What Instrument Do Angel Investors Use to Invest?

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.

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Create Term Sheets
for Convertible Note and
Preferred Stock Transactions

Tech startups generally start with a single class of Common Stock.  You may hear Common Stock referred to as Restricted Stock, which means that the Common Stock has certain restrictions on transfer, usually surrounding vesting, or Founder Stock, which simply means the recipients of the Common Stock are founders (although there is an uncommonly used form of Preferred Stock designed for founders that may also be referred to as Founder Stock).

When the startup gets further along and raises money from venture capitalists, it implements Preferred Stock.  The VCs negotiate the terms of the Preferred Stock and inspect the company to ensure it’s generally in good condition and can offer desired tax treatment on the deal and moving forward.

Angel investors often look to proceed on the VC path.  This means using Preferred Stock as the investment instrument.   However, structuring an angel round as a Preferred Stock deal is uncommon, because of the costs of doing such a deal.  The negotiation of the terms of the deal, inspection of the company’s affairs, and “clean-up” of any necessary issues involves transaction expenses that typically make this deal structure unappealing for deals under $1 million.  As such, angel investment deals generally use instruments that entail conversion into Preferred Stock.

The common instrument that provides investors with the ability to convert to Preferred Stock, while keeping the present investment transaction simple enough to avoid being cost-prohibitive, is the Convertible Note.  Convertible notes are simple loan documents (i.e., promissory notes) that have a right to convert the loan amount into Preferred Stock under various circumstances.  The primary right is triggered if there is a financing.  The conversion right then typically provides a discounted purchase price.  There is also usually a conversion right triggered by a sale of the company prior to a financing or maturity of the loan, and sometimes an optional conversion right in lieu of loan repayment upon maturity.

Using convertible notes for seed investments allows early investors to participate in the VC track at transaction costs commensurate with the early investment round.