Joe is a Seattle-based attorney who has been working in the early-stage company space since the late 1990s. He has worked with hundreds of founders and investors on too many financing and M&A transactions to count. Okay, maybe he hasn’t seen it all. But he has seen a lot. Joe represents startups, investors in startups, and founders and executives of growth companies. He is a member of the Angel Capital Association’s public policy advisory council, where he is actively involved in trying to make the law better for investors and founders.
Pete has played many roles in the startup ecosystem, and has been an angel investor for 10 years. As a serial entrepreneur, he raised over $25M in seed financing and venture capital, and had two successful exits, an acquisition for 2Market and an IPO for RedEnvelope. For 25 years, Pete has advised startups on fundraising and product strategy, both individually and as part of accelerators like Techstars. He has the dubious distinction of losing most of his first $200K in angel investments, in part because he didn’t have the knowledge and wisdom in this book. He strongly believes that one learns more from the failures than from the successes, and his goal is to give you the benefit of those hard lessons without the financial (and emotional) pain.
After his first two years of angel investing, Pete had the equivalent of a bad hangover. $200K had disappeared into companies that had looked very promising but had failed. He had invested too fast, committed too much to a single investment, failed to do thorough enough due diligence in one case, and committed one or two other angel investing mistakes. It can be gut wrenching to watch a company you have invested in fail, and take with it a couple years of your kid’s college tuition, or more.
Angel investing can be fun, financially rewarding, and socially impactful. But it can also be a costly place in terms of money, time, and missed opportunities. This book is intended to help you optimize your experience as an angel investor and avoid some pain by learning from those who have gone before you.
If you want to read a book about “How to make millions in angel investing without even trying,” this is not it. In this book you are going to learn from our successes, failures, and collective experience working on angel deals. We are going to talk about how to be good and thorough at the often rewarding work involved, how to increase your chances of success in a world where 80%-90% of startups fail,* how to position yourself to stay involved with your companies, how to increase your payout when your investment succeeds (we’ll show you how VCs do it), and what to do if things go sideways. In short, we want to help you improve how you go about angel investing so that you make the most of your money and your time.
If you invest in a successful startup, your economic return will be driven by the legal arrangements you have with the company. You don’t want to miss out on a great economic return because you failed to ask for an important legal term when you made an investment. It is a terrible thing to find a great company, make an investment, but ultimately miss a great financial outcome because you overlooked something important. To that end, we discuss many of the legal and business issues investors face when evaluating deals, negotiating terms, and working with entrepreneurs in good and bad situations. This knowledge should allow you to engage in angel investing with more confidence in every aspect of the process. This book will reduce your need to seek expensive legal advice; and when you do need to talk to a lawyer, you will have the context that will make those conversations more efficient.
Whenever possible, we have included conventional wisdom about being a successful angel investor, based on the experience of successful investors and data about angel investing outcomes. When it comes to legal matters, we have tried to be as accurate and up to date as possible, but you should know that in some cases there are multiple definitions for some commonly used terms. We endeavor to always explain the ones we use. Additionally, angel investing isn’t a science, it’s situational—for every piece of specific advice, someone will have a counter example. Every company and investment opportunity is unique, which is part of what keeps it interesting. We don’t pretend that every piece of guidance applies in every case, but have endeavored to give you the context that will help you make your own decisions.
This book will help both new and seasoned investors gain confidence. If you are interested in angel investing or already actively engaged as an angel investor, this book is for you. We do not assume any prior knowledge of how to find or evaluate companies, or investment techniques or terms. But we do go deep enough that even a seasoned investor can learn something new, and we have endeavored to organize the book as an easy reference for many of the common investment forms and terms.
founderThis book will also be helpful for founders raising an angel round. The content covered here will help you understand the point of view of the investors, where they can be found, and how to meet them. It will also help you understand the term sheet when you negotiate one with an angel or angel group. We explain what all the terms mean, how they work, and why they may exist in your term sheet and investment documents. (In this book, material with a founder perspective is marked with this icon.)
We also explain how investors (and entrepreneurs) should think about due diligence and what should be covered. This can be a handy reference as you prepare to make an investment or seek funding.
We had the feedback of a lot of our friends in writing this book. To give thanks to just some of who helped us, and not in order of importance: Thank you Mary Baker Anderson, Bryan Brewer, William (“Bill”) Carleton, Barnaby Dorfman, Jeff Greene, Mitchell Hymowitz, Mike Koss, Adam Lieb, Josh Maher, Brandon Nett, Dave Parker, Gary Ritner, Dan Rosen, and Nancy Thayer. If we have forgotten anyone, please forgive us.
Pete would also like to thank The Academy, and his lovely wife Carol and charming daughter Katelyn for putting up with his long hours of writing when he should have been mowing the lawn or waxing the skis or baking bread. And, of course, he would like to thank the book’s editor, Rachel, who made the whole process fun.
All errors are entirely ours.
Although this book contains a lot of legal information and is intended in part to be a guide to frequently encountered legal issues, it does not constitute legal advice, nor the establishment of an attorney–client relationship with any reader. Nor does this book constitute financial advice. You should always consult with your own legal and financial advisors before investing in a startup or early-stage company.
Angels invest typically in very early-stage companies, providing capital for growth in exchange for equity—partial ownership—in the company. That equity can translate into enormous rewards, or nothing at all—angels tend to have an appetite for risk, and the means to take risks with confidence.
An angel investor might consider herself a patron of experiments, the first outsider tasked with judging a company’s real potential for success.* That outside money can become, for those who choose to let it, a path to the inside, where an angel becomes an advisor and confidante, helping founders make good business decisions and supporting them when things get tough. Other angels will choose a less involved path, staying out of the company’s way after making their initial investment.
Angel investing is different from other types of investing. Like venture capitalists, angels typically invest in companies they hope will grow rapidly and eventually reach a liquidity event. But as the earliest outside investors who do not invest through institutions like VC firms (though individuals may invest as part of an angel group), angels take on more risk. Their investments are also typically smaller than those that VCs make; while VCs can invest tens of millions of dollars (or a lot more), angel investments are typically $25K–$50K and top out at $100K, though they can go higher. To make an investment, an angel must be deemed an accredited investor (which we’ll discuss in detail), meeting income and asset thresholds set by the Securities and Exchange Commission.
Angels usually don’t invest in companies that are expected to stay private and generate an ongoing cash flow for their investors,* the way an LLC might be organized to start or grow a real estate business or chain of grocery stores.
While there are many risks to angel investing, the rewards, both financial and personal, are real. If you like spending time with entrepreneurs and learning about new technologies and methods, if you want a ringside seat at the ongoing disruption of industries, if you want to flex your knowledge and experience, or if you want the chance to make an impact, angel investing can be fun, educational, and exciting.
Maybe you bought this book after reading that Peter Thiel made a billion dollars from Facebook out of a $500K investment.* You might even have friends who invested $25K in a business to see it return 18 times that amount. But beware—the majority of angel investments return nothing to investors.
As a benchmark for purely financial return, large portfolios of well-screened angel investments either aggregated by so-called “super angels” or across active angel investing groups can generate internal rates of return of 20% or more.
Angel investing can be challenging for a number of reasons. It can be time-consuming and may require you to quickly come up to speed on industries or technologies you know little about. It can involve negotiating investment terms and dealing with unfamiliar legal issues. Additionally, once you invest you may have very little insight into what is happening to your investment and very little (if any) control over what the company does. You will also be impacted by the rights and valuations the company negotiates with any follow-on investors, which can have a dramatic impact on your return. The goal of this book in part is to help you understand the legal issues, deal terms, rights, and limited controls that will have an impact on your outcomes. Ultimately an angel investment is a gamble, and your goal is to try to increase your odds of winning before you place your bet.
Angel investing can be time-consuming if you are actively involved in selecting your investments. A typical active angel investor may see 50–100 investment opportunities in a year. They attend angel group meetings, meet with individual entrepreneurs who reach out to them, and see deals from within their network of other angels. They may be interested enough to look into ten of those deals and engage in serious due diligence on a handful or more. On the deals they decide to move forward with, they will spend time negotiating terms and reviewing legal documents. All that work might result in three or four investments in a year.
Your degree of involvement and time commitment is up to you, especially if you are part of an angel group (formal or informal) where members split up a lot of the work. So while it is possible to take a “free rider” approach and jump in on deals someone else recommends and has negotiated, your colleagues may eventually ask you to share some of the workload.
There are a number of reasons it is beneficial to join an angel investing group.
An angel investing group (or angel group) is a syndicate of angel investors that collaborate on deals. These groups can be large and formal (like Seattle’s Alliance of Angels, which has over 140 members as of this writing), or small and informal (especially when not based in a major metropolitan area). They can help green investors learn the ropes of angel investing, improve access to deals, and share the work and potential costs of due diligence and negotiations.
There are over 400 angel groups spread across the U.S. and Canada according to the Angel Capital Association, which maintains a directory on its website. You might also be interested in the Angel Capital Association’s FAQs About Angel Groups.
important If you want to educate yourself before joining a group, or if you can’t find a group that aligns with your interests or investing goals, then this book will go a long way towards getting you up to speed on the process, terms, and other topics that will give you the confidence to move forward with your angel investing!
Startup CEOs spend a surprising amount of time trying to raise money. Over the course of five to ten years they will likely raise many rounds of financing from many different sources, including angel investors. Each round of financing impacts the value and rights associated with the previous rounds of investors, and as we will discuss later on, many of the terms negotiated in an angel round will deal with the impacts and opportunities regarding these future rounds of financing. A company may not go through all of the stages laid out below, and it is also possible that they will do multiple rounds of investment in any one stage. Your goal as an angel investor is to get to an exit—a liquidity event—in order to realize a return on your investment.
Bootstrapping refers to the entrepreneurs self-funding, typically through a combination of savings and debt. In the bootstrapping phase, founders are doing their initial research, testing their hypotheses about product demand and features, and perhaps creating a minimum viable product (MVP) to get early customer feedback. The founders may be working full or part-time elsewhere and are drawing no salary for their work on the startup. Hopefully they have engaged a startup attorney and have executed the standard set of legal formation documents, invention assignment agreements, and so on.
Minimum viable product (or MVP) refers to the product that the company has built which it believes it can sell and monetize. The product is far enough along to gauge whether customers will pay for it.
In a liquidity event (or exit), the company in which you invested is sold or the company goes public, allowing investors to cash out of their investment.
Acquisition is a kind of liquidity event that occurs when a company buys at least a controlling interest in another company, for cash or stock of the acquiring company or a combination of the two. Being acquired by another company is the most common outcome for startups, excluding total failure. In 2018, 90% of the exits were acquisitions, while 10% were IPOs.*
Often startups—which are all private companies—are acquired by public companies, in which case the startup’s investors will get either cash or shares in the public company. But the investor may not be able to cash out on those shares right away—they may be subject to a lockup agreement.
For entrepreneurs, raising capital from angels is frequently a grueling process that takes months of pitches, meetings, document preparation, and negotiation—all while trying to build a company.
In a best-case scenario, an entrepreneur may be able to close a round in a month or two. In a more challenging scenario, they might be pitching to and negotiating with multiple angel groups and super angels and smaller VCs for a year to get the round closed. There are no hard rules about this process, and an entrepreneur may be finalizing terms with one angel or group while still preparing to pitch to others.
As an angel investor, you will see some really early companies and have a chance to be the first money in. But there is a huge range in the how far along these companies will be as they raise their first outside investment so before we talk about the angel’s investment process, it is worth a brief discussion about what expectations you should have.
Years ago, when it was expensive to build websites and set up servers in data centers to host a website and license layers of software, founders who didn’t have deep pockets themselves (or rich uncles) had to raise money on little more than an idea and a business plan. If you were creating a physical product, you needed significant cash for molds and prototyping. That was then.
