This post is the fourth of seven posts about angel investment in entrepreneurial ventures.
When an Angel Investor and the entrepreneur have agreed upon the valuation, the next step is structuring the investment. Structuring in this context refers to the form of equity the angel will receive for investment. Some angels do not give structure much thought in the early stages of investment, while others will see it as a highly important detail to be resolved. As with the other steps in investment consideration, each angel will bring his or her unique background and experiences to this step to determine the best structure for their investment needs. Here are three of the more common equity structures considered:
Using the common stock structure, the entrepreneur issues stock in exchange for funds using a mutually agreed upon valuation at the time of the investment. This investment type has a linear relationship in that the value of the stock is directly proportional to the value of the venture; the upside is unlimited, but the downside can fall to zero (Koss, 2007). This structure is perhaps the riskiest for the investor because it limits the investment to the initial shares, raises the possibility of dilution as more stock is sold, and in most cases cedes control of the investment to the entrepreneur (Amis & Stevenson, 2001). This said, it is the simplest form of investment equity and may be preferred by the angel.
Entrepreneurs should consider that interests may be better aligned if both the entrepreneur and investor have common stock (Amis & Stevenson, 2001). Entrepreneurs will typically retain the freedom to run the company without much involvement or interference from the investor aside from requested mentoring. Be aware, though, that some angels will seek registration or tag-along rights that, for example, limit the entrepreneur’s ability to take cash out of the company (Amis & Stevenson). This approach is reasonable and should be considered, if not offered, by the entrepreneur as a sign of good faith in the investment relationship.
Preferred Stock and Participating Preferred Stock
Preferred stock owners are prioritized if a venture is liquidated or goes bankrupt. More specifically, holders of preferred stock will get their capital returned, while those who have participating preferred stock owners will get their money returned in addition to any unpaid dividend, before owners of common stock (Koss, 2007). Restitution of capital assumes, of course, that the venture has assets that can be converted to cash for distribution. This approach enables some downside protection for the investor, although may limit the upside unless the preferred stock can be converted to registerable stock with tag-along rights (Amis & Stevenson, 2001). A savvy angel who desires this approach will likely know how best to protect his or her downside and secure an upside in the deal and will negotiate firmly.
Entrepreneurs should be more seasoned and have a knowledgeable investment attorney when considering this structure. Such a structure with aggressive terms might give the investor the right to call votes, remove management, stop raising funds or take funds raised (Amis & Stevenson, 2001). Although offering such a structure might seem like a good trade-off to gain experienced investors, an overly aggressive structure could severely hamper the entrepreneur’s control and vision of the company. The good news is that it is unlikely that seed or early-stage Angel Investors will request this structure due, in part, to the complexity.
Convertible notes are different from common stock, preferred stock, and participating preferred stock because they are debt instruments rather than equity instruments (Koss, 2007). Convertible notes enable the investor to convert the debt to equity at some pre-specified event and provide the advantages of both debt and equity participation (Amis & Stevenson, 2001). With this structure, the investor could convert the debt to preferred stock at a “discount rate” in subsequent equity rounds, or receive payments and interest on the notes at a mutually agreed upon interval while the notes are outstanding should the company be unable to secure additional financing (Koss, 2007). This is a sophisticated approach, although it provides the investor with significant downside protection.
Entrepreneurs should be mindful of the complexity of such a structure. Also, keep in mind that convertible notes may create challenges as you seek additional investment. For example, notes that have higher discount rates could dissuade future investors because the later investments might be diluted. Additionally, if subsequent rounds of financing do not occur, the investor may have expected payments on the notes to realize some level of return. The investor may also desire to renegotiate the deal.
Considering that Angel Investors often want a twenty-to-fifty percent ownership stake in early-stage companies how that investment is structured is as important to the entrepreneur as it is for the investor (Koss, 2007). While the structures noted above are seemingly the most common, they are by no means the only structure options available. Moreover, any one of these might be used with some variation of terms. The most important thing to remember is that while investors will be looking for the financial upside at the exit, they also want you, the entrepreneur, to be successful. Your success is their real upside.
Amis, D., & Stevenson, H. (2001). Winning Angels: The Seven Fundamentals of Early-Stage Investing. London: Pearson Education Limited.
Koss, A. (2007, July). Best Practice Guidance for Angel Groups – Deal Structure and Negotiation. Angel Capital Education Foundation. Retrieved June 18, 2017, from http://www.angelcapitalassociation.org/data/Documents/Resources/AngelCapitalEducation/ACEF_BEST_PRACTICES_Deal_Structuring.pdf
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