Most investors have a little gambler in them. Angel investing and gambling both involve risk. But for most, gambling is an occasional short-lived activity, while angel investing triggers an involvement that may last years and bring investors’ great rewards.
The following are three deal terms that help an angel investor protect their position and optimize your return.
Protect Your First in Line Position
As an early-stage investor, you want to protect your share of the venture. There are just 3 types of equity you can invest in; Common, Preferred, and Participating Preferred. Whenever possible, you want to ensure that you are first in line when a company issues distributions.
Investing in a deal with Participating Preferred equity typically guarantees that you will get your investment back first, and then participate ratably in the rest. The term sheet that I most commonly work with is a participating preferred term sheet offering investors a 100% (1X) return on their investment, followed by a pro-rata share of the remaining distributions. Additionally, a preferred equity deal often offers the 1X only upon the liquidation (winding up) of the company, followed by a percentage of any remaining funds. Common stock is— well common, with no pre-emptive rights in distributions.
I see many term sheets that offer what I refer to as non-participating preferred equity – you get your 1X (or sometimes 2X) return but don’t share in any excess unless you waive your preferred position and just take a pro-rata share of the distribution. This protects the downside if the company fails, and there is a sale of assets, but if the company is successful and reaches a positive liquidity event, you lose your preferred position.
Protect You Position in Future Rounds.
As an angel investor who is taking on higher risk, you want to make sure future financing deals contain terms that do not unduly dilute your investment value or lead to someone moving into a superior liquidity position. If I am to lead the investment round on behalf of an angel group, I want to lead the follow-on round as well so that we can protect as much of the position as possible. A strong term sheet will pave the way for these kinds of protections.
Let’s take a look at a simple example; if the company is successful in growing and getting its products to market, a follow-on round will almost always dilute your percentage holdings in the company, but the new investors are likely paying more per share of stock than you did and they are buying in at a higher company valuation than you did. If you invested at $1.00 per share at a $2m valuation and the next round of investors are paying $2 per share at a $4m valuation, your position is exceptional – your shares have doubled in value! You now have the right to “double down” by investing in the new round if you want to preserve your percentage holding in the company, so long as the term sheet includes pre-emptive rights.
Protect Your Right to a Return.
As an investor, you want to maximize the chances to get a return on your investment in all possible exit scenarios. Not all your investments will be home runs, and not all will outright fail. Some of your investments may turn out to be great lifestyle businesses – great for the founders and the management team – but marginal at best for the investors.
This is where the astute term sheet negotiator shines! By adding a “Put Right” in the term sheet, it protects the right, typically after 5 years, to force the company to buy back the equity at the current value if they have not returned the original 1X investment. Additionally, investing in a company that becomes a strong lifestyle business can be a great investment if it is passing profits to investors via distributions.
Even experienced investors find there is a lot to learn when they become angel investors. Angel investment groups can fill gaps in knowledge and experience. Most, like Keiretsu Forum, a national network of accredited investors, are well structured and offer high caliber peer networking—and in the case of Keiretsu Forum Mid-Atlantic and South-East there is an investor academy. Most angel investors who join a group find they can better understand their risk, navigate complex term sheets and protect their position with less stress and a better use of time.
Author: Howard Lubert, Founder Keiretsu Forum Mid-Atlantic, South-East, and Accelerator Venture Partners Fund
In his career working with early-stage companies, Howard estimates that he has seen over 10,000 pitches across every business silo. His experience working as a Fund Manager and as a private angel investor gives him an exceptional vantage when assessing new deals.For additional information, go to www.KeiretsuForum.net or email info@keiretsuforum.net.
Learn more: Five Deal Mistakes Angel Investors Must Avoid to Stay in the Driver’s Seat
