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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:. Companies typically issue convertible debt when they are not raising enough money to justify a preferred stock round.
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. 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. Immediate access to funds. 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. 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. 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. Debt sits on top of equity; meaning, if the company goes defunct, debt holders are entitled to be paid first, before equity holders.
Common provisions of a convertible debt financing include:. 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. What is the conversion discount? 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 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.
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. 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.
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.
Investors like preferred stock rounds for a number of reasons:. 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. 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 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:. Techstars intermediate-length term sheet. 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. The amount of the equity the investor is entitled to receive is determined in the same way as a convertible note. 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. 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. However, sometimes founders will issue themselves a special class of common stock with 10 or votes per share and protective provisions. Common stock usually has one vote per share, no liquidation preference , no anti- dilution adjustment protection, and no protective provisions.
However—and though many angels will refuse to buy common stock—common stock deals are not necessarily bad deals. Revenue loans are another relatively new financial innovation in the early-stage company space.
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. 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. 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.
Investors may want the right to continue to invest and thereby minimize their dilution as much as possible as the company grows. 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.
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. 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. 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. 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. 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.
The two parties could agree that they would each vote their shares to elect each other to the board of directors. 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.
You may have heard of A valuations for startups. The common stock in a private company can be valued through a formal process called a A valuation. 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. 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. Issued and outstanding shares are the shares that have been issued to founders, employees, advisors, directors, or investors. Issued and outstanding shares do not include stock options that have been reserved in the option pool.
Ownership percentage calculated on an issued and outstanding basis is determined by dividing the number of shares owned by an individual or entity by the total issued and outstanding securities. 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.
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. Over the first few years that equity gets allocated to the new hires, members of the board of directors , advisors, and independent contractors. 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.
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. They are calculating the ownership on a fully diluted basis. 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 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.
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.
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. Consolidating the cap table above Figure 3 to aggregate founders and employees prior to investment:. Now they are giving up a third of the company in the first external round. 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:. 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. 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. 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. If you look back to Figure A2, you will see that the stock option pool is down to 6.
The founders go from A big difference. 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? 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 number of issued and outstanding securities was 10,, per the cap table in Figure 3. So the conversion of the notes before any other actions would have the cap table looking like this:. Those conditions result in the cap table represented in Figure 7 below. You can see that our Converting at the valuation cap generated 1,, 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. 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. 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. Delaware corporate law is also the most familiar to the investment community. You might be interested in investing in an S corporation.
Shareholders in S corporations can generally only be individuals who are U. Shareholders cannot be other business entities or organizations. When a venture capital firm invests in an S corporation, that companies loses their S corporation status and convert automatically to a C corporation.
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. 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. For federal income tax purposes, an LLC can be classified as either:. 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 , 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. Even if the corporation is nearly dead, it still may not be dead enough for you to take a loss.
Some angel groups set up programs to facilitate these types of assignments. As an angel investor, you may be asked or choose to negotiate a board seat or advisory position with a company you invest in. 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. 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. 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.
Understanding why startups can fail will make you a better angel investor. This section should be helpful for founders as well. 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.
CBInsights looked into stories, and listed the top twenty reasons they found that startups had not succeeded. This is nearly completely avoidable if a startup is following lean startup principles. With this approach, the team should have really strong validation about what customers want and are willing to pay for before they build the product.
If you are not conversant in lean startup methodology, read the book that launched the movement: The Lean Startup , by Eric Ries. There is even a page summary ebook version for Kindle on Amazon. How to avoid this scenario. To be clear, they may not have paying customers yet, or even customers, or even a product. But they should have talked to lots of potential customers to understand their needs and pain points deeply and validate that the features the entrepreneurs have in mind will be seen as valuable.
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. 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.
Not having a market for the product or service is the number one reason startups fail. 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. 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. 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.
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. 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. 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. Pete Baltaxe. Remember, this book is meant to be a helpful reference guide, not an encyclopedia. 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. Getting too excited over a deal can keep you from properly performing due diligence.
Move slowly. 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. Angel investing is all about situational awareness. Joe Wallin. 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. Convertible Note Offering Term Sheet. To the extent that these terms are inconsistent with the underlying legal documents a Promissory Note , the terms of the Note control. Term Sheet. Series A Preferred Stock Offering. Common Stock Offering. Term Sheet for a Revenue Loan. However, neither of the parties have any obligations to one another until they enter into and sign definitive agreements.
