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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
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.
founderHowever far along a company’s product is, the team should be following Lean Startup principles. Lean Startup had its origins in Steve Blank and Bob Dorf’s book, The Startup Owner’s Manual, and was then popularized in Eric Ries’ The Lean Startup. (Here is a quick primer.) The basic idea is that startups are a series of experiments and need to be managed very differently than more mature businesses; and most importantly, that before you build anything, you should be validating every iteration of the idea with potential customers—even if it is drawing on the back of a napkin. This process is called customer discovery or customer development. So at a minimum, even if the entrepreneurial team has not written a line of code or printed their first plastic widget, they should have done dozens, ideally hundreds, of potential customer interviews. (There is even a book called Lean Customer Development you can check out.)
So in short, given the time, entrepreneurs should be able to make quite a bit of progress in terms of understanding and gathering data around whether customers really want this product or service, and building a prototype or MVP before they need to raise money. Again, exclusions apply, but this context will be helpful if you run into one of those exclusions.
Not all startups you meet will be at this MVP stage. Entrepreneurs who are just getting started on their idea may approach you for advice on when they should start raising money. Wise entrepreneurs may start meeting casually with angels long before they need to raise money in order to build those relationships for when the time comes. Investing in very early-stage companies (that have no paying customers) is a bit like speed dating. You are betting on the entrepreneur him or herself almost exclusively, with very little else to go on. You have to be passionate about the idea, ideally know a lot about the industry, and really click with the entrepreneur.
At the other end of the spectrum, you may be approached by companies that have been around for years, are on their third or fourth generation product, have dozens or hundreds of customers or hundreds of thousands of consumer users. You will see companies raising their first external round who have self-funded for years because the founders had prior exits or other resources that allowed them to pursue their idea. You will also see entrepreneurs who need the validation and external money to be able to quit their day jobs and engage full-time in their startups.
Finally, as an angel investor, you will see deals where the company has a sizable team and has raised several rounds of investment prior to pitching to you. These opportunities often have higher pre-money valuations and can require more due diligence, but they can be great investments too if they have executed on the prior money and decreased a lot of the risks.
As an investor, you will find your comfort zone, whether that is getting in very early when there are the biggest risks and biggest rewards, or waiting until there is more evidence of potential success.
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.
The follow-up meeting. If there is investor interest from the pitch, the investor(s) will have a much longer meeting with the startup where the founder(s) provides more detail on many aspects of the business and perhaps demonstrates the product in detail. The investors have a chance to meet the other members of the team and ask detailed questions about the company’s technology, go-to-market strategy, customer traction, et cetera.
Selecting a lead. If after the follow-up meeting(s) there are interested investors, and they agree that the high-level deal terms offered by the company are acceptable (or likely to be negotiable), they will coordinate to select a lead investor among themselves and then start to plan the due diligence and more detailed negotiations of the term sheet. If the investors feel that the investment terms offered by the company are not acceptable, there is often an effort to negotiate the valuation and other key terms to an agreeable place before investors are willing to engage in time-consuming due diligence.
Commencing due diligence. The investors within the group will divide up the due diligence tasks. Typically over some number of weeks, the investors complete their diligence tasks and share their findings with the group.
Negotiation of the term sheet. If the early due diligence is looking favorable and enough investors signal their continued interest in investing, the lead investor will negotiate the primary terms of the investment. The terms of the deal depend on the type of financing, and are covered in Part III.
Agreement on the term sheet. If the investors and the entrepreneur cannot agree on the principal investment terms to be captured in the term sheet, the deal could fall through. The purpose of the term sheet is to ensure that all parties are in agreement on the principal terms before the costly work of preparing the definitive documents gets underway. A signed term sheet, usually contingent on a final round of due diligence, is a major milestone for all parties.
Final due diligence. A company may not want to let you talk to their big customers or take up a lot of their engineers’ time with a technical deep dive or review their employee contracts until they are pretty confident that a deal is going to get done on reasonable terms. That is why some diligence items may have to wait until after a term sheet is agreed upon to conduct an in-depth technical review, customer contract or customer number reviews, and review of some important legal items.
