editione1.0.2
Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Our goal with this book is not to make you a legal expert such that you don’t ever need to hire a lawyer. Our goal is to give you enough background and context such that your time with a lawyer is efficient.
We will discuss for which parts of the investment process you or your lead investor would engage legal counsel, and additional considerations if you are investing alone. If you or your group of investors engage legal counsel for the investment, it is typical that the same lawyer would review the term sheet, any legal due diligence issues that you choose to pass on to them, and that they would create and/or review the definitive documents to make sure that they are consistent with the term sheet terms and are otherwise in proper legal form.
The lead investor typically makes the decision on when to bring in legal counsel and who to hire to represent the investors. They will also lead the negotiation over who pays for legal fees to document the deal. The sections below are useful for the scenario in which you are responsible for, or have influence in, deciding when to bring in an attorney.
When you are first introduced to an angel investing opportunity via a pitch, you will likely get a very high-level summary of the proposed investing terms from the entrepreneur, such as:
“We’re raising $1M in a Series Seed on a pre-money valuation of $3M,” or
“We’re raising $400K in convertible notes with a 20% discount and $3M cap.”
Once you’ve read through Part III: Financings and Term Sheets, you will know what these terms mean and you can negotiate the pre-money valuation or the discount on a note without the help of a lawyer.
If instead you get a deal that does not look like one of the common forms that we describe in Part III, you might want to seek the advice of a lawyer to better understand what you are dealing with and determine whether it can be structured as something more familiar. As mentioned early on, you may save a lot of time and legal expense if you bring in a lawyer to help architect the deal.
Typically, if you (alone or as a group) and the entrepreneur agree on the top-level terms like the amount and the form of financing, the real action starts with the term sheet. Because angel groups often have forms for the most common term sheet types* and experienced lead investors within the group, it is common to get to a final term sheet without needing to engage counsel.
That said, it is often worth having the attorney who is going to be engaged in drafting the definitive documents review the term sheet, since they need to be comfortable expressing the agreed terms across a number of legal documents. Because term sheets are short and concise, it should not cost a lot to have a competent attorney review one (typically less than $1K). One of the benefits of working with an experienced attorney who specializes in early-stage investment transactions is that they can give you a sense of what terms are typical or unusual or highly favorable to one party. They can also help you craft rights that can mitigate legal and financial risks that you might be particularly concerned about for a specific investment. As you can imagine, legal time (and money) spent in the term sheet negotiation is usually much more efficient than trying to change terms once the definitive documents are being negotiated.
Whether you (as a group or individual) want to engage a lawyer for legal due diligence depends in large part on the history of the company you are considering investing in.
There are some scenarios in which you may not need to hire a lawyer for legal due diligence. If a company has just come out of an accelerator that takes an ownership stake as part of the program, or if the company has completed a prior financing round with competent investors who had skilled counsel, theoretically there is much less need to dig in deep on legal due diligence. Accelerators and incubators will typically clean up any pre-existing corporate legal issues as part of taking their own equity interest.
Similarly, if a company has worked with experienced legal counsel from the start, that should give you confidence that corporate matters are properly documented. In many cities there are law firms that will provide entrepreneurs with attractive packages of corporate formation documents, employee agreements, et cetera, and even act as secretary at board meetings. They provide this service at low cost as a loss leader, an investment in an ongoing relationship. They start to make their money when the entrepreneurs raise financing that has to be documented.
If neither of the above scenarios is true, remember that entrepreneurs are scrappy by nature, and legal counsel is typically expensive. So, if the startup has not worked with a competent law firm consistently, or if there are elements of a messy background you become aware of, you’ll want to have legal counsel review the company’s situation and standing.
exampleA company has been around for years and started out as an LLC, before becoming a Delaware C Corp. Some initial founders have left, and at some point the company sold off some intellectual property to raise money. They have raised some money in the past in the form of convertible notes from friends and family, and while the notes have expired, the investors are “patient.” They promised some equity to some former advisors and an early contract developer, but it was never properly papered because they were bootstrapping.
Any one of the details in this scenario is not as rare as you might think. Remember, good entrepreneurs are determined and will find a way to keep going despite obstacles. While it would be highly advisable to hire an attorney to review the company’s history in the above situation, you have a practical difficulty. If the company has not spent money on legal services along the way, playing catch up and cleaning things up that weren’t done right in the first place can be very time-consuming and expensive. This is one reason to look for companies that have hired able and competent counsel and have taken the time to do things correctly.
