Angel Investments - Considerations for the Term Sheets
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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies and investors. The information on this page should not be construed as legal advice. |
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Angel investors can come in many shapes and sizes, and can run the gamut in terms of investing experience. Sometimes a friend, family member, or an interested individual might want to invest in the company. On the other end of the spectrum, there are professional investors who belong to angel investor networks, which review formal applications from entrepreneurs and businesses. Additionally, some institutional investors (VC firms) finance seed rounds. There are some that focus primarily on seed rounds, and they are referred to as micro-cap VCs or super-angels, depending on who started the fund. Angel investors most often provide the seed money required to get the developments to the end-user in exchange for convertible notes, equity, or preferred stock in the venture.
For plan submissions to angel investor groups, a detailed plan will need to be provided. An initial review of the entrepreneur's plan will be conducted to determine if the venture meets the investment criteria of the group. If so, the angel group will contact the entrepreneur and prepare them to give a presentation for some or all of the group. The presentation will typically be 20 minutes and will be followed by a question and answer session of 20 minutes, though some groups will allot shorter periods. If any of the investors are interested, they may schedule a follow-up meeting. If they decide to move forward, they will begin their due diligence process, where attorneys will review the company and the representations made by it. When that is completed, the negotiations begin.
Term sheets, which are proposals that contain the key terms of the transaction are used to negotiate the structure of the agreement. Term sheets represent the fundamental terms of what will ultimately be a set of documents. In Series A transactions, the documents will be an amended charter (Articles of Incorporation for CA, Certificate of Incorporation for DE), a stock purchase agreement, an investor's rights agreement, a voting agreement, and perhaps a right of first refusal and co-sale agreement, and various other documents depending on the attorney who is preparing the deal. For seed round transactions, the attorneys will often execute a similar, but lighter version of the Series A, preparing only an amended charter, stock purchase agreement and investor rights agreement. If negotiations are successful, and an agreement is made, the term sheets are used as the basis for the final agreement documents. The funds are then transferred to the entrepreneur.
Prior to the term sheet negotiations, entrepreneurs should be thoroughly prepared to negotiate an agreement that protects their interests. Below are some of the general considerations that may be involved. I am not discussing specifics, such as anti-dilution provisions, redemption rights, or dividends. For a description of the particular components of the term sheets, read this article. Entrepreneurs should be aware that the considerations below could also have some impact in the decision of investors to invest. Investors will likely only select the companies they feel have the potential to negotiate an acceptable agreement and provide those considerations that investors find desirable.
Valuation and Equity Stake - The most fundamental terms will relate to the amount of money that will be invested and the equity share of the venture. If the entrepreneur needs a fixed amount of capital for their venture, the investors will want the equity share they believe accurately reflects the value of business post-money. Often, entrepreneurs value their company based on what they believe it will become. The investors, on the other hand, are often using valuation methods that provide a current value of the business that reflects a significant risk premium for startup capital transactions. If there is serious disagreement about the value of the business, the negotiations will likely fail.
Liquidation Preference - Most investors have ongoing relationships with attorneys and will use similar or identical terms from investment to investment. Institutional investors will probably use big law attorneys, most of which structure these transactions with Preferred Stock. I know of at least one that does not, and classifies a majority of the investment funds as debt, with the remaining contribution used to purchase a portion of the Common Stock. The entrepreneur also purchases some of the Common Stock to create the appropriate equity split. This can be helpful for tax reasons, primarily IRC §83(a). However, the Preferred Stock transaction is generally easier to structure, and has become the standard for Series A transactions and even seed round transactions. Either way, the goal is the same - to ensure that in the case of liquidation, the investors get a return of their investment money before any distributions of profit are made. This does not usually cause a problem for the entrepreneur, because they are not typically seeking seed money with the hopes of liquidating below a break even point.
Control - The investors will not likely hand over a check without maintaining some input into the affairs of the business. Most of these investors are successful business people, having served as CEO's of major companies. The entrepreneur's experience in their field may not necessarily convey confidence in their management abilities. Typically, investors are willing to lend a helping hand, as their own interests are aligned with the overall financial success of the business. In some instances, the business owner's and investor's interests are not aligned, and for that reason, the investors will insist on board placement, with unanimous requirements for decisions like employee compensation, raising additional capital, sales of assets, and significant contractual obligations. Creativity in the negotiation process and in the drafting of the final agreement documents can satisfy the investors and give the entrepreneur significant deference.
Walkaways and Performance - Investors are likely to insist upon clauses that ensure the entrepreneur will not walk away from the venture. If the entrepreneur finds a more lucrative venture to pursue, their departure would serve them well, but leave the investor with no return on their investment, and an inability to do much with the venture. To protect against that possibility, investors will likely seek a clause that states that the key employees will make this venture their primary employment for a specified time frame. Additionally, the investors might seek time or performance vesting stock to incentivize the continued human capital contributions of the entrepreneur. Time and performance vesting stocks are a good idea for the Company, as well, if there are multiple founders involved.
Time/Return & Exit - Many angel investors enjoy what they do. As retired CEO's they are often very savvy and successful business people. As investors, they get to exercise their savvy in a limited function. As much as they may enjoy this, and may like the entrepreneur as a person and inventor, the investor's number one goal is a return on their investment. Not only do they want a return on their investment, but they want in a prescribed amount of time. Investors hope for a return in 2-3 years on the low end, and up to 6-7 years on the high end. Depending on the type of funding sought and the operations of the company, the investors might have different desires for exiting the transactions. In some cases, a sale or a subsequent private equity deal at the end of the transaction might be the clean break the investors desire. The structure of the agreement is going to have to account for the anticipated and acceptable exit options.
Investor's Rights - Aside from the above mentioned issue of control, the investors will want a right to participate in future equity financing rounds. If this venture is successful and the company decides to issue subsequent offerings, the investors will want the opportunity to participate, to ensure they can maintain their proportion of ownership and/or invest more money into an attractive venture. This typically does not concern entrepreneurs, who seem willing to agree to accept future funds from the investors they are already doing business with. Registration rights are also something that investors desire. This requires the company to register the securities to enable the investors to sell them. I do not include these in seed round financing, because it is burdensome for startups and the exit plan or redemption rights should give the investor the opportunity to liquidate their interest.
Networks of angel investors exist around the country and are typically centered around Silicon Valley, San Francisco, New York, Boston, metropolitan areas, and college towns. To view a list of California angel investor groups, click here. Note also that many venture capital firms will also finance seed rounds. Venture capital firms that do this are referred to as super-angels or micro-cap VC's. To view a list of Bay Area venture capital firms, click here.
Feel free to use our term sheet generator to structure the terms of your seed round transaction.