Dear Angel Investor,
All too often, the excitement of an angel investment gets the best of you.
You’re pumped about the opportunity you’ve found… and you pull the trigger!
But where exactly have you put your money?
I’m not talking about the startup here, I’m talking about how the deal is structured. That’s a critical piece of the investment and can have a huge impact on your end results and overall return.
They expect to hit profitability Q2 of this year–then the checks should start rolling in.
But that’s just one of my recent investments. You can see both of them here.
All that to say… if you don’t understand how a deal is structured, it’s hard to know what you’re getting.
Today, I’m unpacking the three most common types of security.
Making Sense of Securities
If you want to get the big bucks as an angel investor, you need to understand the different types of securities. Most of the time, our goal is to see a startup through investment rounds all the way to initial public offering (IPO) or a buyout. This is where you get big returns.
But let’s not get ahead of ourselves. Long before the coveted IPO, you will need to take part in seed investing.
Depending on the startup, you will have access to one of the three major types of securities. Knowing the ins and outs of these investment types can help you to negotiate for a better position. Angel investing is a high-risk, high-reward game. To maximize your chances of success, you need to have the right information.
So, buckle in, and get ready to learn everything an angel needs to know about securities.
Where Angels Fly
The first step for a young startup is to get initial financing from founders, friends, and family. This means maxing out their credit cards, asking grandma for some dough, and scrolling through their contacts looking for anyone who might throw down a chunk of cash.
Once the startup gets things moving, they’ll come looking for you, an angel investor.
At this point, the company has proven its sales potential and has a great pitch — but not much else. Based on the business model alone, angels will hop on board. Angels pump cash into the startup and use their skills to guide it.
Angels get involved in the earliest stages of a business’s life cycle. Often an idea alone is enough to motivate investment. For this reason, angel investing can be risky. But, it offers more potential than venture capital investing, stocks, bonds, etc.
Almost everything pales in comparison to an angel investing payday.
To mitigate risk in these uncertain waters, you need to make sure you are on track to meet your financial goals. This, and ensuring a clear exit plan, comes down to the type of investment you make.
The type of security will dictate your options and strategy.
With equity financing, angels buy capital stock from the startup. This means you buy a fraction of the company based on its current valuation. Owning stock makes you a part-owner of the company and grants you certain privileges and opportunities.
While the founders are contributing sweat equity for their work, you are injecting vital cash into the ecosystem. This cash is used for market research, marketing campaigns, and the general expansion of business operations.
All in all, equity financing is a pretty sweet deal for startup founders. They opt for equity investment because the investment isn’t considered debt. This means angel investors can’t come knocking, looking for their money at a bad time.
However, other startups may avoid selling equity due to a few caveats.
For one, equity or stock negotiations create costly legal fees. There will be more documents to draft and more terms to negotiate. Also, this system forces the startup to lock in its valuation at a very early stage.
Valuation is a big concern. If the company agrees to a valuation to sell an angel investor equity and then lowers its valuation for Series A financing, it could trigger damaging legal consequences or give the perception that the company is struggling financially. I’ll explain more in my discussion of Preferred Stock.
There are two basic types of equity investments: common stock and preferred stock. Most angel investments fall under preferred stock.
So, what do you need to know about stocks?
Preferred stock provides investors greater rights and privileges than regular ol’ stock.
The first benefit — if the company pays dividends when there’s extra revenue, preferred stockholders get paid before common stockholders.
In the startup world, this isn’t so common. Extra cash should be reinvested into the startup for maximum growth. The goal of angel investment isn’t steady income, it’s a giant return down the line. But, earning dividends can happen, so this is a nice little benefit.
Next, preferred stockholders have more claim to the startup’s assets and earnings. In the case of bankruptcy and liquidation, preferred stockholders will be paid before other investors and founders. And that can be a huge bonus.
Angels can convert preferred stock into common shares at a predetermined time. Often, these shares will be changed at a premium redemption rate that benefits the angel. Conversion isn’t possible with common stock.
There can be multiple series of preferred stocks issued. And the last series of preferred stock issued has the greatest claim (because the investors paid the most for it). For example, Series B preferred stock gets their payouts before Series A preferred stock, and so on.
Ever wonder what the difference was between Series A, B, C, etc.? There’s your answer right there. It all has to do with the preferred stock being issued.
Finally, preferred stocks are protected against dilution.
Imagine that stock represents a piece of the company — a slice of the pie. As the number of stockholders increases, each person’s slice shrinks. For example, you bought 100 shares, which constituted 10% of a company. The company then raised another round, selling another 1,000 shares. Now your shares are only worth 5% of the company.
This kind of dilution is all well and good in the world of angel investing. We expect that we’ll own a smaller and smaller piece of the pie, but the pie will be worth so much more, it’s worth it to us.
However, sometimes… When the pie isn’t worth more… That’s when angels get screwed.
This happens when a startup stumbles. They miss key milestones or encounter unforeseen obstacles. They need more money, but now investors are skeptical. So they have to lower their valuation.
Now, your 10% of the company is only 5% of the company, and the value is less than when you first invested. (Ouch.)
That’s where preferred stocks come in. Preferred stocks are often tied to an anti-dilution provision, which prevents or mitigates the exact situation I just described. If your startup is forced to lower its value to raise again, your stock is automatically reevaluated to the levels of the new raise. You owned 10%, now, suddenly, you own 20%! That 20% is going to be diluted when other investors jump in, but you’re taking much, much less of a hit.
Convertible Debt Instruments
This next type of security avoids some of the setbacks of equity but offers its own challenges.
Convertible debt is basically an IOU for future stock. Angels buy convertible debt today that they can collect down the road.
The convertible debt note will dictate the amount of interest, number of shares, and maturity date.
When the startup gets new financing, the convertible debt instrument matures, or the company is sold, the angel investor can swoop in and have their note changed for stock with ease.
These investments have priority much like preferred stock. Holders of these notes will get cashed-out first.
Startups like convertible debt instruments because they don’t need to lock in their company’s valuation to get cash. This way, claiming a certain valuation down the road won’t hurt them. This makes future financing more flexible.
Finally, we have SAFE investments. SAFE stands for Simple Agreement for Future Equity. This system was created by Y Combinator, a Silicon Valley accelerator, as a simpler alternative to convertible notes.
Like convertible debt notes, SAFEs serve as a placeholder for an equity investment in future financing.
SAFEs are great for startups because they have no interest rates or maturity date. They are very short, 5-page documents that make financing speedy and simple. Also, startups don’t need to decide on a valuation to take SAFE investments.
Angel investors love SAFEs for many reasons. SAFEs with valuation caps can allow for massive gains for investors. This means that, once the value of a company crosses a certain threshold, your Because there is no equity value ceiling, the sky’s the limit for angels. You’ll get paid based on the startup’s growth with no upper limit.
The needs of startup founders and the goals of angel investors will dictate the type of security used. There is no right or wrong answer — there are just different tools for you to leverage.
Angel investing is a dynamic, high-risk high-reward sport. The wise angel investor can see a company’s potential, weigh an investment, and create an exit strategy with any type of investment.
Whether you are a savvy, experienced angel or one that’s just starting out, education is essential. Always look to expand your knowledge of the game. Like Warren Buffet says — “the more you learn, the more you earn.”
Now that you’ve learned the strengths and weaknesses of preferred stock, convertible debt, and SAFEs, you can make smarter investing decisions and get bigger payouts.
Be sure to check back to our Angel Insights to find more must-know tips, tricks, and strategies for the angel investing world.