Tag Archives: Angel Investors

Angels Asking For Control

Occassionally, a startup will get a term sheet from an angel with a pre-money valuation less than the investment amount (i.e., the angel wants control of the startup). And “control” isn’t just defined as a majority of the shares of the company — if the angel asks for approval of all budgets & hires or for a board seat (and they would represent 1/2 of the board) they are still asking for control.

When this occurs, you need to determine the reason why your potential angel investor wants control. Is it based out of fear or corporate narcissism?

That is, you have to figure out whether your angel wants control because he or she doesn’t know any other way to protect the investment in your startup or because he or she believes they can run the startup better.

If the request for control is based on fear, the investor needs to either (a) not invest in your startup, or (b) get educated on various terms of an investment that could help protect their investment. This education could come from you or your lawyer, but preferably from the angel’s lawyer.

If the request for control is based on corporate narcissism, you probably need to find a new investor. Most angels have the ability to make an angel investment in your startup because they successfully managed/owned/exited a company or ten. And they probably started this when you were busy collecting Garbage Pail Kids. Thus, they likely you view as “not ready from primetime” and their future employee.

If the corporate narcissist angel’s background involves tech (or at least something similar to what your startup is implementing), then the control aspect can be somewhat tolerable…in the short run. But you never want to end up with an angel controlling your tech startup during the day, then calling you at night because he can’t get his iPad to work on his wifi network.

Investor fear is workable, but corporate narcissism is a deal breaker. At the end of the day, don’t give up control to any angel. And from my experience, the good angels don’t want it.

The Convertible Note Discount and Price Cap

If you follow this blog, you know that I think convertible debt is a good structure for a startup’s angel round. The main feature of the convertible note is that the debt investment made by the angel investor will typically later convert into equity. For this article, let’s assume this equity is the Series A Preferred Stock purchased by a venture capital fund.

Convertible Note Discount

As a sweetener to the angel investor (i.e., compensate the angel for the early risk), the convertible promissory note will have an automatic conversion discount feature by which the angel investor will exchange the convertible debt for shares of the Series A Preferred Stock at a discount to the price per share paid by the venture capital fund at a Qualified Financing.

For example, if a venture capital fund purchases Series A Preferred Stock at $1.00 per share, the discount may allow the angel investor to purchase the same Series A Preferred Stock at $0.75 per share. (For more background, check out this post for an example of how convertible debt and the conversion discount works.)

Incentive Misalignment

Convertible notes have drawbacks — they aren’t perfect. The main drawback is the quirk that the lower your pre-money at Series A, the more equity your angel investor gets.

EXAMPLE 1: If a VC invests $2,000,000 at a $5,000,000 pre-money valuation and an angel investor has a $100,000 convertible note with a 25% discount, the angel investor will own 1.9% of the startup immediately after the Series A round.

EXAMPLE 2: But if the VC invested at a $15,000,000 pre-money, the same angel investor would own 0.78% of the startup right after the Series A.

Because of this quirk, an angel investor may not have much incentive to help increase your pre-money valuation before a Series A…regardless of the conversion discount. Meanwhile, you and your co-founders are doing everything possible to increase the startup’s valuation.

Convertible Note Price Cap

To provide upside protection, angel investors like to put a “price cap” on the convertible note discount. This price cap is expressed in terms of a pre-money valuation and effectively acts as a share price ceiling. Thus, an automatic conversion discount with a price cap might read something like this:

“The conversion discount shall be the lower of (i) a 25% discount to the Series A Preferred Stock share price, or (ii) the price per share if the Series A premoney valuation was set at $[6,000,000].”

Using the hypothetical in Example 2 above, an angel investor using this $6,000,000 pre money price cap would receive 1.45% instead of 0.78% as of right after the Series A.

Price Caps as a Weapon

The original idea was that price caps would provide upside protection for an angel investor. But occassionally I’ll see an angel throw in a really low price cap (<$400k) in the automatic conversion section. How many Qualified Financings are going to take place lower than $400k (and make the conversion discount percentage even a legit term)? Lowball price caps are essentially a “#$!@ you” to the startup.

Selling Your Startup with Convertible Debt

I previously mentioned that convertible debt is a good way to raise capital for most startups. The main reason why convertible debt is beneficial for startups is that it delays coming up with a valuation figure at the seed stage–the valuation conundrum is essentially punted to the Series A (or “qualified financing” stage).

But what happens to the convertible debt if you sell rather than raise capital?

In most situations, the investor will receive more than the interest due + principal balance of the loan. I’ve seen anywhere from 1.5X-3X the outstanding principal amount of the loan due the investor upon the closing of the “change of control” event. This 1.5X-3X payment is, of course, made in full satisfaction of the startup’s obligations to the convertible debt investor.

In this unique situation, your startup essentially skips the “qualified financing” and goes straight to the exit. If the convertible debt investor wasn’t able to enjoy the upside in the event of an acquisition, such investors would be more reluctant to invest this way (and you’d be left to grapple with the valuation debate). Or worse, the investor would demand a higher interest rate. Or much worse, they would require their consent to prepay the convertible note before the qualified financing or maturity date of the loan.

