As an angel investor, after valuing the opportunity and the deal has been considered, the next stage for angels is to discuss with the entrepreneur/owner about choosing deal structure and setting the terms.
Each angel may have different strategies when it comes to structuring deals. When you and the entrepreneur agreed on some basic terms, as a result it is time to determine and create a more detail term sheet. Many times the angel investor wants to be involved and hands on with the business, specific structure deal and terms that you want to bring win-win situations. If you can find an investor that has connections and advice from experience this may be a huge benefit for the company’s growth also. This stage should be clearly from the beginning because you will be carried this structure for the life of the deal. In some cases, “if you’re late in the process you have to accept the structure and terms that have been agreed to by others,” says Darryl Wash.
According to the authors Amis, D. and Stevenson, H. Winning Angels: The 7 Fundamentals of Early Stage Investing. Pearson Education Limited, 2001, there are three fundamental structures in angel investing:
- Common stock
- With NO rights
- With pre-emptive and tag-along rights
For example, if the deal is set up as an equity stake in exchange for cash, if the company is valued at $1,000,000 and you invest in $150,000 cash, it means you would get 15% ownership of the company. Like the authors said, this is the simplest structure and “used most by family, friends, and fools,” and “angels rely more on the integrity of the entrepreneur as well as their own ability to source and evaluate.”
- Preferred convertible with various terms:
The structure is not simple and “will require some significant interaction with the entrepreneur in the hoped-for event that additional capital is raised or an exit obtained.”
- Convertible note with various terms:
When the angel and the entrepreneur cannot agree on some valuation and others, they may opt to have a convertible note and it is setup as a loan to the company. This is used more popular as a tool for the investors.
For example, if the investor put in the company $150,000 as a convertible note, it would mature (come due) at a specific date in the future and will likely accrue interest. At the maturity date in the future, the investor can choose to either ask to be repaid back in cash (like a loan) or convert that money back into the company as equity based on a valuation determined at that time.
On each structure, there are some major considerations:
- Exit impact
- Relationship impact
- Downside protection
- Upside protection
- Entrepreneur protection
- Worst case scenarios
- Best case scenarios
- Notes and suggestions
- …and anything else you can think of that you may want to consider.
By choosing either approach for investment, you are deciding how much equity you will get, plus preparing yourself to continue the future rounds if the deal is successful and on worst scenarios if the deal is fail.
Before determining which structure to choose, make sure you completely understand each deal structure and terms and if you feel comfortable and or already thoroughly reviewed with a lawyer, then you may start proposing that structure.
Amis, D. and Stevenson, H. Winning Angels: The 7 Fundamentals of Early Stage Investing. Pearson Education Limited, 2001.