“It is, of course, cleaner to just lower the price per share, but often there are reasons (e.g., a higher-priced friends and family round) not to do so,” he adds.

If the price per share in the friends and family round is high, issuing a lower price per share in the Series A round may significantly dilute the value and holdings of friends and family investors. Seasoned angels usually try their best, within reason, to keep entrepreneurs happy. No entrepreneur wants to tell his or her friends and family that their holdings have been diluted substantially.

Discounts

Photo Credit: dizznbonn

Receiving a discount means you get to purchase shares at a lower price than the price per share for that round.

Warrants

Warrants give you the right to purchase additional Series A shares within a specified time frame.

Purchasing additional shares allows you to increase ownership and enjoy the upside if the company does well.

In cases where the company issues new shares and dilution is inevitable, exercising your warrants would help protect your percentage of ownership up to a certain amount, which would help reduce the impact of dilution. [1]

Here’s the beauty of warrants: They provide you with potential upside and dilution protection (albeit limited), but you don’t have to pay up-front. You have a choice – you can exercise them within the agreed time period, or not.

For the company, issuing warrants allows it to sweeten the deal without reducing the company’s valuation, or price per share.

Even so, warrant does come with its own set of issues. (What doesn’t?) We’ll discuss those some other time.

Exercise Price

The “exercise price” is the price you pay to purchase the warrants. The exercise price is usually set at Series A price.

Warrant Coverage

The warrant coverage is expressed as a percentage. Twenty-five percent coverage for a $750,000 Series A investment would give you the right to purchase $750,000 x 25% = $187,500 worth of additional Series A shares.

Expiration

Most warrants can be exercised from a couple of years to 10 years after closing.

In the event of an acquisition or IPO, however, warrants typically expire immediately. [2]

“Acquirors do not want to assume warrants and generally demand that warrants be exercised prior to closing,” explains Yokum Taku, corporate and securities partner at Wilson Sonsini Goodrich & Rosati (WSGR).

And “many companies prefer to have warrants expire on an IPO to eliminate the share overhang associated with the warrants.”

Seasoned angel investors always make sure the clause that gives them the option to exercise their warrants immediately before these liquidity events (e.g. M&A and IPO) is included in the agreements.

References

The minimum threshold is sometimes required as a condition to the first closing because angels want to make sure the company has raised enough money to get to the milestone. This way, even if additional closings don’t occur (i.e., the company can’t raise additional funds), it will be less likely to run out of cash during development.

Photo by: jurvetson

For example, if the startup needs $500,000 to reach the milestone, but it can only raise $250,000, seasoned investors might refuse to close because by doing so they might put their investment in jeopardy — the funds might be spent, but the startup might only be halfway through the milestone. Both the startup and the investors are doomed if the company can’t raise follow-on money on time.

Example #1

The first closing will be for at least $500,000 and will close on [date].

Example #2

Closing: As soon as practicable following the Company’s acceptance of this Summary of Terms and satisfaction of the conditions described below under “Conditions to Closing” (the “Initial Closing”). Up to two (2) additional closings may occur at any time during the 90 day period following the Initial Closing.

* This is Part 3 of a 3-part series. Visit Part 1 at “Angel Deals: Quick Discussion on Common and Preferred Stocks.”

Issuing only one class of stock also allows the company to incorporate as an S corporation for tax advantages. However, as elaborated in “C Corps vs. S Corps vs. LLCs: Which Corporate Structure Should Angels Invest in and Why the Form of Entity Matters,” you may want to reconsider investing in S Corps if you were to become a professional angel. Companies, too, should think about whether to incorporate as an S corporation if they plan to raise money from sophisticated investors.

Unless the company is perceived as “hot,” most early stage companies don’t have the leverage to issue common stocks to experienced investors.

