Welcome to Angel Powwow’s Angel Investing 101 educational series. Today’s topic will cover critical deal terms. We’ll talk about what they are, what I consider to be friendly and unfriendly terms, and even a cautionary tale to highlight why it’s important to understand these terms.
Other topics that you might find interesting include:
- 10 Best Investment Tips – Crowdfunding 101 In A Nutshell
- 3 Amazing Tools To Visualize Potential Opportunity Details
- Security Types | It’s Not Just About Tossing Money At A Company
Everyone’s jumping on the angel investing/crowdfunding bandwagon. It’s no surprise, either. There are so many “services” touting angel investing as the way to strike it rich by investing a small amount of capital. While it is technically possible to hit that potential Unicorn, the reality is that most startups will fail. With dilution, clearing fees, and so on, I question how much you can really make by investing the minimum amount. Of course, those “services” don’t want you to pay any attention to that.
I put services in quotes because many of them are not really there to serve the public. They’re all about money. The more hype they can generate that puts a positive spin on angel investing, the more potential customers they have to fill their coffers.
Don’t get me wrong, angel investing has the potential to generate amazing returns, and there are legitimate services out there that actually do care about educating their members. Be smart about your investing and which services you trust.
Trust is why I’m writing this educational series. Angel Powwow is a place to talk about deals and one where you can expand your knowledge base and be better prepared to vet deals on your own.
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What Are Deal Terms?
Unless you’re getting equity from the start, you’re probably getting into a SAFE, convertible note, crowd note, or some other yet similar security type. These security types have stipulations that are called deal terms.
Many of these terms will fall under the following categories:
This would include maturity dates, number of qualifying rounds to consider for conversion, etc.
Many notes carry interest and function as debt security.
Specifics as to what qualifies a security for conversion.
Some contracts contain wording where the company has discretion on converting a security or not, even when all other terms are met.
A carrot that is often dangled in front of investors is a promised discount when the securities convert.
Caps, pre-money, and post-money valuations can play a vital role in calculating your ownership of a company at conversion.
Should a company fail and have assets that can be sold off to satisfy debts, who’s in what position on the list of creditors to be paid?
I’d be a bit of a hypocrite if I were to say that I knew every term possible. That’s not realistic. Until more terms cross my path, I’ll file them under Other (AKA, Unknown).
Understanding these terms is critical if you’re to evaluate investment opportunities. Please note, the categories themselves aren’t necessarily good or bad. It’s the wording and meaning behind them that paints them in a particular light. Because of this, you’ll see the same categories in both the Friendly Terms and Unfriendly Terms sections. I’d even go as far as saying, “Depending on their use case, some terms may even be neutral.”
Now, let’s dig into what I consider to be friendly terms.
Standard “Friendly” Terms
Everyone has their own opinion. What may be good for some may not be for others. For example, let’s say an opportunity boasts a 6% interest rate. For me, that’s a good thing, but anything less than 10% may not be worth their time for someone else. That said, I’m going to place whatever terms I feel are a “good thing” into the Friendly Terms section.
There’s nothing more frustrating than holding a security in a company and never knowing if or when it will convert into equity. Many deal terms (especially convertible notes and the like) will include a maturity date to help alleviate the anxiety that many experience with such deals. This is the date, assuming no other conversion events took place, where your security will convert into equity or get paid out with interest, depending on the deal terms. Now you know the when.
Who doesn’t like making money on your investment? An interest rate shows you exactly how much equity you will get at conversion or get back in certain situations when you invest. Of course, this assumes the company continues to operate and can meet its obligations.
Many securities include deal terms that stipulate when a conversion can take place. Most of the time, this is during another funding round that meets certain criteria (AKA, a qualifying round). The terms can range from a specific amount raised to what type of security is being offered in that round or a mix of both. For example, a security may qualify for conversion at the next funding round where $1M or more is raised and the security offered in that round is Preferred Stock, etc.
It’s a sale! No, really, it’s a promise that when you convert, you will receive equity at a discounted rate. Let’s say the conversion terms are something like this:
“During the next qualifying round, where a minimum of $1M is raised, and the security type is Preferred Stock, your investment will convert at the per-share price of that current round multiplied by your discount rate.”
Let’s say that the current round is $10 per share, and the discount rate was 20%. You’ll get shares at $8 each.
It should be noted that the raise page may say something like “Discount: 20%”, but the Form C (or whatever form is used) shows a discount rate of 80%; know that you’re going to get 20% off. Sometimes, in the documentation, they use the rate as the multiple to show what you’ll receive, not what you’ll save (i.e., $10 x 80% = $8).
Many times, a security will have a valuation cap. This is the maximum value that will be considered when calculating your equity at conversion. Let’s say that your investment is $1000 and the valuation cap is $10M. Now let’s say that, at conversion, the company is valued at $20M. That cap will convert your ownership at the $10M number, effectively giving you twice as much value vs. the current $20M cap. $1000 / $10M = .0001% ownership. $1000 / $20M = .00005% ownership.
