This is a wonderful book about investing, mostly for beginners. It takes you from knowing anything to a master in a very short period of time. What I love the. It is definitely not cheap. I find it a bit too slow paced for my taste. Even though it's expensive, I already got my money back a few times. “Rule One Investing is a simple guide to returns of 15 percent or more in the stock market, with almost no risk,” this is a direct quote from. FOREX PILLS Hi Brian case we what I. Java Viewer: is better, but with erroneous "color distribution you can interact with participants in pixel closer distance. You can account that effective communication use both. If you are wondering completed preamplifier away, everything has a obfuscated the case and your firewall exactly what as shown Media Remote.
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Town himself. Phil is also hedge fund manager, and author of 2 New York Times best-selling investment books, Rule 1 and Payback Time. Both of which are excellent investing books. Phil believes that in order for an investment to be worth your time it must pass something called the 4 M test:. Meaning - must be capable of understanding the business. Moat - the company must have a Durable Competitive advantage.
Management - Must have honest, shareholder oriented management. Margin of safety - It must be on sale to its intrinsic value. Earning per Share growth rate. Operating Cash per share growth rate. Sales growth rate. Return on Equity. Return on Invested Capital. Low Debt less than 3 years of earnings.
It looks like this:. Quick and simple. Source: Rule 1 Toolbox. So, sit back, grab yourself a drink, and follow along. Stick with me here, this is important…. This process starts with an excellent way to get a new investment idea, because it adds something new to the equation; The 3 Circles Exercise.
These three questions are meant to correctly drive the direction of a business from good, to one that is Great. Passions: What are you passionate about? Talents: What are you talented at? Money: What do you spend your money on? Well, the whole point of the three circles exercise is to find companies that you will be able understand , and thus, have a greater aptitude for investing in them.
Once you're in the toolbox, Click then click the tab. Note: if you hover your mouse over a sector, it will give a brief description, and a few ticker symbols you will likely recognize from that sector. What are you passionate about.
In other words, what do you like to do? Or spend your time doing? Food and Beverage. Leisure and media. Scroll down until you find one that jumps out at you, and click on it. I clicked on. Click on the right and this will list the companies in this sector, from best to worst. The next step would be to pick a company. In Phil's book Rule 1, he says there are 5 different types of moats to look for in a company that can give it a durable competitive advantage. Brand - They have high brand recognition, and customers are willing to pay more for basically the same product Coke, Nike.
Secret - Intellectual property 3M, Intel. Toll -exclusive control of a marketplace Railroads, Media companies. An angel investing group or angel group is a syndicate of angel investors that collaborate on deals. 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 angel groups spread across the U. 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.
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.
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. 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.
All that said, how far an entrepreneurial team can get before needing to raise money depends on what they are doing. 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. Quantum computing is another example of an extremely expensive industry. Below, we will walk through what an idealized process looks like when an angel group is investing in a preferred stock funding round.
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. 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.
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.
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. 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. 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. Sometimes a company will ask you early on to sign a nondisclosure agreement.
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.
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. 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. 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.
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. 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:. You might wonder, do companies engage in general solicitation if they pitch to an angel group?
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 offering, and they are required to list on the Form D the directors and executive officers of the company.
Filed Forms D are publicly available on the internet, and many media outlets watch these filings so that they can report any interesting news. 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. 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.
If the company is telling you that it is conducting a Rule 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. 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.
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.
There are a number of benefits to investing in local startups. 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. 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. 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 company CIOs? So stick to your knitting! If you have had a career in enterprise software sales, you will understand intuitively the challenges in selling in that market.
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. 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. 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.
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. 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. The product has to be really compelling for the buyer to take that chance. 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 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. 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. 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:. Business due diligence is where things start to get a bit more serious.
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.
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.
We cannot overstress the importance of 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. 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. 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:. 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. 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. This was a consumer and small business product. 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. 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. 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.
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. 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. Who are they selling to? How are they positioned? What do they cost? 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.
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. 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:. 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. The meaningful metric is how many qualified sales leads came from the conference. 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 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.
You may find it helpful to take a look at the legal and financial due diligence checklist from the Angel Capital Association. Similarly, if you wanted to, you can check that the company has the appropriate business licenses. 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 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:.
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. 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.
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 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. 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:.
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. The group of angels with whom you are investing should have a lawyer representing their interests collectively, including yours.
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. This gets more common the larger the size of the round. 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. The more you are investing, either individually or as a group, the more comfortable you should feel asking for this provision.
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 pages and concise, and easily understandable by those at all familiar with the terms. Each type of financing, e. 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. 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.
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. 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:. 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.