Experienced Angels Invest in Common Stocks When…

Photo by: John-Morgan

Experienced investors almost always push for preferred stocks, but this is not to say that they would never purchase common shares. There are always circumstances under which investors may consider purchasing common stocks, such as:

• The entrepreneur is experienced and has put much of her own money into the company, and the investor trusts (based on personal experience with that individual) that the entrepreneur will treat investors well, remarks Dan Rose, chairman of Seattle Alliance of Angels. [3]
• The founder is a well-known, successful, serial entrepreneur – someone in whom investors fight to invest.
• The deal is perceived as “hot” or competitive, where the founder has received multiple term sheets from different investors. This often occurs when investors believe the company has significant upside potential, i.e., the next Google.

On a related note, an experienced founder who has the luxury to choose her backers and doesn’t want to give too much control to investors may prefer a term sheet that prices her company at a lower valuation in exchange for common shares, as opposed to one that offers a higher valuation but demand for preferred shares.

Similarly, she would likely rather opt for a term sheet that prices her company at a lower valuation in exchange for preferred shares with fewer rights, as opposed to one that offers a higher valuation but demands more rights.

* This is Part 3 of a 3-part series. Visit Part 1 at “Angel Deals: Quick Discussion on Common and Preferred Stocks.”

References

Unlike common stock, preferred shares are issued in series to represent each round of financing. For instance, Series A typically refers to the first round, Series B the second, Series C the third, and so forth.

* This is Part 2 of a 3-part series. Visit Part 1 at “Angel Deals: Quick Discussion on Common and Preferred Stocks.”

Image by: Stefan Baudy

Rights granted to investors of later series typically rank ahead of preferred shareholders in earlier series and common shareholders. That is, rights held by Series C investors would have more weight than Series B and Series A investors, who in turn rank higher than common shareholders; and rights held by Series B investors would have more weight than Series A investors and common shareholders. As they say, new money always has more power.

Experienced angels are careful as to the requests they make in early rounds. They know that their terms will set a precedent and that later investors will always want more rights than existing investors. Smart angels know that they might end up hurting their economic benefits by demanding onerous terms in the early stage. Their advice to new angels: Don’t complicate early stage deals.

Preferred Rounds Difficult To Justify For Small Rounds

The structure of preferred shares is more complicated than that of common shares because of the extra features (e.g., liquidation preference and anti-dilution protection, among others) that come with preferred stocks. The legal fees for a preferred round, if done properly, are around US $50,000. This makes preferred deals more difficult to justify for small rounds.

In general, experienced angels who don’t accept convertible notes usually request preferred shares if the round is larger than US $500,000. One angel said he requests preferred stocks if the round exceeds US $250,000, but added that he rarely invests in rounds of such small size, i.e., less than US $500,000.

For contextual purposes, angels who are willing to use convertible notes may accept capped notes in seed rounds between US $250,000 and US $1 million, according to the observations of Yokum Taku, corporate and securities partner at Wilson Sonsini Goodrich & Rosati, from January 2010 to January 2011. [2]

Again, though convertible notes are out of context in this brief, you may learn more about convertible debt deals in “Starting Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Up next: When Do Seasoned Angels Invest in Common Stocks?

While novice investors may agree to buy common stocks, experienced investors almost always request preferred stocks. There are exceptions, of course, as discussed in this short, three-part series.

Angels Used to Purchase Common Stocks

Before 2000, angel investing was relatively new, and established best practices were lacking. Hence, angels mostly purchased common stock. [1]

Image by: GDS Infographics

However, as angels learned from their mistakes and gained a sharper understanding of the industry after the dot-com bubble, they began to adopt best practices from the venture capital (VC) community and started doing preferred stock deals.

Since then, the angel world has split in the past decade, with experienced investors doing almost exclusively preferred stock deals, and “naive, friends and family angels” investing in common stocks and straight convertible notes. “Virtually no outside investors do common stock deals [nowadays],” says one angel.

Sidenote: Some seasoned angels are willing to do convertible debt deals as long as the notes come with a price cap. Convertible notes is a big topic on its own, and you can learn more about using convertible notes as a pre-Series A deal structure in a special report called “Startup Investing: What You Need to Know About Convertible Notes.” This brief focuses on common and preferred stocks.

