This post is part of the Angel Powwow Educational blog post series. Feel free to look at our other offerings.
Many times, when someone thinks of angel investing, they focus on the glamour of getting in at the beginning and riding the wave of success to financial freedom when the company has an exit event such as an acquisition or IPO. That’s a great perspective to have, but it doesn’t illustrate the many facets of angel investing or take into account what’s truly needed to make sound investment decisions.
Yes, you do toss money at a company and hope that it’s the next unicorn, but there’s a lot more to it than just that. The startup investing world is not a one size fits all place. There are subtle differences and nuances that make each deal unique (even if they’re competing for the same market space and offer similar products or services).
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Today’s post, Security Types | It’s Not Just About Tossing Money At A Company, will focus on one aspect of the angel investing process, the security type. This is just one piece of the puzzle and is extremely important when it comes to understanding your investment and potential returns. Over time, I’ll post articles on the other pieces until the puzzle is completely assembled.
Table of Contents
Let’s start with the primary security types…
Primary Security Types
There are two primary security types; Convertible Debt and Equity. These are entirely different beasts, and it’s crucial that you know the fundamental differences between them.
Convertible Debt is a short-form of debt that converts into equity. It’s structured much like a loan, and you may consider it an IOU. You loaned the company money, but you don’t own a piece of it yet. The conversion trigger is defined and usually occurs in conjunction with a future financial round.
One thing to understand about debt is that debts are paid before any other claims should the company fold, and an insolvency issue arise. This, of course, assumes that there’re any funds left to disburse and that you haven’t already been converted to an equity holder.
Equity is quite a bit different from convertible debt. You own a piece of the company as soon as you invest in it (much like stock). This is usually obtained via a priced round where you buy the stock at a set price and own its relative piece of the company at that time.
Unlike, convertible debt, equity holders are paid after debt claims have been settled and, if you’re a common stockholder, usually after the preferred stockholders have been satisfied.
Now that you know how convertible debt and equity differ, it’s time to look at the more common angel investing offerings, see which primary security type they fall under, and what makes each one unique.
We’ll start with stock offerings…
Most people know what stock is. You buy some, and you now “own” a piece of the company. That said, a lot of people don’t realize that there’re different types of stock.
There are two stock types that you’ll see when it comes to angel investing; Common Stock and Preferred Stock. Each comes with its own pros and cons. Let’s take a closer look…
Common stock is most commonly held by founders, employees, and some early investors. Generally, common stock comes with voting rights, which may be limited and potentially have lesser rights than preferred shareholders. Common stockholders can only claim their share of a company’s assets after the claims of debt holders and preferred equity holders have been met (much like debt vs. equity holders above).
Preferred Stock is usually issued to outside investors and grants special rights and privileges, potentially providing greater protection to the investor. Preferred stock can also provide avenues of greater influence on company decision-making, including anti-dilution rights, pro-rata rights, liquidation preferences. Investors can claim their preferred share of a company’s assets before common stockholders (much like the debt vs. equity holders above but also in profit-sharing bonuses such as dividends).
Which type of stock is best for you will depend on your investment strategy and requirements.
If you’re unsure of a company, debt or preferred stock may be preferable, in case the company folds and you want a better chance to recover your investment.
That said, if you’re unsure of a company, to begin with, skip it and invest your money in a company you don’t have reservations about.
Let’s move onto the next investment offering, the note…
There are many types of notes. Some are considered a debt instrument, and others are not. Just like a stock, each note type has its own pros and cons. Let’s take a closer look at the more common note types and see what they have to offer…
Convertible notes are considered debt instruments. They are often used when a startup is not ready to set a valuation or expect it to change dramatically in the next round, yet need cash now. They usually come with interest rates and a conversion date as part of the deal. Convertible notes typically convert into shares of preferred stock.
SAFE notes are not considered debt instruments. One reason startups like to use the SAFE note is that it helps them avoid some of the less desirable (at least for them) aspects of a convertible note, such as interest rates and conversion dates. Instead, SAFEs give the investor the right to purchase equity at a future point in time worth the amount of their initial investment. What makes a SAFE note attractive to investors is that many times, SAFEs come with valuation caps, discount rates, and so on, but not always.
A crowd note is basically a modified convertible note. Here are some of the key features of a crowd note:
- They always convert to preferred stock.
- A company may extend or convert the Crowd Note at its option upon each qualified financing.
- Investors lock-in the conversion price per share of the initial qualified financing and preferred stock, even if the note ends up converting later.
