VC Deal Lawyer

What are Angels? 

Angels are individuals that invest their own personal money in private companies, typically at a very early stage.  They are generally Accredited Investors under Reg D of the Securities Act of 1933 (meaning they have a net worth of at least $1M or that they made more than $200k the past three years or more than $300k, together with their wife, the past three years).  Most angels made their money themselves as entrepreneurs or executives.  A few of them deploy old family money, rather than their own.

What role do angel investors play in venture financing?

Angels bridge the financing gap between “friends and family” money and the initial institutional venture capital round.  As former entrepreneurs or executives, angels bring more than just money to the table.  They can be wonderful mentors and advisors.  Due to their backgrounds, they very often have specific industry expertise and/or operational or financial experience.  Also, many angels have stopped earning a paycheck full-time and they look forward to spending a little time in the trenches with the entrepreneurs that they invest in.  Some angels also have enormous rolodexes (for those of you younger than 20, that means contacts) from their own years of raising money and doing deals and can provide great contacts that may speed up the start-up process. 

Types of Angels

Angels come in all shapes and sizes.  At the bare minimum, they are all individuals.  Some desire to invest just that way and they will source their own deals and individually invest their own money. 

Over the past several years, however, many angels began to put some formal structure around their activities and angel networks or groups began popping up.  By involving themselves in angel groups, angels can be more efficient in reviewing possible investment opportunities, diligencing deals, negotiating terms and pooling money to take on slightly larger deals – all with the over-arching goal of achieving more competitive returns.   These groups can be loosely or highly structured.  Some may just be groups of individuals that come together quarterly to hear company presentations over dinner (usually 3-4 a night).  In these loosely structured groups, the ultimate decision to invest is the individual’s and they will all write their own checks.  The more structured groups tend to take on characteristics of funds, with capital calls, investment managers and due diligence teams.  Whereas individual angels would typically put from $10,000 to $250,000 into a company, the structured groups may put anywhere from $250,000 to $1,000,000 into a company.

I would refer to certain groups as angels since they invest at the angel level, even though they may not fit neatly into the categories above.  These groups come from a completely different angle by forming incubators.  Two well-known examples are TechStars and Y Combinator.  They put something like $20,000 into their incubated companies in return for 2-10% of the company and they provide the companies with high-end accounting, legal, operational, financial, sales and marketing support.  It’s sort of like the difference between a stove and a microwave.  Like the microwave, the likes of TechStars and Y Combinator seek to highly charge their start-ups in a short period of time, hopefully catapulting them past their competitors.

Where do you meet angel investors?

Finding angels is not necessarily easy.  They don’t advertise.  They are not in the yellow pages (if you find one there, I’d suggest you run in the opposite direction).  Some tend to like the obscurity because they don’t want to be overwhelmed with opportunities.  In fact, many angels rely on an informal network of filters to make sure that by the time someone does find them (sort of like when Dorothy found the great Oz), they’ve already been vetted a couple of times both from an opportunity as well as a personality perspective.  In that regard, the best place to hunt for angel investors is in your own network, through trusted advisors like accountants and venture attorneys (who interact with angel investors constantly), through institutional venture funds (some of these guys may even do some angel investing on the side with their own money), angel networks and angel groups. 

How do angel investors structure deals?

It can run the gamut from convertible debt, common stock or series preferred stock.  Most angels investors though will have a preferred method and will consistently invest the same way.  If you raise money by selling common stock or series preferred stock then you will have to negotiate a valuation with the angel investors.  This can lengthen the time to get an angel deal closed.  It can also, if you don’t engage the right kinds of advisors, wreak havoc on your next financing round (which, if all goes right, will be institutional venture money).  If the rights, privileges and/or preferences attached to the common stock or series preferred stock are too rich it may give the venture capitalists in your next financing round serious indigestion.  Not that you cannot overcome that, but it will greatly lengthen how long it takes to get the next financing round done (in addition to significantly increase your legal and accounting expenses).  Why?  Because some of the rights your angels have may have been more appropriate for a Series C round and now your Series A investor is saying – if the angels keep those rights we are not doing the deal.  The Series A investor is going to want the angel investors to restructure and re-align their investment so that it properly sits within a broader financing plan for the company.  If your angel investor decides he/she doesn’t like that, then you just bungled your Series A round and you’ll need to hit the fundraising trail again. 

