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Wednesday, May 16, 2012

Angel Education is Sometimes Required

Angels are qualified investors willing to take a risk and invest their money in an early stage company or startup.  They may have made money in the field of the investment but this is not necessary.  They may or may not even know about the space they are investing.  Angels may wish invest but they can be very unfamiliar with investing in private companies.  Thus, some Angels require help in understanding the business and investment criteria.

Educating any investor on the business is customary.  The company is the expert in the space and has done all of the work to identify the market, placement in the market, and development of the products.  They have developed budgets, timings and milestones reflected in their business plan.  Helping sophisticated investors to see the vision of the company is expected, especially if the company wants the investor to share the vision.  Remember, investors are like partners and will be around for a long while.  An excited and motivated investor is more likely to assist in other ways to help the company progress; including investing more money.

Angels are not professional investors.  They need to be educated on the business just as the professional investor, but sometimes they need help with investment choices.   Take for example a PRIVATE PLACEMENT OF CONVERTIBLE PROMISSORY NOTES.  Typical terms on a convertible note include such things as: interest, discount, conversion definition, ties to future round of financing, and possibly liquidation preferences.  Even if the note does not have all these, the investor may be entitled to all the terms of the investor to follow the Angel round. 

One common place to use a convertible note is when the valuation is difficult to define and agree on; e.g., at startup.  The note allows the Angel to make an investment and gain the financial benefits associated with a future investment round by a professional investor that defines a company valuation.  The Angel would get all the benefits of negotiated by the future investor plus the benefit defined by discount and accrued interest.  For example, if the discount rate is 20% the Angel gets an additional 20% of the original investment in equity when the note converts to common stock.  An investment of $100K would be worth $120K of stock for example.  In addition, if interest were 6% for 2 years, the Angel would receive stock based on $120K plus around $12K for a total of around $138K at the time of conversion.

Liquidation preferences over the last several years have been as high as 3x the invested funds.  This is rather high and 1x is more likely these days.  A 1x liquidation preference would mean the Angel would receive their original money plus accruals returned to them on the sale of the company.  This happens before any of the common shareholders receive any funds.    Then they will participate in the distribution of remaining funds from the company sale.  The participation is proportional to the percentage of the company they own.  Assume the company is sold for $1.138M and the investor owns 10%.  First the investor receives the $138K for the preferences then 10% of the remaining $1M.  The net for the investor would be $238k for the 2 years.

The terms in financial offerings are not always clearly understandable.  In a few cases, it has taken extended explanations to help the investor understand the upside.  They also, may not understand the downside.  In many cases, there are no tangible assets in startup companies.  The downside is loss of all invested funds.

Terms and structures of financings vary.  Entrepreneurs having never raised capital will first have to learn what the financing vehicles are and then understand them.  They may have to help educate the Angel investors that are unfamiliar as well.  In short, “Angel Education is Sometimes Required” but this may also be the case for the Entrepreneur as well.