- Investors receive at least a 2x acquisition premium if an acquisition occurs before initial qualified financing (investor protection against an early exit).
- No voting, information, or inspection rights. To the extent investors are required to vote by law, investors automatically agree to vote with the majority of the preferred.
- Valuation cap and discount but no maturity; enables startups to potentially keep the note outstanding longer, past the initial qualified financing.
KISS notes are very similar to a SAFE note but add some downside protection as well. Here are some key features of a KISS note:
- A KISS accrues interest and has a maturity date after which the investor may convert the underlying investment amount, plus accrued interest
- KISSes provide basic information rights on financial statements to investors and the right to participate in future equity funding rounds.
- All KISSes in a series are on the same terms, so they do not allow for high-resolution financing (i.e., raising finance at different valuation caps).
- Kisses include the most favored nation clause (see more about this below).
- An investor does not usually have any management rights or receive any dividends until the KISS converts into shares.
- A KISS is not considered a debt instrument.
Now you know a bit more about some of the most common note types in angel investing. As you can see, each one has it’s place and, depending on your investing style and needs, you may favor one over the other.
Note types are important, but what I consider to be equally if not more, important are the terms contained within each note type. Let’s take a look at some other considerations that will help you determine if a particular deal is worth your time and money…
The note basics are fine, but it’s the terms contained within that can make or break a deal. Let’s take a look at a few of the more common options that you’ll see in various investment rounds…
A discount rate is pretty straight forward. The whole point of the discount is to induce you to invest now and then covert your investment into equity shares at 20% off the stock price at the time of conversion. At this time, you’re basically seeing a 20% gain on your investment.
Some notes include interest terms. Think of it just as you would a CD. You have an interest rate and a maturity date. The only difference is, instead of getting money at the maturity date, your investment gets converted into equity equaling your initial investment plus the interest accrued.
Most Favored Nation Clause
A Most Favored Nation clause (MFN clause), is a convertible note term that allows the note holder to elect to inherit any more favorable terms that are offered to subsequent investors following the original investor’s investment, and before the next equity round.
Many companies will offer perks to get you to invest more. Most of the time, the perk is a mention on the company website or blog page, one of the company’s products or services, and so on. Other perks may include options like pro-rata rights or more. Usually, perks increase as your investment increases.
If your investment provides you with pro-rata rights, it means that you have the right to participate in a subsequent round of funding to maintain your level of percentage ownership in the company.
A valuation cap entitles noteholders to convert the outstanding balance on the note into shares of stock at the lower of (i) the valuation cap or (ii) the price per share in a qualified financing (or, if there is a discount in the note, then the discounted price per share).
Sometimes you’ll see a discount and a valuation cap together in an offering. You should note that you’ll convert at one or the other, but not both. The conversion will be whichever benefits you, the investor, more.
Let’s say you invest $1M (this amount is just to make the math easy) in company X with a discount rate of 20% and a valuation cap of $10M.
Now, the company starts its next round with a $20M valuation. Your discount would have you converting with an effective cap of $16M ($20M – 20%). In this case, your better option would be to convert at the $10M cap (your money buys you a more substantial part of the company, at 10% equity, vs. converting at a $16M valuation, which only provides you with 6.25%).
Let’s look at the other side of the coin…
We’ll assume the same investment of $1M and the same terms of a 20% discount rate and $10M valuation cap.
This time, the company converts at the $10M valuation. In this case, the 20% discount is better for you, the investor, because you’ll be converting at an $8M valuation ($10M – 20%). By going with the more favorable discount rate, you end up with 12.5% equity in the company vs. 10%, if you used the valuation cap.
Knowing these things can help you make a better-informed investment decision.
As you can see, there’s a lot to consider when you’re looking at deals to invest in. It’s not just the company, service, and product. It’s about the deal terms and security types.
I know I haven’t touched on everything here. If there’s something you’re unsure of or an aspect of security types I didn’t cover, but you want to know more about, please let me know. I’ll be happy to update this post with additional information.
So what do you think? Did I miss anything? Do you have a different perspective? I’d love to hear your thoughts on this topic. Simply comment below, and I’ll be sure to respond.
Now, that you’ve read this post, Security Types | It’s Not Just About Tossing Money At A Company, I hope that it answered some of your questions and gave you a better understanding of angel investing in general. The next time you’re on Wefunder, StartEngine, Republic, and so on, you’ll be better prepared to make an informed investment decision.
Please note that I plan to create a course on this topic and others. Once they have been published, you can find them here.