We tapped Operator Collective LP Einat Meisel, a partner at Silicon Valley law firm Fenwick & West, for an explanation of the most common financial instruments angel investors use. This is part 2 of our So You Want to Be an Angel series, a resource for anyone who wants to explore angel investing. (Check out the legal considerations in part 1 here.)
Moving the Money: Convertible Equity
You’ve identified the company you want to invest in. You have high conviction in the founders. You’ve done the initial due diligence. Now it’s time to finance the deal.
Startups most commonly issue convertible equity to early stage investors. This is a legal document that gives angel investors a right to receive a negotiated amount of stock in the company at a later point in time in exchange for the seed money. With convertible equity, the stock is not issued up front. Instead it will be issued after there has been a VC financing round at a negotiated valuation. Most angel investors won’t know precisely what percentage of the company they own until this valuation is done.
Why? Many early stage companies want to avoid having the conversation of valuation with angel investors. That’s because proof of concept, repeatable revenue, and other key metrics and milestones all inform valuation. Early stage companies are working to build those key metrics, and that’s why they’re taking angel investment.
A convertible note is one of the most common instruments of convertible equity. It’s a loan that an angel investor gives to the company. The convertible note has an interest rate (market rate, typically 2-6%) and a maturity date (typically 18-24 months). If the company raises VC money during the period of the note, the note will convert into the type (typically preferred stock) and number of shares represented by the investment given the negotiated valuation.
Angel investors don’t have a say into how the valuation happens. But they do have the ability to negotiate the financial terms of the note. These terms include a discount the angel investor receives on the valuation once the VC round happens, the angel investor’s right to continue investing in future rounds, and other future rights. The angel’s leverage in these negotiations will be determined by how big and how early the angel investment comes in, as well as how confident the company is that they’ll secure VC funding and how quickly they think they can close it.
A Simple Agreement for Future Equity (SAFE) is the other commonly used convertible equity instrument used in angel investing. The SAFE is similar to a convertible note in that it is a legal agreement that gives the angel investor the right to acquire the type and number of shares issued to the VC investors at a future point in time within the framework of pre-negotiated terms. Unlike a convertible note, the SAFE does not carry an interest rate, nor does it become due on a defined maturity date. Rather, the SAFE survives until it converts in a qualified preferred stock financing event or some other kind of exit. SAFEs don’t require the company to carry debt on their books, and they’re shorter and more straightforward to negotiate than full blown investment documents, containing legal costs for the young company, which is what makes them more attractive to startups.
Like the convertible note, the SAFE gives angel investors the ability to bet on a promising company early in exchange for a negotiated discount on preferred stock at a future point in time. Another similarity: the angel investor receives the shares after the negotiated valuation, and the investor won’t know exactly what percentage of the company they own until after that has happened.
Angel investors betting on a company early are taking a bigger risk (and typically seek bigger rewards as well). Some use “side letters” to secure additional investor protections including:
- Pro rata rights: The ability to continue to invest in future rounds.
- Information rights: The ability to have access to board packages, quarterly updates, and ongoing financial details.
- “Major Investor” status: The ability to access additional rights such as the Right of First Refusal (ROFR) which allows the angel investor to purchase common stock that founders or employees may have to sell before it’s offered up to an outside third party.
Find out more about the key legal considerations of angel investing by checking out the first part of this So You Want to Be an Angel series.