Mutual Confidentiality Agreement. Re: Your investment in [Company] , a [Delaware] corporation. Letter Agreement. Re: Anti-Dilution Protection. 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:.
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. 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. 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 Wiltbank should focus more on the question of why the distribution of returns is a power law.
Power laws appear in many different contexts, but their appearance is not random but rather a signature of path dependence. Not taking that into account in establishing an investment strategy is a huge mistake since fighting the power law is like building a home at the bottom of an avalanche prone mountainside. As one paper by another author notes:. The idea is that investors who have failed and left the business are not sampled.
This means that surviving investors are oversampled. Investors who remain in the business are likely to have been more successful than those who have left…. Having said that about selection and survivor bias, the data is complete enough for the power law to be identified and the optimal strategies adopted. If Angels were earning 2. Angel investing as a market is more inefficient than public markets, but is not inefficient enough for returns to be that high overall. It is possible that top tier Angels are generating these returns but that again is section bias, survivor bias and the Matthew effect at work.
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Business … Expand. Journal of Research in Marketing and Entrepreneurship. View 8 excerpts, cites background and results. Angel network affiliation and business angels' investment practices. Journal of Corporate Finance. This paper provides preliminary evidence on the effects of membership in an angel network BAN on the investment choices of business angels.
Using a novel dataset containing qualitative and … Expand. View 2 excerpts, cites background. Investor type and new-venture governance:cognition vs. We study the specific rationale governing entrepreneur-investor relations in young ventures which raise equity capital from different investor types in pursuit of a strong growth strategy. Special … Expand. Investment practices and outcomesof informal venture investors.
Abstract This study explores a model of venture investing developed from the literature on formal venture capital research in the setting of angel investing in the USA. The model explores the role of … Expand. View 4 excerpts, references background. This research compares risk avoidance strategies employed by business angels and venture capital firm investors. It finds that differences in their approaches to evaluating risk lead them to hold … Expand.
Predictors of performance of venture capitalist-backed organizations. View 2 excerpts, references background. Angels: personal investors in the venture capital market. The role of private investors in the equity financing of new technology-based ventures is examined. The research studies the venture capital market from a demand and supply perspective and delineates … Expand.
View 2 excerpts, references results and background. This study is a preliminary step in examining whether reputation effects are operating in the UK informal venture capital market. We test the notion as to whether deal-makers rely on fundamentally … Expand. Highly Influential. View 2 excerpts, references methods and results. Limited attention and the role of the venture capitalist.
View 2 excerpts, references background and results. Is it worth it? The rates of return from informal venture capital investments. View 5 excerpts, references methods, background and results. If you want more detail on these things, you can go crazy in the full reports.
Angel investors seem to bring more variety to the strategies in how they invest and build companies, relative to formal venture capital. They are different than formal VCs. Some investors focus on capital efficiency, some on shooting the moon with as much capital as they can get.
Some actively seek VC involvement, some deliberately avoid VC involvement. Many other approaches develop all of the time. The data on valuations, activity levels, geographic and industry distribution is quite interesting, and over time, this will provide a quarterly gauge on angel investment returns, as well. The picture again seems more representative of angels as legitimate entrepreneurial investors.
A little less than one-third of IPOs are of venture capital-backed firms. While this is really impressive given that VCs invest in less than 1 percent of new ventures, it still means that two out of every three IPOs are of companies that never had any venture capital investors. No one celebrates taking out a loan, but for some reason some people like to celebrate taking on venture investment. Best case: equity investment whether angel or VC is a tremendous asset with a commensurate financial obligation.
Just like angel investors, VCs want their money back — times 50 if they can get it. The idea that angels are suckers while VCs have cornered the market on building great companies is simply not supported by the data.
Here are some important things to note: In any ONE investment, an angel investor is more likely than not to lose their money, i. It is risky. However, once investors had a portfolio of at least six investments, their median return exceeded 1X. Irving Ebert, of the Ottawa Angels, has done some outstanding Monte Carlo simulation with this data, finding that making near 50 investments approximates the overall return at the 95th percentile. Most investors will be somewhere in the middle, of course.
The production of cash is highly concentrated in winners; 90 percent of all the cash returns are produced by 10 percent of the exits. This is essentially the same concentration as in venture capital. These returns happened all over the place geographically NOT all in the Bay Area or Boston , happened across industries, and most often happened without having any follow-on investment from VCs. In fact, VCs eventually invested in only one out of three of the ventures, and the ventures in which they did invest produced lower returns than those where VCs did not invest.