Another potentially messy scenario, which is also not uncommon, is when a startup spins out of an existing business, having leveraged the earlier business’s employees and resources to develop the startup’s idea and assets. Pete has personal experience with this scenario, and raising the first institutional round for the spun-out startup required extensive legal documentation of the separation of the assets from the parent company and agreements with many of the employees of the earlier business to document their respective contributions, assignments, and ownership of the new business.
With the exception of perhaps a simple individual convertible note, as mentioned above, the lead investor will almost always have a lawyer representing the investors when the definitive documents are being negotiated and drafted. Often the lead investor will prefer to have their attorney draft the definitive documents. If you are investing alone, we recommend that you have a lawyer review the documents to insure that they accurately represent the terms negotiated in the term sheet.
Whether you should engage your own lawyer depends on a number of factors, including your level of experience, how much you are investing, and the context in which you are investing.
If you are investing as part of a group of experienced angel investors, and someone else in the group is the “lead” in performing due diligence and negotiating deal terms, then it is likely that you do not need your own lawyer. The group of angels with whom you are investing should have a lawyer representing their interests collectively, including yours. Angel groups often work with the same law firm for many deals, and so they usually have high confidence in that firm’s skills and experience.
In addition to managing deal terms, the lead investor in the group will play a role in assessing the need for and organizing any legal due diligence on the company. If you have any specific concerns regarding legal due diligence, whether that involves corporate formation, governance, or intellectual property rights, you can bring those concerns to the lead investor. If you do not feel your concerns are being adequately addressed, you can hire your own attorney to do a review.
That said, if you have a lot of money at stake or you do not have complete confidence in the law firm or individual lawyer representing you and your co-investors, then you can hire your own attorney (at your own expense) to review the documents for you. It would create an awkward dynamic, however, if your lawyer was also negotiating directly with the entrepreneur. You might instead hear the advice of your lawyer where it differs from the way the deal is being negotiated and documented, and bring it to the attention of your lead investor.
If you are investing on your own, especially if you are fairly new to angel investing, it is highly recommended that you use a qualified attorney with experience in early-stage investments to represent your interests.
important It’s common when investing solo to do so through a convertible note. You may find an opportunity to invest in an exciting company via a convertible note with rewards for being an early investor. Convertible notes can be quite straightforward, but as we discuss in the section on the topic, a properly drafted note which covers all of the potential scenarios of acquisition, default, non-qualified financing, and so on can become quite complex. If you have not made a similar convertible note investment before, we would recommend that you have a lawyer review the note. You can negotiate directly with the entrepreneur based on your knowledge of the general deal terms while making it clear to the entrepreneur that you will still have your lawyer review it after you have come to general agreement on terms. A legal review of a convertible note should not be expensive.
examplePete is a scrappy investor (having been a scrappy entrepreneur), and he came across an opportunity to invest early in a startup that had just come out of an accelerator. Pete did his business due diligence of this very early-stage company and relied on the reputation of the accelerator and the major law firm that it used for all of the companies in its class to give him confidence that no legal counsel was required for the legal due diligence. He also used a very standard two-page convertible note term sheet with an early investor preference and so was able to complete his $25K investment without incurring legal fees for himself.
Another common scenario is that you are investing in a deal as a solo investor alongside an angel group or VC. The lead investor might be a VC or other institutional investor or another angel investor. You generally benefit from following their lead (figuratively and literally) in this scenario, with a couple of important caveats:
Major vs. non-major investors. A “major investor” is usually defined as someone investing above a certain amount of money, depending on the amount the company is raising (in a $2M deal, major investors might be those investing $250K or $500K, for example). They may get certain rights that non-major investors do not get, such as information rights and pro rata participation rights. Review carefully any mention of rights that apply only to major investors.
Non-participation penalties (pay-to-play provisions). Be aware of any terms that penalize investors who do not step up to the next round pro-rata (commonly referred to as pay-to-play provisions). You may not have the resources to participate in future investment rounds for a company. Follow-on rounds in companies that are succeeding is part of the institutional investment model, and so those institutional investors may be motivated to capture a bigger share of their winners at your expense.