Why Angels Want Preferred Stocks

Common shares are cleanly and simply structured. Founders, employees and friends and family investors typically hold this type of equity.

So unless they’re dying to get into a deal, sophisticated angels rarely purchase common stocks, as this type of equity offers investors little protection.

Unlike friends and family investors, professional angels don’t invest due to their warm, fuzzy feelings toward entrepreneurs; also, they invest hard cash as opposed to the founders’ and employees’ sweat equity. Thus, experienced investors want to protect themselves with rights that rank ahead of common shareholders.

This is where preferred shares come in. This type of equity includes a list of unique rights that protect investors’ downsides. Holders of preferred shares are entitled to preferential treatments over holders of common shares.

Among the special rights, the most important one, which differentiates between common and preferred shares, is called “liquidation preference,” a feature that entitles preferred shareholders to get paid in full first in a liquidity event (e.g., a sale, IPO, or shutdown); common shareholders receive the remaining proceeds. The payment to preferred shareholders is typically a multiple, for example, 1x or 2x, of what they originally paid for their stocks.

Outline

• Angel Deals: Quick Discussion on Common and Preferred Stocks
• Angel Investing: What Is a Preferred Stock?
• When Do Seasoned Angel Investors Invest in Common Stocks?

* This is an excerpt from a special report. Download full report at “C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters.” Again, this is not legal or financial advice. Please consult with your lawyer and accountant.

Having only one class of stock means that equal rights must be given to all shareholders – no special rights or preferential treatments can be granted. For this reason, experienced investors typically require an S Corp. to convert into a C Corp. or LLC before backing the company.

C Corps can have different classes of securities while LLCs can have multiple classes of units. Both structures are free of the one-class stock restriction inherent in S Corps. Still, it appears that in this instance, at least, the C Corp. is the more favorable structure. Let’s see why.

Photo by: Podknox

Tax Implications Upon Exits

While LLCs offer short-term tax efficiencies with its flow-through ability, the C Corp. structure offers a number of potential benefits upon successful exits.

For example, you can “achieve a tax-free exit through a stock for stock exchange with another corporation,” ACEF reports. [3] “There can also be favorable capital gains in tax rates for early stage investors in certain C corporations that have raised less than US $50 million.”

In addition, if you hold the stock for more than five years, you may cut half of your tax payment upon a liquidation event. “If you think there is going to be big home run, paying 7.5 percent instead of 15 percent can be a huge advantage,” says Jeff Solomon of LKN+S.

Subject to specific conditions in the Internal Revenue Code (IRC) and the type of C Corp. you invested in, you may treat the losses as ordinary, rather than capital, losses, which may result in higher personal tax savings. If there are profits, you may roll them over into a future investment to postpone tax payments.

Talk with your tax specialist to see which (legal) tax minimization strategies you’re eligible to implement.

Because LLC members own membership interests rather than stocks, members aren’t entitled to the benefits tied to stock ownership, as discussed above.

However, in certain exits, the benefits of an LLC’s flow-through ability can be substantial. For example, in an asset-sale type of exit, the proceeds will be taxed only once as opposed to twice in the C Corp. structure, according to Adrienne Randle Bond, an attorney who specializes in partnership and securities law and mergers and acquisitions. [6]

* This is an excerpt from a special report. Download full report at “C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters.” This is not legal advice. Please consult with your lawyer.

Bruno: Yeah, if you are a foreign investor you need to be patient to make your first investment, but the return could be much quicker than it is in the US.

* This is an excerpt from an interview report. Download full report at Angels and Startups, Don’t Play in China Until You Read This.

Right now, there’s a lot of hot money in China. The differentiation you can make is the people you know on the ground. Being here, or working with people whom have been here for a while, is one of the keys of succeeding as an investor here. I have been able to — and my group as well — to find companies that are both a good investment from a team perspective, as well as from a valuation perspective.

