCs do. They help nascent businesses pay for nuts and bolts, rather than fund expansion. Angel investments are called “seed money” because they plant seeds for future growth. These early bets make angel investments riskier than their venture capital counterparts.
Angels have seeded companies that define their industries. A $100,000 angel check helped launch Google. Uber’s early investors turned $5,000 into multimillion-dollar profits when the ride-hailing startup went public.
Venture capitalist vs. angel investor: Key differences
The terms angel investor and venture capitalist might seem interchangeable because both describe investors who fund entrepreneurs and nascent businesses. However, there are notable differences.
- Investor type. Venture capitalists usually invest via funds that are usually structured as partnerships, whereas angels tend to be wealthy individuals or groups of individuals.
- Funding source. In VC, funds come from limited partners and financial institutions. Most angels, by contrast, are investing their own money.
- Investment amount. VC funding often starts in the millions of dollars. Angels make smaller investments, generally between $5,000 and $250,000.
- Investment timing. While some VCs offer seed funding, many will only invest once the enterprise shows some signs of growth. Angel investments occur in the early stages of development.
- The investor’s role. Neither VCs nor angels run the companies they invest in. VCs may take a board seat, whereas angels can advise and support a startup.
- Stake size. VCs typically seek equity stakes of 25% to 50% and may own as much as half the business when the company sells shares to the public or is purchased by a bigger business. Angels typically take stakes that average around 20% but can seek 50% of a young company.
- Investment returns. VCs expect returns of 25% to 35% or more. Angels usually look for returns of between 20% and 25%.
Benefits and drawbacks of venture capital and angel investing
Venture capital and angel investments offer both benefits and drawbacks for investors.
Venture capital potential benefits
- Potential returns. Few startups hit it big but those that do can reward investors with hundreds or thousands of times their initial investment.
- Diversification. VC investors have access to diversified portfolios of high-risk/high reward companies and a variety of entrepreneurs rather than single mature companies.
- Experience. Venture capital firms typically have years of experience with early-stage companies and can make well-educated investment decisions after performing due diligence.
- Measurable metrics. VCs expect businesses to perform on a schedule and reach measurable targets.
Venture capital risks
- High risk. Most startups fail, costing VC investors much or even all of their investment.
- Poor performance. The startup may miss goals and founders may get distracted trying to recover. Managers may not execute the planned exit strategy or stay with the company.
- Macro events. Recessions, government shutdowns, new regulations, and other upheavals can sink a young company.
- Market changes. The market for a company’s product or service may never emerge, the product may become obsolete, or competition may limit customers.
- A long time before recognizing gains. Businesses may take years to go public or be sold, allowing an angel to realize a return.
Angel investing potential benefits
- Potential returns. Angels can earn higher returns than they may receive with many other types of investments. Studies suggest a portfolio of angel investments can return 27% or more annually, almost triple the stock market average.
- Diversification. Investing in startups diversifies an investor’s typical portfolio of stocks and bonds.
- Driving innovation. Angels can be on the ground floor of breakthrough technologies.
- Passion projects. Investors can put their money into businesses that are important to them.
- Limited obligation. Investors are not responsible for running the business. Many angel investors, however, do mentor young companies.
- Learning new skills. Angels may learn new skills such as structuring a deal and serving on a board. They can apply their existing skills to new ventures.
Angel investing risks
- High risk. Investing in early-stage businesses is risky. Research estimates that half to 90% of new, small businesses fail.
- Potential losses. Angels can lose all of their money if the company folds.
- A long time before recognizing gains. Businesses may take 10 or more years to go public or be sold, allowing an angel to realize a return.
- Market events. New technologies, economic conditions, and other unforeseen developments can overtake an emerging business before it becomes viable.
- Additional funding needs. The venture may not receive the additional funding it needs to grow.
- Tax implications. Investing in a startup has unique tax risks and the rules can be complicated.
Other funding options
Venture or angel funding are not the only options when a young business needs money. Startups can consider loans and sometimes tap alternative funding sources including:
- Bank loans. Traditional banks can help a startup figure out where it stands with financing needs. However, banks often require that entrepreneurs have strong personal credit, the business generates revenue, and has two or more years in operation.
- SBA loans. The U.S. Small Business Administration offers lenders a federal guarantee on business loans. This makes it less risky for banks to lend, allowing them to charge lower interest rates. The SBA also connects startups with favorable rates from traditional lenders.
- Online term loans. Internet-based lenders provide financing or lend to businesses that can’t qualify for SBA or bank loans. These lenders generally have less-stringent rules and may work with startups with bad credit.
- Online credit lines. A business line of credit allows a company to tap into a credit line and pay interest on only the portion of money borrowed.
- Business-to-business investors. So-called B-to-B investors supply funding for other businesses. They can be an individual or an organization that helps companies in a specific industry.
The bottom line
Venture capital and angel investments finance fledgling businesses. Angels and VCs share many characteristics, but typically diverge in terms of when they invest, whose money they invest, how much they commit, and how much they expect in return. Both financing methods carry tremendous risk because most startups don’t get off the ground. However, the ones that do can yield huge returns—angels and VCs count Uber, Google, and Facebook among their successes.