What’s The Best Structure For A Pre-VC Investment?
I received the following question earlier this week. It’s conveniently timed, as I recently participated in two angel investments – each with one of the structures defined below.
What’s the best/preferred structure of investment money pre-VC investment. We’re in the beginnings of raising angel capital (~500k) and were wondering what, if any, considerations we should make regarding the investments to allow for VC later. Should we take convertible loans or issue straight preferred stock? What are the other options that are out there for investment structure? Is it too much of a hassle to handle future investments when there is an “angel group (say 5 doctors banded together)” versus a singular angel?
Assuming that you are planning on raising VC money some time in the future, there are two different typical structures for the first angel financing: (1) convertible debt and (2) preferred equity.
Convertible Debt: This is the easier approach of the two. In this case, the investment is in the form of a promissory note that converts into equity on the terms of a “qualified financing” (where qualified financing typically is defined by having a minimum amount – say $1m of total investment.) The note will either convert at a discount to the price of the qualified financing (usually in the 20% – 40% range), will have warrant coverage (usually in the 20% to 40% range), or both. This discount and/or warrant coverage gives the angel investors some additional ownership in exchange for taking the early risk. This note should be a real promissory note with the conversion and redemption characteristics clearly defined to protect both the investors and the entrepreneurs from any misunderstandings.
Preferred Equity: This is also known as a “light Series A” – it’s preferred stock that is similar to that a VC will get, but usually with lighter terms due to the relatively low valuation associated with it. For a very young company, a $500k investment can receive between 25% and 50% of the equity in the company and, as a result, many of the terms associated with a typical VC investment are overkill.
While either of these work, you’ll find some angels that strongly prefer one over the other. In addition, if you don’t believe you are going to raise additional VC money and will only be relying on additional small angel-type investments, the preferred equity approach is fairer to the investors as they’ll more clearly be participating in the upside on terms that are agreed to early in the life of the company.
Finally, I don’t think there is a difference between having “an angel group” vs. a single angel investor. However, you should try to insure that all of your investors are accredited and – if some aren’t – make sure you understand the implications of this.