The (Not So) Puzzling Behavior of Angel Investors

Angel investors fund start-ups in their earliest stages, which creates a contracting environment rife with uncertainty, information asymmetry, and agency costs in the form of potential opportunism by entrepreneurs. Venture capitalists also encounter these problems in slightly later-stage funding, and use a combination of staged financing, preferred stock, board seats, negative covenants, and specific exit rights to respond to them. Curiously, however, traditional angel investment contracts employ none of these measures, which appears inconsistent with what financial contracting theory would predict. This Article explains this (not so) puzzling behavior on the part of angel investors, and also explains the recent move toward venture capital-like contracts as angel investing becomes more of a professional endeavor. I. Introduction Where do entrepreneurs turn for funding once their credit cards are maxed out, friends and family are no longer taking their calls, but it is still too early for venture capitalists to invest? They turn to "angel" investors. Angel investors are wealthy individuals who personally finance the same high-risk, high-growth start-ups as venture capitalists but at an earlier stage.1 Well-known angels include Microsoft co-founder Paul Allen, EDS founder H. Ross Perot, and Dallas Mavericks' owner Mark Cuban. But the prototypical angel may still be rich old Uncle Joe, the wealthy, distant relative or family acquaintance.2 Angels come in many forms, yet together they constitute an essential source of entrepreneurial finance, providing some $25 billion to new ventures each year.3 Not only are angels important for the amount they provide to new start-ups, but for when they provide it-at a crucial stage in the start-up's growth that allows entrepreneurs to build the financial bridge from friends-and-family funding to venture capital. Despite their importance, angels are surprisingly underappreciated in the popular press and academia, especially legal academia. Venture capitalists are credited for Silicon Valley success stories such as Google, Amazon.com, and Apple Computer. But each of these companies first relied on angels and might never have attracted venture capital without them.4 By investing their own funds in startups with no operating history, angels take significant risks. Start-ups benefit from angel risk-taking, but so do venture capitalists, who rely on angel funding to help start-ups develop and use angel funding as a mechanism for sorting among the countless new start-ups that later seek venture capital. Without angels, the venture capital model could not exist in its current form. Even more importantly, without angels our entire innovation-based economy-which relies on start-ups' success and has produced over 12.5 million jobs and up to eleven percent of our gross domestic product in recent years-would be in jeopardy.5 One contribution of this Article is to reveal the importance of angel investors in entrepreneurial finance. Once people realize how important angels really are, they will want to know more about them. Although this Article begins broadly, it quickly hones in on one of the many interesting aspects of angels yet to be explored: the angel investment contract. Angel investment contracts have escaped academic attention, yet they present an extremely interesting study in contract design that informs financial contracting theory in important ways. Start-up investments are rife with uncertainty, information asymmetry, and potential agency costs in the form of potential opportunism by entrepreneurs. Venture capitalists mitigate these problems by using their leverage over cash-strapped entrepreneurs to insist on comprehensive investment contracts. These contracts allow venture capitalists to screen, monitor, and control their investments through a combination of staged financing, preferred stock, board seats, negative covenants, and specific exit rights. Angel investing as it has long been practiced, on the other hand, is strikingly informal. …