One way angel investors avoid all of the subjective issues behind valuation and the rights, privileges and preferences associated with issuing stock is they structure their investments as convertible debt.  Some people are fine with this, others have issues.  To each their own.  I think it is a very acceptable way to structure an angel investment.  What you do is the angel investor loans the company money, rather than investing it as equity.  The loan is structured to be convertible into equity at a later date, with the conversion being automatic if the next financing round meets certain parameters (e.g., institutional venture fund money, minimum valuation, minimum aggregate amount raised, etc.).  Convertible debt provides the advantages of both debt and equity.  No time is wasted determining a valuation.  The financing is not dilutive to the entrepreneur unless and until they raise their first institutional round and the debt converts.  Convertible debt may or may not be secured.

Yes, angel investors earn interest on their debt.  But that is not the only compensation.  Angel investors deserve some sort of “kicker” for taking the risk of lending money (when no bank would) to a company with no assets.  In order to compensate for that risk, the company usually does one of two things:

• the company will issue the convertible debt accompanied with warrants to purchase common stock (usually at an exercise price of $0.01 per share).  The convertible debt will automatically convert at the next financing round (usually if it meets certain parameters as noted above) into the types of shares issued in that financing round and at the price per share of that financing round.  So if the angel investor loaned the company $250,000 and the next financing round sold Series A Preferred Stock at $0.75/per share, then the debt would convert into 333,333 shares of Series A Preferred Stock ($250,000/$0.75).  The angel investor keeps the warrant for taking the risk; or
• the convertible debt is structured to convert at the next financing round (again, usually if it meets certain parameters as noted above) into the types of shares issued in that financing round but it will convert at a discount.  The angel investor gets the discount for taking the risk.  Using the same example above, and assuming the discount was 20%, then the debt would convert into 416,667 shares of Series A Preferred Stock ($250,000/($0.75 x .8)). 

 Advice on raising angel money

• Be wary of the angel investor with only big company experience- I hate to generalize here, but for all the experience that former big company executives may have, the one thing they critically lack is startup experience.  In a startup, there are no big company budgets to create fancy marketing plans, or admins to run around making copies of the next investor pitch.  Not all former big company executives understand the mindset of an entreprenuer in startup mode.  These angel investors may disagree with you on where to spend your (their) money, how to market the product, etc.  At the same time, they may offer some big company strategies that fit well in the startup environment.  Just know the issue is there and be wary of it.
• Ferret out the tire kickers – In order to save enormous time during the fundraising period, do whatever background checking you can to ferret out which angel groups actually put money into companies versus which angel groups consist mainly of a bunch of bored retirees that just want to meet quarterly for dinner while networking and be entertained by company presentations.  The former is worth all your time, the latter you just need to ignore or use only as a practice run to work out the kinks in your presentation.
• Down economy means less angels- Many angels retrench in down economies.  Remember that these individuals invest their own personal funds.  When the economy hammers their portfolios, many angels will cut back on their angel investing.  This may seem contrarian since a poor economy may mean better investment opportunities (i.e., good companies with lower valuations), but it still happens.  See this article. 
• Take care to carefully craft the angel investment terms- As I noted earlier, a poorly structured angel investment could hamper or even kill your next financing round.  The goal is to provide the angel investor with reasonable terms without negatively impacting your next financing round.  One example of this is the discount rate on a discounted convertible note.  If the discount rate is too high, the Series A investors may take offense because the angel investors is buying into their round at a wonderful valuation.  Never mind that the angel investor is only being compensated for taking the early risk – it will still pieve the Series A investors and they may seek to have the angel investor adjust the discount as a condition to the financing round.

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