The environment has improved dramatically in this regard. Startups don’t have to buy servers and rack space in data centers now, they rent servers by the hour from Amazon Web Services or Microsoft’s Azure. There are many existing software services that can be leveraged to create a software prototype, including drag-and-drop website builders and mobile app prototypers. There are dozens if not hundreds of low-cost offshore app development companies that can build version-1 products. In the physical product space, one can buy desktop laser cutters and 3D printers. There are simple computers like Arduino and Raspberry Pi that are designed to be embedded in hardware as controllers. It’s a golden age for innovation!*
All that said, how far an entrepreneurial team can get before needing to raise money depends on what they are doing. The more fundamental a company’s innovation is, the more money it may take to get to a working prototype or functional product. Artificial intelligence is a hot investment area, for example, but it can take a lot of processing power to develop and test and train new algorithms. The last AI startup that Pete worked at was spending sometimes over $100K a month on cloud processing costs to support its customers and development! Quantum computing is another example of an extremely expensive industry. Rivian, the electric vehicle startup that built a completely new and innovative electric vehicle platform, raised $1.3B without a product to take to market.
Below, we will walk through what an idealized process looks like when an angel group is investing in a preferred stock funding round. (We discuss the types of financings and the relevant terms in Part III, but you don’t need to know all those details now.)
A preferred stock round is usually closed in one or more coordinated “closings” when, after months of pitching, due diligence, and negotiation, the formal documents for all investors are signed and the funds delivered to the company at the same time. At that point the entrepreneur and team pop a bottle of champagne and collapse in exhaustion.
In contrast, convertible note rounds are often much simpler than priced rounds, and the process is typically much faster. The time between first meeting with an angel and the writing of the check can be as little as a couple of weeks (or even less). If the company is raising a large round through convertible notes, say $500K, and is pitching to angel groups, then the process will look much more like the process outlined here:
The pitch. A presentation by the CEO to an individual or group of angels using a slide deck to cover the key points of the business and often the top-level fundraising terms. The terms typically include the amount of money the company is hoping to raise and the pre-money valuation if it is a priced equity offering, or the valuation cap if it is a convertible note offering. In most settings, the pitch is followed by a question and answer session, where investors seek clarification on any aspects of the business or team. This whole process may take 20 minutes if there are multiple entrepreneurs pitching to a gathering of angels, or it could take an hour over coffee if you are meeting with an entrepreneur one-on-one.
Legally you are not committed to the investment until you sign the definitive documents and send in your check. Typically both the entrepreneur and the lead investor will be checking with investors throughout the diligence and negotiation process to gauge the level of interest and commitment of each investor. An entrepreneur will want to know whether he or she is negotiating over $100K or $500K of collective angel investment, so they will likely also be checking with investors. It is normal for investors who expressed initial interest to drop out because they discovered issues in due diligence that make them less enthusiastic, or because they do not like where the terms negotiation ended up, or because of other time or financial commitments that arise for them during the weeks or months that the process takes.
Angels are free to increase or decrease their intended level of investment as they go through the diligence process and term sheet negotiation.
important No one should complain if you decide anywhere in the process that you will not invest or will invest less than you had initially indicated, until you are asked for your firm commitment from either the entrepreneur or the lead investor. Firm commitments are used to generate the definitive documents, so pulling out after those are generated likely requires more work and legal costs for the parties involved and would be viewed as very bad form. If you are making a verbal commitment or “handshake deal,” we suggest following Y Combinator’s handshake deal protocol.
Almost always in priced equity rounds, and often in convertible note rounds, there is a lead investor.
The lead investor is typically an experienced angel investor (or institutional investor) who negotiates the detailed terms of the deal with the entrepreneur, including the valuation. They also often have the thankless task of coordinating the due diligence efforts, working with the lawyer(s) representing the investors (including hiring and paying them, to be reimbursed later by the company), and reviewing the final documents. They may also be coordinating with other angel groups or investors on the closing date.
cautionThis is time-consuming work, and it can feel like herding cats at times—wealthy, busy, sophisticated cats. Investment rounds can bog down if no one is willing to step up and be the lead. We would not recommend that you take on this role until you have invested in a couple of deals and have some experience with the process.
If everyone is motivated, the deal is priced attractively, and there are few if any red flags, getting through this process can take as little as four to six weeks. Unfortunately, this process can often drag on for several months or more, in which case it becomes a big time and energy drain for the entrepreneur who is trying to build a company.
important It behooves angels to move as quickly as is prudent to get the deal done if they want to maintain the momentum of the company they are investing in. As an angel, be respectful of the lead investor’s time, and be responsive to their inquiries and requests, as they have taken on the extra work and responsibility for no additional gain.
Paul Graham, in his essay “How To Be an Angel Investor,” writes that being a “good” investor is defined by the following traits:
Decide quickly whether you want to dig in on a deal.
Sometimes a company will ask you early on to sign a nondisclosure agreement.
A nondisclosure agreement (or confidentiality agreement or NDA) is an agreement in which you agree to keep a company’s confidential information confidential. In the broader business world, companies consider almost all their information confidential unless it is publicly available on their website, for example, or has been made public through press releases or financial filings. The startup world is a more specialized context, in which the investors will need to know a lot about a company before they consider investing, and will likely be pitching to groups of potential investors and sharing key details of the business in the process.
founder It would be atypical to sign a confidentiality agreement as part of the early conversations with an entrepreneur. Unless you are truly accessing and reviewing company confidential information, such as full customer lists, source code for a patentable software algorithm, chemical formulas, or other intellectual property that represents the core innovation of the company. That typically wouldn’t happen until you were deep in due diligence. Business ideas, early revenue numbers, and other elements that you would expect to find in a company’s pitch are not normally what an investor would sign an NDA to gain access to. Unsophisticated founders may ascribe a lot of value to their idea. Experienced investors know that there are very few unique ideas and that the largest determinant of success is whether the team can execute the idea quickly and effectively.
There are a lot of rules and regulations governing how companies can solicit and raise capital from investors. These rules exist at both the federal and state levels. At the federal level, the Securities and Exchange Commission is the primary regulatory body. Each state also has its own securities division in charge of regulating the issuances of securities in its jurisdiction.
The term security is defined very broadly under U.S. securities law.* In general, a security is an investment in a common enterprise purchased with the expectation of profit, the value of which depends on the efforts of others.*
danger If a company is not following SEC rules around securities, it can lead to serious problems, such as investor rescission demands or government investigations,*—and the money to respond to such problems can come out of your investment. While these scenarios are not common, it is worth understanding the law so that you can avoid investing in companies that are flaunting it.
Understanding the rules will also help you understand why in some environments companies do not discuss fundraising as part of their pitch, and why in other circumstances companies might ask you for specific documentation on your income or assets. There are red flags to watch out for here as well, such as third parties soliciting funds for a startup for a commission.
important As a general rule, you cannot be an angel investor unless you are accredited.
Startups raise money from accredited investors: either individuals or entities who meet the qualifications set by the Securities and Exchange Commission. According to the SEC, investors must meet a minimum level of income or assets (either high net worth or high income) in order to be accredited. The SEC rules make it challenging for companies to raise money from non-accredited investors who do not meet these standards.
For individuals, an accredited investor is someone who falls into one of the following categories:*
income of at least $200K a year for the two years prior to the year of investment with the expectation of the same in the the year of investment, or $300K with spouse; or
The Securities Act (also known as the Truth in Securities Act) states that “every offer and sale of securities be registered with the Securities and Exchange Commission (the ‘Commission’), unless an exemption from registration is available.”
An exemption (or exempt offering) is an offer and sale of securities that does not have to be registered with the SEC because the SEC has adopted an exemption from registration that you can qualify to use.
The two most common ways for private companies to sell securities are through the following exemptions:
an “All Accredited Investor Rule 506(b) offering”
You might wonder, do companies engage in general solicitation if they pitch to an angel group? The SEC has provided specific guidance around angel groups and how they can facilitate companies meeting angels without triggering the general solicitation rules:*
Question 256.27
Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?
In general, the law does not require that private companies disclose the names of their owners or investors, with the exception of what is required to be disclosed on the SEC’s Form D.*
If you accept a board seat, or if you become an executive officer of a company, the fact that you are a member of the board or an executive officer of a company may be disclosed on the Form D the company files with the SEC. Companies are required to file the Form D with the SEC when they raise money in a Rule 506 offering, and they are required to list on the Form D the directors and executive officers of the company. You can review the Form D from the SEC. Filed Forms D are publicly available on the internet, and many media outlets watch these filings so that they can report any interesting news.
caution Though they are not required to do so, a company may want to issue a press release or otherwise publicly disclose the fact that it has closed its investment round, and in those releases, the company may want to disclose the names of its investors. If you do not want your name disclosed in this process, you should take special care to require the company to agree to keep your name confidential.
danger A few important pitfalls when it comes to securities law and fundraising:
Make sure the company is complying with the law in regard to its fundraising. When you are evaluating a company, you should make sure the company is following the rules of whichever securities law compliance path it chose.
For example, if the company is telling you that it is conducting a Rule 506(b) offering, but it is advertising its securities offerings on its website, that is a red flag. It means that the company is not complying with the law. The company may not be getting good legal advice, which is a signal that other things might be amiss as well.
While you’re investigating the company’s fundraising history, note that many angel investors are leery of companies that have crowdfunded or taken money from friends and family, partly because there may be a large number of non-accredited and potentially naïve investors on the cap table, which can complicate future fundraising.
If you run across a company with a large number of non-accredited investor shareholders, this may make it more difficult for the company to receive venture capital funding. The presence of a large number of non-accredited investors on the cap table can also indicate the company has not received good legal advice, and other things in the company’s corporate records are not correctly done either.
In this section, we will look at finding potential investment opportunities and how to determine if they are interesting enough to warrant investing time and effort in due diligence. Many angels will engage in due diligence on less than 10% of the companies whose pitches they hear. The goal of due diligence is to investigate and validate all the aspects of the pitch that got you excited.
Legal due diligence will follow. This effort is focused on making sure there are no red flags in how the business was formed and structured, how it has been funded to date, and whether the founders and early employees have assigned their inventions and innovations to the company and are properly motivated to stay with it.
To have the opportunity to make a good investment, you have to see a lot of deals.
Deal flow refers to the number of potential investment opportunities you review during a particular period. Ideally, if you are active, you will have the chance to review, if not all, a substantial portion of the investment opportunities in your particular area.
founderIf you’re new to angel investing—or a founder looking for ways to get in front of investors—here we include some recommendations on how to get access to deal flow.
There are a number of benefits to investing in local startups. When considering making an investment, you may want to visit the startup’s office, talk to key team members, and perhaps see a demo of a not-yet-released version of a product. You will want to get to know the CEO over the course of several meetings. Many of these activities are more easily done if the company is within an easy drive.
Once you’ve decided to move forward with the investment process, being physically close to the company makes it easier for you to stay in touch with the CEO over the occasional lunch, and perhaps introduce them to potential local hires or customers. In the event that things go poorly with the company after you invest, or they are unresponsive to your inquiries, you will be able to just go to their offices and talk to them. Finally, by investing locally, you will be helping your local startup ecosystem.
You can learn more about investment opportunities in your community through the following channels:
Angel investing groups. Angel investing groups are a great place to get exposed to potential investment opportunities. We discuss this in detail in Joining an Angel Group.
If you don’t live somewhere with a robust startup ecosystem, or if you are looking for startups in quite specific technologies, you may have to look more broadly.
Let your network know that you are interested in making angel investments. Mention angel investing on your LinkedIn profile. You will be surprised at how many people reach out to you. You can also join investor-centric networks like AngelList, where many entrepreneurs may be looking for investors who share an interest or expertise in their industry.
Whether you are interacting with the local startup community or creating a profile on a national site like AngelList, it will be helpful to have an elevator pitch about the types of deals you are interested in. You might be interested in a particular industry or technology focus or a stage of company. Communicating your desired focus will help get the right deal flow while minimizing the noise.
