Type of Angel Investments
Investor or entrepreneur: Regardless of which side of the table you're sitting on, the goal is the same – to create personal wealth. And each of you wants to get to the next investment round. Because the angel investment creates a "baseline," whatever you get as an angel, the next round investors will want to improve upon. So it's important you don't turn the screws too tight or there will be little room for follow-on investors. You want protection that's adequate for the size of your investment but encourages – or at least doesn't discourage – follow-on investment.
Investing in early-stage businesses generally falls into one of three forms: common stock investment, a bridge, or a preferred stock investment.
Common Stock
While this method of investment is definitely the most straightforward, it creates issues with respect to stock option pricing and fair market value for future incentive stock grants. More importantly from your perspective, it subjects angels to a greater risk of dilution from future stock issues. While twenty years ago, it wasn't uncommon for angel investors to make their investment in common stock, today it's virtually unheard of for the very important reason that a common-stock investment offers slim protection for your investment. Imagine the following scenario: On Monday, you invest $100,000 in Company ABC. On Tuesday, the ABC founders decide they have a better idea, so they're going to close down ABC. Suddenly your $100,000 is being distributed pro-rata according to shareholder ownership percentages. That $100,000 only bought you 20% of the company. Guess where 80% of your investment is going!
Bridge
A bridge investment is structured as a loan to the company that converts to equity when the company secures follow-on equity financing. The bridge enables the company to keep operating and moving forward while looking for that VC money. At the same time, it allows the angel to take advantage of the venture capital firm's greater experience and expertise in valuing the company and defining the market terms for the investment in which you'll participate. And, if properly structured, the bridge will give you additional rewards for taking the earlier risk, most often in the form of warrant coverage. As a creditor, you get your money out before any shareholders – including preferred shareholders – can take theirs in the event of bankruptcy. Naturally, if things get this dire, there may be little to get out of the company. In addition, you can secure your investment in the company's intellectual property. However, protections such as these reduce or retard the company's chances of getting follow-on financing.
On the flip side, you should be fairly confident that the anticipated VC round is more than just wishful thinking. A bridge without land on both sides is merely a pier. And, having not locked down the terms of your investment – and it is an investment – you run the risk that the VC won't like your terms and will squeeze you out, either by forcing you to renegotiate the terms or by paying off the note.
Preferred Stock
Preferred stock allows you to secure added protection for your investment. Unlike common stock, preferred stock usually has several rights attached to it, which are negotiated by the company and the investors. At the core, the difference between preferred stock and common are a dividend preference and a liquidation preference. Most investors are savvy enough to understand that dividend payments aren't in the company's or the investor's best interests at this stage of the game. That money should be used to continue building value in the company. But other preferences should be considered:
Conversion Privilege: The goal is for your preferred stock to convert to common so that it can trade when the company goes public. Preferred stock typically is defined so that it converts 1:1 with common stock, and conversion should occur when:
1. you elect to convert;
2. when a majority of the investors agree. You can make this conversion occur when a super majority agrees, but never accept a conversion that can only occur when all the investors agree (unanimity). That's a sure way to hold up an event.
3. when the company goes public. Typically you want to define what kind of public offering will be acceptable for conversion. With angel stock, that often looks like a return of at least 5x of your original investment, with a minimum raise sufficient to buy the company some "running room."
Liquidation Preference: A liquidation preference allows you to get your investment back out of the company and should kick in whenever the company is liquidated or whenever the company is sold in a change-of-control transaction. The amount of the preference varies depending on market conditions. Some years ago it was 1x, but recently the preference has been as much as 2-4x the original investment. There will also be priorities attached to the liquidation preference. At a minimum, it should be paid before the common shareholders get anything. In follow-on rounds of investment, you may get the follow-on investor to pay out your preference pro rata with his.
Participation Rights: If your investment has participation rights, then after you receive your liquidation preference you get to share in at least some the remaining proceeds as though you had converted your shares to common. If your liquidation preference is high, you should expect to forego getting any participation rights. If your liquidation preference is low, participation rights are more likely. Often participation will be capped so that you get your money back and then you get to participate until you achieve a ceiling on your return, i.e. you get 1-2x your money back, then you participate with common as though converted until your get a total of 3-4x back.
Antidilution Protection: Antidilution provisions protect you in the event the company's stock sells at a price less than you paid for it. It's usual to see weighted-average antidilution protection as well as protection against stock splits and recapitalizations.
Board Seats: It's not unusual to demand board representation when the angel investment amounts to a significant ownership percentage, e.g. 20%. This gives you the added protection of being involved in at least two levels of management, rather than only able to exercise your management interests in shareholder votes.
Registration rights: In order to get a return on your investment, you have to have a way of disposing of your stock. Generally, you're required to hold onto your stock unless it becomes registered with the Securities Exchange Commission (SEC). Furthermore, there's no general market for your stock until it becomes publicly traded, at which time its value should increase significantly. Registration rights ensure that you're able to register your stock so that it also can be publicly traded. Registration rights for angels typically include piggyback and S-3 rights, and if the public offering is sizeable, you might also get demand rights.
Piggyback rights allow you to throw your stock into the offering along with the stock the company intends to sell. S-3 rights allow companies who have already publicly traded their stock to use a less administratively burdensome and inexpensive process by which to put more shares on the public market. S-3 rights generally are allowed a couple times a year for some minimum number of shares at each offering, somewhat like a mini-demand right. Often, if a company does an S-3 offering, it will trigger piggyback rights, too.
Demand rights allow investors to force the company to register their stock. The right typically triggers after some period of holding and requires the investors to put a minimum number of their shares up for sale. Strong demand rights are unusual in angel rounds unless the round is relatively sizeable. It is exceedingly rare that such demand rights would be used to force a company to do an initial public offering (IPO) and more likely that the demand rights would be exercised after the company is public.