July 11, 2007
Larry Ribstein on Ibrahim's Angel Investors
Posted by Christine Hurt

Darian Ibrahim’s paper is a very useful discussion of the generally overlooked topic of "angel" investors.

These investors fill a gap in the venture capital world. Traditional venture capitalists fund startup firms until they are ready for the next stage – usually a public offering but increasingly to another private equity firm. But traditional venture capital involves costly contracting and monitoring, and therefore demands some scale. What do smaller entrepreneurs do before the VC firm arrives but after they’ve maxed out their credit cards?

They look for angels, of course.

As Darian explains, angels differ from standard-model venture capitalists in that they don’t use the usual, and costly, protective contracting mechanisms such as preferred stock, board monitoring, covenants. The main puzzle is why the angels don’t just leave the entrepreneurs with their credit cards. Darian has found, by my count, five explanations. I found these explanations useful and credible but not completely satisfying for the reasons discussed below.

First, angels are individuals, and therefore don’t have to face their investors like other VCs. But assuming the angels, who are businesspeople themselves, aren’t simply giving away their money (more on that below) they would surely need some assurances, wouldn’t they? The main difference between the contexts is the absence of agency costs on the funding side when the angel uses her own money. This necessarily introduces some rigidity in the relationship between the VC and the entrepreneur – part of the Gilson’s "braiding" of the two relationships. But it would seem that the agency costs between the investor and the entrepreneur would remain and demand some constraints.

Second, Darian talks about trust between the angel and the entrepreneur. Perhaps some of this comes from the fact that the angel funds local entrepreneurs. Reduced information costs mean reduced risk, other things equal, and therefore lower costs of trust. But Silicon Valley and its imitators similarly function as information-cost-reducers in the standard VC context. Does the trust come from family and friendship relationships? Probably not exclusively. Anyway, there’s the fundamental rule of MCE (money changes everything).

Third, the smaller scale makes it harder to use conventional VC-type mechanisms. To be sure, custom-designing constraints is costly. But are there off-the-rack contracts that might be used? More likely, as Darian says, the angel can’t use costly governance that a VC would later have to dismantle. And monitoring may be costlier per dollar invested, though it doesn’t seem the angels scrimp on monitoring – only on formal contracts. In any event, this factor would seem to restate the puzzle: why are angels willing to invest even if they can’t cost-effectively constrain the entrepreneur?

Fourth, perhaps the angels rely on self-enforcement, particularly including reputational mechanisms. But it would seem that there’s no more repeat play at work here on the entrepreneur’s side than in standard VC investing. Perhaps, as Darian says, the entrepreneurs are disciplined by the fact that they have to look good for the second-stage VC. But it’s not clear why this enforcement would be higher-powered than the VC entrepreneur’s incentive to look good to the investment banker and the public markets.

Fifth, and perhaps most persuasive, Darian discusses the angel’s private benefits, specifically the satisfaction they get from altruistically helping start-up entrepreneurs. In other words, maybe these really are angels! Darian refers to this as for-profit philanthropy. But that’s an oxymoron. Angel investing is qualitatively different from the sort of real philanthropy that AIO’s (see below) use, like endowing universities or funding soup kitchens. Angels want the entrepreneurs to be successful businesspeople, and that means earning money. Perhaps the altruism comes specifically in the form of a time contribution. The entrepreneurs could not pay market value for the time and expertise the angels devote to their investments. And time and expertise are the critical contributions that the angel makes.

Darian makes an additional and important contribution in his discussion of the development of angel investment organizations, which start to look a bit like venture capitalists, or at least like a gap-filler between angels and VCs. The key is that AIOs use the formal mechanisms that standard-issue angels eschew.

This is an important part of the discussion because it suggests the addition of a margin on which angel investing works, which enriches our understanding of the nature of angel investing. But in order to understand this better I’d like to know more? Are AIOs the next evolutionary stage of angel investing? Or do they handle a different set of firms? If so, what’s the difference between an angel-backed firm and an AIO-backed firm?

I’d also like to know more about the organizational structure of AIOs? Are they lps, like VC funds? Or non-profit corporations? (Limited partnerships can’t be non-profits). Does this structure influence how they operate, compared to standard VC firms?

I guess the value of this project is best demonstrated by the fact that I do want to know more. Darian has found an interesting, but under-theorized and under-explored niche, and has aptly suggested where future research in this area should go.

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