Don’t Go Crazy with Complex Rounds of Seed Funding

I loved Pitch Camp. Flip Flops. Free donuts and pizza. Hours of “unauthorized” advice from the angel investor, venture capital, and journalism communities. It sure beat the heck out of any legal conference I’ve ever attended.

At Pitch Camp, a fund’s partner told the crowd that he turned down a startup simply because the startup’s capital structure was ridiculous. Think several classes of stock with several valuations. Basically, the fund didn’t want to spend time chasing down all the shareholders and otherwise untangle the mess. I can’t blame them.

Keep in mind that even the best legal documents won’t get you funding. It is all about your product, your team, and your pitch. But a poorly-structured seed investment (or a series of them) can help ensure your startup company won’t get funding. Seed funding (friends & family and angels) should be conducted in a manner that will facilitate a later financing, not prevent one. And that’s even if you don’t anticipate needing venture capital.

Personally, I like the convertible note approach to a seed round. Your startup can get capital without having to deal with the valuation issue. If your startup decides to give equity in exchange for seed capital, I suggest limiting the equity investment to your startup’s common stock.

Initial Thoughts on the Y Combinator Angel Investor Documents

I wanted to give my initial thoughts on the Y Combinator Series AA Angel Investor Legal Documents that were officially released late last week. I plan to write a document-by-document breakdown in the coming week:

Term Sheet – August 29th
Stock Purchase Agreement – August 30th
Board Consent – August 31st
Stockholder Consent – September 1st
Amended and Restated Certificate of Incorporation – September 2nd
Investors’ Rights Agreement – September 3rd

But until then, the following are my general comments about the documents and are geared towards those readers thinking of using the Y Combinator documents on their own:

“Neutral” is all about perspective. Entrepreneurs are often worried about being taken to the cleaners by their investors. Thus neutral legal documents appeal to the startup entrepreneur. But in order for an entrepreneur to be taken to the cleaners by an investor, the investor or investor’s counsel must be sophisticated regarding these deals. That isn’t always the case. (I have experienced situations where both investor and investor’s counsel were unsophisticated about these types of financings…and no I don’t have their contact information for you.) So keep in mind that you could be giving away terms instead of getting better terms by using these documents.

Delaware corporation and not [Insert state and type of legal entity here]. There’s a reason why the documents have a Delaware corporation as the default entity. A Delaware corporation is really the only option if you want to do these types of financings and move on to venture capital. I have written a few posts about “Why Incorporate in Delaware?” and “Why a Corporation for Venture Capital?” explaining the subject. Of course, the Series AA documents aren’t for venture capital financings, but the underlying reasons for using a corporation exist in an angel round.

Read between the disclaimer’s (many) lines The lawyers at WSGR didn’t add the legal disclaimer at the top of each document just to run up Paul Graham’s legal bill. Sure, WSGR doesn’t want to get sued. But implied by WSGR not wanting to get sued is that people will take these documents and royally screw up.

And don’t think only those that do large amounts of editing to the sample documents will screw up. Legal documents must reflect the deal. You could be in a bad situation if you sell (or believe you have sold) your investor one thing and the documents reflect something different.

No legal document is dispute-proof. Don’t assume that you are immune from disputes because you used “neutral” document or “boilerplate” provisions. If I created a dispute-proof legal document, I’d be (a) the first lawyer in the history of the world to accomplish that, and therefore (b) be on my way to Boracay for a 12-month sabbatical.

And finally, I think you should take a look at this article at the Startup Company Lawyer. It is written by Yokum Taku, a partner at WSGR (the law firm that wrote the Y Combinator documents), and therefore he will have fantastic insight regarding these documents.

Next – The Y Combinator Term Sheet

Making Dallas the City of Angels

I could use more palm trees here in Dallas and while I’m at it a Togo’s. However, the “City of Angels” reference in this post’s title is about bridging the gap between entrepreneurs and angel investors rather than going “Under the Bridge.”

The startup ecosystem in Dallas is discombobulated if not broken. “Underperforming” would be a kind word to describe Dallas relative to other startup communities. To improve the Dallas startup scene, Alex Muse of Big in Japan is taking action and starting an entrepreneur-angel investor group:

The basic idea is to form a group designed to a) generate LOCAL dealflow for angel investors, b) assist entrepreneurs in the creation of fundable startups and c) provide investment capital for startups. Instead of charging angels and entrepreneurs a fee to participate require that they instead invest their time.

If you are interested in helping organize this group I invite you to attend. At this time we are seeking a) angels with experience, b) angels without experience, c) entrepreneurs interested in helping and d) entrepreneurs interested in pitching. The idea is not to create an angel group in secret or without the input of entrepreneurs, but to instead create it by and for all parties.

The first meeting was last week and it went pretty well. We’re in the process of defining the vision (i.e., do we change the world or change one entrepreneur/angel at a time) and laying out the ground rules. In other words, the group realizes planning is essential to ensure an entrepreneur-angel improvement in Dallas.

From what I’ve experienced, Dallas investors are comfortable investing in real estate and oil & gas deals–but not in traditional startups. Maybe it’s because real estate and oil & gas deals tend to be structured as limited partnerships, and therefore the deal documents and language therein for startup investments might be too foreign for Dallas investors. Or maybe people in Dallas just know more about real estate and oil & gas.

Any thoughts on this from the Dallas crowd?