Angel Investors are a special breed. They take on the riskiest investments at a stage that VCs will not engage. That’s why they call them angels. For a struggling entrepreneur they are heaven sent. They are usually experienced entrepreneurs that have built and sold several companies. They love to help start companies, solve the tough problems, build a great team, and be actively involved in finding customers, partners, and key employees. They tend to invest in companies that are within a one hour drive so that they can be actively involved and leverage their network of friends and business associates. They commit significant personal time to building these companies, usually with no compensation. If they can't commit their time and be actively involved in the major decisions of the company, they will probably not invest.
Angels tend to invest just like VCs except they do smaller investments $200K to $2M and they do about 15 times as many deals as VCs. Angels will be easier to convince than VCs if they know your business well, but harder than VCs if they don’t have experience in your area. Angels have the same investment criteria and expectations of significant returns that VCs do. The "average" angel group makes 8 investments per year for a total of about $2M. The average deal size (seed stage) is about $250K.
Angels are compassionate and have a soft spot for budding entrepreneurs, but they are not stupid. They have discipline. They invest in what they know, where they can apply their experience, and in deals where their money can have impact. They don't tend to invest as part of a larger round with VCs, or in areas where they have no expertise. They will pass on good deals where they can't add value or have significant impact.
Boston has around 20 Angel Capital groups. Some of the larger groups are; Beacon Angels, Boston Harbor Angels, Common Angels, eCoast Angels, Hub Angels, and Launchpad. See the Angel Capital Association site for leads to angel groups in other parts of the United States.
Convertible Notes – Some Angel investors will use Convertible Notes to fund seed stage companies. Personally, I am not a fan of convertible notes for reasons I will explain later. First, lets explore why convertible notes might make sense.
Valuation – Early stage companies are hard to value. How do you place a value on a couple people, some ideas, and a business plan? Rather than haggle endlessly about the valuation, Angels will sometimes invest now and agree to convert their note at the price set by the Series A investors. The theory is that at Series A, more will be known about the business, market, competition, technology, and it will be easier for the founders and investors to agree on a valuation.
Terms – Convertible Notes usually have pretty simple terms. Interest rates are usually around 10%. The interest isn’t actually paid…it is rolled into the conversion to preferred stock at Series A. Warrants to purchase additional shares are common, usually 20%, but sometimes more based on how long it takes to raise the first round. The notes are usually secured by all assets and IP of the company.
Cost – Convertible Notes can be put together quickly by a lawyer for a small fee. Series A docs are complicated, expensive, and time consuming. If you are only raising $100K of seed money it doesn’t make sense to spend $25K to $50K on lawyer fees for Series A docs.
OK, sounds great. So why aren’t convertible notes good for Angel investors? Well, when everything goes according to plan…they are fine. The problems come when it takes much longer to raise the Series A, or you never raise a Series A. Let’s explore some potential issues, and possible solutions.
Let’s say an Angel invests with the expectation that there will be a Series A within 4 to 6 months at a valuation somewhere around $2M. What happens if a year or more passes before the Series A investment, the company is doing great, and the valuation goes to $6M? The Angel took all the risk, helped build the company up, waited a year or more, and then gets none of the benefit of helping to build the company valuation to $6M. By helping to build the company they are actually working against themselves in terms of valuation. What happens if the company gets acquired for $10M or more before they ever get to a Series A? Again, the investor loses out on all that value creation.
What happens if the company never raises a Series A? That could happen for several reasons; they fail and go out of business, they become cash flow positive and never need to raise money, or they get acquired. The terms of the Note should cover all these scenarios.
Conversion Values – The investor problems with Convertible Notes can be solved by having specific conversion values for each of the scenarios described above. For example, the note should say something like;
- If Series A is raised within 6 months the notes convert at the same price as Series A investors.
- If Series A takes longer than 6 months the notes convert at a valuation of $2M, regardless of the Series A valuation
- If an acquisition happens within 6 months, and prior to Series A, the notes convert at the lesser of; $4M or the acquisition valuation.
The conversion trigger dates and values should be adjusted to reflect the situation of the company. The point is to allow the Angel investor to participate in the upside value creation in exchange for taking the early risk and helping to build the company.
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