Alternatively, many angels prefer to remain as anonymous as possible. That is fine too. There is really no wrong way to go here.
Do you know what the key success factors and milestones are for a medical device startup? How about a messaging app targeted at teens? Do you know how long it takes to sell an enterprise software solution to Fortune 500 company CIOs? You will be a more effective investor if you understand the market and/or technology that is the focus of the startup.
importantIn 2011, Rob Wiltbank of the Angel Resource Institute completed a study of angel investments made by members of angel groups.* He found that angels had a 60% better return on their investment when they invested within their area of expertise. So stick to your knitting!
Why? If you have had a career in enterprise software sales, you will understand intuitively the challenges in selling in that market. You’ll know how potential customers evaluate solutions, allocate budget, calculate ROI, what their risk tolerance is, who the influencers are, how long the sales cycle takes, what supporting proof is required, what marketing techniques are effective, and so on. You will have colleagues and friends in the industry that you can contact to litmus test some of the assumptions being used by the startup you are considering. You will be in a much better position to evaluate an idea, scrutinize the team, gut check the financials and perform effective due diligence if you are looking at companies in an area you know something about.
If you do decide to evaluate companies in areas outside your expertise, it makes sense to do so with the support of an angel group or someone in your network who does know the industry well. You can lean on the knowledge of other angel investors, but it will always be easier if you yourself know—or are at least willing to learn—what questions need to be asked and can converse with a founder intelligently.
Of all the opportunities you’re likely to come across, how do you narrow your list down to the companies you’re willing to spend the time and effort of due diligence on? There is an ongoing debate among venture capitalists and angel investors about what is most important in determining the likelihood of a startup’s success: a strong team, a big market, or a compelling idea? They are all important, so we will cover how to evaluate all three below.
Ideas are everywhere, and there are very few unique ones. There is a long road between the idea and an actual compelling product, and longer still to a revenue-generating business (and longer still to profits!). It is the team that is going to build the business out of the idea, so you should be as confident as possible that the people pitching to you are going to be able to execute. Many believe that one of the best predictors of success is an entrepreneur who has built and exited one or more successful companies. Absent that scenario, below are some key things to consider after hearing the pitch. (We’ll address team issues in more detail in Business Due Diligence for Angel Investments.)
Your goal here is to figure out whether the team is particularly well-suited to tackle the problem that they have set out to solve because of their skills, background, and experience.
A good team generally has domain expertise in the industry that they are now planning to disrupt, and ideally in the functions that are core to succeeding with that disruption.
The other aspect of an investment opportunity that can sway an investor is the sheer size of the market opportunity presented. Angels and venture capital investors frequently focus on the size of the market for the company’s product to evaluate the potential return on investment.
important It is important that the company can convince you that they can be a $100M-revenue company while owning only a small fraction of their target market. That suggests that the company needs to be targeting a $1B market or larger. Angel investors typically do not want to invest in a lifestyle business* that tops out at less than $10M in revenue, because there are fewer exit possibilities, and it is hard to achieve the levels of returns that VCs and angels seek if the company is going after a small market.
A typical scenario for a startup is that they are targeting a large market, but are starting with a very focused market entry strategy. This is a smart approach: create a beachhead and initial traction with a very focused product in a very specific market and then expand to the broader market as their resources for engineering and sales grow. So while the initial market may be small, the total addressable market (TAM) in which they believe their product, service, or approach will be superior, should be large.
Angel investors will often categorize an idea as a painkiller or a vitamin. A vitamin is something that makes the customer’s life a little easier or a little better, whereas a painkiller is something that solves a real pain point for the customer. The assumption is that if you are addressing an actual problem a customer has, they will have a greater urgency to purchase your product or service and will more readily take on the risk of buying and using a product or service from a startup.
B2B startups have a particular challenge in that they are asking their customers to take a chance on the product and the company. If a customer buys a startup’s product, invests in setting it up and training their employees on it, and then the company disappears in a year because they ran out of money or pivoted, then the customer is up a creek, and that purchasing manager has some explaining to do to his or her boss. The product has to be really compelling for the buyer to take that chance. It is often not enough that it has better features than existing products or that it saves the customer 10%-20% on their costs.
Even for B2C companies, it can be challenging to get consumers to change their behavior. The product has to be significantly better than the alternatives to get consumers to switch and stick around.
Sales to paying customers is the greatest validation of an idea, and the product that delivers on the idea. Traction is a term that most often refers to a startup’s progress in getting customers.
A company’s traction with customers indicates that there is actually demand for the product or service. This is sometimes referred to as (or as an important part of) product/market fit,* meaning that there is a validated market for the product at the stated price. Traction also shows that the company has actually built a working version of their product, and that they can sell it to businesses or generate consumer demand, for B2B or B2C offerings respectively.
In many cases you, the angel investor, will not be the intended customer for the startup’s product, and without interviewing lots of potential customers it can be challenging to assess the appeal of the product. Traction tells you unequivocally whether the intended customer is willing to use and pay for the product. You do not need to be an expert in the domain or up to date on the competition, because the customers are making rational decisions with all that information.
caution Keep in mind that traction with a free product is not necessarily indicative of customers’ willingness to pay.
A little bit of competition—especially from other early-stage companies—is a good thing: competition validates that a market exists. Hopefully, the company in question has some well-articulated advantage over the competition. Crowded markets are more challenging for investors and companies because it is harder to define a clearly superior product or differentiated value proposition when there are lots of products in the mix. Even if it is a clearly better widget, it is hard for new entrants to rise above the noise and gain significant mindshare.
In addition to looking for a first-to-market advantage, investors often look at whether the company can build barriers to competition. If the idea proves great and the company begins to get traction, they will also gain the attention of potential competitors who could move to address the same market:
Can the company lock up key customers, distributors, or vendor relationships?
Do they have intellectual property that will act as barriers to competition?
Business due diligence is where things start to get a bit more serious. You’ve evaluated opportunities and chosen a handful of companies that might merit an investment. Due diligence digs deeper and sometimes wider to validate whether the story told by the entrepreneur stands up under scrutiny.
Due diligence (or business due diligence) refers to the process by which investors investigate a company and its market before deciding whether to invest. Due diligence typically happens after an investor hears the pitch and before investment terms are discussed in any detail.
important Due diligence is arguably the most important part of the angel investing process. The amount of due diligence that is done on a company is the factor most correlated with investor return; the more due diligence you do, the more likely you are going to invest in companies that make you money. Rob Wiltbank looked at the amount of due diligence completed by angel investors, and found that the number of hours of due diligence performed on a company was one of the key success factors in angel investing outcomes.* In fact, investors got a 2X better return on an investment when they did more than 20 hours of due diligence versus when they did less than 20 hours. We cannot overstress the importance of due diligence.
confusion You may know of active angel investors making investment decisions with little due diligence. These are likely angels investing alone, and making those investments based on prior relationships or the recommendation of a fellow experienced angel. In part, this is because they have more money and less time. They can afford to lose the money on some percentage of investments more than they can afford to spend the time doing rigorous due diligence on all their investments.
As we discussed in Evaluating Opportunities, the startup team may be the most important determinant of a company’s success. While you should have gotten a good sense of the team’s potential when you were first evaluating the opportunity, digging deeper into the makeup of the company during due diligence will help you gain certainty on your initial impressions.
There are also legal considerations when it comes to diligence on the company team; we discuss employee assignment agreements and vesting of founders’ stock in Legal Due Diligence for Angel Investments.
Below are a few personality traits to consider. Throughout the diligence process you will likely have multiple conversations with the founding team. Try to assess some of these important traits:
In Evaluating Opportunities we discussed why you want to make sure the startup in question is targeting a large market. In performing due diligence, you may want to do a quick check on that market size calculation.
Let’s start by defining what we mean by market size. A common mistake entrepreneurs make is to use the value of the target industry they are selling into, rather than the value of the product or service they are selling. Using a fictitious example:
exampleA startup wants to sell an IoT tire pressure sensor that costs $10 and is compatible with 19” wheels. The total addressable market is not the value of cars sold, or even the value of wheels sold: it is the value of sensors sold.
Jared Sleeper at Matrix Partners has written a useful article about different ways to calculate the TAM (total addressable market), including “top-down” and “bottom-up”:
Because traction is such a critical indicator of potential success, it is important to do diligence on the stated customer count and customer engagement and motivation.
examplePete once got excited about a company that claimed to have 85K customers. This was a consumer and small business product. After a few probing questions, it became clear that these “customers” were acquired when the company’s product was an add-on to a large ecosystem. These customers were on a free tier of the product, and the company determined that it could not monetize them, so it pivoted to a different value proposition. Entrepreneurs know how important customer traction is to investors, so the pressure to present numbers in a positive light can be extreme.
caution Early-stage companies may end up signing very unfavorable contracts to secure key deals or early customers that they need to move the business forward. If the company or its valuation is heavily dependent on a particular distribution contract or customer letter of intent (LOI), ask to see it.
In every pitch deck there should be a slide about competition.
danger If a company says there is no competition it may be a red flag that they don’t understand their customers or their market. If you were the inventor of the first car, for example, you might have been tempted to say that there was no competition; but in fact the competition was horses and carriages and trolleys and trains and bicycles and human feet.
founder Most entrepreneurs know that they have to be better than the competition or at least differentiated to get funded, but their products are early and as a result are often lacking in features. This creates a temptation for founders to be dismissive of certain competitors or to leave them out of the competitive slide in their pitch altogether. They shouldn’t—again, these are key indicators of how well a founder understands her market, customers, and product. Evaluating competition is very company-specific, but the following are some general guidelines for angels to follow when doing diligence on competition:
Start with the list of competitors provided by the company and look at those products closely.
Look at each company’s website. Who are they selling to? How are they positioned? What do they cost?
If it’s possible for you to try out their product, do so.
Read reviews of those products.
You may even want to call up a salesperson from one of the competitors to hear their pitch and their counterargument to the “weaknesses” identified by your entrepreneur.
At a minimum, you should get a thorough demo of the company’s product (if it has one). If it is a product that you can use yourself, then use it as much as you can even if you are not the target customer. Is it elegant and effective or confusing and buggy?
It is not uncommon for an entrepreneur to show a very polished demo of their product using a very specific scenario, and it may turn out that the product only works elegantly under quite specific constraints.
exampleLet’s say the startup you’re considering has an app that finds adventure activities for travelers, and the demo shows someone going to Belize looking for a scuba diving trip. The demo shows five options with pricing information, and everything else you’d need to know. Great. Now you should try the app yourself and search for glacier walks in Iceland, rock climbing in Patagonia, whatever you can think of. Are the results just as good?
Every pitch deck has a financial projections slide showing that in 3–5 years the company will have millions or tens of millions of dollars in revenue and be profitable. Those projections come from a financial model built on a set of assumptions about growth rates, customer transaction size, customer acquisition costs, attrition rates, and others more specific to the type of business.*
The model and the assumptions will be very specific to the type of business. Especially in B2C businesses, the profitability will be very sensitive to some of those assumptions. Any of the pirate metrics mentioned above will likely have big impacts on profitability. The entrepreneur should be able to defend any critical assumptions in the model by pointing to comparable businesses. For B2B businesses, some of the critical assumptions will be conversion rates in the sales pipeline we mentioned above, attrition rates (how many customers don’t renew their contracts), length of the sales cycle (impacts growth rate and cost of customer acquisition), contract size, and how much revenue a single salesperson can generate.
Ask for a copy of the model and work with it until you understand what the key drivers of growth and profitability are. Test the impact of the key assumptions:
dangerWhether listening to a pitch or conducting due diligence, beware of vanity metrics.
examplePete was doing due diligence on a consumer mobile app startup a few years ago that said in their angel pitch that they had achieved 30K downloads from the Apple App Store in their first week. That sounds impressive, but how many of those downloads turned into real engagement that could eventually be monetized? A few probing questions revealed that the founder knew one of the editors of the App Store and was able to get the app featured. It turns out that 30K downloads is pretty typical for a featured app, and that once that visibility was gone, the download rate fell precipitously. The entrepreneur was not lying, they were just touting a vanity metric. While downloads are necessary, they are not sufficient or directly indicative of potential profitability.