To be credible, to be consistent, and to make sense, you need to be on the ground for a little bit. When you’re confident that you’re working with the right people on the ground, let’s say AngelVest, my angel group, or any other person that you feel is trustworthy, then once you have made the first investment it’s actually pretty quick to…

Photo: ~Brenda-Starr~

Rich: So, the patience comes not so much with the return, but with getting started, making sure you’ve got your feet on the ground and that you’re working with credible people.

Bruno: Yeah, and it’s much easier now than it used to be because you can now easily connect to investors in the US as well as China.

To be confident that you understand the market well enough you need to spend time on the ground. Otherwise you’ll need to rely on other people; however talented they may be, it’s always better if you see the company that you’re going to invest in.

The other thing is investing here in China is no different. Because the market has been educated about this offshore legal structuring, it is not that difficult to invest here in China.

What you have to focus on is actually the same as what you have to focus on elsewhere, which is the team, their talents, and their track record.

And you need to understand the regulatory environment because this is apparently a component that is not as strong as it is in the US, especially in the Internet arena.

* This is an excerpt from an interview report. Download full report at Angels and Startups, Don’t Play in China Until You Read This.

You bet it does. The differences in taxation, the flexibility in ownership, and the capital structuring among these three company structures can be significant.

C Corp., S Corp., and LLC: A Brief Introduction

C Corporation (C Corp.): Owners of a C Corp. are called “shareholders” or “stockholders.” As an investor, you’re a part-owner and are given stock certificates to evidence that ownership.

Additionally, from a legal perspective, a C Corp. is treated as a separate entity from its owners/shareholders. This separation shields you from debts or obligations the company may incur.

S Corporation (S Corp.): Like a C Corp., owners of an S Corp. are also called “shareholders” or “stockholders.” You, as a part-owner, are given stock certificates as proof of that ownership.

An S Corp. is also a separate entity from its shareholders, shielding you from debts or obligations the company may incur.

The main difference between a C Corp. and an S Corp. is how the income is taxed. We’ll expand the discussion of taxation later on in Part 3, “Company Structures and Your Tax Money.”

Limited Liability Company (LLC): Owners of an LLC are called “members.” Instead of stocks, you (as a member/part-owner of the LLC) receive “membership interest.”

This membership interest is usually expressed in percentages (e.g., a 10% membership interest) or in units (e.g., 10 units), which generally correspond to your percentage in ownership. [1]

Unlike shareholders of a C Corp. and an S Corp., who receive stock certificates to evidence ownership, LLC members receive charter documents, e.g., “Articles of Organization” and “Operating Agreement.”

An LLC also protects members from debts or obligations the company may incur.

Note: Although all three entities intend to shield members and shareholders from obligations incurred by the company, there’s no absolute guarantee that they will be shielded. Please consult with your lawyer.

What You’ll Learn in This Report

• Which corporate structure has a high flexibility and why you need it
• Which structure angel funds can’t invest in
• 2 reasons why seasoned investors don’t like to invest in this structure
• Why experienced investors care about employee options
• Which company structure allows you to make that agreement do whatever you want
• Tax payments and tax filing requirements for C Corps, S Corps, and LLCs
• Double taxation and single taxation and how they affect your investments
• Losses in this company structure can be used to offset future company income, which will result in tax savings
• Which structures may effectively lower your net investment and raise your internal rate of return
• Which structures require you to pay tax even if the company hasn’t actually distributed any profits to you
• Which structures require you to file a separate state income tax return in each state in which the company earns income
• Which structures make individual tax reporting more complicated and slow
• “One prominent angel”  said he won’t invest in this structure because he was spending an inordinate amount of money on his personal tax returns
• Which company structure do seasoned investors favor
• You may cut half of your tax payment upon a liquidation event with this structure
• Which structure allows you to roll the profits over into a future investment to postpone tax payments
• Which structure can create significant issue with employees in technology companies
• Which structure is better for employees in tech companies
• You should invest in a C Corp. if you fit at least 1 of these scenarios
• Why VCs typically don’t invest in this structure

Bonus

When you invest in this report, you’ll also receive a quick, easy-to-read 5-page report called “5 Reasons Seasoned Investors Prefer Companies Incorporated in This State” – a must-read for new angels and first-time entrepreneurs who are planning to raise money from professional investors.

