By: Paul A. Jones
At a time when lean startups often require considerably less than $1 million dollars to develop the proverbial minimum viable product and even validate the same with some customers, angel investors are playing an increasingly important role in startup financings. And that’s a good thing, particularly in places outside of the major venture capital centers, where institutional venture capital is scarce.
Most startups successfully launched with angel capital will want to tap deeper pools of capital later on, often from traditional venture capital investors. That being the case, entrepreneurs and their angel investors should make sure that the structure and terms of angel investments are compatible with the likely needs of downstream institutional investors. Herewith, some of the issues entrepreneurs and angels should keep in mind when they sit down and negotiate that first round of seed investment.
- Don’t get hung up on valuation. Seed stage opportunities are difficult to put a value on, particularly where the entrepreneur and/or the investor have limited experience. Seriously mispricing a deal – whether too high or too low – can strain future entrepreneur/investor relationships and even jeopardize downstream funding. If you and your seed investor are having trouble settling in on the “right” price for your deal, consider structuring the seed round as convertible debt, with a modest (10%-30%) equity kicker. Convertible debt generally works where the seed round is less than one-half the size of the subsequent “A” round and the A round is likely to occur within 12 months of the seed round based on the accomplishment of some well-defined milestone.
- Don’t look for a perfect fit in an off-the-shelf world. In the high impact startup world, probably 95% of seed deals take the form either of convertible debt (or it’s more recent twin convertible equity) or “Series Seed/Series AA” convertible preferred stock (a much simplified version of the classic Series A convertible preferred stock venture capital financing). Unless you can easily explain why your deal is so out of the ordinary that the conventional wisdom shouldn’t apply, pick one of the two common structures and live with the fact that a faster, cheaper, “good enough” financing is usually also the best financing at the seed stage.
- On the other hand, keeping it simple should not be confused with dumbing it down. If the deal is not memorialized in a mutually executed writing containing all the material elements of the deal, it is not a “good enough” financing. The best intentioned, highest integrity entrepreneurs and seed investors will more often than not recall key elements of their deal differently when it comes time to paper their deal – which it will at the A round, if not before. And the better the deal is looking at that stage, the bigger those differences will likely be.
- Get good legal advice. By “good” I mean “experienced in high impact startup financing.” Outside Silicon Valley, the vast majority of reputable business lawyers have little or no experience representing high impact entrepreneurs and their investors in financing transactions. When these “good but out of their element” lawyers get involved in a high impact startup financing the best likely outcome is a deal that takes twice as long, and costs twice as much, to close. More likely outcomes include unconventional deals that complicate or even torpedo downstream financing. This suggestion is even more important if your deal is perchance one of those few that for some reason does need some custom fitting.
- Finally, a pet peeve. If you think your startup’s future includes investments by well regarded institutional venture capital funds, skip the LLC tax mirage and just set your company up as a Delaware “C” corporation. If you want to know why, ask one of those “experienced high impact startup lawyers” mentioned in point 4 above.