Vanity metrics are numbers that may sound exciting but don’t translate in any direct way to the health of the business.* In a B2B scenario, a vanity metric would be how many people came by the sales booth at the conference. The meaningful metric is how many qualified sales leads came from the conference.
examplePete invested very early (pre-launch) in a company that had locked down a vendor contract allowing them to be the sole consumer sales channel for a very desirable subscription mobile communications product. On one of the first investor reports, the company touted how many different states they were getting web traffic from. Not how many unique users were visiting the site, or the cost of that traffic, or the conversion rate to purchase. There are likely hundreds of web crawlers on the internet working continuously to visit and index every website. How many states the traffic came from means absolutely nothing. Even website traffic means nothing until you can convert it at a reliable rate to a registration or a transaction. One can always spend money to buy traffic to a website via paid advertising. What matters is the cost of acquiring paying customers and for how long they continue to pay.
Legal due diligence refers to the process of reviewing a company’s legal documents to ensure that the company has not made and is not making any legal errors that will put the investment at risk.
Legal due diligence is separate and distinct from business due diligence; its purpose is to make sure that there is no reason from a legal perspective that an investment should not proceed. You typically turn to legal due diligence after you have completed your initial business due diligence and have come to terms on the transaction.
Should you hire a lawyer to help you with legal due diligence? This depends a lot on the circumstances of the company you intend to invest in, and your own comfort level. We discuss when it might be appropriate to hire a lawyer a bit later—whether or not you do, it’s wise for the person making the investment to have some familiarity with the topics and issues that might need to be looked into during this stage.
You may find it helpful to take a look at the legal and financial due diligence checklist from the Angel Capital Association.
It is a typical part of legal due diligence to review a company’s charter documents.
In the corporate context, charter documents are a company’s articles or certificate of incorporation, bylaws, and any other corporate agreements, such as shareholder agreements, voting agreements, and so on.
dangerMake sure the company is in “good standing”—that is, the company has not let its corporate charter lapse. You can usually find out if a company is in good standing by reviewing the Secretary of State’s website in the state in which the company is formed. Similarly, if you wanted to, you can check that the company has the appropriate business licenses.
One of the ways startups conserve cash and attract talent is to pay employees lower cash salaries but reward the risk they’re taking on the startup by promising them a portion of ownership in the company—equity. Typically, employees are not given ownership directly, but the option to purchase stock in the company, an option that can be exercised not right away but over time, referred to as vesting.
Equity can be awarded in different ways, most typically through stock options, but also through warrants and restricted stock awards.*
Compensatory equity awards are awards of stock, options, restricted stock units, and similar awards issued to service providers of a company. Under the securities laws, companies may issue compensatory equity to service providers without those service providers being accredited if they comply with another exemption, such as Rule 701.
founderIt is not uncommon for founders to form companies themselves, without any legal assistance. In almost all situations this means the founders have missed something. It is not uncommon for founders who try to do it themselves to not timely file 83(b) elections, fail to adopt bylaws, fail to execute stock purchase agreements at all, and other mishaps.
If you are reviewing the corporate documents for a startup, you should see at least the following documents:
Certificate of Incorporation, or Articles of Incorporation
Most people procrastinate on their taxes. Entrepreneurs are busier than most of us, building a company and a product and hiring and selling and raising money. With a small team, there may be no one focused on finances and accounting and taxes. Entrepreneurs tend to focus on how much cash they have and how quickly they are burning through it.
caution That said, you don’t want a big chunk of your investment going to pay taxes owed. Even if the company has no revenue, it may still need to file tax returns; and even if it is not making a profit, sales and payroll taxes still accrue.
founderWe discuss the various corporate forms (C-corp, S-corp, LLC) and the tax implications in detail (you can also visit Appendix B for further information on the differences between these entities, which will be helpful for founders). You can check in the public record whether a company has tax liens filed against it (or any other lawsuits). But here are the general tax issues to look into as part of your legal due diligence:
Section 83(b) elections. The founders should have given the company copies of their filed elections.
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
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.
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.
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.
Often accelerators and angel groups have boilerplate term sheets that they like to use as starting points in negotiations. You can find an example at Alliance of Angels, and take a look at the Techstars Series AA Term Sheet.
To be clear, there are no “standard” terms for term sheets. There are typical terms and industry norms, but there is still quite a range out there. Some accelerators, like Y Combinator, put forth very entrepreneur-friendly term sheets and encourage very little negotiation of them. Some angel groups put forth very investor-friendly term sheets. Once you have reviewed the types of investments here and seen a few in the field, you will start to get a sense for what is typical for different financings.
The term sheet outlines the details of a specific financing and is usually non-binding (save perhaps for exclusivity and confidentiality clauses). For the deal to be closed, legal contracts representing the details of the investment terms need to be drafted, negotiated, and signed. These contracts and potentially amendments to corporate documents are referred to as the definitive documents.
Definitive documents are the legal contracts between the buyers (investors) and seller (the company) that spell out in detail the terms of the transaction, and are drafted by a lawyer. The definitive documents will set forth the entire understanding of the parties. Definitive documents can include an amended corporate charter and/or articles of incorporation that need to be filed with the secretary of state in the state in which the company is incorporated and would be available for the investor to review. The documents must be signed by all parties in order for a closing to be reached.
Closing refers to the moment at which you sign the definitive documents requiring your signature, and send the company your money, typically either in the form of a check or a wire transfer. The company signs the required documents and delivers to you the security purchased.
What definitive documents are will depend on the specifics of the transaction, but they typically include:
Convertible debt is the most popular financing structure startups choose when they are raising less than $500K. Companies typically issue convertible debt when they are not raising enough money to justify a preferred stock round. This is because a company raising $200K, for example, can’t really justify the legal fee cost or time needed for a preferred stock financing. Convertible debt is relatively straightforward.
Convertible debt (or convertible note or convertible loan or convertible promissory note) is a short-term loan issued to a company by an investor or group of investors. The principal and interest (if applicable) from the note is designed to be converted into equity in the company. A subsequent qualified financing round or liquidity event triggers conversion, typically into preferred stock. Convertible notes may convert at the same price investors pay in the next financing, or they may convert at either a discount or a conversion price based on a valuation cap. Discounts and valuation caps incentivize investors for investing early and not setting a price on the equity when it would typically be lower. If a convertible note is not repaid with equity by the time the loan is due, investors may have the right to be repaid in cash like a normal loan.*
Convertible note rounds can be as small as $50K–$100K in size, but more typically they are on the order of several hundred thousand dollars (but below $500K). Rounds in this size can also be raised by selling convertible equity or common stock (which we’ll cover), but neither method is as popular as convertible debt.
Frequently a company will start a convertible note offering by showing potential investors a term sheet, rather than the note itself. This is also true in fixed price financings. You can see an example convertible note term sheet and an annotated convertible note in the appendix.
founder Convertible debt can be beneficial for startups in the following ways:
Immediate access to funds. Unlike a fixed price equity round where there is typically a formal closing date on which a substantial portion of the money comes in, notes can be signed in small amounts ($25K) which individual investors and the company can start using right away. An exception to this is if the convertible note document itself requires a minimum amount of funds to be raised, but this is unusual. If a company is short on cash or needs additional funds to hire engineers or kick off patent work, this quick access to cash as individual investors come on board can be very useful.
Lightweight deal documentation. A convertible note may be only a few pages long, whereas the documentation for a fixed price equity round typically spans multiple long documents. As a result, notes can be executed quickly and legal costs are usually significantly less. If a company is raising $250K or less it does not make sense to spend $10K–$15K or more on legal fees for a fixed price round. Legal fees for a convertible note round are typically on the order of $5K.
Ability to reward early investors. There are several mechanisms for rewarding investors who come into the deal early, in addition to the general accumulation of interest over time. These can include a discount rate on conversion, a valuation cap, or some combination of those factors (each of which will be discussed in detail). It is also possible for the earliest note investors to get higher discounts and lower caps than subsequent convertible note investors.
For example, the first investor in a startup might get a 25% discount and a $1M conversion cap on their note, while an investor who comes in two months later could get a 15% discount and a $2M cap.
When a startup is trying to get its fundraising going it can be helpful to create inducements for the early investors. And as an investor, if you have faith in the company early on you can reap rewards for taking on the extra risk of being first in.
Angel investors used to complain that convertible notes prevented them from getting fairly compensated for taking on the added risk of investing in a very early-stage company. A priced round by contrast would allow them to lock in a low cost for their shares. With the popularity of the valuation cap* as a feature of the convertible note, that argument has largely been addressed; but some investors still do not like notes.
From an investor’s point of view, sometimes convertible debt can be better than a fixed price equity round, because:
Debt sits on top of equity; meaning, if the company goes defunct, debt holders are entitled to be paid first, before equity holders.
Noteholders can have favorable conversion provisions, such as discounts and caps.
Common provisions of a convertible debt financing include:
The interest rate. Usually somewhere between 4% and 8%.
The maturity date. Usually 12–24 months.
A mandatory conversion paragraph. Specifies the minimum size of the round that the company must close in the future (a qualified financing) to cause the debt to automatically convert into equity of the company.
Sometimes notes will specify what happens in the event the company defaults on the note. Most of the time the primary default is the non-payment of the note on the maturity date. Higher interest rates in the event of default are not common.
It is not uncommon for a note to require that before an action is taken against a company to enforce the terms of the note, the holders of a majority in principal amount of the notes approve the action, rather than just one note holder. Sometimes the majority required is a supermajority, set at something like 70%, to ensure that a large minority investor has a veto right on any amendments.
exampleIf there are eight investors, three who put in $100K and five who put in $50K, there are $550K of notes outstanding. Holders of notes with principal amounts aggregating more than $275K can, with the company’s consent, amend the note.
important When negotiating a convertible note financing, focus on the following elements of the term sheet:
What is the valuation cap?
What is the conversion discount? (10% to 20% typically.)
Preferred stock rounds are the most common type of fixed price round for angel investments—in fact, when investors and founders refer to a fixed price round or a priced round, they usually mean a preferred stock financing, although common stock fixed price rounds are possible. Preferred stock is equity that has specified preferences relative to common stock and potentially to other classes of preferred stock. Those preferences are negotiated as part of the term sheet and documented in the definitive documents of the stock sale.
The most common preferences conferred to preferred stockholders are:
a liquidation preference
a dividend preference
A fixed price financing (or fixed price round or priced round) is a type of financing where the investors buy a fixed number of shares at a set price (in a common stock or preferred stock round), as opposed to rounds in which the number of shares and the price of those shares will be determined later (such as convertible note or convertible equity rounds). The most common type of fixed price round are preferred stock deals, which often represent rounds larger than convertible rounds, greater than $500K for example, which justifies the legal cost of documenting the round.
By definition, in a fixed price financing a price must be set or fixed for the security being sold (preferred stock, or less frequently, common stock) by the company. There are a number of factors that come into play when determining the price, and some of those factors are a function of negotiation. In order to provide a full understanding of how this works, in Part IV we’ll dig into pre-money valuation, post-money valuation, stock option pools, and dilution generally.
We talked about some of the advantages of convertible notes in the prior section. Convertible rounds are built on the assumption that the company will raise another round in the future that will fix the price of the non-priced round. But if no subsequent round is planned, then a non-priced round is not a good fit, and a fixed price financing is called for.
Investors may prefer fixed price financing over convertible debt so they can lock in the valuation of the company earlier (while it is presumably lower) and receive the rights and preferences associated with preferred stock. Some investors are also wary of convertible debt or convertible equity rounds because they don’t want to have to wait to become a shareholder, or because they believe (or they believe founders believe) that convertible debt creates a conflict of interest between the founders and the investors.
founderEntrepreneurs have a mixed perspective on preferred stock, depending on the particulars of the preferences. On the plus side, raising a preferred stock round means they are raising a significant amount of money, and that is likely what they need to keep going and growing.