At any point in the due diligence process, red flags may emerge which cause some or all of the investors to drop out. More commonly, if investors discover issues that give them concern, they may try to negotiate for more favorable terms (such as a reduced pre-money valuation) that more accurately reflect the state of the company’s progress or its risk factors.
For example, a B2B company may represent that it has six customers. Reviewing the contracts or talking to those customers may reveal that only two are paying, three are in free trials evaluating the product, and one is in negotiation but has not signed the purchase order. Investors may decide that the situation represents significantly less customer traction than they were led to believe and warrants a lower pre-money valuation.
In many cases, especially when a fund or other “institution” is among the investors, the lead investor will coordinate the results of the due diligence efforts into a final report summarizing the findings of the diligence team.
Investor commitments. Once due diligence is complete and the term sheet is negotiated, the lead investor will typically ask for firm commitments from the investors, including how much they will invest and contact details of the angel or the legal entity through which they are making the investment. This information will be included in the final documents along with the number of shares being issued and other key items.
Preparation and negotiation of draft definitive documents. The drafting of the definitive documents can start while due diligence is still ongoing. This is where the lawyers on both sides earn their money. The definitive documents for each deal type are covered in Part III.
Agreement on the definitive documents. If you have confidence in your lead investor and the law firm representing the investors, you may not need to invest the time in reading all of the definitive documents, though we recommend that you do, as it is often educational and generally prudent to understand the terms of your investment.
Closing. On the closing date, you should be prepared to sign and return documents (usually by email) and deliver checks or wire funds to the bank account specified by the company. You will typically know the closing date a few days in advance, though sometimes it can be a moving target as issues come up during the final document negotiation and preparation.
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.
After you have done your diligence, be decisive about whether you are going to invest. Stringing entrepreneurs along while you are waiting for their company to make progress is bad for them and will not lead to your getting deals referred to you.
Don’t get too aggressive on deal terms, as there is plenty of room for a win-win if the company is successful.
Be helpful where you can, whether or not you invest.
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.
danger You should be wary when asked to sign an NDA, especially if the request is made early. If you sign one, and the company then shares its “business idea” with you, and you decline the investment—but then decide to invest in another company with a similar idea—the first company may threaten suit, claiming you violated the NDA and “stole” their idea. As absurd as this may sound, people have been sued in situations like this.
If you are asked by a company to sign an NDA early on in your discussion, you should politely decline. In general, tell the company that it is not typical for a prospective investor to sign an NDA when discussions are still at a very high level. If there is pushback but you are still interested, you can refer the company to one of the many resources on this topic, such as those by Paul Graham, who wrote:
If you go to VC firms with a brilliant idea that you’ll tell them about if they sign a nondisclosure agreement, most will tell you to get lost. That shows how much a mere idea is worth. The market price is less than the inconvenience of signing an NDA.Paul Graham, ”How To Start a Startup”
If you proceed into more detailed due diligence, then it might be appropriate and reasonable for you to sign an NDA. For example, if a company wants to begin sharing detailed intellectual property information and wants to protect its intellectual property rights and ability to patent its inventions, then an NDA may be called for. Down the road, if you are going to receive information rights from the company and receive its financial statements, or board observer information, it is typical to sign a confidentiality agreement with respect to that information.
danger If you are going to sign an NDA, ensure that it doesn’t include any type of covenant that will prohibit you from investing in any other deal that you find. Make sure it doesn’t include any sort of non-compete or non-solicit clause, and that it has the standard exclusions (see section 3 of the example NDA included in the appendix).
Sometimes companies will offer an incentive to invest before a certain date. For example, you might see incentives like these:
An investor who invests before a certain date may get warrant coverage, or
An investor who invests before a certain date may get a better price per share (this could be done, for example, by selling the shares at a discount to the price per share for investors who invest before a certain date).
caution These promises are not necessarily problematic from a legal point of view, but we would caution not to permit these inducements to cause you to jump into an investment in haste. It’s not worth getting a good price on a bad deal.
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.