Angel Financings: Legal Tips For Entrepreneurs – Part 1by Scott Edward Walker on December 2nd, 2009
I am currently working with several smart, young entrepreneurs who are trying to raise capital from “angels” (i.e., wealthy individuals who invest in startups). Indeed, since I moved to Los Angeles from New York City in 2005, I have been involved in a number of angel financings; and what’s interesting from my perspective as a corporate attorney is that the deals run the gamut from an angel handing a check to an entrepreneur and instructing him to “send the paperwork when it’s ready” — to an angel retaining a large, aggressive law firm and insisting on shares of preferred stock, with all the “bells and whistles.” Below are five tips for entrepreneurs to help them through the angel financing process. (This is part one of a two-part series; I will provide five additional tips in my next post.)
Five Tips for Entrepreneurs
1. Push for the Issuance of Convertible Notes. As noted above, angels will sometimes request shares of preferred stock for their investment; however, unless the startup is raising at least $750,000 to $1 million, it is generally not in the startup’s interest to issue such shares. Indeed, preferred stock financings are complicated, time-consuming and expensive. Moreover, the company would need to be valued, which is obviously difficult at such an early stage and could be extremely dilutive to the founders. Accordingly, entrepreneurs are better served by issuing convertible notes to angel investors, not equity — i.e., the angels would loan money to the company, which would automatically convert into equity in the Series A round of financing. This approach will keep the financing relatively simple and inexpensive and will defer the company’s valuation (i.e., the pricing) until the Series A round. Bill Reichert, Managing Director of Garage Technology Ventures, briefly discussed the “note vs. equity” issue on The Frank Peters Show (starting at the 22:51 mark) and expressly advised that: “If you’re putting a few hundred thousand [dollars] in, it’s just not worth all the brain damage to price the round. . . [and] it’s not worth spending too much on lawyers.”
2. Understand the Key Business Terms. Regardless of whether the company issues convertible notes or preferred stock, it is imperative that the entrepreneur understand all of the key business issues. In a convertible note financing, the key business issues include: (i) the amount of the discount on the conversion price (generally 20%); (ii) the valuation cap, if applicable; (iii) the interest rate on the note (generally 5-6% per annum); (iv) the maturity date (generally 18-24 months); (v) the conversion rights of the noteholders; and (vi) what happens if the startup is acquired prior to the maturity date. In a preferred stock financing, the key business issues include: (i) the pre-money valuation; (ii) the terms of the liquidation preference; (iii) the terms of the anti-dilution provisions; (iv) the Board composition; (v) dividend-related issues; (vi) whether and to what extent vesting will be imposed on the founders’ shares; and (vii) the protective provisions. Needless to say, an experienced corporate lawyer will help negotiate the foregoing issues; however, as Chris Dixon (co-founder of Hunch) aptly pointed out in a recent blog post: “you can’t outsource the understanding of key financing and other legal documents to lawyers.”
3. Diligence the Angel(s). In the course of my 15+ years of practicing corporate law (including nearly eight years at two major law firms in New York City), the most common mistake I have seen entrepreneurs and inexperienced deal people make in any dealmaking context is the failure to investigate the guys (or gals) on the other side of the table. Indeed, in the angel financing context, the entrepreneur will, in effect, be married to the angel for a number of years. Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs and founders who have done deals with the angel in order to make an informed judgment as to whether the angel is an appropriate individual with whom the entrepreneur should be partnering. Issues to consider include: What is the angel’s motivation to invest? Is the angel a good guy or a jerk? Can the angel be counted-on and trusted? Will the angel add significant value (e.g., through his contacts, domain expertise, etc.)?