The downsides for the entrepreneur are:
The benefits of the preferences that accrue to investors in a preferred stock round come generally at the expense of the entrepreneur and the pre-existing stockholders. Convertible note and convertible equity holders usually convert into the same class of stock (the preferred) that is creating the qualified financing and triggering the conversion. (The most common exception to this is when the convertible debt or equity is converted into a subclass of the preferred stock to avoid the problem of the liquidation overhang.)
Negotiating the preferences and pricing can consume a lot of legal resources, especially if they are unfamiliar with the terms. (If you’re a founder raising your first angel round, we suggest reading the Holloway Guide to Raising Venture Capital, which dives deep on term sheets from the entrepreneur’s perspective.)
Investors like preferred stock rounds for a number of reasons:
The price is set and the investor knows what percentage of the company they own.
If an investor has participated in non-priced rounds like convertible debt or convertible equity, they will finally know what they have bought for their money. This is the case as long as the preferred stock round is a qualified financing that converts the convertible notes into stock shares and any convertible equity into actual stock shares on the cap table.
The investors get specific preferences reflected in the definitive documents that can improve their outcomes in both good and bad scenarios, and sometimes give them a measure of control beyond what their specific share count would provide.
The term sheet for a preferred stock offering will contain the following key elements:
The type of security (for example, series A convertible preferred stock). (Note that the word “convertible” here refers to the fact that the preferred converts to common.)
The amount of money being raised in the round (referred to as an “offering”).
The topics below are important elements of a preferred stock financing. These issues may or may not be represented in the term sheet.
In early-stage company financings, preferred stock is almost always convertible into common stock at the option of the holder. It is also typically converted automatically upon an event such as an initial public offering that meets a certain size, or upon the election of a majority (sometimes supermajority) of the preferred stock to convert to common. This clause in the term sheet will typically specify the conversion ratio of preferred stock into common stock (always at a 1:1 ratio) and any events or other provisions that would impact that conversion ratio. For example, take a look at the Series Seed Term Sheet, which says:
Preferred stock term sheets come in a variety of different shapes and sizes. You can find example preferred stock term sheets at the following sites:
Series Seed (a simple term sheet that’s appropriate for smaller preferred stock rounds)
Techstars (intermediate-length term sheet)
NVCA (full-blown, full-length VC-style term sheet for large rounds)
While purchasing convertible debt and preferred stock are the most common types of investments angels make, there are other financings out there that you or a company you’re investing in may prefer. Some of these are newer to the angel investment world.
Convertible equity is an entrepreneur-friendly investment vehicle that attempts to bring to the entrepreneur the advantages of convertible debt without the downsides for the entrepreneur, specifically interest and maturity dates. The convertible equity instrument the investor is buying will convert to actual equity (stock ownership) at the subsequent financing round, with some potential rewards for the investor for investing early. Those rewards are similar to the rewards for convertible debt, such as a valuation cap and/or a discount.
The amount of the equity the investor is entitled to receive is determined in the same way as a convertible note. The investor usually (but not always) converts at a discount to the next round’s price or at the valuation cap if that would result in a better price. As with convertible notes, the company avoids pricing its equity, which can be helpful when hiring employees.
Convertible equity is expressly defined as not being debt, so it does not bear interest. Nor does it have a maturity date.
Convertible equity is similar to convertible debt in that the documentation is simple—and therefore much cheaper—compared to a priced round, and so it is appropriate for earlier, smaller investment rounds, which can be anywhere from $50K to several hundred thousand dollars in size.
As an angel investor, from time to time you might be asked to invest in common stock.
Common stock is stock that entitles the holder to receive whatever remains of the assets of a company after payment of all debt and all preferred stock priority liquidation preferences. Common stock does not usually have any of the special rights, preferences, and privileges of preferred stock (although it is possible to create a class of common that does, such as a class of common stock that has multiple votes per share, or is non-voting, or that has protective provisions).
When a corporation is initially organized, typically only common stock is issued to the founders and set aside for issuance under the company’s stock option or equity incentive plan for service providers. (However, sometimes founders will issue themselves a special class of common stock with 10 or 100 votes per share and protective provisions.)
important Though common stock can be raised in a priced round, it is not usual for angels to purchase common stock. Common stock usually has one vote per share, no liquidation preference, no anti-dilution adjustment protection, and no protective provisions. As we have previously discussed, preferred stock is “preferred” because it has these types of special preferences. However—and though many angels will refuse to buy common stock—common stock deals are not necessarily bad deals. In fact, one of the best investment returns Joe has ever seen was a $100K angel investment in common stock that turned into $20M in cash.
Revenue loans are another relatively new financial innovation in the early-stage company space.
A revenue loan is a loan that has a monthly or periodic repayment amount that is a percentage of the company’s gross or net revenue in the period with respect to which the payment is going to be made (for example, the preceding month or quarter). The payment amount is typically somewhere between 5-10% of the preceding period’s gross or net revenue. In other words, the payment amount is not set and fixed like in a traditional loan. It goes up and down based on the performance of the business. A revenue loan may have a four-, five-, seven-, or ten-year term, and is considered repaid when the lender has received the negotiated multiple of the loan amount (anywhere from 1.5X-3X) and any other costs of the loan.
Revenue loans may or may not be secured by the company’s assets and may or may not be guaranteed by the company’s founders. They may or may not have any financial operating covenants. They may or may not have any equity component (for example, they could come with warrant coverage. They may also come with a “success fee,” meaning a payment of some additional amount to the lender on the sale of the company.
Revenue loans fill a gap between typical commercial loans and traditional equity-based financing instruments. They are often used by companies that have cash flow and are looking for expansion capital but do not want to give up any equity in the business. For example, if a new coffee shop is doing really well and the owners want to open three more locations, they may not have the working capital required for that expansion. A traditional bank may not see enough operating history or might want personal guarantees from the owners along with constraining financial covenants. With a revenue loan, once those new venues start generating cash the owners can use margin on that new revenue to pay off the loan over time. The other advantage of the revenue loan structure is that if it took several months for those new locations to ramp up sales, the company would not be burdened with a high fixed monthly loan payment from a traditional loan. The revenue loan payments would start low and ramp directly with the sales.
A warrant is a contract entitling the warrant holder to buy shares of stock of a company. It is not stock itself. It is merely a contractual right to buy stock.
A warrant will set out:
In the sections so far covering the different investment vehicles, each section has included terms that are unique to or typically associated with that investment type. This section includes the general investment terms that could show up on any term sheet, regardless of the investment vehicle. We have touched on many of these terms already, but in this section we will go deeper.
We have grouped the terms into subsections, and you can use this chapter as a reference whenever you come across one of these concepts.
The rights in this section address how you can participate in or get impacted by future investment rounds. For example, if the company has to raise money in the future at a lower valuation, you do not want to get your ownership stake heavily diluted or “washed out.” If the company is doing well, you may want to ensure that you have the right to keep investing.
Investors may want the right to continue to invest and thereby minimize their dilution as much as possible as the company grows.
cautionSometimes investors ask to never be diluted below a certain percentage of a company. For example, an investor might offer to buy 5% of a company but want the company to obligate itself to never dilute the investor below 5% of the company. This is an unsophisticated and impractical request. There is no realistic, practical way to accomplish this in a company that expects to raise multiple rounds of funding. Remember, everyone gets diluted, including the founders.
Control and governance refers to how the company is controlled (hiring and firing officers, issuing equity, M&A transaction approval) and who controls it. The primary control mechanism is the board of directors and protective provisions. We covered a number of protective provisions within our discussion of preferred stock. Drag-along agreements are worth mentioning because they impact who is not in control of a transaction (potentially you).
If you are a significant investor, you may want to negotiate a board seat. We cover boards of directors and boards of advisors in detail in Boards and Advisory Roles.
If you do take a board seat, as part of the term sheet, you may want to insist that the company obtain directors and officers insurance to protect you in the event of a lawsuit. In addition, it is always a good idea to have a lawyer who is familiar with these insurance policies to work with company management and the company’s broker to make sure that you are getting a policy with the coverages you want and without exclusions that might leave you unprotected.
What if you made an investment in an early-stage company and never heard from them again; or only received documents to sign when they wanted to authorize more stock? Many investors like to know what is going on with their investments, and the rights described in this section make sure that you as an investor can get regular updates and access to management if you want that.
Information rights are the rights to receive certain information about the company at specified times—for example, the right to receive quarterly and annual financial statements, the right to receive an updated capitalization table from time to time, and the right to receive the company’s annual budget. Sometimes, information rights are only made available to investors who invest a certain amount in a financing (typically referred to in the investment documents as a “major investor”).
importantCompanies that go dark, or that do not communicate with their investors on a regular basis, can be a significant source of angst for investors. If an entrepreneur or lead investor (who might be a major investor while you are not) pushes back on inclusion of all investors in information rights, you can stress that there is no additional work required by the company. The documents are already being prepared, and they just need to add you to the electronic distribution list.
Terms in this section impact how and when you might get cash back out of the investment. We discuss liquidation preferences in the section covering preferred stock, since a liquidation preference is most typically a facet of a preferred stock financing.
Redemption rights (or put right) are the rights to have your shares redeemed or repurchased by the company at the original purchase price or some multiple, usually after a period of time has passed (perhaps five years). It is also possible to prepare these provisions to allow redemption in the event the company fails to reach a milestone, or breaches a covenant.
cautionBe aware, however, that even if you have redemption rights, if a company is insolvent it will not be able to legally satisfy a redemption demand. Under most states’ corporate laws, corporations are disallowed from redeeming shares when the corporation is insolvent either on a balance sheet or ability to pay its debts as they come due, and directors are personally liable if they authorize a redemption when the corporation is insolvent.
Representations (or reps) and warranties can cover a broad range of topics in a financing transaction and they typically get more thorough as the amount of money gets bigger. In general terms, a representation is an assertion that the information in question is true at the time of the financing, and the warranty is the promise of indemnity if the representation turns out to be false. For example, a company might rep that they have no unpaid salaries, or that they are not currently being sued. We address two more specific reps below.
If you want to get a taste of probably the most typical sort of representations and warranties companies give in private financings, you can review the representations and warranties in the Series Seed documents.
A capitalization rep or cap rep is a representation and warranty in a securities purchase agreement in which the company makes assurances to you about its ownership and capital structure. For example, the company may represent and warrant that it has authorized 10M shares of common stock and that it only has 2M shares outstanding. If they are wrong, the investor can sue for damages and remedies.
We’ve discussed some of the definitive documents specific to the different types of angel investment types above. Below are definitive document agreements that can be associated with a broad range of financings.
A Voting Agreement is an agreement between the voting stockholders of a company in which the parties agree to vote their shares in a particular fashion to ensure that certain persons or their designees are elected to the board of directors. The agreement must be signed by the stockholders, because under corporate law it is the shareholders who elect the directors of the company; if your agreement is just with the company your right will not be enforceable.
exampleA two-person company is owned 60% by one person and 40% by the other. The two parties could agree that they would each vote their shares to elect each other to the board of directors. This would ensure that the 60% owner cannot throw the 40% owner off the board.
Understanding how ownership percentages in a company are impacted by valuation, and diluted as the company raises money and hires employees is crucial to being a good investor and a smart entrepreneur. This section will walk through these key concepts as we tell the story of one fictional company.
Valuation is how much a company is worth; valuation and value may be used interchangeably, or valuation may refer to the process of determining a company’s value. A public company’s value is expressed by how much people are willing to pay for the shares on the stock market. For a private company, the company’s value is determined in negotiations between the founders raising money and the investors.
You may have heard of 409A valuations for startups.
The common stock in a private company can be valued through a formal process called a 409A valuation. 409A valuations are done for purposes of granting compensatory equity (typically stock options); they have little or no bearing on how much angels or VCs are going to pay for preferred stock in a company.
