Do Angels Lose The Start-up Game When VCs Take Over?

When it comes to board room decisions, all is not always rosy between angel and venture capital investors of fast-growing start-ups. And the top angel investors in India have brought to the fore a few friction points that currently exist between angels and venture capitalists.

According to Deepak Shahdadpuri, managing director of BCP Partners, as a company grows and raises a VC round, the VCs and Series A investors sometimes insist that the angels exit (sell their stake) when the VCs make their investment. Off late, Shahdadpuri has observed this trend in his angel-funded companies and he is definitely not happy about. "I think the new VCs may give angels the option to exit but I do not think that they should be forced to exit," he said.

The decision on the composition of the board is, however, something the promoter and other shareholders take together. "I do not see any reason why an angel must be on the board if he or she isn't the right person," Shahdadpuri added.

Shahdadpuri was speaking at the second edition of VCCircle's India Angel Summit 2011, held in Mumbai on December 1. More than 250 investors and start-ups attended the event. Rahul Khanna, managing director of Canaan Partners, who steered the panel Post-Angel Funding: Raising Your First Early-Stage VC Funding, came up with some relevant questions that brought out their takes, pointers and insider views on the fundraising runway and how a start-up should go about raising its first early-stage VC fund.

Mahesh Murthy, founder of Seed Fund, believes that venture capital investors have an extremely narrow gate, compared to angel investments. "Angel investors are primarily part-timers and this suits young start-ups because during the angel phase, they need more time and freedom. But once they raise institutional funds, it becomes a bigger game, with higher stakes," he has explained. Mohanjit Jolly, managing director of Draper Fischer Jurvetson India, is of the same opinion. As VCs ensure that both cash and value are added to start-ups, they demand more in return, he feels.

So should a start-up pick a VC over an angel? Many of the large institutional funds are also willing to do seed rounds today and this has made it a difficult choice for entrepreneurs. Prashanth Prakash, Partner at Accel Partners, has noted that these are interesting options and start-ups should decide on the basis of the sector under consideration. If the VC has a lot of portfolio companies in the same space, it becomes a worthwhile proposition. Moreover, it does not hurt to have a top VC brand attached to your company name.

Prakash sees a lot of very early stage start-ups with incomplete products searching for VC funding. According to him, start-ups which have received initial traction and which are looking for institutional funding, often raise around $5 million at a 5x valuation. However, if it is a lifestyle business, many of the VCs may not fund that start-up. Eventually, Murthy has asked the pertinent question, "Do you think you will get any attention from a large VC?"

The investors have also shed light on the relevant parameters which start-ups on the fundraising runway have to consider – namely, timing, due diligence on investors, stakes, capital to be raised and the timing. Here are the seeds of wisdom shared by the excerpts:

Due diligence: Just as venture capitalists do more due diligence, founders of a start-up should also undertake their own due diligence on their investors.

Capital required: In order to guard against calamities such as stock market crashes, start-ups need to take enough money to keep them going till they achieve break-even. Jolly believes that an amount which will fund them for the next 6-12 months should be sufficient.

Stake control: Murthy has said that start-ups should be cautious about diluting a large stake at the angel round. Otherwise, when they go for VC funding, they might be reduced to minority shareholding and that would diminish the entrepreneur's incentive to run his business.

Asked whether claw-back rights for entrepreneurs in firms funded by angel investors (based on milestones) is an option, Khanna of Canaan has said, "Start-ups have many moving parts. We cannot fix metrics such as profitability and growth. We typically shy away from arbitrary milestones like these."

Murthy has added that claw-back becomes problematic due to regulatory issues. "We have faced this problem and the Reserve Bank of India has suggested that warrants, for instance, is a no-go area," he has clarified. He was apparently referring to issue of warrants in unlisted companies as equity convertible warrants are common tools for raising funds and bringing in financial investors in the public-listed space.

Timing: Accel's Prakash has said that most fundraising discussion at an institutional level have a six month timeframe. Therefore, such discussions should be planned 3-6 months before a start-up goes broke.

Angels impact funding decisions: Asked if he gauges a start-up on the basis of the funds already raised and the angel investors backing it, Jolly has pointed out that the credibility of investors clearly has an impact on such decisions. "But the entrepreneur is important, too. So that it does not become a Tu Tu Mein Mein situation in the long run," he has added.

How Angel Investors Pick Start-ups

Sharing his process of picking a start-up in which to invest, Shahdadpuri has said that he works with entrepreneurs with whom he likes to have fun and who are clued into new trends. Moreover, he only invests in start-ups who operate in the sectors which he understands and who will definitely raise institutional funding in the next 6-24 months. Plus, he would like to go for more repeat investments in companies where he has already invested.

Finally, Jolly does a gut check when he invests in a start-up. "Based on the capital raised, I look at what was accomplished and need to see an initial traction. It also depends on the sector in which I am investing. But the bottom line is always capital efficiency," he has added.