Investment Structures for Angel Investing

Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies and investors. The information on this page should not be construed as legal advice.

 

Early investments in tech startups are influenced by the convention of investments that might happen down the line.  Those later investments (i.e., VC rounds) occur through the sale of preferred stock.  VCs generally exercise a high level of process in their investments to assess whether the company is in good order, whether the investment optimizes tax treatment, and other issues that can impact the value of the investment.  Angel investments defer to these later potential rounds for two reasons: (1) they can reduce the costs of the present transaction by deferring some of the process and negotiation to a later stage when VCs are involved; and (2) engaging in an investment that ignores the structure and process of later investments could significantly reduce the appeal of the later investments, which would not benefit anyone involved.

Deferring to the later round means that angel investors use an instrument that will lead to them acquiring preferred stock (more common for deals < $1 million) or they simply buy preferred stock in the early investment (less common for deals < $1 million).  The instruments that lead to angel investors acquiring preferred stock are:

A. Convertible Notes

Convertible notes are loans that have a contractual conversion mechanism that is triggered by a future investment (i.e., the VC round).  Upon such a conversion, the principal amount of the note plus any accrued and unpaid interest is converted to the securities sold in that round, at a predefined discounted price.  The note typically has a conversion option in the event of the sale of the company or the loan becoming due, if either of those things happens prior to the conversion triggered by the financing.

Convertible notes are relatively easy to execute, since there are no changes to the capital structure of the company, and since investor rights and other contractual issues are deferred to the later investment.

[More on using convertible notes for angel investments]

B. Convertible Securities

Convertible securities (or convertible equity) are similar to convertible notes, except that the amount provided to the company is not categorized (at least by design of the instrument) as debt. Presently, these are mostly only used by accelerators

For a variety of reasons, angel investors may want to invest with preferred stock over one of the instruments noted above.  Because there are more contracts to negotiate and execute, and more process to exercise, the use of preferred stock is more expensive than using convertible notes.  As such, convertible notes tend to be the more popular instrument for deals under $1 million.  If, however, preferred stock is used for smaller deals, a more simplified version of preferred stock financing documents, such as the Series Seed or AA documents may be used.  These documents omit some of the components of preferred stock financing documents that have less relevance at the early stage and defer some components to later preferred stock financings.

Related Articles: Convertible Notes vs Preferred Stock Investment Rights in Convertible Note Deals  Convertible Note Term Sheet  Preferred Stock Term Sheet  Startup Investments