The pre-money valuation is the agreed upon value of the company immediately prior to the investment. The pre-money valuation is the single most important factor, but not the only factor, in determining how much of the company you will own when you invest a specific amount of money.
founder It is useful for both entrepreneurs and investors to understand the mechanics of dilution, how dilution and ownership are calculated, and how the cap table will be impacted by investment.
Dilution is the decrease in ownership percentage of a company that occurs when the company issues additional stock, typically for one of the following reasons: to issue to a co-founder who came on after incorporation, to sell to investors, or to add to its stock option pool.
When a company is formed, the certificate or articles of incorporation states the total number of shares the company is authorized to issue, called authorized shares. If the company decides it needs more shares at some point, it will need to amend its certificate or articles of incorporation, and that typically requires approval of a majority of stockholders. Authorized shares can include common stock and preferred stock.
In this section we will begin our example of a fictional company to explain some more key concepts, and illustrate how valuation and dilution effect ownership as represented in the cap table, starting with the initial company setup.
exampleJoe and Pete started a software company, Pext, Inc., which is developing an app to help pets send and receive texts. They retained a well-known startup lawyer who incorporated their company in Delaware and helped them assemble and execute all of the correct documents with respect to the formation and organization of the company. The corporation was initially authorized under its charter to issue a total of 30M shares, 25M shares of common stock and 5M shares of preferred stock. Thus, the company had a total of 30M authorized shares.
The stock option pool is a specified number of shares set aside and reserved for issuance on the exercise of stock options granted to employees under a stock option plan or an equity incentive plan. Equity incentive plans have more awards available under them to issue than stock options (they also have stock bonuses, restricted stock awards, and sometimes other types of awards as well). The shares reserved under an equity incentive plan should be reflected on the cap table. Options are granted out of the pool via grants that are approved by the board. Each grant reduces the remaining available pool, until it is topped up again by the board authorizing the reservation of additional shares under the plan from the authorized shares. The strike price is the exercise price of the stock option.
important Because stock options can be executed to purchase stock, they need to be accounted for in the cap table; and the stock option pool impacts both the percentage ownership calculation and potentially the price per share, as we will see below.
founder When a company is founded, the founders are wise to set aside 10–15% of the equity in an option pool for future new hires, contractors, and advisors. Over the first few years that equity gets allocated to the new hires, members of the board of directors, advisors, and independent contractors. When the company goes to raise money, savvy investors will want to see that option pool topped up to 10% or 15% again in anticipation of the company hiring many more employees.
Why does the stock option pool need to be so big? The earlier the stage of the company and the more senior the employee, the more equity that employee will demand. Bringing in a seasoned CEO to a very early-stage company (if one of the founders is no longer going to be the CEO) may require giving them 10% of the equity, likely vesting over four years. That is the high end, but even an experienced senior engineering lead or sales executive might command 2%-3% of the equity.* Steve Ballmer received 8% of Microsoft stock when he joined as the 30th employee, and now owns more of the company than Bill Gates. Smart CEOs track a budget of equity for employees, directors, and advisors. That stock gets allocated via stock option grants approved by the board of directors. As the company matures it needs to give out less stock to each employee, even senior ones, but the number of employees it is hiring is also increasing.
The simplest example of dilution comes from adding another co-founder. This is different from adding another employee, which we will explore below. It is similar to the impact of selling shares in a priced round, but we will save that discussion for further on in our example so that we don’t tackle too many variables at once!
exampleJoe and Pete decide to add a technical co-founder, Rachel. After negotiation, the parties agree that Rachel will receive 15% of the company. Rachel buys her shares directly from the company out of the corporation’s authorized but unissued shares.
This is what the cap table looks like after Rachel purchases stock from the company such that she owns 15% of the issued and outstanding shares.
When a company hires an employee and gives them stock options as part of their compensation, they usually issue the options out of the shares reserved for issuance under the company’s stock option plan (not the company’s authorized but unissued shares).
Joe and Pete hire a very experienced head of marketing and give them a stock option to purchase 3% of the company.
To translate the 3% of the company into a number of shares, Pete and Joe multiply 3% by the company’s issued and outstanding shares plus its entire stock option pool reserve. They are calculating the ownership on a fully diluted basis. This way, if they issue 3% to another executive the next week, that executive would get the same number of shares. Effectively, you don’t want each employee to dilute the next employee, especially since the board of directors may be approving option grants to five employees at the same time. This is how most companies translate negotiated percentages into share numbers; it does not have to be done this way, but it is the most common way.
What follows is a simple example of how ownership gets diluted with the selling of shares. In the next section, we’ll bring it all together and talk about how those shares get priced.
In a priced round, the company issues shares out of its authorized stock, either common stock, or more typically preferred stock. A specific number of those shares are sold to investors at a specific price. This new stock gets added to the cap table, which increases the number of issued and outstanding shares. All the existing shareholders (founders, prior investors, employees with stock options, advisors) have the same number of shares or options they had before the transaction, so they are all diluted in their ownership by the increase in the denominator (total number of shares).
founder Every time founders raise more money or issue stock options for new employees, they dilute their ownership. Prior investors are also diluted by these activities. The degree of dilution is determined largely by the ratio between the amount of money being raised and the pre-money valuation. If the founders raise too much money before they can justify a high valuation, they give up too much of the company too early.
importantThe 50% ownership mark is an important threshold for founders. Those who control more than 50% of the company’s stock have a lot of control over the company. Any significant corporate activity around issuing more stock or how the board is structured, for example, can ultimately be controlled by owning a majority of the stock—unless the founders have agreed to specific control provisions for investors. Once the founders have sold off more than 50% of their stock to investors, they have essentially lost control of the company they founded. Because of this, you may see resistance among founders to going below the 50% threshold too early.
examplePext, Inc. raises its first external round as a priced round, closing a $250K raise with a $1M pre-money valuation. (If you have been reading carefully, you would rightly object to a priced round for a raise of only $250K, and suggest a SAFE or convertible note instead, but bear with us so we can illustrate the dilution!) If the pre-money is $1M, the post-money valuation in this case will be $1.25M (pre-money valuation plus amount raised), and the percentage of the company sold will be 20% ($250K/$1.25M). Let’s say that our savvy investors insist that their ownership should be calculated on a fully diluted basis.
Consolidating the cap table above (Figure 3) to aggregate founders and employees prior to investment:
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 96.67% | 86.96% |
| Employee 1 | 345,000 | 3.33% | 3.00% |
| Issued and Outstanding | 10,345,000 | 100.00% | |
| Option Pool Available | 1,155,000 | 10.04% | |
| Total Fully Diluted | 11,500,000 | 100.00% |
For comparison now, let’s look at scenario B, where the founders raise $500K instead of $250K on the same $1M pre-money valuation. Now they are giving up a third of the company in the first external round.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 62.13% | 57.97% |
| Employees | 345,000 | 2.14% | 2.00% |
| Round 1 Investors | 5,749,138 | 35.72% | 33.33% |
| Issued and Outstanding | 16,094,138 | 100.00% | |
| Option Pool | 1,155,000 | 6.70% | |
| Total Fully Diluted | 17,249,138 | 100.00% |
In scenario A, the founders owned roughly 70% after the first raise, in scenario B, they only own 58%. They have given up 12% of the company for the extra $250K. They would have to make a lot more progress on that extra $250K in order to bring up the pre-money valuation for the next round well beyond what they could have done with only $250K.
In the dilution examples above, we determined ownership percentage and the number of shares to be sold to the investors without ever calculating the price per share. We did that by first calculating the percentage being bought by the investors using the pre-money valuation and the investment amount:
To calculate the number of shares, we had to decide which total share number we were going to use (issued and outstanding or fully diluted); and because we wanted as many shares as possible, we chose fully diluted. The formula for getting to the number of shares is:
exampleLet’s look at the difference in the two approaches using our cap table from our scenario A example just above, where the Round 1 investors are buying 20% of the company for $250K at a $1M pre-money.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 96.67% | 86.96% |
| Employees | 345,000 | 3.33% | 3.00% |
| Issued and Outstanding | 10,345,000 | 100.00% | |
| Option Pool | 1,155,000 | 10.04% | |
| Total Fully Diluted | 11,500,000 | 100.00% |
Using the fully diluted basis, the price per share is $1M/11,500,000 or $.087 per share. When this company IPOs at $17 per share, you’ll have a 20X return! Checking the math, 2,875,000 shares purchased by the investors (see the post investment cap table in Figure A1) at $.087 each is $250K.
As we saw in the pricing discussion above, the difference between a calculation based on issued and outstanding shares versus fully diluted shares can be significant. The option pool is typically the biggest component of the difference between issued and outstanding and fully diluted shares, and so the size of that option pool tends to get a lot of scrutiny at the time of any investment.
As a company hires employees, it issues grants of options on the stock that is reserved for the stock option pool, thereby slowly depleting that pool. It is common that a company has to top up its stock option pool several times as it grows from no employees to dozens, to hundreds, to potentially thousands. It increases the pool by allocating shares from the company’s authorized stock. When the company adds more shares to the option pool, it dilutes all the existing stockholders (when using the fully diluted ownership calculation). It is a round of dilution without directly bringing in any money (the way a stock sale to investors does). So companies aren’t anxious to top up the pool by themselves.
Savvy investors know that the company should have a healthy stock option pool so it can motivate the new employees it wants to hire with the money it is raising. So as part of almost any priced investment round there is a discussion about how big the pool should be and who is going to take the dilution hit. New investors want to allocate additional shares to the pool in a way that dilutes the existing equity holders before the new investors come in. The company would prefer if the option pool were topped up after the new money came in, as the dilution to the founders and prior investors would be less because the new investors would be sharing in that dilution.
exampleBelow is an example of how Figure A2 would change if the Round 2 investors had insisted that they are buying 20% for their $750K, and they still agree to the $3M pre-money, but now they also insist that the stock option pool be topped up to 15%. If you look back to Figure A2, you will see that the stock option pool is down to 6.43% post investment if it is not addressed. Because the investors have established their 20% post investment ownership (on a fully diluted basis) as part of their investment terms, the full burden of the dilution in this case is borne by the founders and existing investors (and existing employees). The founders go from 55.65% ownership post investment to 49.17%. A big difference. The investors for their part get more shares, 473,942 more, because they require 20% of a larger total of fully diluted shares now.
So far, we’ve walked through the story of a company that goes straight to raising a priced round, and explored a couple of scenarios to demonstrate some key concepts and mechanics. In this section, we’re going to pick up the story of the same company back after they added their first employee. Instead of going straight to a priced round, the company first raises a convertible note, then a preferred stock round. How will this series of events affect the cap table and investor ownership?
Let’s find out!
exampleAfter adding their first employee, Pext, Inc. decides to raise a small amount of external capital, $400K, in order to pay some contract developers for the MVP of the product and to cover some marketing expenses to do early customer acquisition testing. Because they are raising less than $500K, and want to minimize the legal costs, they raise capital in the form of a convertible note. The note has the following key terms:
While note conversion terms can be written in slightly different ways, for our purposes, we will use a simple example where the stock price using the valuation cap conversion option was specified to be calculated as follows: Valuation cap divided by the issued and outstanding securities immediately prior to the sale of the preferred. The valuation cap was $3M. The number of issued and outstanding securities was 10,345,000 per the cap table in Figure 3. The price per share is therefore $3M/10,345,000 or $0.28999517.
