Let’s talk about debt and equity, the two types of structures your angel investments will take. You’ll get more out of this series if you’ve read part 1 on the high-level angel investing guidelines that matter most.
There are two main ways in which startup funding is structured: debt and equity. But even though these are different mechanisms, they’re ultimately both equity investments. Everyone invests because they hope to get equity in a later round, not because they think they’re going to get paid back or make money on interest.
The two most common forms of debt investments are convertible notes and SAFEs (which stands for “Simple Agreement for Future Equity”). They are essentially the same thing, except that a SAFE is usually simpler and more geared towards founders’ benefits compared to investors’. If we’re going to get technical, a convertible note is a loan that converts into equity if a certain milestone (or “trigger”) is met, whereas a SAFE is a right to buy stock in a future equity round.
In a convertible note investment deal, the investor makes a loan to the company (the debt), and that loan converts into equity at some point in the future, with an extra bonus to the investor for taking on the higher risk of backing the early-stage startup. That trigger is typically a financing round where the value of the company is higher than a certain amount. Usually that bonus is getting equity for cheaper than the later investors get it. Convertible notes also generate interest, which is paid back to the investor in the form of equity when the note converts.
Accomplice has a template for a simple convertible note here.
The law firm Cooley has document generators for term sheets and other common startup documents here.
Because debt investments avoid deciding this question of the company’s valuation, they’re simpler, faster, cheaper, and easier to do (about 1/10 as expensive as equity rounds). There are fewer requirements, which means shorter documents, fewer terms to negotiate, not as many lawyer hours to bill, and thus more savings.
Trying to figure out what a very young company is worth is a guessing game. It’s more art than science. You’d have to price intangibles, like how smart and motivated the founders are, or how long you think it’ll take them to build a product. When you do a debt investment, you’re kicking the problem of valuation down the road to whenever an equity round happens. At that point, the company will have to set a valuation, whether through negotiating with the new investors, getting a 409A valuation done (which is expensive for a small startup), or a combination of both.
Instead, caps end up where they “feel right,” using comparisons to other businesses and rounds raised. But it’s important to note that even though it’s technically true that using debt instead of equity lets everyone delay having to determine the value of the company, caps act so much like valuations that they end up having basically the same impact.
In an equity round, also called a priced round, the company offers and sells newly-created stock at an agreed-upon per share price. Investors get stock, or equity, in the company, which gives them an ownership stake. Generally there are two classes of stock: common and preferred. Common stock is the most basic unit of equity ownership, belonging first to the founders and then to the employees. Holders of preferred stock tend to be angels and VCs. The preferred stockholders get additional rights tied to them, including getting paid back first if there’s an exit, board seats (usually for bigger/institutional investors), receiving regular reports on how the company is doing, and getting the right to invest in future rounds.
In an equity round, you’ll have a pre-money and a post-money valuation. Here’s a simple example of what these terms mean. Let’s say the company is raising a $5M round on a $10M pre-money valuation. The post-money is just the pre-money plus the amount raised. In this case, the post-money valuation is $15M ($5M round + $10M pre-money valuation). Investors calculate their ownership out of the post-money valuation. For example, if you’re an angel with $50k in the company discussed above, you’ll own 0.33% of the company after the $15M raise. Before the raise, you owned 0.50%. The addition of the new funding diluted you a few percentage points.
Key terms in notes, SAFEs, and term sheets
Convertible notes and SAFES may look like dry legal documents, but only a few terms truly matter. Also keep in mind that as an angel who likely won’t be putting in the largest check in any round, you will be following onto an existing note or term sheet and not setting the terms yourself. Typically the largest investor in a round is called the “lead.” This party negotiates the terms with the founders, and once they’re set, other investors will join the round at the existing terms.
Think of the valuation cap as the closest thing to setting a value for the company. If you set a cap of $x, you’re telling the startup that if they raise a future equity round where they’re valuing the company at more than $x, your investment will convert as though $x is the value. Setting a cap aligns your interests as an angel with the interests of the founders in raising a big future round. Why? Because otherwise, a high valuation in the next round means that the angel gets a smaller percentage ownership in the company. If you’re investing $20k in a company that’s worth $1M, you’d have 2%. If you’re investing $20k in a company that’s worth $4M, you’d have 0.5%.
Without a valuation cap, angels might want to discourage the founder from getting a big future value for her company, because it makes their ownership percentage worth less. Setting a cap means that the angels’ investment converts to equity at the cap, not at the higher valuation. To continue our example, if you’re investing $20k in a company with a $1M cap, and they go on to raise an equity round at a $4M valuation, you’d get 2% of the company instead of 0.5%.
You may see an uncapped note in extremely competitive deals. If the founders can pick and choose to take money from many investors, you’ll have to withstand the uncertainty and dilution that will come with a later round if you want to be involved. A tiny piece of a really valuable company is better than no piece at all, but given the risk prevalent in any early investment opportunity, it’s generally understood that uncapped notes are a bad situation for angels.
Lets the existing note holder (so you, if you’re the angel) buy the newly valued stock at a discount from the stock price that the new investors established, thus getting more shares for the money. The discount rewards you for investing in the company very early, before many of the signs of success were there.
For example, let’s say you’re an angel and you put in $20k on a convertible note during the seed round, and then the company later raises a Series A from a VC. They price the company at $1 per share. You get a 20% discount on the terms of the convertible note. That means that you’re only paying $0.80 per share, giving you 25k shares for your $20k investment, as opposed to the 20k that you would have gotten if you paid the same price as the Series A investors.
If the convertible note includes both a discount and a cap, you’ll usually take whichever gives you the better deal (the cheaper stock).
This is the right to maintain your ownership percentage in the company in future rounds. For example, if you own 2% of the company after a seed round, and the company raises a Series A at a $10M valuation, you have the right to invest more money to maintain your 2%. In this case, 2% of $10M is $200k. Having pro rata rights is great because it gives you the option to resist being diluted in companies that are showing signs of being successful. However, the more successful the company gets and the higher its valuation, the more you’ll have to pay to maintain that ownership percentage. For a small angel, it gets too expensive quickly.