New Venture Financing and Venture Capital `Funding Hole'

An entrepreneur usually chooses to receive seed funding for a new project from an angel investor (angel) or a venture capitalist (VC), a choice complicated by the implications of follow-on financing required at the next stage of the venture. The size of the follow-on round is typically much larger than the seed round and the first-stage investors, including the angel almost certainly, and the VC with a significant probability, do not extend follow-on financing. A project released by the original investor faces unfavorable valuation risk from a new financier at the second stage due to asymmetric information, and may even be denied funding and disappear into a ``funding hole." We show theoretically and empirically that the risks are asymmetric for initially angel-funded and initially VC-funded but otherwise identical projects. The risk is elevated with initially VC-backed projects because the original venture capitalist is presumed to decline further financing to all negative-NPV projects in her stable, along with some positive-NPV projects depending on her other opportunities, while an angel declines in all cases. Thus, a positive-NPV project released by a VC enters a diluted pool with more negative-NPV projects than a project released by an angel. On the other hand, the original venture capitalist adds value to all projects in the first period with her guidance and advice and projects that receive follow-on funding have no valuation risk due to asymmetric information. We show that an entrepreneur should choose seed funding from a VC when the follow-on rate of the VC is low or high, but select angel financing for intermediate follow-on rates. We examine seed fundings by the top US angel investors and venture capitalists from 2010-2015 and show that projects released by venture capitalists are less successful raising funds after release, and that follow-on rates by venture capitalists tend to be either high or low, supporting our theoretical findings. Our results are new to the existing literature and offer interesting implications, including that angel financing and VC financing are sometimes complementary, and not always substitutes as in conventional thinking. Angel financing may rescue an entrepreneur when VC financing leads to a funding hole.