The 5% interest on the $400K in notes would have generated an additional $20K in the intervening year, so the convertible note investors will be converting $420K into shares at $0.28999517. Running the math, the convertible note holders will get $420K/$0.28999517 = 1,448,299 shares. So the conversion of the notes before any other actions would have the cap table looking like this:
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 84.79% | 77.23% |
| Employees | 345,000 | 2.93% | 2.66% |
| Convertible Note Investors | 1,448,299 | 12.28% | 11.19% |
| Issued and Outstanding | 11,793,299 | 100.00% | |
| Option Pool Available | 1,155,000 | 8.92% | |
| Total Fully Diluted | 12,948,299 | 100.00% |
Now the option pool has to get topped up such that it will be 15% of the fully diluted shares after the dilutive effect of the preferred stock sale. Because the preferred stock sale will cause a 20% dilution (selling 20% of the company) across the board, the option pool must be 18.75% prior to being diluted by the preferred stock:
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 84.79% | 68.90% |
| Employees | 345,000 | 2.93% | 2.38% |
| Convertible Note Investors | 1,448,299 | 12.28% | 9.98% |
| Issued and Outstanding | 11,793,299 | 100.00% | |
| Option Pool Available | 2,721,531 | 18.75% | |
| Total Fully Diluted | 14,514,830 | 100.00% |
The terms of the stock sale stipulated that the preferred stock investors would own 20% of the company on a fully diluted basis, and that at that time the option pool would represent 15% of the company on a fully diluted basis. Those conditions result in the cap table represented in Figure 7 below.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 64.84% | 55.21% |
| Employees | 345,000 | 2.24% | 1.90% |
| Convertible Note Investors | 1,448,299 | 9.39% | 7.98% |
| Preferred Stock Investors | 3,628,708 | 23.53 | 20.00% |
| Issued and Outstanding | 15,422,007 | 100.00% | |
| Option Pool Available | 2,721,531 | 15.00% | |
| Total Fully Diluted | 18,143,538 | 100.00% |
You can see that our 18.75% option pool in Figure 5 has been diluted by the new investment as well, and is now at the target 15%.
We started working through the impact of the preferred stock investment on the cap table by assuming that the note holders would be better off with the valuation cap conversion than the discount conversion, but let’s check.
If the noteholders had converted their $420K at the 20% discount, they would be paying $0.55116 multiplied by $0.80 per share, or $0.44093 per share. And $420K divided by $0.44093 is 952,532 shares.
Converting at the valuation cap generated 1,448,299 shares, so that was clearly the more advantageous conversion option.
After two years with the company, Joe, one of the founders, has become restless and decides to leave the company to become a crabapple farmer in New Zealand. Because the company was set up by competent attorneys, the founders were on four year vesting schedules. Joe is exactly halfway through his vesting schedule, so upon his departure, the company will buy back 50% of his shares, or 1,700,000 shares. These shares were purchased by Joe as part of the company setup for a fraction of a penny per share, let’s say $0.001 per share. Joe would have originally bought his shares two years ago for $3,400, and will sell half back for $1,700. But aren’t Joe’s 1,700,000 shares, which represent 9.37% of the company—which a year ago had a post-money valuation of $10,000,000—worth close to a million dollars? They might be, but the terms of stock purchase agreement and the vesting schedules therein would have stipulated that upon departure the company has the right to buy back any unvested shares at the issuing price, in this case $0.001 per share. This is a bummer for Joe, but he is, after all, walking away with the 50% of his stock ownership which he had vested. When the stock is repurchased by the company it is typically retired or returned to the treasury, so for all practical purposes, it is removed from the cap table.
The good news for the other stock owners is that by removing a large chunk of the issued and outstanding stock from the cap table, their ownership stakes go up.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 8,300,000 | 60.49% | 50.48% |
| Employees | 345,000 | 2.51% | 2.10% |
| Convertible Note Investors | 1,448,299 | 10.55% | 8.81% |
| Preferred Stock Investors | 3,628,708 | 26.44% | 22.07% |
| Issued and Outstanding | 13,722,007 | 100.00% | |
| Option Pool Available | 2,721,531 | 16.55% | |
| Total Fully Diluted | 16,443,538 | 100.00% |
In Part III: Financings and Term Sheets, we covered the most common investment scenarios. In this section, we will review the most common types of entities in which you might consider investing, as well as the relevant tax issues that arise.
Angel investing involves a number of different tax issues for investors. You might wonder, for example, when can you recover your investment in a company for tax purposes? Can you deduct your investment in the year you make the investment? Is there a tax credit for making the types of investments you are making?
The tax consequences of any particular investment will depend on the type of entity in which you invest—typically either a C corporation, S corporation, or LLC taxed as a partnership—and how you invested—stock purchase, convertible debt or convertible equity, interest in an LLC taxed as a partnership, and so on.
The most common type of entity in which you will likely invest will be a Delaware C corporation.
A C corporation is a type of business entity which is taxed for federal income tax purposes under Subchapter C of the Internal Revenue Code. C corporations pay the taxes that are due on their income; their shareholders are not taxed on and not liable for taxes on the corporation’s income (in contrast to S corporations and limited liability companies, which are taxed as partnerships).
As we discussed in Legal Due Diligence for Angel Investments, Delaware is the most popular place for early-stage companies to incorporate because of the state’s corporate law history and the business-friendly legal precedents there. Delaware corporate law is also the most familiar to the investment community.
You might be interested in investing in an S corporation.
caution S corporations can only have one economic class of stock. Meaning, you will only be able to buy common stock; you won’t be able to buy preferred stock.
An S corporation can divvy up governance rights as long as the economic rights of all of the shares is the same (for example, an S corporation can have voting and non-voting stock, as long as the voting and non-voting stock have the same economic rights).
Sometimes founders form LLCs as an easy way to get started.
Limited liability companies (or LLCs) can be simpler to form than corporations. LLCs also have the benefit of being pass-through entities for tax reasons by default. Meaning, the losses flow through to the personal tax returns of the owners, unless an election to be taxed as a corporation is made.
important The financial and tax consequences of your investment depend on how the LLC is taxed for federal income tax purposes. This is a legal and business due diligence point you will want to run down right away.
It is not uncommon for founders to have forgotten what their tax accountant did when they formed the company. If you are considering investing in a business organized as an LLC, you must confirm the tax classification of the LLC. It is preferable to do this sooner rather than later. Don’t assume that because the company is formed as an LLC that it is taxed as a partnership. For federal income tax purposes, an LLC can be classified as either:
dangerPlease always consult with your tax advisors regarding credits and losses and other tax matters. Tax law changes frequently and the summaries in this book may not accurately describe how the rules apply to your particular situation.
The federal income tax law does not, in 2020, provide a tax credit for investing in startups. However, the state in which you live, if it has an income tax, might. You should consult your local tax CPA to find out what incentives your state might offer.
What happens if you invest in a company and the company fails? Can you deduct your loss? If you can deduct your loss, what sort of loss is it, capital or ordinary?
An ordinary loss is the best type of loss because it can be set off against ordinary income (your salary). Capital losses are only deductible against capital gains plus $3K of ordinary income per year. If you don’t have much in the way of capital gain, because of this $3K per year limitation, it might take you years to fully deduct your losses.
In general, investments in corporations result in capital losses only when the corporation’s stock is completely worthless. The “completely worthless” test can require that the company be completely dissolved and wound up.* Even if the corporation is nearly dead, it still may not be dead enough for you to take a loss. One way to take the loss on a nearly defunct company is to assign the shares for $1 to an unrelated third party. Some angel groups set up programs to facilitate these types of assignments.
While capital losses are problematic because they are only deductible against capital gains and then up to $3K of ordinary income per year, Section 1244 of the tax code converts some capital losses into ordinary losses. In order to take advantage of Section 1244, your stock must be Section 1244 stock, which is generally stock that represents the first $1M invested in a company. But Section 1244 is limited, to $50K for individual taxpayers and $100K for married couples filing jointly.
As an angel investor, you may be asked or choose to negotiate a board seat or advisory position with a company you invest in. We’ve mentioned boards a few times throughout this book, so let’s dig in to the details.
In a corporation, the board of directors (or BOD) controls the company. It is typically made up of one or more founders, investors from each round, and one or more advisors. The board’s authority is expansive: it can fire the CEO and the other officers of the company; approve all equity issuances, including all stock option grants to employees and all equity financing rounds (including convertible note rounds); approve leases and other significant financial commitments; approve or deny the sale of the company or decide to shut the company down. On the board of directors, each director has one vote.
If you are on the board of directors, you are said to have a board seat. Sometimes, angel investors might want to have a board seat so that they can more closely monitor their investment. At other times, a company might want to give you a board seat for reasons of reputation or risk management.
In an early-stage company, the board of directors should be small. It is often made up initially of just the founders or a subset of the executive founders if there are more than three. Sometimes the founders will have added an industry veteran to the board to provide credibility and advice. The CEO is always a member of the board. Typically, the lead for each round of investment or their representative is added to the board, allowing them a small measure of control as well as visibility into the progress of the company. As the board grows, the founder board members, other than the CEO, may be replaced with representatives of the new investors.
Board representation is typically negotiated as part of each investment round. Because the board of directors is so powerful, you should expect entrepreneurs to be careful about adding members.
Sometimes companies establish advisory boards to advise the senior management of the company (sometimes just the CEO) on strategic matters. Serving as a member of an advisory board for a company can be a great way to get to know the company in depth and keep track of what is happening. It will also help you develop a deeper relationship with the CEO and gain insight into the disruption of an industry. If you have useful domain expertise and the time to be an advisor, you may be able to increase the likelihood of success of your investment through your advice.
Being an active advisor can take time, and like BOD members, you will likely be asked to help with introductions to potential customers and sources of future funding, as well as recruiting of key employees, in addition to any domain-specific advice you may be able to offer.
confusion Advisory boards are not governing boards. That means that advisory board members do not have fiduciary duties. Nor are companies bound to observe the recommendations of an advisory board.
The advisor responsibilities and compensation are codified in the advisor agreement (advisory agreement or advisory board agreement). Advisor agreements will typically lay out the duration of the agreement, the amount of equity vested over the course of the agreement, and the vesting schedule.
founder A majority of your startup investments will likely fail to return your investment. Understanding why startups can fail will make you a better angel investor. This section should be helpful for founders as well.
The fact that the majority of companies don’t get acquired or execute an IPO doesn’t mean that you should just accept it when you have a portfolio company in trouble. While your legal options to take action are often very limited, you may be able to help with your own efforts and expertise and by rallying your fellow investors. First, we’ll look at common reasons startups fail, and then discuss how you can get involved in a struggling startup should you choose to.
CBInsights looked into more than 110 stories, and listed the top 12 reasons they found that startups had not succeeded. Let’s take a look at the top three reasons and the implications for things to watch out for.
Some might argue that running out of cash is not the reason a company failed, but a symptom of another problem, like a lack of paying customers. That might be true for a company that has already raised its first round and cannot convince investors to put in more money. What is relevant to this discussion is that fundraising takes time and is best achieved when a company is making good progress and has hit its milestone goals promised in the prior round.
How to avoid this scenario. Make sure that the company is raising enough money to reach its next key milestone and will have a minimum of 12–18 months of runway. Keeping in touch with your investments’ cash burn rate and bank balance can help a lot, so negotiate for information rights at a minimum, and ideally observer rights to board meetings. The company should start looking for its next round no later than when it still has at least four months of cash in the bank.
The best hope to avoid a complete failure of a startup you have invested in is to stay informed and keep up-to-date on how the company is doing. A good startup CEO will send out regular communications to the investors. This should cover good news, bad news, and how the investors can help the company. If you are getting these reports, you should definitely read them, and you should have an idea of whether the company is executing well, when it is thinking about raising another round, whether the company is struggling to fill a key slot on the executive team, or failing to land key customers.
If you are not getting updates, be proactive in reaching out to the CEO or the lead investor in your financing round or other investors in the round who may be connected to the company.
Negotiating for information rights and board observer rights can be really useful, because being informed of problems early gives you the best opportunity to do something about it before the company runs out of runway.
