I received the following question earlier this week. It’s conveniently timed, as I recently participated in two angel investments – each with one of the structures defined below.
What’s the best/preferred structure of investment money pre-VC investment. We’re in the beginnings of raising angel capital (~500k) and were wondering what, if any, considerations we should make regarding the investments to allow for VC later. Should we take convertible loans or issue straight preferred stock? What are the other options that are out there for investment structure? Is it too much of a hassle to handle future investments when there is an “angel group (say 5 doctors banded together)” versus a singular angel?
Assuming that you are planning on raising VC money some time in the future, there are two different typical structures for the first angel financing: (1) convertible debt and (2) preferred equity.
Convertible Debt: This is the easier approach of the two. In this case, the investment is in the form of a promissory note that converts into equity on the terms of a “qualified financing” (where qualified financing typically is defined by having a minimum amount – say $1m of total investment.) The note will either convert at a discount to the price of the qualified financing (usually in the 20% – 40% range), will have warrant coverage (usually in the 20% to 40% range), or both. This discount and/or warrant coverage gives the angel investors some additional ownership in exchange for taking the early risk. This note should be a real promissory note with the conversion and redemption characteristics clearly defined to protect both the investors and the entrepreneurs from any misunderstandings.
Preferred Equity: This is also known as a “light Series A” – it’s preferred stock that is similar to that a VC will get, but usually with lighter terms due to the relatively low valuation associated with it. For a very young company, a $500k investment can receive between 25% and 50% of the equity in the company and, as a result, many of the terms associated with a typical VC investment are overkill.
While either of these work, you’ll find some angels that strongly prefer one over the other. In addition, if you don’t believe you are going to raise additional VC money and will only be relying on additional small angel-type investments, the preferred equity approach is fairer to the investors as they’ll more clearly be participating in the upside on terms that are agreed to early in the life of the company.
Finally, I don’t think there is a difference between having “an angel group” vs. a single angel investor. However, you should try to insure that all of your investors are accredited and – if some aren’t – make sure you understand the implications of this.
What’s the best structure for a pre-VC investment?
Brad Feld offers advice on structuring angel investment:
Assuming that you are planning on raising VC money some time in the future, there are two different typical structures for the first angel financing: (1) convertible debt and (2) preferred equi…
Comment by Startup Fever — February 26, 2006 @ 3:09 pm
The note will either convert at a discount to the price of the qualified financing (usually in the 20% – 40% range), will have warrant coverage (usually in the 20% to 40% range), or both.
Comment by bfeld — January 7, 2009 @ 1:55 am
Brad,
Do you typically see warrant coverage on these deals? If so, how is that calculated?
-Khris
Comment by Khris — January 7, 2009 @ 1:55 am
Brad-
Great post. Does your advice change for a start-up, organized as an S corp, that seeks a single angle round of ~$800K to jump start a medical services business that will acheive profitability in <12 months? (i.e. does not want subsequent VC financing)
Jim
Comment by Jim — January 7, 2009 @ 1:55 am
If you can do a single class of stock, an s-corp would work in this situation. If you are sure that you wont raise additional capital, you could consider an LLC. However, if you ever go the VC route, you will need to do a c-corp.
Comment by bfeld — January 7, 2009 @ 1:55 am
Yes – you can easily have multiple classes of “units” in an LLC. LLC’s have “units” rather than “shares” but they are effectively the same thing.
Comment by bfeld — January 7, 2009 @ 1:55 am
Your blog is very informative. However, Keeping the trading balance on pre-VC investment and to avoid pressure is pretty hard task but your post and experienced serve and teach me how to handle and make it more simple and manageable.
Thanks for the tips… Best regards.
Comment by Insurance Australia — January 7, 2009 @ 1:55 am
Is it permissable to offer preferred stock as an LLC
Comment by william — January 7, 2009 @ 1:55 am
[...] Brad Feld, What’s the Best Structure for a Pre-VC Investment? [...]
Pingback by Venture capital is not broken. But it could use an alternative incentive structure. | Unstructured Thoughts by Taylor Davidson — February 19, 2009 @ 5:16 am
[...] Compare this to angel investments, which are typically done via convertible debt. Brad Feld has an old post on this that’s very good What’s The Best Structure For A Pre-VC Investment? [...]
Pingback by “Seed financings are “priced” like Series A deals, meaning a valuation for the company is set and an ownership stake is taken at the time of the investment.” « ecpm blog — August 28, 2009 @ 11:16 am
Hi! I was surfing and found your blog post… nice! I love your blog.
Cheers! Sandra. R.
Comment by sandrar — September 10, 2009 @ 5:56 am
I love your site.
Love design!!! I just came across your blog and wanted to say that I
Comment by angelina jolie — September 10, 2009 @ 9:13 am
Sign: umsun Hello!!! rcuwwymhyw and 9790ssgfhphzye and 5704Hi! I was surfing and found your blog post
Comment by megan fox — September 11, 2009 @ 8:42 am
Sign: yyams Hello!!! punht and 843dhursyvpxd and 7004 My Comments: Cool!
Comment by jenna — September 21, 2009 @ 9:49 am
[...] time, I soured on the “convertible note seed funding” approach. I’ve written about this in the past, but at the minimum I think it misaligns the entrepreneurs and the early stage VC. More [...]
Pingback by Some Complexities of Venture Capital Seed Investing — October 18, 2009 @ 10:49 am
Hey. This page is the best, and I’ve been looking for this site for a long time and I’m so blessed I eventually got here.
I am 21 years old and starting my bachelors at Princeton.
I’m the kind of guy who loves to try unprecedented stuff. Presently I’m fabricating my hold photovoltaic panels. I am making it all alone without the aid of my men. I am utilizing the net as the only way to acheive that. I stumbled upon a truly amazing site that explains how to build pv panels and so on. The website explains all the steps involved in building photovoltaic panels.
I am not exactly sure bout how correct the data given there is. If some people over here who had experience with these works can have a peak and give your feedback in the thread it will be grand and I would highly appreciate it, cauze I extremely passion solar panel construction.
Comment by DrielvelE — December 19, 2009 @ 1:05 pm