Protecting Your Principal in Angel-Scale Investments
Ater Wynne LLP
I. HOMILIES, aka THE WISDOM OF THE AGES
A. The best way to protect your downside is to insure your upside.
1. Do your diligence.
2. Know the management.
3. Know the market, and the customers.
4. Keep some powder dry so you can help rescue the company if things don't go perfectly.
5. Add your talents as well as your cash, whenever you can, without taking over management: your networks are more powerful than you think. Especially, help the company SELL.
6. Don't protect your investment so hard it ties the company from doing what it needs to do to have a shot at making you wealthy.
B. It's not a zero sum game.
1. The goal is to create wealth. If you don't create wealth, you are going to lose it all.
2. You will rely on management and founders to create the wealth: treat them with respect; help them, and remember they want to get rich too. Treat them like partners you WANT to succeed, and they will do the same for you.
3. The company's biggest asset is management's and the founders' energy. ADD to it, and reinforce it. ("The only difference between a bankrupt turnaround and apure startup is the energy and belief of those involved.")
C. The perfect is the enemy of the good - and often the enemy of the possible.
1. Your ultimate protection comes from the company's success. Don't be foolish about what you sign, but don't treat a $25k investment as if it requires more lawyering than when you bought your $500k house, either. It's a waste of the resources you've just put into the company, and it's a waste of your own money.
2. You can make a rocketship safe against virtually any sort of crash. Of course, you will have made it so heavy that it will never reach orbit if you do. Get reasonable protection, and then put your energy into making the company a success.
II. WHAT TO LOOK FOR IN PREFERRED STOCK
When you buy stock, you typically pay in cash equal in proportionate value to the agreed-upon value of the "idea" that is the company. You don't want the founders to turn around the next day and have a new idea: to distribute out your cash pro-rata according to shareholdings, and shut the company down! Angel preferred stock is designed to protect you against that, and still allow you to get the benefit of the success of,the (original) idea, if it happens. It contains a balancing of a number of other things too. Here's what to look for:
A. Conversion privilege. If this company goes public, it's common stock that will trade. Preferred stock is typically defined so that it is convertible one to one into common stock. Conversion should happen:
1. On your election. You should always be able to choose this.
2. When a majority in interest of investors agree: you don't want one recalcitrant shareholder to be able to hold up conversion if it's otherwise agreed to by a majority. Sometimes this can be a supermajority, but it should not be unanimity.
3. When the Company goes public at levels that mean you are doing fine. Typically for angel stock that's a return of 5X your original investment, with a minimumraise large enough to give the company some running room.
B. Liquidation Preference. A liquidation preference means if the company is liquidated or sold, you get this amount before the common shareholders get anything. It should have these attributes:
1. Available whenever the company is liquidated.
2. Available whenever the company is sold in a change-of-control transaction.
3. Paid before common gets anything.
4. Variants:
a. Amount of preference: Currently 2X to 4X your original investment is usual; five years ago it was 1 X, this is a question of the market.
b. Priority: Typically paid before common gets anything. On follow-on rounds, you want to see the next investor agree to pay out your preference pro rata with his, but sometimes that's not achievable. Sometimes you see a mixed preference. MINIMUM should be that you get your money back out before the common get anything.
C. Participation rights: Once the preference is paid, if the preferred is "participating" you get to then share in proceeds as if you had converted. If it is "nonparticipating", you don't.
1. High liquidation preferences: If you have a high liquidation preference, expect no participation rights: to get more proceeds than a 4X your money back liquidation preference, you'd need to convert to common.
2. Low liquidation preferences: The closer you get to no liquidation preference, the more likely you get participation rights.
3. Capped participation: Not unusual to see preferred structured to say: "You get 1 X (or 2X) your money back, then you get to participate with common as if converted until you have a total of 3X (or 4X) your money back, then that's it." In this kind of arrangement, called "Convertible preferred stock with a (1 X) liquidation preference and a (3X) participation cap", you would watch to see what the common gets, and if you are better off converting before the distribution, you would convert. Best is when the conversion is automatic for you.
4. Other complicated variants can arise.
D. Antidilution protection: Typical to see weighted-average antidilution protection, as well as universal to see protection from stock splits of the common and recapitalizations.
1. How antidilution protection works: If the company later sells stock for less than you paid for it, the ratio at which your stock converts to common stock gets adjusted to compensate . The formula says: Figure out what the company's market cap is, at the price you paid, before the new offering. Then add in the new dollars raised to that total. Then divide that new value by all of the shares outstanding after the new offering (but before your conver-sion ratios are adjusted.) The result is a price per share. Your conversion ratios will be adjusted so that you get that effective price per share.
2. What's excluded: It's typical to exclude issuances from a stock option pool that your class of stock has approved, or that a director you've elected has approved. It's typical to exclude issuances on exercise of options and warrants that have already been taken into account. It's typical to exclude certain financing warrants that leasing companies have started to demand for lease lines.
E. Voting provisions: IF the "angel preferred" has a substantial portion of the company (say, more than 20%) it's common that the preferred gets to elect a board member. Sometimes these are in a separate "voting" or "shareholders' rights" agreement.
F. Protective Provisions: Typical to see things the company can't do without the consent of your class of stock, written into the articles of incorporation. Venture pre-ferred stock typically has a longer list, but for angel preferred, the list is typically pretty basic:
1. Amend the articles of incorporation;
2. Increase the number of shares of Series A Stock;
3. Issue any class of preferred with superior or equal liquidation rights;
4. If your class of stock is entitled to a board member, change the number of folks on the board.
5. Liquidate or sell the Company.
III.TAX ISSUES
A. Downside Protection: Section 1244 Stock. IRC Section 1244 basically allows you to treat a total loss of your investment in a company as ordinary loss, in the year realized. That's handy, because half your angel investments are likely to turn out that way. But there are limits: you need to have invested your dollars as part of the first $1 million invested. Look for a representation that you have done that. Basically this provision lets you use pre-tax dollars for your loss investments.
