Structuring

After you have completed the sourcing, evaluation and valuation of the potential investment, you move into the structuring of the potential deal. Depending on what stage or round of investment the startup is in, this may take a few different forms. Just like the previous stages of investment, it is important to remember that this process must be customized to make everyone involved feel comfortable. This process becomes easier with time and angel experience.

            In the novel “Winning angels, the 7 fundamentals of early stage investing”, David Amis puts forward three major types of equity that is exchanged for capital in the early rounds of investing. The first of these is common stock. This is the most basic type of stock and comes with the least amount of protection. It is used most commonly in family and friend businesses because it doesn’t require a large amount of time to organize. This stock has no effect on exits from the industry and is only advised if the entrepreneur also holds common stock. Some of the recommendations put forward are the use of tag along rights and preemptive agreements. A pre-emptive agreement gives an early round investor a chance to invest additional capital to prevent a dilution of their equity shares. A tag along prevents the entrepreneur from selling his shares off without also offering the investor an opportunity to exit. Next up is preferred convertible stocks and their terms. These stocks are negotiated with special previsions and offer the investor first rights to the venture’s capital in the event of liquidation. This paired with additional clauses, such as buyout or board seats, give the investor significantly more power in the event of a failure by the management team or entrepreneur. Finally, is the convertible note with various terms. This is a newer model of investment that allows the investor an exit from a failing venture as well as a preferable position on preferred stock later. In this method the investor receives a promissory note that offers a discount based on when the next round of investment takes place. Usually if this round doesn’t take place within a specified period, the investor can receive payment for reimbursement.

            No matter which structure you take, the timing of the deal remains an important factor. In early rounds of investing, it can ultimately hurt potential gains if term complexity hinders future rounds of investment. One way to defend against this is by keeping these terms as simple as possible. It is also important to consider whether the valuation on the business is correct. If the first investor overpays, or the management team is undercompensated, motivation may be affected for future contributions.

            Ultimately it is important to consider the potential downside that can accompany the mismanaging or judgement of an investment. The first put forward by Amis is the emotional toll from attaching oneself to a failure. For entrepreneurs, failure is part of the growth process and thus is expected. This optimistic mindset is often not shared by investors that haven’t started a venture of their own. The next factor is the financial toll that it can take. Amis suggests that you should never invest more than you are able or willing to lose. Going in over one’s head can lead a person to make decisions emotionally rather than rationally. Finally, the name of the investor may be at risk if the venture doesn’t preform as expected. This can come both from poor financial performance and unethical practices by the management team or entrepreneur. This can damage your network and close future opportunities if not properly managed.