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Understanding Angel Investors
Part 2 of a series on ownership
This is part two of a series on ownership for founders. This isn’t a series on how to raise, but how to understand different owner perspectives, including your own.
What happens to the founder/shareholder dynamic when you add outside investors for the first time?
In the last post, “What does it mean to be a shareholder?”, I explored ownership from the perspective of three founders who had just issued founder stock in their startup.
Now they want to raise money so they have to consider another side to the table: Angels.
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Friends and Family
Friends and family who invest are motivated more by supporting your dreams than making money. But you should always ask about their expectations especially if they have never made an Angel investment. Say the words “are you ok to lose this money?” Never assume the answer is yes.
What type of ownership should you offer?
A good approach is to say they’ll have shares that are no better but no worse than what founders have. Those are usually common shares. Obviously you will exclude special features like reverse vesting or a board seat (tip: do not put your mom on your board).
The important thing is that they’ll have roughly the same protections you do, and they’ll get paid when you do. That’s fair and also easy to explain.
One thing not to do is take advantage of their relatively light diligence to bump up the valuation. That can cause problems when more sophisticated investors disagree with that value. It’s also a signal that if that’s how you treat your friends…
Organized or professional Angels are intentional with their investing. They’ve done it before. They enjoy investing in entrepreneurs but have an expectation of a return.
To understand the Angel perspective I reached out to Christopher Mirabile. He’s personally invested in 65 companies, was the Chair of the ACA representing over 15,000 Angels, is Executive Chair of Boston-based Launchpad Venture Group, and Chairs the SEC’s Investor Advisory Committee.
So he spends a lot of time being an Angel and thinking about Angels.
What is the biggest potential mis-alignment between Angels and founders?
“One of the biggest issues is not being on the same page in terms of the capital path and exit. There are many ways to grow and harvest a company; broadly speaking, you can raise a ton of money, spend a lot of years, and try to get a huge exit, or you can try to move quickly, be efficient with the amount of investor capital you take in and sell the company earlier in a smaller (and more statistically probable) exit. Both paths are viable, but the capital efficient path often works out better for both entrepreneurs and investors and can provide superior IRRs, even if the cash on cash multiples are a little lower. Neither path is right or wrong, but disaster ensues when investors and founders are not in alignment about what path they are pursuing.”
Here’s a big takeaway: there’s more than one path to success. Most founders have been trained to pitch a story of how they’ll become a Unicorn following the standard VC playbook.
But Angels who have seen many deals have a more refined perspective. They would be thrilled with a big exit or an IPO (depending on how long it takes) but they’ve learned the value of having options, like early exits, along the way. Ask them about their war stories.
Assuming you and your Angels are aligned, I asked Christopher about how much structure is the right amount at this stage.
What is a right-sized amount of structure (eg formal shareholder agreements) for an Angel investment? Does it depend on how much is invested, friends/family vs professional Angel?
“It does depend on how much is invested. The structure of a priced round with its superior alignment, lack of debt overhang, and thoughtful allocation of both upside potential and downside risk is always better in theory, but at the earliest stages with the very tiny rounds, the transactional costs of a priced round may not be justifiable. I still think they are worth doing even in small rounds because they can be extended later, allowing you to amortize the transaction costs across two rounds, but for very early very tiny rounds, you see a lot of convertible securities like notes and SAFEs.”
Many founders I speak with have strong opinions about SAFEs vs priced rounds, but they don’t know why.
When do priced rounds, i.e. selling shares at a set price, create better alignment between founders and Angels?
For starters, investing in a priced round means Angels are actual shareholders. They and the founders can prioritize building the company. In a SAFE note (or convertible note) one of the goals must be to raise more money so Angels can convert into shares.
That can cause mis-alignment if founders can’t or don’t want to raise capital in the expected timeframe.
To learn more about specific terms and protections that Angels seek, read Christopher’s article on “Angel Fundamentals: Understanding Equity Deal Terms - Investor Rights/Protection.”
Whether Angels invest in a priced round or SAFE, in tech there is almost always an expectation there will be a future VC round. This may be the plan, and the desire of the founders, but as Christopher explains below, it may not be the only path, or even the best path, for Angels.
How much should founders structure Angel deals to set the table for VCs?
“In my experience this is not a factor entrepreneurs should spend time worrying about. They should focus on bringing in the best investors they can find in the early stages and doing it on market reasonable terms that provide good alignment. Thinking about later investors you may or may not even work with down the road, and speculating about what their priorities might or might not be is a waste of time. Obviously you want to avoid stupid off-market or unusual terms in your early rounds, but aside from that, what you should be focusing on is the quality of your investors and execution, execution, execution. If you are growing well and have clear product market fit, later investors will sort themselves out. And if you aren’t, then you are not getting good later investors no matter what your earlier deal terms are.”
Founders should understand that Angels do not just see themselves as a feeder system for VCs. Many have had bad experiences of being “crammed down” by VCs who apply the Golden Rule: i.e. the people with the gold make the rules.
I personally experienced this as an Angel investor when a VC blatantly required me to give up a large chunk of my shares, otherwise they wouldn’t invest. Still bitter.
I like what Christopher says about execution: “If you are growing well and have clear product market fit, later investors will sort themselves out.”
As our three founders contemplate raising from Angels they should be thinking about the following:
Friends and family are investing in you and in it for the long term. Offer them shares that are as close to founder shares as possible.
Angels may have good reasons to prefer buying shares now vs getting a SAFE note.
Raising VC may be good for the business, but may not lead to the best outcomes for early investors. Be aware of that perspective.
In the next post I’ll cover things that look likes shares but aren’t: SAFEs, convertible notes, options and warrants. Ownership is getting complicated.