What to look for when making angel investments?
Here, I’ll try to share some of the things I had to learn the hard way so that for whoever wishes to enter into angel investor, there’s some work cut out for them.
Note: this is something I am still learning along the way so please do correct me if I got it wrong
Everybody has their own philosophy (or simply put, whatever makes them tick). Here I’m sharing some of mine:
- Investor base – I only invest in companies along with other high profile investors (which would allow the company to have great access for future business development if or when required)
- Winning formula – I invest in companies with a winning angle (either by a special algorithm, patent protection, lack of competition etc). User traction is important but is not the only factor
- Profitability – Having sheer user numbers is meaningless since a company could spend more money on performance marketing. A clear path to profitability is way more important (and how marketing turns into revenue)
- Valuation – I am ok with high valuation but it has to have some sort of support to it.
- Region – Most people invest in regions they are close to / understand well. I only invest in US startups but increasingly consider European and Asian ones (yet to do my first one)
- Management team – Some people insist of having the management team having successfully exited at least 1-2 startups. For me, I don’t have much of this restriction – as long as they aren’t straight off from college / business school.
The key here is to stick with the rules you set for yourself here. There would be occasions where you see investment opportunities which meets 4 or 5 out of 6 of the criteria, and you are really debating whether to break the rule just this once or not. (And don’t kid yourself, it happens more often than you think!). Rule of thumb is – never break / twist rules you set for yourself to meet one investment opportunity. Better ones will always present themselves further down the line.
There are a couple of terminologies used which you would frequently see: Capital raise, pre-money and post-money valuation.
- Capital raise: the total amount a company is raising in a particular fundraising round
- Pre-money valuation: the value (equity value) placed on a company before adding the capital being raised
- Post-money valuation: Pre-money + capital raise
You would constantly see a company quoting a pre-money valuation in any given round as a basis, simply because pre-money valuation would stay the same while you continue to build up the amount you are raising, and to prevent re-calculation / re-drafting of termsheets if you quote a post-money valuation.
Type of security
There are two ways one could invest in a startup – Straight equity or convertible note. From many perspectives there are lots of differences, which I’ll try to layout a few.
1. Convertible note: Essentially a company is issuing a debt to investors, with the upside of converting to equity shares upon a few pre-determined conditions. Typical financial terms to look for include
- Principal amount: The amount you are subscribing to in that particular convertible note
- Interest rate: An accrued interest payment, calculated from the date of signature of the convertible note until the conversion of the note into equity secuirities
- Equity cap: Different styles of convertible notes would call them slightly differently, but essentially this is the maximum pre-money valuation of your particular conversion, whereas the Series A priced round could be converting at the same time at a higher pre-money valuation. This matters particularly when you expect the Series A pre-money valuation is significantly ABOVE than the equity cap quoted here.
Discount rate: In case the Series A pre-money valuation is BELOW equity cap amount stated, then the pre-money valuation for the convertible note holder would be the pre-money stated by the Series A lead investor, less the discount rate stated here.
- Expiry date: If the company does not raise an equity round on or before the expiry date, the convertible note is automatically converted (unless with written consent from both ends to forfeit the conversion and company agrees to pay investors back in debt holdings)
2. Equity round: Much less terms to look for (Pre-money valuation, capital raise) etc, but there are much more non-financial terms to look for within an SPA (share purchase agreement), e.g. voting rights, board seats, right-of-first-refusal (ROFR), right-of-first-offer (ROFO), and any other terms to protect minority shareholders investing into the company. The SPA can be a handful to read, spanning some 60-80 pages of legal languages. There would also be preference shares terms, as well as a money cap (e.g. 2x / 3x invested capital)
A convertible note is very popular in US for multiple reasons
- Timing and legal issues: Drafting a convertible note purchase agreement is very fast, usually taking a few hours based on set templates. An SPA, however, could take days for the company attorney to draft, and another few days for investors to review and comment. If more than one investor(s) have edits on SPA, that could go on for much longer, and adding to due diligence period, an equity round takes months from termsheet to closing.
- Valuation: Placing a pre-money valuation at such early stage could be difficult. If too high then there isn’t enough risk-reward benefit for angel investors; too low then the founders risk selling too much at early stage. The convertible note is a “time buffer” which allows both parties to leave the valuation issue to the Series A lead investor, after proper due diligence and analysis.
- Equity cap gain: Usually when convertible note investors subscribe to the note, there is a good expectation of the company leading to a Series A equity round within a short period of time (6-12 months). There would also be an expectation that the equity cap amount is significantly low enough that, upon a Series A conversion, would allow the angel investors have a much lower pre-money valuation than the Series A investors. Effectively, their price per share is much lower
- Security: If an angel investor subscribes to an equity round pre-Series A, they get common shares. If a convertible note holder convert as Series A, all investors get Series A preference shares pari passu. There is downside protection to preference shareholders, and if upon a sale / IPO of the company that the asset is higher than the money cap, then all preference shareholders will elect to convert to common shares (i.e. upside is the same)
Usually a convertible note has a minimum commitment of $25k (although there are occasions where startups might accept smaller commitments). If you only have a few thousands to space, AngelList’s Invest Online function could be another option (although as I stated previously, I personally don’t prefer it)
Hopefully after the above, you’re equipped with the basics to understand how to do angel investments!
Posted on September 30, 2013, in Angel investments and tagged angel investments, Angel investor, Convertible bond, Investment, Post-money valuation, pre-money valuation, Right of first refusal, Series A round, valuation. Bookmark the permalink. 9 Comments.