Since angel investors have no legal right to be repaid the way a lender does, their only path to repayment is through the success of the company. It is only natural that they would want to have an advisory role, a voice on critical decisions, and some protection against a Founder taking an action that could damage the company.
There are three ways an angel investor can achieve this—that protects their investment as the funded company moves forward. They can take board seats, require information rights and utilize founder restrictions.
An investment package should protect against founder behavior that could be damaging to the company. Significant investments may call for an investor Board seat combined with governance provisions requiring board or committee approval for a list of important operational activities (or even in some cases reserving a veto right for the investor board member).
An investor board seat is usually not term limited. However, as more investors come in, the Board is expanded. Overtime, early directors may leave or drop down to become advisors. For early investors, it is important to take a seat during this nascent period when the company experiences the most risk with their particular funding.
If the investment level does not warrant an investor Board seat, it is essential to require that the company regularly share investors’ information on the company’s financial and business condition. Although some CEOs will voluntarily update investors as frequently as once a month, most information rights clauses merely obligate the company to provide quarterly management reports with some financial or management dashboard data.
To address the risks associated with relying on a small number of key founders to make the company successful, investors may insist on important founder-related provisions.
The first provision addresses the risk that a key founder will walk out leaving a gap in the team and potentially its know-how, as well as take stock which will dilute the investor’s position. To prevent this, investors typically insist on what is called “founder vesting”. These clauses impose a right on the part of the company to buy back some portion of the founder’s stock.
“Founder vesting” creates a strong financial incentive to remain with the company and avoids a situation where a disgruntled former executive controls a large voting block. The clause typically phases out over time. so that more and more of the stock returns to being unrestricted each quarter or year.
As a universal practice, investors will forbid departed employees from using the company’s confidential information for any purpose or hire away any employees for a period following their departure. In jurisdictions where it is allowed, investors will often also require that founders to sign non-compete agreements.
Whether or not advisory terms in a term sheet represent a fair compromise is a function of the market and the investing dynamics around a particular company at a particular time. 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 investors who join a group find they can better navigate complex term sheets and protect their position with less stress and a better use of time.
Read more: Five Deal Mistakes Angel Investors Must Avoid to Stay in the Driver’s Seat
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.