There is an outstanding video discussion on Mixergy.com of how the angel process works (and what could happen if you don’t adequately diligence your angels) between Brandon Watson, a smart entrepreneur (currently at Microsoft), and Andrew Warner, the founder of Mixergy. Brandon is extremely candid and discusses how he got “bullied” by his Board. Moreover, he expressly notes in the comments section of the post (in response to my comment) that: “The diligence factor was that I knew them, but had never taken money from them.” He also adds that: [O]ur legal counsel wasn’t worth a damn, and they were the expensive Silicon Valley kind. My issue was that the partner would bill for a lot of stuff that I felt shouldn’t have taken as long (my whole family are lawyers). I know that this could have been a partner specific issue, but my experience with the expensive SV lawyers has been a mixed bag at best.” (I discuss the big firm problem in my recent post, “Behind the Big Law-Firm Curtain: The Good, The Bad, The Ugly.”)
4. Never Subject Yourself to Personal Liability. It is self-evident that founders should not be personally liable to angel investors if their company fails (other than in connection with fraud). Indeed, that’s one of the principal reasons for forming a corporation or limited liability company: to protect the entrepreneur against personal liability (see tip #1 of my post “Launching a Venture: Ten Tips for Entrepreneurs).” Unfortunately, there are angels and inexperienced business attorneys who will request that the founders personally make certain representations and warranties, such as intellectual property matters. In fact, I was involved in two separate angel financings in the past 18 months in which the angel’s legal counsel insisted on just that; and in one deal, the angel requested a personal guarantee from the founder (but dropped the request when I pushed back very hard). My tip here for entrepreneurs is simple: Never agree to potential personal liability. Every sophisticated player understands that angel investing is a “high-risk, high reward” proposition, and there is no reason whatsoever that an entrepreneur should be sticking his neck out and subjecting himself to any personal liability if the deal sours. If an angel is pushing this issue, it’s time to find a new angel.
5. Comply with Applicable Securities Laws. Whether the company issues convertible notes or shares of common stock or preferred stock, it will be issuing a “security” within the meaning of Section 2(a)(1) of the Securities Act of 1933, as amended (the “Securities Act”). Accordingly, such security must be registered with the Securities and Exchange Commission (the “SEC”) and registered/qualified with applicable state commissions, or there must be an applicable exemption from registration. For startups, there are certain prescribed transaction exemptions which may be applicable in connection with an angel financing, the most common of which is the so-called “private placement” exemption under Section 4(2) of the Securities Act and Regulation D promulgated thereunder. The rule of thumb in connection with private placements is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506 thereof. There are two significant reasons for this: (1) Rule 506 preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996 – which means, in general, that the issuer merely must file with the applicable state commissioners (i) a Form D (see my recent post regarding Form D), (ii) a consent to service and (iii) a filing fee; and (2) there is no prescribed written disclosure requirement if the investors are “accredited” (i.e., no requirement to deliver, for example, a private placement memo).
There are eight categories of investors under the current definition of “accredited investor” — the most significant of which for entrepreneurs is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase (not including their primary residence) or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year. Indeed, if a company offers or sells securities to non-accredited investors, it opens a pandora’s box of compliance and disclosure issues, under both federal and state law. Accordingly, the entrepreneur must ensure that the angel is an “accredited investor” by requiring the execution of an “investor questionnaire” andy by requiring certain representations and warranties in the applicable transaction documents. Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (see my recent post “Rescission Offers: Five Tips for Entrepreneurs”), injunctive relief, fines and penalties, and possible criminal prosecution.
In part two of this series, I will provide five additional tips for entrepreneurs in connection with angel financings, including (i) how to work with angel groups (such as the Band of Angels, Tech Coast Angels, etc.); and (ii) why having a superstar angel as an investor (such as Ron Conway, Jeff Clavier or Kevin Rose in the San Francisco Bay area; or Matt Coffin, Kamran Pourzanjani or Jason Calacanis in the Los Angeles area) trumps all other tips.
Tags: angel, angel financings, angels, business attorneys, convertible notes, corporate attorney, entrepreneurs, liquidation preference, personal liability, Regulation D, rescission offers, SEC, securities laws, tips for entrepreneurs