Are you thinking about investing in a startup company for the first time? If so, such topics as preferred stock, convertible notes, and dilution might sound like startup hocus pocus, but you’ll want to know what they’re all about.
In this post, I provide an introduction to several concepts that you should understand before entrusting your hard-earned cash to the founders of what might — or might not — be the next great thing. This post is a basic introduction to angel investing, which covers concepts common to most angel investments.
Startup investments are speculative and illiquid
True to my lawyerly training, I’ll start with the warnings: The first thing to know about investments in startup companies is that they are speculative. Many startup companies fail. This is true of those that gain early traction and successfully raise money from angel investors and venture capital firms, as well as those that don’t. When such enterprises fail, people who’ve invested in them can expect to lose much or all of their investments. So you probably don’t want to invest the kids’ college fund in startups.
Although angel investors can put themselves in a better position by conducting appropriate due diligence before investing, risk is in the very nature of early stage growth companies.
Even if a startup company doesn’t fail, investors might not see their money again for a very long time. Investors typically get money out of companies they invest in through dividends, sale of stock in a public offering, and sale of stock in the private sale of the company. High-growth startups (i.e., the type of companies that tend to attract investments) basically don’t pay dividends. That leaves stock sales as the most common avenue available for investors to see a return on their investments. Even in successful startups, sales of stock via IPOs and private company sales tend to take place only after a lengthy period of growth, and the investors’ money will be tied up in the interim. In the meantime, investors may not be permitted to sell their stock on their own — assuming they can find a willing purchaser.
A number of companies don’t really fail but they don’t really succeed either. This leaves investors’ money tied up indefinitely as the companies soldier on — not doing so badly to cause them to shut down, but not doing well enough to return money to their investors either.
Everyone who has built a business or put a business deal together knows that things generally take longer, are more expensive, and are more complicated than you would expect them to be. This is true of startup business plan execution, also. Even assumptions that seem to be conservative often turn out to be optimistic in retrospect.
High-growth startups are designed to be fed cash. The need for future cash is baked into the business plan of most of them. For example, if execution of a business plan would require $10 million before the company could be sustained by cash from operations, the founders might put in $100,000 of cash from savings, friends, and family; go to angel investors for the next significant infusion of cash; and rely on one or more rounds of venture capital investments to make it to profitability and to roll out the concept on a larger scale. At each round of financing, the investors don’t know whether the company will perform well enough to attract the next round of financing. If there’s a hiccup and the next round can’t be raised, it’s likely that the company will die, the next round of financing will seriously dilute the interests of current investors, or the company will turn into a zombie company that neither succeeds nor fails — nor returns cash to its investors.
For more background on startup fundraising, check out How Funding Rounds Differ: Seed, Series A, Series B, and C…. The post discusses typical financing rounds, what the money’s used for, and who invests in them.
Is common stock a good investment for angel investors?
Angel investors typically purchase common stock, preferred stock, or convertible notes (which are a bit of a hybrid of debt and preferred stock). The most important aspects of these investments are economic ownership in the company and control in the form of a vote, which allows an investor to protect his or her investment.
Common stock
In a typical corporation, each share of common stock has a right to one vote per director to elect the board of directors. Thus, holders of a majority of the shares of common stock control who sits on the board of directors, and thus who controls the company. In addition to voting for directors, common shareholders also have a right to vote on such things as amending the certificate of incorporation, proposed mergers, and the sale of the corporation’s business in the form of an asset sale. Again, holders of a majority (or in some cases supermajority) of common stock have the final say on whether changes in corporation’s governing documents and significant transactions can take place. (The company’s issuance of preferred stock or granting contractual rights, discussed below, can affect common stockholders’ rights.)
Shareholders also have access rights to certain company information such as stockholder records and other corporate books and records.
Founders usually hold common stock, which gives investors in common stock the protection of owning the same type of stock that the founders own. However, angels usually purchase a minority interest in the corporations they invest in, which means that even though they hold voting stock they can’t vote anyone onto the board of directors, and they usually can’t block mergers, asset sales, or changes to the certificate of incorporation. Thus, once they’ve invested their money, common stock investors won’t have much, if any, say in the success or failure of the company. However, as discussed below, holders of common stock can negotiate such protections through contractual rights.
The other major aspect of common stock is economic: all shares of common stock typically participate equally in any dividends that are paid and in liquidation proceeds after creditors and preferred shareholders have been paid upon liquidation of the company.
Preferred stock
Preferred stock has certain protective features that common stock doesn’t have. Here are some typical features:
Liquidation preference. If the corporation liquidates, the preferred shareholders are in line before the common stockholders, but after the corporation’s creditors. A liquidation preference is downside protection in case things don’t go well.
Conversion option. Holders of preferred shares typically have the right to convert their shares to common stock under certain circumstances. This allows them to enjoy the upside if things go well.
Antidilution protection. Preferred shares typically have antidilution protection which kicks in when the corporation issues shares below the price that the purchaser of preferred stock paid. This is protection against dilution of the preferred shareholder’s ownership interest in a later round of financing or other issuance of stock. Again, this is downside protection.
Blocking rights. Preferred shares often have rights to block major activities, such as selling the company, raising additional money, and increasing the number of stock options available to the company’s management.