B. Upside Benefit: Section 1202 Stock. IRC Section 1202 says: if you buy original issue stock in a small business, and you hold it for five years before you sell it, you only pay capital gains tax at half the normal rate. That's a nice bonus, but it has to be original issue stock - and there are provisions that look forward and back to see if the company buys back someone else's stock around the same time as it sells you yours. Those provisions are designed to keep us from gaming the system by, say, buying a founder's stock, but doing it by having the founder sell it back to the company and then we buy stock from the company. It's nice to get representations that, at the time the stock is sold to you, it qualifies as Section 1202 stock. You can't realistically expect the company to promise it will never lose that designation for you, because there are legitimate reasons why it might buy back founders' stock within the test window.
IV. LIQUIDITY
Your investment is useless to you unless you can someday sell it. Here's a few ways that's mediated:
A. Registration Rights. With a few exceptions, you can't sell your stock to the general public unless it is registered with the SEC. It's also usually 1 that your stock is worth much more if it is publicly traded: the existence of a market for it means someone else is less afraid to buy it. The rights you have to insure your stock will be registered are called "registration rights." They come in these fla-vors. For Angel Preferred Stock, you should look for at least Piggyback and S-3 rights, and if the offering is big enough, also demand rights:
1. Demand rights. A demand right typically says to the company: "Anytime after X years from now, we can tell you to register our stock, and you have to do it. We have to be prepared to offer a minimum number of shares, but you can't say no." It's unusual to see strong demand rights in angel preferred stock, but for larger angel offerings, you do see them. IT IS EXTREMELY RARE TO HAVE A COMPANY FORCED TO GO PUBLIC THROUGH EXERCISE OF A DEMAND RIGHT. However, it's not so rare to see a demand right exercised after a company IS public.
2. Piggyback rights. A piggyback right basically says to the company: "Anytime you are registering your own stock, or anyone else's stock, we get to piggyback on the offering and you have to register ours too. " Piggyback rights are common in Angel Preferred Stock, and are com-monly used.
3. S-3 Rights. "Form S-3" is the name of an SEC registration form, and it's used in a short-form and inexpensive registration process available to companies that are already publicly traded. One or two S-3 registration rights a year, for some minimum number of shares each time, is a common right; it's like a mini-demand right. Note that if the company does an S-3 offering, it may trigger piggyback rights also.
B. Redemption Rights. Sometimes companies decide they'd just as soon stay private, or even if they'd like to go public, find themselves topped out at a reasonable little business that has no expectation of being able to do so. Then your investment can get stranded. Sometimes you see investors put in a right to force the company to redeem their shares after a certain number of years, but it's rare - primarily because it can get in the way of the company's ability to attract other new capital.
V. BRIDGE NOTES
Sometimes companies want to do a venture capital financing round, but need smaller amounts of cash to tide them over until they can find an investor. Often in these situations, they go find investors to do a "bridge round". A "bridge" is a loan designed to enable the company to survive and thrive until it is able to complete a venture round. The loan is designed to convert into equity at the time of the next round.
A. Advantages of a Bridge. For the investor, a well-designed bridge will allow you to take advantage of a professional venture capitalist's ability to value the company and define market terms for an investment which you can then participate in. And, a properly designed bridge will give you some advantage in value over that venture capitalist, since you took earlier risk.
B. Dangers of a Bridge.
1. There isn't always a venture capitalist who shows up. That turns the bridge into a pier. A pier is a bridge to nowhere.
2. The venture capitalist who shows up sometimes doesn't like the terms of your investment. You can find yourself squeezed out. When offered the opportunity to take a fraction of your invesment, or nothing, you can find yourself without much alternative.
3. Don't fool yourself into thinking that your promissory note in a bridge means you are taking less than equity risk. You are. You just don't know the price yet.
C. What to look for in a bridge.
1. Conversion Rights Defined. Your conversion rights should be into the next substantial equity round that brings in substantial new money. You don't want the company to be able to sell a small round and force your conversion; you want the professional, large investor you bargained for.
2. On sale/after due date conversion rights. You are taking equity risk. If the company decides it never needs to sell more equity, you want equity upside, not just a return of your money with interest. So you should have an optional conversion feature which you are allowed to exercise if the company sells, or after a certain date, at a price that seems reasonable to you.
3. Majority provisions. In general, you want the notes you sign to be amendable and convertible on vote of a majority of the notes of your class. If things change, you don't want one recalcitrant fellow angel to be able to hold up a change that, while unpleasant, is probably rational for everyone.
4. Risk Adjusted Benefit. You are taking (in theory) MORE risk per dollar invested than the venture capitalist who will ultimately price your stock. Look for some "kicker" to reflect this. Common kickers are: common stock warrants, often priced "at the next round", or preferential pricing "at the next round" -1.5 to one pricing, or 2:1 pricing. In general, warrants will be better received by the subsequent VC than preferential pricing. Sometimes this kicker is time-adjusted, so it grows as the wait for the next round extends, but that's a complexity that can get out of hand.
5. Reasonable Due Date. You are lending money, and there should be a point in time at which you get to declare what you have a "pier" and at which the company has to pay it back (unless you elect to convert.) In general, that time should be rationally related to the company's business plan, but long enough that you don't punish the company for not executing perfectly. Twice or three times the expected time to the next financing is common.