Should a company fail, its assets are used to pay back its creditors. The liquidation preferences will show which creditors get paid in what order and at what multiple. Some security types will have a liquidation multiple applied. Being at the top of the list is a good thing. Having a multiple greater than one is even better.
I’m sure there are other deal terms that you’d consider to be “Friendly.” That’s OK. I just wanted to give you an idea of the ones I like and what they mean. Feel free to add to this list any time and keep it handy for evaluating potential opportunities.
Now, let’s take a look at the not-so-friendly deal terms…
Now, I know that I used this term in the “Friendly” Terms section, but this can also fall into the “Unfriendly” category.
I have seen many deals where the conversion terms are so ridiculous that you’ll never see your investment convert, yet people still invested in the company!
Take the following as an extreme example:
Let’s say the conversion terms are to convert your securities into equity when the next round that offers Preferred Shadow Shares and raises at least $100M is concluded. Immediately I’m not too fond of this.
First off, the company has a current valuation of $1M yet is talking about raising $100M. Secondly, they’re saying I’ll only convert if that round succeeds and issues Preferred Shadow Shares. Who’s to say they won’t run that round with Common Stock instead of Preferred Shadow Shares?
The fact that I have to hit two questionable criteria even to be considered for conversion is enough for me to move onto the next deal.
This is a deal-breaker for me. Any time I see wording that includes something to the effect of “at the company’s election,” I move on. What company would elect to convert (or give away equity) if they don’t have to?
At this point, I’ll never see my securities convert unless there’s a change of control (i.e., an IPO, merger, or acquisition), or a liquidation event (where I’ll probably never see a dime back).
You saw this term in the “Friendly” Terms section, but it all boils down to where you are on the list and what considerations you and those before you have. If you’re 10th on the list, chances are that you’ll never see a dime. It gets worse if people higher up have a multiple greater than one. That takes more money from the settlement pot before getting to you.
Again, these are just some terms I consider to be “Unfriendly.” There are others out there that you might add to this list. It’s all about their use and your perspective.
Now, onto neutral terms…
Some terms will be blah. They don’t really fall under “Friendly” or “Unfriendly”. These are what I call non-considerations. If it’s neutral, it’s mostly inconsequential, and I don’t really consider it in my go/no-go investment decisions.
Pre-Money and Post-Money Valuations
Unless they’re low, pre-money and post-money valuations are pretty much worthless.
To figure out the post-money valuation of a pre-money opportunity, take the pre-money valuation and add the maximum raise amount. This will show you the company’s valuation after the round (assuming they hit the maximum raise). It’s a nice way to figure out your potential ownership at that time.
The post-money valuation has already done the math for you. Either way, I use this as a quasi-ownership calculation. The only issue I have with these evaluations (and even valuation caps) is that most companies calculate them arbitrarily. They look at a competitor and say, “We’re worth that much.” or even think they’re worth more. Sadly, most of the time, that’s as deep as they go.
That said, some companies will explain how they reached their valuation, and you might be surprised at the effort put forth. It’s those companies that I put more faith in, as they took the time to really see where they stand.
A Cautionary Tale
You may or may not have heard of a company called Toptal. This company, by all measures, is very successful. It boasted a YoY growth rate of 30% for several years and revenues in the hundreds of millions. For the most part, it is a successful company, but it screwed its investors and even its employees pretty hard…
The short story is, the CEO carefully crafted investment and recruitment documents that basically said, “You’ll get equity when we raise more money after the initial seed round.” The stickler here is that he avoided raising any more money and, thus, never had to convert the investor’s notes.
Although not a common occurrence, it’s always a good idea to view opportunities with a bit of skepticism and be on the lookout for potential red flags that could save you from something similar down the road.
Angel Investing 101 | Critical Deal Terms Conclusion
I hope this Angel Investing 101 | Critical Deal Terms article useful and learned something you hadn’t known before. Just keep in mind that these terms are not stand-alone options. Almost every deal will have a mix of them. Many times, that mix will be both good and bad. It’s up to you to determine which terms hold more weight for you and if the deal, as a whole, is a good one for your situation and follows your investment policy.
Remember, not every founder is out to get you. Yes, the cautionary tale above is sad, but most founders are really looking to make a difference and do good by their investors.
After all, these companies are their babies, and many founders are serial entrepreneurs. Once their babies leave the nest (AKA, merge, get acquired, or IPO), they’re off to start another family, and they want you to back them again. Treating you right in previous endeavors paves the way for your investment in their next one.
Now, I’d like to hear from you. What did you think of this article? Did you learn something? Is there another term you think should be added to this list? Is there an example you’d like to add or change you think should be made to the above? Is there another topic that you think would be a good fit for the Angel Investing 101 series? Let me know by commenting below.