Other rights. Investors in preferred stock sometimes receive rights to have a person on the board of directors, rights to more detailed information about the company on an on-going basis, and a right to participate in future rounds to protect their ownership percentage.
It’s important to note that, although the protections that are typical of preferred stock aren’t built into shares of common stock, common-stock investors can obtain some of the protections via a voting agreement or other contractual document. Angel investors should also understand that startups are wary of giving blocking rights and board seats to inexperienced angel investors.
When things go well, each round of financing fuels company growth such that the company is worth more each time it sells equity to new investors. Thus, although the early investors’ percentage ownership in the company decreases over time, the investors have a smaller slice of a larger pie and the value of their investment grows. In this scenario, many of the protections of preferred stock often aren’t necessary.
When things go poorly, however, preferred stock protections can be valuable. Antidilution features protect against dilution if the startup has to price a round of financing relatively low due to company struggles or a downturn in the economy. Joe Wallin’s Startup Law Blog post How Dilution Works is a good introduction to how dilution works. Liquidation preferences make it more likely that investors will get some of their money back if the company fails completely or has to be sold at a loss, since holders of preferred stock are ahead of holders of common stock when a company liquidates.
Convertible note
A convertible note is a promissory note that can be converted into common or preferred stock at the option of the noteholder or upon certain triggering events, such as a later financing round or meeting of developmental milestones. There are a number of potential features of convertible notes. The various features and their pros and cons are discussed in detail in this three-part article about convertible notes.
A note about authorized and issued shares
A corporation’s certificate of incorporation provides how many authorized shares — both common and preferred — the corporation can issue. A corporation can issue shares up to the number authorized. Issuance of additional shares requires an amendment to the certificate of incorporation. Thus, if a corporation has 10 million authorized shares of common stock and 1 million authorized shares of preferred stock, it can issue 10 million shares of common and 1 million shares of preferred before having to amend the certificate of incorporation to increase the number of authorized shares. If when you invest, 1 million shares of common stock have already been issued, that leaves another 9 million shares available for issuance to you, later investors, and management via stock options.
The specific features of preferred shares are generally not initially contained in the certificate of incorporation. Those features are set forth in a certificate of designations, which becomes part of the certificate of incorporation by amending the certificate when shares of a series of preferred stock are first sold.
Which type of security should an angel investor invest in?
There’s no set answer to which type of security is best for angel investors. Each situation is different, so the type of security that is appropriate in one situation might be different than the type that is appropriate in another. However, here are some things to consider:
Negotiating leverage is important
As in most transactions, the relative negotiating leverage between the investor and the startup is important. If the startup has several financing options and plenty of runway before it needs the capital, the startup will be less likely to agree to additional investor protections. The converse is true, also.
Later investors tend to receive more protection
As the company matures, the valuation tends to increase, the amount of money raised in each successive round of financing tends to increase, and the sophistication of the investors tends to increase. Thus, investor-protective features are more common in later rounds of financing than in earlier rounds. Formal angel groups, super angels, and venture capitalists all tend to invest in preferred stock, and the preferred stock issued in later rounds tends to have more investor protections than early-round preferred stock.
Early rounds set the floor for later rounds
Whatever concessions a startup gives to investors in a round of financing will be the starting point for negotiations with later investors.
Complexity costs money in legal and advisor fees
The simpler the investment, the more quickly it can be concluded and the lower the professional fees. Although it’s important to push for appropriate protections in light of such factors as how early in the process you’re investing, how much money you’re investing, and the relative valuation you’re being given, the transaction costs of purchasing preferred stock (for both the investor and the startup) tend to be higher than the transaction costs of purchasing common stock. And the transaction costs of purchasing preferred stock with a lot of investor protections tend to be higher than the transaction costs of purchasing simpler preferred stock.
Due diligence
Almost every investor will perform due diligence on the company he or she is investing in before closing the investment. The extent of due diligence that is appropriate depends on a number of factors, but the single over-arching consideration is that the due diligence you conduct must be sufficient to give you reasonable comfort to invest in the company given the nature of the business opportunity, the amount of money you’re investing, and how important that money is to you. That said, here are a few considerations:
- The earlier the stage of the investment, the less due diligence there will be. This is partly due to the fact that early-stage companies don’t have much operating history or complexity, as well as the fact that you’re probably investing more in the idea and the management team than in past performance.
- Negotiating leverage is important. If the startup has a number of potential investors eager to invest, it’ll be less willing to undergo a protracted due diligence ordeal. On the other hand, if it desperately needs your money, it’ll be more willing to let you look under the hood.
- The more committed you are to making the investment, the more receptive the startup will be to providing information to you. Startup founders tend to be wary of giving tire kickers access to the inner workings of the company.
Some of the areas to investigate in the due diligence process include:
- The company’s corporate documents (articles, bylaws, list of shareholders);
- Capitalization table;
- Authorized and outstanding securities;
- Business plan and presentation slides;
- Market and customer attributes;
- Analysis of the competition;
- Financial projections and financial statements;
- Tax returns;
- Cash on hand and monthly burn rate;
- Intellectual property and protection (e.g., patents and trademarks);
- Material contracts;
- Use of the proceeds of the offering;
- Reference and background checks of the members of the management team; and
- Information about employees and employee benefits.
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