What You Get

• C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters (PDF report: 11 Pages | Word Count: 2,700+)
• 5 Reasons Seasoned Investors Prefer Companies Incorporated in This State (PDF report: 5 Pages | Word Count: 1,100+)

Available to Members Only

According to Basil Peters, an angel fund manager and the author of Early Exits, convertible notes became popular in the aftermath of the dot-com bubble, a painful time in which many angels suffered from down rounds and dilution. [8] The convertible debt structure allows angels to invest now without having to price (place a valuation on) the company, thereby helping angels and startups avoid the possible down round, says Peters.

This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Fans believe that convertible notes are not only simple and inexpensive to structure, but that they also offer the best of both worlds – safety from debt and the potential upside of owning equity.

Photo: misteraitch

Safety from debt: If the company just gets by, angels will remain as creditors and still get their debt repaid, plus interest.

Potential upside: If the company goes on to raise an A round, the angels’ notes will convert into stocks, and they’ll enjoy the potential capital gains as stockholders.

Moreover, “a convertible note agreement is usually structured so the angel investors received the same type of shares as the VC’s, but at a pre-agreed discount to the next round,” explains Peters. When the notes convert, angels will receive the same type of stocks that the VCs buy in the equity round, which is almost always preferred shares. Yet angels/note holders will pay a lower price for these stocks because they will have received a discount for investing early.

Among Entrepreneurs

There are two major reasons that entrepreneurs often push for this structure.

First, as Dan Rosen, chairman of Alliance of Angels, suggests, lawyers often advise entrepreneurs to go with convertible notes because they know their startup clients can’t afford the fees for a priced round or preferred equity agreement. “Legal fees for a priced round are usually in the range of US $25,000 to US $50,000. So for a small round, the legal fees can be a significant portion of the round.” [9]

Second, as Mark Suster, general partner at VC firm GRP Partners, observes, “Entrepreneurs are increasingly trained to think convertible debt is better (when often it’s not).” [10]

Whether convertible notes are better than preferred shares is always up for debate. We’ll examine the advantages and disadvantages of the convertible debt structure in Part 2 and 3, where we will expand the discussion on uncapped and capped convertible notes.

This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”

This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”

Photo: AGeekMom

The loan is “converted” as if investors had literally put money in that equity round. Because investors take an early risk to invest in an unproven company, they usually receive a discount when their notes convert.

“Sometimes the notes come with warrant coverage and/or other features that are designed to provide additional benefits to the early investors,” says Riaz Karamali, partner at Sheppard Mullin Richter & Hampton LLP. [7] We’ll cover investment terms in Part 5, Term Sheet Negotiations.

Defer Valuation

With convertible notes, investors are essentially lending money to the company until an event triggers a debt-to-equity conversion. Because they are loaning money rather than investing in equities, they don’t need to determine valuation, or price per share, of the company at the time of their investment. The valuation is deferred until the company raises an A round, in which VCs come in and establish a value for the company.

In other words, angels can use convertible notes to invest now, and let the VCs do all the valuation work when they come in later. The ability to defer valuation is arguably one of the main benefits of using convertible notes. Startups, by definition, have virtually little or no sale records and financial histories, which makes them nearly impossible to value.

From Creditor to Shareholder

If a company successfully raises an A round, the entire principal amount of the angels’ notes, plus any accrued and unpaid interest, will be converted, usually at a discount, into equity. Upon conversion, they will become a stockholder instead of a creditor and thus get to enjoy the potential capital gains of owning stocks.

Similarly, the company is a “debtor” who owes the angels money until the notes are repaid, plus interest, or until the notes are converted into stocks. Once the notes are converted, the company becomes the angels’ investee instead of a debtor.

This is an excerpt from a special report on using convertible notes as a pre-Series A deal structure. Download full report at “Startup Investing: What You Need to Know About Convertible Notes (2nd Edition).”