Assuming you discover that things are not going well, you need to decide how much time and energy you want to invest to try to get things back on track. Part of being engaged as an angel investor is helping where you can when a portfolio company needs it, and if you have focused your investments in domains that you know well, there should be plenty of opportunities to help, including:
Talent gaps. It is very common for angels to get involved in helping a startup source and recruit key talent. Many active investors have strong networks, and they may even know seasoned executives and consultants that they can bring in on an interim basis if necessary to get companies “over the hump” on whatever issue is holding them back. This can be an effective stop-gap solution while the company continues to recruit for a permanent executive.
Specific execution challenges. Founding teams are necessarily small, and young entrepreneurs often have gaps in their business experience. For example, strong technical founders may need help driving customer growth, which might be slow due to poor positioning, inefficient marketing, ineffective pricing, or a poor initial user experience. Arrange a working session with the team and spend several hours digging into a specific issue. You may be surprised how effective your own business experience, domain expertise, and seasoned perspective can be in overcoming challenges.
Angels can help with product feedback, finances, and introductions to potential customers or marketing/distribution partners as well.
Not having a market for the product or service is the number one reason startups fail.
A pivot, a term popular in startup culture, happens when a company realizes that their current product or business strategy is not going to work and they change course to a new product and/or business model. A classic pivot scenario is that a company is struggling to sell their product, while potential customers keep asking them if they can solve a different but related problem.
exampleA company may be struggling to sell a digital advertising network product. Their sales prospects don’t see the need, since the existing solutions are sufficient; but they keep saying that what they really need is an ad network analytics product to inform them on how the advertising networks they are using already are performing. The company uses the same team and pivots its product strategy to an analytics product.
The history of successful startups is full of pivots: Twitter started out as a podcast directory; Pinterest was initially a shopping app called Tote. Some successful startups have pivoted multiple times, in some cases to completely new product categories. So if your portfolio company is simply not finding paying customers for its current product in its current market, perhaps they need to pivot. You can be helpful by encouraging that exploration and acting as a sounding board for new ideas.
In writing this book, we wanted you to benefit from our collective wisdom. With Joe’s extensive legal experience working with startup financings, and Pete’s experience as a startup founder and executive of successful and failed companies, and as an angel investor in Seattle, we believe our perspective will help you avoid the mistakes we’ve made along the way, and look forward to successes.
Keep in mind that when you start angel investing, it is all great. You invest in smart teams chasing big opportunities, and you are getting in early. But the sad fact is that most startups fail. It is only after a few years that you will start to see which of your portfolio companies are doing well and which are underperforming.
We have found that we learn more from the failures than the successes, so we’re passing along some of those painful lessons. By following the guidance in this book and doing your due diligence, you will hopefully decline to invest in a lot of companies with poor prospects, and get the most out of the investments you do make that succeed. Below are some of the keys we’ve found to unlock a great angel investing journey.
I have enjoyed every conversation I have had with an entrepreneur, whether I thought their idea was brilliance or lunacy. If you are a curious person and like to learn about new industries and technologies, and how intelligent, motivated, energetic people are trying to solve big problems, angel investing is incredibly satisfying. If you are fascinated by the entrepreneurial journey because you have lived it yourself (or aspired to), it is fun and fascinating to follow your portfolio companies’ successes… and challenges, along with many other companies that you can follow through your angel investor colleagues. Angel investors tend to be smart, successful people who share the same excitement and passion for startups. It has been a great way to meet people and make new friends. Don’t do it just for the payout. As much as the destination of a big payout appeals, it’s the journey that makes becoming an angel investor really worth it.Pete Baltaxe
Remember, this book is meant to be a helpful reference guide, not an encyclopedia. Don’t be afraid to reach out for help. Rely on your mentors, your friends, your colleagues, get a good lawyer, and come back here when you need a reference. Always remember that angel investing is optional. Keep your objectivity. Don’t get emotional, don’t. Getting too excited over a deal can keep you from properly performing due diligence. Move slowly. Don’t think negatively, but think neutrally. There’s no opportunity so great that it’s worth writing a $25K check without knowing what’s going on or how it’s going to affect you down the road. At the same time, don’t get so caught up in the minutiae of the deal terms that it becomes a source of angst or stress. All of the rules, advice, and admonitions found in this book or anywhere else only have value in the right situations, and following these rules too closely can breed arrogance and even ignorance. You don’t want to be so strung up on following ‘rules’ that you’re gummed up on taking any action and miss out on a great deal. Remember that the best return I ever saw went to an angel who wasn’t too stuffy to take a common stock deal—even though you wouldn’t normally be advised to buy common stock! Angel investing is all about situational awareness. Don’t lose your perspective, don’t lose sleep, and don’t invest money you can’t afford to lose.Joe Wallin
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[COMPANY]
Convertible Note Offering Term Sheet
This term sheet summarizes the principal terms pursuant to which [Company], a [Delaware/etc.] ________ corporation (the “Company”), will raise up to $________ through the issuance of promissory notes (the “Notes”) to a limited number of “accredited” investors. The Company will make available to each investor all information the investor reasonably requests so that the investor can familiarize him/her/itself with the Company’s business. To the extent that these terms are inconsistent with the underlying legal documents (a Promissory Note), the terms of the Note control.
For your convenience, this template document is available as a Google Doc to make it easier to copy and edit. All material here is provided for illustration only; please read the disclaimer before use.
[COMPANY]
Term Sheet
Series A Preferred Stock Offering
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[COMPANY]
Term Sheet
Common Stock Offering
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Term Sheet for a Revenue Loan
This Term Sheet is non-binding, and is meant to try to capture the parties’ intentions about the terms of a potential investment. However, neither of the parties have any obligations to one another until they enter into and sign definitive agreements.
| Amount of Loan: | $________ |
|---|---|
| Monthly Repayment Amount | ________% of the borrower’s preceding month’s net revenue, due and payable on or before the [5th] day of each month. |
| “Net Revenue”: | “Net Revenue” means all of the borrower’s revenues and cash receipts, from all product or service sales, except customer returns and shipping charges. |
| Repayment Amount: | The note will be considered paid in full when the borrower has paid the lender [___ times] the amount of the loan, not including any penalties, attorneys’ fees or similar items. |
| Maturity Date: | As soon as the borrower has paid the lender the Repayment Amount, or 5 years. |
| Security Interest: | The borrower will grant lender a first priority security interest in all of the borrower’s property. |
| Acceleration of Repayment Amount: | The Repayment Amount will become immediately due and payable upon a change of control of the borrower, a sale of all or substantially all of the borrower’s assets, or the borrower’s insolvency or an event of default (as defined in the definitive documents). |
| Reporting: | The borrower will report to the lender its monthly Net Revenues each month. The borrower will also provide the lender customary information rights. In the event that the borrower underpays the lender, the borrower will pay the lender the deficiency plus a fee of 5% of the underpayment the lender’s audit costs in uncovering such deficiency. |
| Success Fee: | On a sale of the borrower’s business, the borrower will pay the lender a success fee in the amount of $________ or X% of the amount paid to the borrower’s owners as a result of the sale. |
| Closing Fee: | The borrower will pay the lender closing fee of $________. |
| Lender’s Expenses: | The borrower will reimburse the lender’s legal fees for documenting the loan. |
| Closing Conditions: | The loan will be subject to the lenders due diligence and the borrower’s execution of the lender’s standard loan documents. The loan documents will contain customary representations and warranties. |
| Negative Covenants: | The borrower may not incur additional indebtedness or grant additional security interests on any of its assets, make loans or advances, dispose of all or substantially all of its assets, or consummate a change in control without the consent of the lender. |
| Accounting: | The loan will be treated as such on the borrower’s balance sheet. In no event will the loan be treated or considered equity. |
| Confidentiality: | The borrower will hold this term sheet in strict confidence. This is a binding term. |
| Non-Binding: | Except for the paragraph titled Confidentiality, this term sheet is non-binding, and shall not imply any obligation to negotiate. Either party may terminate discussions at any time. |
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Mutual Confidentiality Agreement
This Agreement is made and entered into as of ________, 20__ (“Effective Date”), by and between [Company], a ____________ corporation (“Company”) and _____________ (“Other Party”).
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[Company Letterhead]
[Date]
Re: Your investment in [Company], a [Delaware] corporation
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OBSERVER AGREEMENT
THIS OBSERVER AGREEMENT (the “Agreement”) is entered into as of ________, 20__, by and between _____________ (“Observer”), and ____________, Inc., a [Delaware] corporation (the “Company”).
SECTION 1
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Letter Agreement
[Investor]
Re: Anti-Dilution Protection
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MINUTES OF MEETING OF THE BOARD OF DIRECTORS OF
_____________, INC.
_____, 20__
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THIS CONVERTIBLE PROMISSORY NOTE HAS NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED. NO SALE OR DISPOSITION MAY BE EFFECTED EXCEPT IN COMPLIANCE WITH RULE 144 UNDER SAID ACT OR AN EFFECTIVE REGISTRATION STATEMENT RELATED THERETO OR AN OPINION OF COUNSEL FOR THE HOLDER SATISFACTORY TO THE COMPANY THAT SUCH REGISTRATION IS NOT REQUIRED UNDER THE ACT OR RECEIPT OF A NO-ACTION LETTER FROM THE SECURITIES AND EXCHANGE COMMISSION.
CONVERTIBLE PROMISSORY NOTE
Note Series: ___________________________
founder If you are going to start a company, one of the first legal decisions you will have to make is what type of entity to form. This can be a more complex question than you might think.
In general, for federal income tax purposes, there are three types of entities to choose from:
C Corporations,
S Corporations, or
Investors generally prefer C corporations. If you plan to raise money from investors, then a C corporation is probably a better choice than an S corporation. Your investors may not want to invest in an S corporation because they may not want to receive a Form K-1 and be taxed on their share of the company’s income. They may not be eligible to invest in an S corporation. Thus, if you set yourself up as a C corporation, you will be in the form most investors expect and desire, and you will avoid having to convert from an S corporation or an LLC to a C corporation prior to a fund raise.
Only C corporations can issue qualified small business stock. C corporations can issue qualified small business stock. S corporations cannot issue qualified small business stock. Thus S corporation owners are ineligible for qualified small business stock benefits. Currently, the QSBS benefit is a 100% exclusion from from tax on up to the greater of either $10M of gain or 10X the adjusted basis of qualified small business stock issued by the corporation and sold during the year, QSBS held for more than five years, and the ability to roll over gain on the sale of qualified stock into other qualified stock. This is a significant potential benefit to founders and one reason to not choose to form as an S corp.
Traditional venture capital investments can be made. C corporations can issue convertible preferred stock, the typical vehicle for a venture capital investment. S corporations cannot issue preferred stock. An S corporation can only have one class of economic stock; it can have voting and non-voting common stock, but the economic rights of the shares (as opposed to the voting characteristics), have to be the same for all shares in an S corporation.
Traditional venture capital investments can be accepted. The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments. Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents.
Traditional equity compensation is available. C corporations can issue traditional stock options and incentive stock options. It is more complex for LLCs to issue the equivalent of stock options to their employees. Incentive stock options also are not available to LLCs.
Ability to participate in tax-free reorganizations. C corporations can participate in tax-free reorganizations under IRC Section 368. LLCs cannot participate in tax-free reorganizations under IRC Section 368. This means that if you think your business may get acquired by a company in exchange for the acquiror’s stock, a C corporation would be a good choice of entity.
Sales of equity. S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder restrictions, generally) than LLCs. For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler). An LLC will have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event). As a practical matter, an LLC will likely need to convert to a corporation before entering the public equity markets, because investors are more comfortable with a “typical” corporate structure.
Traditional equity compensation available. S corporations can adopt traditional stock option plans; in addition, they can grant incentive stock options. It is very complex for LLCs to issue the equivalent of stock options to their employees (although they can more easily issue the equivalent of cheap stock through the issuance of profits interests—see below). Incentive stock options also are not available for LLCs.
Ability to participate in tax-free reorganizations. S corporations, just like C corporations, can participate in tax-free reorganizations under IRC Section 368. LLCs cannot participate in a tax-free reorganization under IRC Section 368.