Help, I can't get VC funding (but you might get angel funding).

VC investing has been booming in the last 10 years, driven by extremely low interest rates. Bonds/Cash generated little to no interest, prompting investors to look at alternatives like investing in start-ups. The focus was/is on companies that can scale fast in large Total Addressable Markets. Generally, these are Tech companies and, to a lesser extent, Life Sciences companies and Deep Tech.

The abundance of money has created two problems that are now starting to manifest in the ecosystem.

1. Valuations were inflated as investors chased the hottest deals, paying little to no attention to valuations.

2. Many similar types of companies were created, competing with each other to create intense margin pressure for these hot sectors.

Raising investment is becoming increasingly difficult, partly because interest rates have returned to a more normal 4-5%. Limited Partners (LP), who are the investors in a venture capital (VC) fund, see that existing VC investments are not as profitable and valuable as originally promised by the VC. With the higher interest, they have safer and more liquid alternatives like bonds. Without LP funding, the VCs can't invest in start-ups.

Why the Federal Reserve has gambled on a big interest-rate cut, Economist Sep 18th 2024

Power law investing is the norm for many VCs

Many startups pursue VC funding, driven by the numerous success stories. In reality, VC investment is only suitable for a very small selection of companies. Companies that most likely fail, but if successful, can grow very fast. This go large or go home investment strategy is called Power Law investing.

Power law investing is based on the Pareto Principle (or 80/20 rule), which states that a small minority of inputs generate a disproportionately large share of the output. In venture capital and startup investing, this means a few "home run" investments will account for the vast majority of a fund's returns, compensating for numerous other investments that may return little to nothing.

Power law investing leads to growth at all costs and a winner-takes-all strategy. It's great if you're invested in a winner, but most investments will ultimately fail. An increasing problem for angels is that even if they have invested in a winner at an early stage, the financial instruments of the follow-up rounds can negate any profit.

Angels don't have to invest as a VC

Angels can and need to be more flexible than the larger VC's. Their financial firepower is significantly less, which is both an advantage and a disadvantage. Unless an Angel is very rich, Power Law investing makes little sense, as they will struggle with providing funding for the rapid growth in the scale phase.

However, Angels have the flexibility to generate a good return on small investments, especially in sectors with good valuations and the ability to generate cash flow relatively quickly. These investments are too small and time-consuming for large investors but work well for smaller investors. They also have the super tax multiplier called (S)EIS.

These types of investments can include tech companies, as well as those from other sectors such as food and drink, manufacturing, or the creative sector. Any SEIS eligible company with the ability to create cash flow in 4/5 years' time is a potential Angel investment as long as the valuation matches the profit potential.

Outperforming VCs

Below is an example of a company raising £50k on a post-money valuation of £500k. The company uses this investment wisely and is able to generate a dividend in years 4 and 5 of £ 100,000. The founder then uses this dividend to buy out the investors in year 5 at a valuation of £2m. The investor gets then 2 times £10k dividend and £200k for their shares on a £25k investment (£25k

This will generate a yearly return of 55% for the investors, and if you assume a 70% failure rate, a 25% risk-adjusted return, beating most VCs. And yes, I cheated slightly because, unfortunately, the dividends will be taxed even if the company is SEIS eligible.

Besides the money, a good investor will help the founder grow using their expertise and network. An investor can make the most significant difference in a startup's earliest years. Hence, it makes sense that the relationship between the investor and the investee company becomes looser over time, leading to the exit.