You always have the right to have your own attorney review any documents at your own expense. Use your own judgment as to how sophisticated your co-investors are and whether or not your interests are aligned in all cases. If you do hire your own lawyer, be tactful as to how your lawyer interacts with the lead’s attorney. In good times and bad, you are going to want a good relationship with your co-investors.
Some very active angel investors have terms and/or rights that they want to have in any deal. For example, they may feel that they don’t want to make any investment in which they don’t have the right to get quarterly financial statements from the company (information rights). Or they have been burned with other investors getting better terms, and they won’t do deals in which someone else who is investing at the same time can get a better deal (most favored nation clause). Rather than arguing with the lead investor as to whether they should be considered a “major investor” and get information rights, for example, they have a side letter prepared to accompany almost all of their investments.
The side letter (or side letter agreement) is an agreement between an investor and the company in which the company agrees to provide the investor with certain rights that are not otherwise present in the investment documents. This side letter usually includes terms like information rights, pro rata rights, and a most favored nations clause.
Assuming that the company is willing to sign a side letter agreement, the investor now has assurance that they have the terms that they specifically care about, whether or not the lead investor worked to secure them those rights.
We have included in a robust investor side letter in the appendix.
If investing in a group, it is not uncommon for the lead investor to ask the company to reimburse its reasonable attorneys’ fees, subject to a cap. This gets more common the larger the size of the round. Venture capital funds almost always have companies reimburse their reasonable attorneys’ fees. Series A rounds very often have a fee reimbursement provision for the investors. It is less common in Series Seed rounds or convertible debt or equity rounds. That said, the Series Seed Documents is a commonly used set of fixed-price financing documents in early-stage investing; and it provides that the company will reimburse $10K in legal fees. The more you are investing, either individually or as a group, the more comfortable you should feel asking for this provision. If you are investing $500K, definitely ask.
Even if you don’t ask the company to reimburse your reasonable attorneys’ fees, or if you ask and the company declines, that doesn’t mean you should not use a lawyer. The trick is to use a lawyer intelligently so that you do not unnecessarily run up legal fees or upset the deal.
danger When you are using a lawyer, your risks include:
You might incur much more in legal fees than you reasonably expect.
Your lawyer might make unreasonable demands of the entrepreneurs, putting you at odds with the company, and jeopardizing your chance to make the investment.
How can you minimize these risks? With regard to fees, ask the lawyer to cap their fees. Get them to agree in writing that their fees for reviewing the legal documents will not exceed a set amount. With regard to the second risk, control the communications. Instead of having your lawyer communicate comments to the company, have your lawyer give you the comments. Then you can decide which comments to pass along to the company, or how to present them.
important The best legal comments are the ones that your lawyer can easily explain the underlying rationale for. If you can’t understand your lawyer’s comments, and why he or she is asking for certain changes, ask for a clear explanation from them so that you can evaluate whether to press for the change in the legal documents or not.
The best way to find a lawyer in your community who is very practiced in the early-stage company space is to ask fellow angel investors whom they like to work with. If you don’t have a network of fellow angel investors yet, look up your local angel groups and reach out to them for recommendations. You could also ask company founders which lawyers they have heard are good in the community.* If there is a dearth of local legal talent working on startup deals, you might have to find someone to work with remotely in a bigger city in your state. Every state has angel groups, so you will always have a place to start your research on an experienced attorney.
dangerWorking with a lawyer who is not really practiced in early-stage investment is not a good idea. Your lawyer needs to know how these deals are typically structured, what risks to look for in a deal, and what is standard and market in the community for these types of transactions.
A term sheet is a summary of the key business terms of the proposed transaction. It should be short, easy to understand, and it should be free of legalese—save perhaps a sentence about the non-binding nature of the proposal. Term sheets are helpful in reaching agreement on the principal business terms as they are very short (1—2 pages) and concise, and easily understandable by those at all familiar with the terms.
Each type of financing, (e.g., convertible notes, preferred stock) will have a fairly typical set of topics that are covered in the term sheet. For convertible notes, this will include interest rates, conversion conditions, and so on. For a preferred stock offering, the term sheet will cover price per share, liquidation preferences, et cetera. Part III will help you understand the common terms in typical angel financings such that you can quickly evaluate any term sheet you may come across. We’ll also cover more unusual terms. Examples of the types of terms sheets you will encounter are collected in the appendix.